College of Business and Accountancy

Fraudulent financial reporting: 1998-2007: an analysis of

U.S public companies

Author: Mark S. Beasley; Dana R. Hermanson; Joseph V. Carcello;

Terry L. Neal

Classwork Performance: Journal Critique Paper 7

Submitted By:

Chona M. Abucayon
Donna Mae L. Bucad
John Lloyd Y. Abines
Jeisha Mae M. Rico
 College of Business and Accountancy

Journal Critique 7: Fraudulent financial reporting: 1998-2007: an analysis of U.S public

companies

I. The Central Purpose of the Study

The main goal of the study, "Fraudulent Financial Reporting: 1998–2007: An Analysis of
U.S. Public Companies," is to provide a thorough investigation of instances of fraudulent
financial reporting examined by the U.S. Securities and Exchange Commission (SEC) between
1998 and 2007. This research seeks to uncover the different cases of wrongdoing and their
impact on the financial industry of US public companies in that period. This research project
aims to further explore the characteristics and consequences related to financial statement fraud,
building on previous studies. Understanding the reasons behind fraudulent activities and the
characteristics of companies involved in them is a special focus. The report carefully details 347
suspected cases of fraud, highlighting a significant increase in both the number and seriousness
of these incidents compared to earlier periods. The writers explore the important consequences
that result from these discoveries, especially for different parties like investors and regulators.
They emphasize the significant need to improve governance and oversight mechanisms. This
enhancement is crucial not just for stopping fraudulent activities but also for preventing them
effectively and ensuring prompt detection of any such activities. The study highlights the need
for more research to fully understand the complex nature of financial reporting fraud. It also
emphasizes the significance of assessing the efficiency of current regulatory mechanisms,
particularly in light of the consequences of the Sarbanes-Oxley Act. In summary, the authors
stress the crucial importance of addressing these issues to enhance transparency and regain trust
in the financial reporting process. Focusing on addressing these issues is crucial for creating a
trustworthy financial environment.

II. Significance of the Study and its Social Value

The study "Fraudulent Financial Reporting: 1998-2007: An Analysis of U.S. Public

Companies" is instrumental in improving our understanding of financial statement fraud. It
examines the intricacies of this matter and investigates its wide-ranging consequences for a
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variety of people involved in the financial system. The SEC conducted an in-depth examination
of 347 instances of suspected deceptive financial reporting in this study. This study highlights
the growing scale and intricacy of fraud incidents, demonstrating that the cumulative
misrepresentation amounted to nearly $120 billion over the study period. This alarming statistic
emphasizes the urgent need for enhanced oversight and governance frameworks in corporations.
Understanding the significance of these numbers and implementing measures is crucial to
protecting the effectiveness and efficiency of organizational activities. The findings of this
research raise significant questions about the effectiveness of existing regulatory measures,
particularly the Sarbanes-Oxley Act, in preventing fraud. This implies a strong requirement for
further research to fully evaluate the impact of these regulations on financial reporting practices.
Additionally, the study emphasizes the crucial significance of leadership honesty,
frequently identifying CEOs and CFOs as key individuals involved in dishonest behaviors. This
observation prompts organizations to critically review how they assess their leadership and
governance frameworks. It highlights the need for a deeper understanding of the psychological
and behavioral factors that drive people to commit fraud. The research results show that revenue
recognition fraud remains the most prevalent type of financial misstatement. This highlights the
significance of creating targeted plans to efficiently address this specific risk area.
In practical terms, the study offers significant implications for various groups such as
investors, regulatory bodies, and corporate boards. These observations can play a crucial role in
informing their future decisions and strategies. This method encourages the implementation of
robust governance procedures, in addition to creating effective audit committees, in order to
enhance the detection and prevention of fraudulent behavior. The study offers valuable insights
by pinpointing the unique traits of companies engaging in fraudulent behavior. This evaluation
provides a structure for organizations to develop and enforce customized preventive measures
tailored to their individual situations.
This research is important for enhancing the ongoing discussion on corporate responsibility
and openness. Emphasizing the significance of ethical practices in the business world, it
highlights the negative impact financial fraud can have on public trust in capital markets. This
underscores the crucial necessity of ensuring that the actions displayed in a company align with
the standards established by the organization. This type of alignment is crucial for fostering a
culture that values honesty and encourages moral decision-making within the entire organization.
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By thoroughly analyzing the systemic problems that lead to financial statement fraud, this study
plays a crucial role in influencing the development of policies that support ethical corporate
management. These initiatives not only improve the credibility of the financial system but also
benefit society in general.

III. Review of Related Literature

The literature by Cohen, Krishnamoorthy, and Wright (2004) provides valuable insights into
the intricate relationship between corporate governance structures and financial reporting quality.
Their analysis of the corporate governance mosaic offers a comprehensive understanding of how
different governance mechanisms can influence the accuracy and transparency of financial
reports. The Advisory Committee on Smaller Public Companies (Advisory Committee) Final
Report (2006) provides also a valuable resource for understanding the unique challenges faced
by smaller public companies in complying with SEC regulations. The report highlights the
specific concerns of smaller companies regarding the cost and complexity of financial reporting
requirements, as well as the potential impact on access to capital. While the report focuses on the
broader regulatory environment for smaller companies, it offers insights relevant to your study of
fraudulent financial reporting. The report's emphasis on the challenges faced by smaller
companies in meeting reporting requirements suggests that these companies may be more
susceptible to fraudulent activities due to limited resources and expertise. Additionally, the
report's discussion of the potential impact of regulations on access to capital underscores the
importance of maintaining financial reporting integrity for smaller companies to attract
investment and ensure their continued growth. This report provides a valuable context for your
research by highlighting the specific challenges faced by smaller public companies, potentially
contributing to a deeper understanding of the factors that may influence fraudulent financial
reporting within this segment of the market.

Furthermore, DeFond, Hung, and Trezevant (2007) contribute significantly to the field by
examining the impact of investor protection on the information content of annual earnings
announcements across various countries. Their international evidence sheds light on the
importance of investor safeguards in enhancing the relevance and reliability of financial
information disclosed by companies.
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In Addition, Deloitte LLP's series of publications in 2008 and 2009 on financial statement
fraud serve as essential resources for understanding the detection and consequences of fraudulent
activities within financial reporting. The "Ten Things" editions offer practical guidance on
recognizing the signs of financial statement fraud and understanding the repercussions of such
misconduct, providing valuable insights for professionals involved in financial analysis and
reporting.

IV. Theories

. This study tries to figure out why companies cheat on their financial reports. One idea they
have is that companies that are struggling financially are more likely to cheat. This makes sense,
as they might feel pressured to make their numbers look better. However, the study found that
even companies doing well sometimes cheated, so it's not just about being desperate. They also
think that the "tone at the top" matters, meaning that if the bosses are willing to cheat, others in
the company are more likely to follow. This makes sense, as the study found that CEOs and
CFOs were often involved in the cheating. But they don't really explain why these bosses might
be willing to cheat in the first place.

The study also looks at the board of directors, who are supposed to watch over the company.
They found that there weren't many differences between the boards of companies that cheated
and those that didn't. This could mean that the boards aren't very good at catching cheating, or
maybe they just aren't doing their job well in general. Ultimately, the study doesn't give a single,
simple answer for why companies cheat. It seems like there are lots of different reasons, and we
need to learn more to understand them all.

V. Methods

This study, done by COSO, looked at cases of companies caught cheating on their financial
reports between 1998 and 2007. It's a big study, but it has a few problems. First, it mostly used
information from the SEC, which is like the government police for companies. This means the
study might not be accurate for all companies, because the SEC only investigates the ones they
think are most likely to be guilty. Second, most of the cheating happened before a new law called
Sarbanes-Oxley was passed in 2002, so we can't really tell if that law made a difference. Third,
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the study had to guess about some things, because the information wasn't always clear. Finally,
the study didn't have enough information to really understand how the new law worked, because
it only looked at a few cases after it was passed. To make this study better, future researchers
should use information from more sources, not just the SEC. They should also compare cases
before and after the new law, and try to be more exact in their methods. They also need to look at
more cases after the new law was passed to get a better understanding of its effects.

VI. Findings of the Study

The COSO-commissioned study "Fraudulent Financial Reporting: 1998-2007" analyzed SEC

investigations of public company fraud during that period, finding an increase in both the
incidence and magnitude of fraud compared to the 1999 study. The study revealed that larger
companies were involved, with a higher likelihood of CEO/CFO involvement. While revenue
fraud remained a prominent technique, the study found few differences in board of director
characteristics between fraudulent and non-fraudulent firms, suggesting the importance of
research on governance processes. The study also highlighted the significant negative impact of
fraud on stock prices and the long-term consequences for companies, including bankruptcy and
delisting. The findings underscore the need for continued attention to fraud prevention,
deterrence, and detection, as well as further research to assess the effectiveness of the Sarbanes-
Oxley Act in addressing fraud.

VII. Research Implications

This study provides valuable insights into the nature and consequences of financial
statement fraud, with implications across various societal, political, technological, economic, and
cultural spheres.

Socially, it underscores the significant social impact of fraudulent financial reporting,

eroding public trust in financial markets and institutions. Large-scale fraud undermines investor
confidence and can lead to a general distrust in corporate governance. Furthermore, the
consequences extend beyond investors, harming employees, suppliers, and communities who
rely on the integrity of companies. Job losses, business disruptions, and economic hardship are
 College of Business and Accountancy
all potential outcomes of fraudulent activities, highlighting the far-reaching consequences of this
behavior.

Politically, it emphasizes the critical role of political action in addressing financial

statement fraud. It provides evidence for the need for robust regulation and oversight of financial
reporting, highlighting the Sarbanes-Oxley Act of 2002 as a direct response to the high-profile
frauds of the early 2000s. The study also underscores the importance of holding individuals and
companies accountable for fraudulent behavior, as demonstrated by the SEC's enforcement
actions and the consequences faced by those involved. These findings highlight the need for
strong regulatory frameworks and effective enforcement mechanisms to deter and punish
fraudulent activities.

Technologically, it underscores the vital role of technology in combating financial

statement fraud. Advanced technological tools and techniques, such as data analytics and
artificial intelligence, are needed to detect and prevent fraud by identifying potential red flags
and anomalies in financial reporting. Technology can also enhance transparency and information
access for investors and stakeholders, providing real-time access to financial data, facilitating
communication between companies and investors, and enabling more effective monitoring of
corporate activities.

Economically, it highlights the serious financial repercussions of deceptive financial

reporting. By disrupting market efficiency and causing improper resource allocation, fraud
erodes investors' capacity to make educated decisions based on trustworthy and precise financial
data. Additionally, fraud can impede economic development by generating uncertainty and
deterring investment. Establishing a robust regulatory framework and promoting a culture of
ethical conduct are vital for creating a stable and predictable economic setting that fosters
investment and underpins sustainable economic growth.

To cultivate an effective ethical culture within organizations is vital for deterring financial
statement fraud. Strong leadership, well-defined ethical guidelines, and a dedication to integrity
are crucial for fostering an atmosphere where ethical conduct is both valued and anticipated.
Additionally, the research underscores the necessity for businesses to adopt corporate social
responsibility, acknowledging the wider consequences of their actions on society and
stakeholders. Ethical practices in financial reporting are an essential aspect of this responsibility,
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ensuring that companies operate in a manner that is beneficial not only to their shareholders but
also to their employees, customers, and the communities they serve.

VIII. Additional Observations

The study has several shortcomings. First, it fails to clearly define the research problem,
despite mentioning the potential consequences of fraudulent financial reporting. Also, delving
deeper into SOX's long-term impact, conducting a psychological analysis of fraudulent behavior,
investigating industry-specific vulnerabilities, considering evolving fraud tactics, adopting an
international perspective, and exploring broader long-term consequences is crucial in this study
and it didn’t thoroughly seen in the study. Second, it lacks a theoretical framework to guide the
study, even though it acknowledges the existing body of research on board governance and
accounting outcomes. Third, the paper provides an insufficient discussion of its limitations, only
mentioning data availability. Lastly, it fails to clearly articulate its key contributions to the field,
despite suggesting potential insights into preventing, deterring, and detecting fraudulent financial
reporting.

IX. Recommendations

The study offers valuable insights into financial statement fraud. However, it could be
strengthened by a more thorough examination of SOX's impact on fraud prevention, a deeper
understanding of individual motivations for committing fraud, a more detailed analysis of the
roles of audit committees and external auditors in fraud prevention, and a more comprehensive
exploration of the consequences of fraud for both companies and individuals. Additionally, a
clear and concise statement of the research problem should be provided, outlining the specific
issue to be addressed. A thorough theoretical framework is essential to guide the study and
provide a foundation for analysis and interpretation. Also, a detailed discussion of the study's
limitations is crucial to acknowledge potential shortcomings and guide future research. Finally, a
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clear and concise statement of the study's contributions should highlight the unique insights and
knowledge gained from the research, emphasizing its significance to the field.