Organizational Culture and Fraudulent FinancialReporting

Organizational Culture and Fraudulent FinancialReporting

By Lotfi Geriesh

In Brief

Cause and Effect

Fraudulent financial reporting can have significant consequences for organizations and for public confidence in capital markets. High-profile cases of fraudulent financial reporting raise concerns about the credibility of the U.S. financial reporting process and the roles of auditors, regulators, and analysts in financial reporting.

The results of the author’s study show that four characteristics of an organization’s culture can predispose a company to consider fraudulent financial reporting as a legitimate accounting policy decision. Companies that issue fraudulent financial statements are more likely to engage in related-party transactions, to have founders that still exert major influence over the company, to employ fewer CPAs, and to exhibit a history of illegal violations.

According to the Treadway Commission Report of 1999, a significant proportion of the companies that committed fraud were owned by their founders and board members. In addition, the Committee of Sponsoring Organizations (COSO) report of 1999 states that in 72% of the fraud cases examined, the CEO appeared to be associated with the fraud and the companies’ boards of directors were dominated by insiders and others with significant ties to the company.

Do organizations that issue fraudulent financial statements have a different organizational culture than those that follow GAAP requirements? To answer this question, the author examined 160 companies, half of which had issued fraudulent financial statements in the last few years and half that have not been found guilty of fraudulent reporting (see Exhibit 1).

The results show that four characteristics of an organization’s culture predispose the company to consider fraudulent financial reporting a legitimate accounting policy decision. Firms that issue fraudulent financial statements are more likely to engage in related-party transactions, to have founders that still exert major influence over the company, to employ fewer CPAs, and to exhibit a history of illegal violations.

Previous Studies and Analysis

Karl Hackenbrack’s 1993 study, “The Effect of Experience with Different-Sized Clients on Auditor Evaluations of Fraudulent Financial Reporting Indicators,” stated that no company, regardless of size or business, is immune to fraud. He argued that normal business activities introduce incentives and opportunities that can lead to fraud. The National Association of Corporate Directors’ 1998 “Report of the NACD Blue Ribbon Commission on CEO Succession” concluded that the primary responsibility for the prevention and detection of fraud rests with management, boards of directors, and audit committees. These conclusions indicate that management should create a culture that deters fraud and should set clear corporate policies against improper conduct.

According to SAS 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, issued in 1988, irregularities include fraudulent financial reporting undertaken to render financial statements misleading, sometimes called management fraud, and misappropriation of assets, sometimes called defalcations. This statement was superseded by SAS 82, Consideration of Fraud in a Financial Statement Audit, issued in 1997, which expanded the responsibility of the auditor to detect errors and irregularities to include fraudulent financial reporting and fraud arising from the misappropriation of assets. SAS 82 explains that even though fraud is a broad legal concept, the auditor’s interest specifically relates to fraudulent acts that create a material misstatement in the financial statements. Furthermore, the primary factor that distinguishes fraud from error is whether the misstatement is intentional or unintentional. SAS 82 also explains that two types of misstatements are relevant to an auditor in an audit of financial statements: misstatements arising from fraudulent financial reporting, and misstatements arising from the misappropriation of assets. SAS 99, issued in late 2002, reinforces SAS 82 by requiring greater consideration of fraud in audit planning and direct inquiries to management about the possible existence of fraud.

Successful crimes lead to more crimes. “Criminal action is developmental and contingent in nature … one thing leads to another,” according to Henry Finney and Henry Lesieur (writing in “A Contingency Theory of Organizational Crime” for Research in the Sociology of Organizations in 1982). Researchers, including Idalene Kesner, Bart Victor, and Bruce Lamont (writing on “Board Composition and the Commission of Illegal Acts: An Investigation of Fortune 500 Companies” for the Academy of Management Journal in 1986), have found that companies convicted of illegal actions have a history of prior violations and a corporate culture that condones wrongful activities. These and other studies suggest a slippery slope of illegal behavior that begins with minor violations, develops into a culture that sanctions illegal behavior, and eventually leads to fraudulent financial reporting.

Writing for the American Sociological Review in 1940, Edwin Sutherland was the first to argue that the culture of an organization and of its industry contribute to white-collar crime. He outlined a theory of differential association, in which illegal behavior “is learned in direct or indirect association with those who already practice the behavior.”

Scott Summers and John Sweeney (writing on “Fraudulently Misstated Financial Statements and Insider Trading: An Empirical Analysis,” in The Accounting Review, January 1998) found that of the 51 companies reported in the Wall Street Journal as having issued fraudulent financial statements between 1980 and 1987, insiders of the fraud companies engaged in higher levels of selling activities, as measured by the number of transactions, number of shares sold, and dollar value of the shares sold.

The Study

The first hypothesis the survey seeks to prove is whether companies that engage in related-party transactions are more likely to issue fraudulent financial statements (see Exhibit 2). A related-party transaction occurs when one of the parties has the ability to influence the other. Under SFAS 57, Related Party Disclosures, issued in 1982, companies are required to disclose the following for each related-party transaction:

Related-party transactions are normally included in the proxy statement under “certain transactions and other matters.”

The second hypothesis is that fraudulent financial reporting is not a company’s first foray into illegal behavior; that is, fraud companies are more likely to have a history of illegal corporate activities than nonfraud companies (see Exhibit 3). The information presented in this survey was obtained directly from five federal government agencies: the antitrust division of the Department of Justice, the National Labor Relations Board, the Environmental Protection Agency, the Equal Employment Opportunity Commission, and the Occupational Safety and Health Administration.

The third hypothesis is that fraud companies are more likely to be influenced by their founders than nonfraud companies. The biographical information in the proxy statement was used to test this hypothesis. The number of company founders as a percentage of members of the board of directors is presented in Exhibit 4.

The final hypothesis is that a fraud company will have fewer CPAs on its board of directors and senior management than nonfraud companies. The proxy statement provides biographical information about the individuals on the board as well as senior management. The presumption is that CPAs who are not on the board of directors but are senior enough to be mentioned in the proxy statement have influence over the firm’s reporting patterns. The frequency distribution of CPAs serving on the board of directors or as senior management is presented in Exhibit 5.

Sample selection. Because no complete list exists of companies that have fraudulently reported their financial statements, two data sources were used:

Matching. Each of the 80 fraud companies was matched with a nonfraud company based on industry, time period, and size, so that these factors were distributed equally in both groups.

Corporate culture is captured through the number of related-party transactions the company had, the company’s history of illegal corporate behavior, as well as the percentage of founders on the company’s board of directors, and the number of CPAs on the board of directors or senior management team.

To test the hypotheses in the methodology report, conditional logistic regression for the 80 matched company pairs was performed. Initially, four univariate conditional logistic regression analyses were performed. The estimated odds ratios were interpreted to determine the univariate effect each covariate had on the company’s propensity for fraud.

Statistical Analysis and Results

Earlier studies found that companies in certain industries are more likely to engage in corporate offenses, as are companies in industries that are suffering from an economic downturn. To increase the power of the tests to determine what factors distinguish fraud companies from nonfraud companies, this study controlled for industry effects by matching the fraud companies with nonfraud companies, based on their Standard Industrial Code (SIC) classification.

Because earlier studies found large companies to be associated with serious criminal charges more often than smaller companies, the companies surveyed were matched on the basis of their total assets in the prior year, in order to control for company size.

Each simple regression analysis produced statistically significant results (all p-values < 0.0005). In other words, each of the four null hypotheses can be rejected in favor of the alternative. Specifically, the data indicate that: