Detecting corporate fraud is undoubtedly a good thing, but research from Rotman suggests that precious little fraud is actually detected, with the overwhelming majority lurking below the surface.
According to the researchers, in a typical year, around 3% of U.S. companies engage in financial misrepresentations while under surveillance. They arrived at this figure by analyzing financial misrepresentations that were 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, between the years 1997 and 2005.
The collapse of Arthur Andersen, an auditing firm that was implicated in the Enron accounting scandal, presented an opportunity for them to investigate how much fraud was detected during a period of heightened scrutiny.
Under the microscope
The scandal resulted in around 20% of all publicly traded companies being scrutinized due to their previous association with the accounting firm.
During the period of 1998 to 2000, the companies associated with Arthur Andersen did not demonstrate a higher likelihood of engaging in fraudulent activities compared to other companies. However, this changed after the spotlight was directed toward these companies following the commencement of Enron’s bankruptcy filings on November 30, 2001, until the end of 2003 when the researchers conducted their analysis. During this time, the new auditors, along with regulators, investors, and the media, scrutinized the ex-Arthur Andersen companies more closely.
“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,” the researchers explain.
Going undetected
The researchers utilized their findings to estimate that the actual percentage of companies involved in fraudulent activities is at least 10%. This is in line with earlier research that approximated the real occurrence of corporate fraud to be between 10% and 18%. Although the researchers’ study was focused on U.S. companies, they hypothesized that the ratio of undetected-to-detected fraud is not substantially different in Canada.
Based on these numbers, the researchers calculated that fraud leads to a decline of roughly 1.6% in a company’s equity value, primarily due to decreased credibility among those who are aware of the fraudulent activities. This reduction represents approximately $830 billion in today’s U.S. dollars.
These statistics also assist in quantifying the value of regulatory intervention, such as the Sarbanes-Oxley Act, or SOX, enacted in 2002 as a response to financial scandals like Enron. While it may be easy to calculate the expenses of SOX compliance, the research shows that the legislation would be worthwhile when examined from a cost-benefit perspective, even if it only reduces corporate fraud by 10% of its current level.
