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FRAUD IN FINANCIAL REPORTING.

Discusses the increase of fraud in spite of government regulations. Contends that a lack of independent audit committees leads to the problem. Escalation of the benefits of management fraud. Reviews ten publicly traded firms that experienced financial reporting fraud in recent years. Concludes that audit committees be responsible to the board of directors.

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FINANCIAL REPORTING FRAUD AND AUDIT COMMITTEES
Introduction
Fraud in financial reporting is not a new phenomenon. Neither is a rising incidence of financial reporting fraud an unusual outcome in period of economic distress. What is somewhat surprising is that both the incidence and the severity of financial reporting fraud continues to increase in the face of efforts by the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and other governmental and professional organizations to minimize the frequency and severity of such fraud (Anthony, Harrison, Linehan, & Palker, 1999).
Financial reporting fraud continues to surface in the face of important regulations and procedures implemented to minimize the freque

> Cendant, a travel, real estate, and financial services firm charged with financial reporting fraud in connection with 1998 financial reports, continues to operate (Rovella, 2 1). Further, the firm's external auditors cooperated with thefirm in the fraud. Retrieved from the Internet 2 1-12-17 at:wysiwyg://16/http://www. This situation has been referred toas the tyranny of institutional investors. (1997, June). Annual report 1996. 3 ). The audit committee was not independent of organizationalmanagement. (1999). (2 1, May 7). > W.R. CPA Journal, 67(6), 22-28. Stamford, Connecticut: XeroxCorporation. Rovella, D. What is somewhat surprising is that both theincidence and the severity of financial reporting fraud continues toincrease in the face of efforts by the Securities and Exchange Commission(SEC), the Financial Accounting Standards Board (FASB), and othergovernmental and professional organizations to minimize the frequency andseverity of such fraud (Anthony, Harrison, Linehan, & Palker, 1999). Livent, Inc. In 1997, the AICPA issued Statement on Auditing Standards (SAS) No.82, Consideration of Fraud in a Financial Statement Audit (Mancino &Fleming, 1997). The extent of the auditor'sconsideration of the latter is influenced by the existence of risk factorsin the former" (McConnell & Banks, 1997, p. Houston, Texas:Waste Management, Inc. The audit committee wasresponsible to the Board of directors. The perpetrators of the fraud werethe most senior executives in the firm and were members of the Board ofDirectors. Cendant attempted to state that the actions were the results ofinappropriate accounting procedures, i.e., reporting franchise incomeeither before it was earned or before adjustments were made for contractcancellations. Grace Co. The audit committee, however, reported to the top executives ofthe company. In seven ofthe 1 sample firms, audit committees were not independent oforganizational management. Annual report. These actions are not in the realm of "alleged financial improprieties,"but, rather, are actions that have been determined by the United StatesCourt for the District of New Jersey to be factual, and for which threeCendant officers have already pled guilty (Koo, 2 , p. > Xerox Corporation, a business machines firm charged with financial reporting fraud in connection with 1999 financial statements, continues to operate ("Xerox Scandal: The Plot Thickens," 2 1). Material misstatements andnonmaterial misstatements are also distinguished" (Mancino & Fleming, 1997,p. Ofthe several types of fraud, the type most relevant to the process ofauditing by the accounting profession is management fraud. Cendant had a functioning audit committee. > Vari-L Co., Inc., a wireless equipment manufacturer charged with financial reporting fraud in connection with 2 financial reports, continues to operate ("Vari-L, SEC Settle Fraud Case," 2 1). Koo, C. In fact, however, the misreporting was more arbitrary incharacter, as the Chief Financial Officer of CUC, one of the mergerpartners that led to the creation of Cendant, directed that fictitious databe used in Cendant financial reports to assure that the financial reportswould be consistent with expected financial performance reported earlier toWall Street analysts. Settling for