Page 357 - Encyclopedia of Business and Finance

eobf_F 7/5/06 3:02 PM Page 334

Fraudulent Financial Reporting

tion of capital markets is compromised when the system ing of financial difficulties in order to avoid failure to
of public disclosure is eroded by reported instances of comply with covenants in debt agreements. Individual
fraudulent reporting. incentives include falsely reporting results in order to
In the mid-1980s the failure of a number of financial achieve targeted results for bonus or incentive compensa-
institutions led various groups to identify possible causes, tion purposes, as well as to avoid penalties for poor per-
including the extent of fraudulent financial reporting formance in achieving targeted profit objectives.
involved in the failures. In August 1986 Congressman The Treadway Commission indicated that the over-
John Dingell and other members of the Subcommittee on sight bodies that establish auditing standards and those
Oversight and Investigations of the U.S. House of Repre- which monitor compliance have a continuing responsibil-
sentatives’ Committee on Energy and Commerce pro- ity to uphold the integrity of the public disclosure system.
posed legislation to amend the Securities Exchange Act of The commission also concluded that many of the SEC’s
1934 to require independent public accountants (audi- fraudulent financial reporting cases against auditors were
tors) to include procedures for material financial fraud for alleged failures to conduct the audits in accordance
detection, reporting on internal control systems, and with generally accepted auditing standards.
reporting of fraudulent activities to appropriate enforce-
ment and regulatory authorities. These legislative propos-
RESPONSE OF THE AUDITING
als were not accepted. The belief that the accounting
STANDARDS BOARD
profession could respond successfully without further
In response to the Treadway Commission report and to
intervention by the legislative branch of the federal gov-
other influences, the Auditing Standards Board (ASB) of
ernment persisted.
the AICPA issued ten new auditing standards in 1988.
A private-sector response to these legislative proposals These ten Statements on Auditing Standards included
was led by the Committee of Sponsoring Organizations requirements affecting the auditor’s responsibility to
(COSO) of the Treadway Commission. COSO oversaw
detect and report errors and irregularities, consideration
the National Commission on Fraudulent Financial
of internal control structure in a financial statement audit,
Reporting (the Treadway Commission). This commission,
and communication with a company’s audit committee.
jointly sponsored and funded by the American Institute of
Certified Public Accountants (AICPA), the American
Accounting Association, Financial Executives Interna- CONTINUING ATTENTION TO THE
tional, the Institute of Internal Auditors, and the National PROBLEMS IN THE 1990S
Association of Accountants (now the Institute of Manage- Continuing attempts were made to gain an understanding
ment Accountants), was formed to identify factors con- of fraudulent financial reporting in the 1990s. The influ-
tributing to fraudulent financial reporting and to develop ence of the Treadway Commission report persisted. Sev-
recommendations to reduce its future occurrence. The eral reports received serious consideration throughout the
Treadway Commission issued its report in October 1987. reporting environment. Nevertheless, in this decade no
changes related to auditor responsibility for reporting
about internal controls if fraud was to be deterred were
TREADWAY COMMISSION REPORT
considered critical. Internal controls continued to be eval-
The Treadway Commission concluded that the responsi-
bility for fraudulent financial reporting was not vested in uated in the context of planning an audit of financial
one group. While the commission conceded that financial statements, but the results of the assessment of internal
statements are the responsibility of a company’s manage- controls and their effectiveness were not reported publicly.
ment, it issued a series of recommendations for the public
company, the independent public accountant, the Securi- INTERNAL CONTROL
ties and Exchange Commission (SEC), and the educa- In 1992 COSO issued Internal Control—An Integrated
tional community. Framework for companies, their managements, and their
The report identified a number of factors that might auditors. The framework is a conceptual paradigm that
contribute to fraudulent financial reporting, including a provides subjective concepts of effective internal control.
number of environmental, institutional, and individual COSO defined internal control as a process designed by a
personal incentives. Environmental considerations company’s management to provide reasonable assurance
included professionalism, codes of corporate conduct, and that the company achieve its objectives in the following
corporate pressures. Institutional incentives include falsely areas:
improving financial appearances in financial statements
• Reliability of financial reporting
for the purpose of maintaining market stock prices or to
meet investor expectations, as well as delaying the report- • Compliance with applicable laws and regulations

334 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION