Two out of three corporate frauds go undetected

To the lead author of a recent study, corporate fraud is like an iceberg: a small number is visible, but much more lurks below the surface.

How much more, he wondered? And, at what cost to investors?

He and his team found that under typical surveillance, about three percent of U.S. companies are found doing something funny with their books in any given year. They determined that number by looking at financial misrepresentations exposed by auditors, enforcement releases by the U.S. Securities and Exchange Commission (SEC), financial restatements, and full legal prosecutions by the SEC against insider trading, all between 1997 and 2005.

However, the freefall and unexpected collapse of auditing firm Arthur Andersen, starting in 2001, due to its involvement in the Enron accounting scandal, gave researchers the chance to see how much fraud was detected during a period of heightened scrutiny. It represented “a huge opportunity,” that rarely comes along, said the present lead researcher, putting 20 percent of all U.S. publicly traded companies – the slice that had been working with Andersen and were forced to find new auditors – under a higher-powered microscope due to their previous association with the disgraced accounting firm.

Those companies did not show a greater propensity to fraud compared to other companies in the 1998 to 2000 period. But that changed once the spotlight was turned on beginning Nov. 30, 2001 – the date when Andersen client Enron began filing for bankruptcy – until the end of 2003, the period the researchers looked at. The new auditors, as well as regulators, investors and news media were all looking much more closely at the ex-Andersen companies.

What the researchers say: “What we found was that there was three times as much detected fraud in the companies that were subjected to this special treatment, as a former Andersen firm, compared to those that weren’t,” said the lead author.

The researchers used the finding to infer that the real number of companies involved in fraud is at least 10 percent. That squares with previous research that has pegged the true incidence of corporate fraud between 10 and 18 percent. While the Canada-based researchers were looking at U.S. companies, they speculated that the ratio of undetected-to-detected fraud is not significantly different in Canada. Or any other Western country for that matter.

Given those numbers, the researchers estimated that fraud destroys about 1.6 percent of a company’s equity value, mostly due to diminished reputation among those in the know, representing about $830 billion in current U.S. dollars.

The figures also help to quantify the value of regulatory intervention, such as through the Sarbanes-Oxley Act, or SOX, introduced in 2002 in response to Enron and other financial scandals. It’s not hard to come up with the compliance costs of SOX. What their study shows is that the legislation would satisfy a cost benefit analysis, even if it only reduced corporate fraud by 10 percent of its current level.

The results should capture the attention of anyone with responsibility for corporate oversight and research, the lead author said: “I spend a lot of time running a program for directors of public corporations and I tout this evidence when I say, ‘Do I think you guys should be spending time worrying about these things? Yes. The problem is bigger than you might think.’”

So, what? Alicia and I have done a lot of work on the psychology and neurogenetics of fraud. Our research, and that of other researchers, has shown that the initiators in most fraud cases are men and that women tend to be accomplices. One of the reasons for this is that fraud is closely linked to testosterone. A person with a high level of this chemical is more likely to commit fraud—or any criminal act. Men tend to have higher levels of testosterone than women.

Fraud for personal gain is also more rampant when people working for an organization are not committed to it. The fraud is justified by the perpetrator as a way of punishing the organization which they feel has failed them in some way.

Often fraud is committed by multiple parties—even the whole of the organization’s ExecCo—and this broader category of fraud often involves outside auditors and accountants.

We have done a great deal of work with most of the prominent accounting firms—including all of the Big 4. Working with their partners, risk departments and firm leaders we have become aware of the huge pressure on client-facing partners to do whatever it takes to please, and keep, their clients. The pressure on partners to meet constantly rising revenue targets can be fierce (the same is true in many large law firms).

However, all of the firms we have worked for spend a vast amount of time, effort and money to make sure that pleasing the client doesn’t include being complicit in fraud. Occasionally, as has been reported in the press, all the checks and balances that accounting firms put in place fail. This present research shows that the failure rate may be higher than was previously thought.