prevention. Weisenborn and Norris (1997) noted that fraud can be defined "as theact of knowingly making misrepresentations of fact with the intent ofgaining unfair advantage over another person or organization" (p. Massive financial fraud at CUC and Cendant. (1999) inflated earnings, revenues, and assets overseveral years in order to attract a continuing flow of investment funds.The two co-founders of the organization (also the top executives) inflatedearnings by $1 million in 1997 and 1998. (2 1). AHREF had a functioning audit committee. Hybrid Networks (1998) persuaded distributors to order equipment forwhich the distributors had no buyers. R. thestreet.com/_yahoo/brknews/general/961188.htm Livent, Inc. Annual report 1997. Xerox Corporation. > Waste Management, Inc., a waste disposal firm charged with financial reporting fraud in connection with 1996 financial reports, continues to operate (Carlino, 2 1). Ethics, however, receives little attention inbusiness schools in the United States and too few corporations in theUnited States make serious attempts to manage ethics. The firm's top executives accomplished this feat bybackdating contracts to allow the firm to meet projected quarterlyfinancial performance. financial Reporting FRaud and audit committees Introduction Fraud in financial reporting is not a new phenomenon. The audit committee wasresponsible to the Board of directors. 23). Sirena had a functioning audit committee. (2 1) reported earnings of $17 from 1996 through1999, although the firm actually experienced a loss of $14 million over theperiod. While the firm had a functioning audit committee, thecommittee reported to the CEO, who was one of the executives accused by theSEC. (2 ) inflated third quarter revenues in 1999 by shifting fourthquarter sales forward. New York Times, BU6. PressRelease. Mancino, J., & Fleming, P. The top executives accomplished this feat byresetting the computer cock on the firm's accounting information managementsystem. Dunlop, A. The expectedfunction of an audit committee implemented by an organization is theprevention of financial reporting fraud (Dunlop, 1999). In 1998, the Cendant Corporation reported that it had discovered thatsome of the firm's financial reports contained fraudulent information.Later, the SEC charged that the firm was responsible from the fraudulentreports and eventually charged several Cendant officers and other employeeswith criminal violations of federal securities laws. SAS 82 "identifies two primary types of fraud: fraudulentfinancial reporting practices and misappropriation of assets. Xerox had afunctioning audit committee; however, the firm's senior executivesconcealed the sale of future income from the committee. Cendant Corporation. RCR Wireless News,2 (4 ), 42-43. W. Annual report 1997. A further action thatis necessary to assure that financial reporting fraud is prevented is tomake the internal auditing function in an organization report directly tothe audit committee, as opposed to reporting to any organizationalexecutive. Essentially, the fraudulent actions taken by culpable personnel(officers and other employees) involved the intentional rigging offinancial data to support predetermined financial performance for the firmthat had been reported to Wall Street analysts (Cendant Corporation, 1999). Where was the audit committee?Financial Executive, 17(8), 44-46. The motivation for Hybrid Networkswas to allow the company to meet its earnings targets in financial reports. Vari-L Co., Inc. Consequently, the auditorcan provide only reasonable assurance that material fraudulentcircumstances will be detected" (p. Three former Cendant execs plead guilty tofraud. Washington, DC: Securities and Exchange Commission, 1-5. had a functioning audit committee. Auditors, thus, must assess riskfactors associated with a potential for fraud. (1999). American Criminal Law Review, 36(3), 1 95-1145. References AHREF. TheStatement focuses on the investigatory obligations, risk assessments andreporting obligations imposed on auditors. E. Testing time for corporate governance.Management Accounting (British), 77(4), 24-25. The most high profile of allegedfinancial reporting fraud in recent years involves the current situation atEnron (Pearson, 2 1). Carlino, B. (2 1, July 23). Weisenborn, D., & Norris, D. (1997, April). The top executives of thefinancially troubled firm participated in the manipulation. (1998). As this case remains in the formative stage,however, the sample for this study does not include Enron. AccountingToday, 15(13), 6-8. (2 1, October 1). Journal of Accountancy,192(3), 99-1 4. Corporate officers, in recognition of the fact that investors (bothinstitutional and individual) reward growth in short-term profits,emphasize short-term profit growth at the expense of long-term stability.Such rewards are higher market prices for a firm's common stock and, inturn, higher compensation for corporate officers. Grace, a conglomerate charged with financial reporting fraud in connection with 1998 financial statements, continue to operate ("Settling for Prevention," 1999). name (Tieman, 2 1). As theliterature indicates that this incongruent phenomenon occurs frequently,there would be little point in investigating the hypothesis, as one wouldknow at the outset that the results of the investigation would lead to arejection of the hypothesis. When actual performancedoes not provide growth in short-term profits, the temptation toartificially cook the books is great. Kirchheimer, B. 29). Grace Co. 24). First, the auditor must distance herself, or himself, from the companyaudited. 32). Los Angeles: TheSirena Apparel Group, Inc. Retrieved fromthe Internet 2 1-12-17 at: hooversonline. Hybrid Networks. National Public Accountant, 42(2), 29-34. > Hybrid Networks, a high-tech (wireless networks) firm charged with financial reporting fraud in connection with 1997 financial reports, continues to operate (MacDonald & Kruger, 2 1). 3 ). AHERF (1998) shifted $99.6 million to the firm's Delaware ValleyObligated Group, which was in serious financial condition, from thereserves of more financially stable members of AHERF. The 1 firmsincluded in the sample are as follows: > AHERF, a hospital holding company charged with committing financial reporting fraud in connection with 1997 financial reports, no longer exists as an independent organization (Kirchheimer, 2 1). The audit committee wasindependent of organizational management; however, the audit committee wasunaware of the purchasing ruse perpetrated by the top officers of the firm. The incongruity of the existence of fraudulent financial reportingwithin and organization with a functioning audit committee intended toprevent such behavior provided the basis for this investigation of thephenomenon. Investigation and Analysis The researcher selected a convenience sample of 1 publicly tradedfirms with functioning audit committees that experienced financialreporting fraud over the past five years. The Street.com. Aiding and abetting.Forbes, 8 -81. National LawJournal, 23(37), A1, A7. (1998). ModernHealthcare, 31, 12-13. (1997). 1). Hundreds of millions of dollars have beeninvolved in some individual cases" (p. The Sirena Apparel Group, Inc. (2 1, April 2). (2 , June 14). The audit committee at Livent was not independentof organizational management. The CEO and the Chief Financial Officer (CFO) at Sirena Apparel Group,Inc. At least threeofficers of the firm pled guilty to the charges brought against them, andother officers and employees are scheduled for trial on the charges broughtagainst them ("Massive Financial Fraud at CUC and Cendant," 2 ; Koo,2 ). W. (2 1, October 1). The motivation for the distributors was to maintain good relations withHybrid, which provided cooperating distributors with letters authorizingreturn of the purchased items at a later date. The audit committee was not independent of organizational management. K., & Banks, G. Xerox Corporation. The audit committee at Vari-L was not independent oforganizational management. SEC "goes criminal" on fraud: Cendantprosecution marks an escalation in war on book-cooking. Past history. (1997, March-April). There is (or should be) a stronginterrelationship between the activities of internal control and auditcommittees (Church, McMillan, & Schneider, 2 1). Y. New round of charges: SEC accuses formerHBOC execs in fraud scheme. Relevant regulatory actions and proceduresinclude mandatory disclosure in financial reports, fraud detection,required levels of internal control, arm's length external auditing, andfunctioning audit committees. Hoover's Online. The audit committee,however, reported to the co-founders of the organization who wereperpetrating the fraud. 23).Traditional auditors, noted McConnell and Banks (1997) further, are"neither trained nor expected to be experts in ascertaining documentauthenticity. (2 1). Pearson, M. The investment brokers, CPA firms responsible for auditing publiclytraded companies, and corporate boards of publicly traded firms on theUnited States would like the investing public to believe that such actionsas the fraudulent activities at Cendant are simply aberrations that are notinduced or coerced by the investment culture that prevails in the UnitedStates. Business Week (3745), 46-47. D. Vari-L, SEC settle fraud case. The findings supported the hypothesis. The perpetrators of the fraud werethe most senior executives in the firm and were members of the Board ofDirectors. The auditcommittee at Xerox was independent of organizational management, althoughthey could have been more alert. Risk factors relating tomisappropriation of assets are categorized as the "susceptibility of assetsto misappropriation and lack of controls. Annual report 1998. > Sirena Apparel Group, Inc., a clothing manufacturer and distributor charged with financial reporting fraud in connection with 1999 financial reports, continues to operate ("The Sirena Apparel Group, Inc.," 2 1). GraceCo. The certifications of financial statements by independent auditors areintended to assure the users of such statements that financial performancehas been presented fairly in accordance with generally accepted accountingprinciples. Waste Management had a functioning audit committee; however, theaudit committee and the firm's internal audit function cooperated in thedeception, as the firm's external auditor ignored the actions. The audit committee was not independent of organizationalmanagement. (1999, July 11). Weisenborn and Norris (1997) noted that: "Over the last four decadesthere has been a marked increase in the number of frauds and their costs"(p. There are, however, reasons to question this contention. Andersen, WMI, & the SEC. M. Vari-L Co., Inc. An argument can be made that people of ethics would not succumb topressures to commit fraud. Retrieved from theInternet 2 1-12-17 at: hooversonline.com MacDonald, E., & Kruger, D. Neither is arising incidence of financial reporting fraud an unusual outcome in periodof economic distress. Retrievedfrom the Internet 2 1-12-17 at: http://www.sec.gov/ news/cendant.htm McConnell, D. If this outcome of an audit is to be attained, two significantactions by the auditor are required to gain and maintain public confidence. Annual report. J., & Schneider, A. The firm's top executives also recognizedunrealized revenue, and they provided false information to the firm'sexternal auditors. (1999). Conclusion The findings of the research indicate that a lack of independence ofaudit committees from organizational management contributes to the abilityof financial reporting fraud to coexist with audit committees. R. HBO & Co. H1: Financial reporting fraud occurs more frequently inorganizations with functioning audit committees when the audit committeesare not independent of organizational management. (1999) senior executives manipulated earnings at thefirm over a period of six years to cause earnings to exceed actual levelsby $1 billion. McConnell and Banks (1997) observed that, as fraud "schemes typicallyare concealed," and can involve both "collusion, which is extremelydifficult to detect in an audit, and falsified documentation" (p. One could hypothesize that an organization with an auditcommittee would not experience financial reporting fraud. Fraud also maybe distinguished within the context of motivation-fraud on behalf of acompany and fraud against a company (Weisenborn & Norris, 1997). Waste Management, Inc. (1997) cooperated with the firm's externalauditors in overstating the firm's earnings by $1 billion over a five-yearperiod. Livent, Inc. (2 , June 14). Annual report 1998. New York: CendantCorporation. W. There is an additional goal of this investigation to the testing ofthe hypothesis. (2 1, June 4). Both the auditcommittee and the internal auditing function, however, were reported to thechief executive officer (CEO) who also was a member of the Board ofDirectors. Church, B. The audit committee wasindependent of organizational management; however, the audit committee wasunaware of the computer clock re-setting action by the firm's CEO and CFO. The motivation forthis action was to hide the fact that the Delaware Valley Obligated Groupwas in such serious condition that it threatened the financial viability ofthe entire Group. R. The risk factors enumerated in SAS 82 "are not to be viewed as allinclusive, but as a beginning point, to be augmented by consideration ofrelevant industry specific risk factors. San Jose, California:Hybrid Networks. The audit committee at AHREF was not independent oforganizational management. (2 1, August 6). The fraudulent actions perpetrated at Cendant included (1) overstatingincome and (2) understating expenses, in order to (3) inflate reportedearnings. (1999). > Livent, a live entertainment production organization charged with financial reporting fraud in connection with 1998 financial reports, no longer exists as an independent organization ("Livent, Inc.," 2 1). (2 1). Denver, Colorado: Vari-L Co.,Inc. Pittsburgh, Pennsylvania: AHREF. The principal tactics employed by the firm to attain this outcomewere (1) recording bill-and-hold sales, recording sales for futurequarters, and overstating inventories. SAS 82 identifies specificrisk factors which must be assessed by auditors. com Tieman, J. The earnings overstatementin 1997 amounted to $22 million. To better assure that financial reporting fraud will be prevented, itis essential that audit committees be responsible directly to the board ofdirectors and that the membership of the audit committees be limited todirectors who do not hold executive positions in the firm. Vari-L had a functioning auditcommittee. Columbia, Maryland: W. Therefore, this study investigated thefollowing hypothesis: H : The occurrence of financial reporting fraud in organizationswith functioning audit committees is unrelated to the independence of theaudit committee of organizational management. Atlanta, Georgia: HBO & Co. Anthony, J., Harrison, A., Linehan, P., & Palker, J. (2 1, November). The Sirena Apparel Group, Inc. Red flags ofmanagement fraud. Thus, the contentionthat Wall Street coerces firms to commit acts such as those that occurredat Cendant appears to be justified to a great extent. The Chief Financial Officer, Cosmo Corigliano, isone of the three officers who pled guilty to the charges (Koo, 2 ). Second, fraud detection must be the primary focus of the audit.With regard to each of these requirements, the auditor is often confrontedwith conflicting demands. Financial reporting fraud continues to surface in the face ofimportant regulations and procedures implemented to minimize the frequencyand severity of such fraud. SAS 82 "requires aspecific fraud risk assessment in every audit engagement, includinginquiries of management concerning areas of potential fraud risk in theentity" (McConnell & Banks, 1997, p. The auditor and fraud.Journal of Accountancy, 183(4), 32-36. Livent had a functioning audit committee. HBO & Co. Annual report. Risk factors relating tomisstatements arising from fraudulent financial reporting are categorizedas management characteristics and influence over the control environment,industry conditions, and operating characteristics and financial stability"(McConnell & Banks, 1997, p. Hybrid had a functioning audit committee. Annual report 1998. Hoover's Online. The auditcommittee was not independent of organizational management. Waste Management, Inc. The new fraud auditstandard. 24). (1999, April). (2 ). It is alsonecessary to assure that board members who hold executive positions in thecompany cannot vote on the appointment of new members to the board or onthe appointment of directors to the audit committee. 24). HBO & Co. (1999, Summer).Securities fraud. AHERF scandal widens. The benefits ofmanagement fraud are escalating. > HBO & Co., a medical software organization charged with financial reporting fraud in connection with 1998 financial reports, no longer operates under the HBO & Co. One incongruent outcome is the existence of financial reporting fraudwithin an organization with a functioning audit committee. Annual report. (2 1, September).Detection of fraudulent financial reporting. Xerox Corporation (2 ) sold future rental income and reported theproceeds of the sale as income in 1999. Furthermore, auditors must apply professional judgment inidentifying and evaluating fraud risk factors. (1999), known as HBOC, artificially increased 1998 revenuesby $27 million. The increasing frequency of fraud cases "has been attributed toan increase in the advantages received from committing fraudulent acts anda decrease in the risk of being caught and punished. Toronto, Ontario: Livent,Inc. K., McMillan, J. Modern Healthcare, 31, 6-8. This goal is to recommend policies and practices toimprove the effectiveness of financial reporting fraud prevention. (2 ).

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