Deterring and Detecting Financial Reporting Fraud Audit

The report contains ideas for mitigating the risk of financial reporting fraud. It represents a first step in advancing longer-term initiatives and collaborations for the deterrence and detection of financial reporting fraud, to benefit investors and other participants in the capital markets.

Center for Audit Quality

Executive Summary

On a number of occasions over the past few decades, major public companies experienced financial reporting fraud, resulting in turmoil in the U.S. capital markets, a loss of shareholder value, and, in some cases, the bankruptcy of the company itself. The Sarbanes-Oxley Act of 2002 has done much to improve corporate governance and deter fraud; however, financial reporting fraud—an intentional, material misrepresentation of a company’s financial statements—remains a serious concern for investors and other capital market stakeholders.

In 2009, the Center for Audit Quality (CAQ), which is committed to enhancing investor confidence and public trust in the capital markets, convened five roundtable discussions (four in the United States, one in London) with more than 100 participants, followed by more than 20 in-depth interviews, in order to capture perspectives on fraud deterrence and detection measures that have worked and ideas for new approaches. The participants included corporate executives, members of boards of directors and audit committees, internal auditors, external auditors, investors, regulators, and academics.

The observations in this report are derived from those discussions and interviews, considered in light of related research and guidance on the topic. The report contains ideas for mitigating the risk of financial reporting fraud, as well as related points to ponder. This report represents a first step in advancing longer-term initiatives and collaborations for the deterrence and detection of financial reporting fraud, to benefit investors and other participants in the capital markets.

Understanding the Landscape

The Fraud Triangle. Theoretically, anyone has the potential to engage in financial reporting fraud, and some individuals who commit fraud had previous reputations for high integrity. Three factors, referred to as the “fraud triangle,” often combine to lead individuals to commit fraud: pressure or an incentive to engage in fraud; a perceived opportunity; and the ability to rationalize fraudulent behavior.

Participants in the CAQ discussions identified the top three pressures for fraud as personal gain (including maximizing performance bonuses and stock-based compensation); the need to meet short-term financial expectations; and a desire to hide bad news. Opportunities for fraud usually are greatest when the tone at the top is lax or controls are ineffective, although even the best controls cannot completely eliminate the risk of fraud. Finally, individuals who commit financial reporting fraud must be able to justify or explain away their fraudulent actions.