Are well-known companies more prone to financial statement fraud?

Last year the Financial Reporting Council, the U.K.’s financial watchdog, closed a multiyear investigation into financial statement fraud at retailer Tesco, putting an end to one of the country’s largest-ever accounting scandals.

In 2014, when the supermarket admitted to inflating profits in the first half of that year by 250 million pounds, the news sent Tesco’s stock tumbling and wiped billions of pounds off the company’s share value. Investors were naturally concerned.

After all, this was the U.K.’s biggest supermarket and a benchmark stock on the country’s FTSE 100 index — hardly a company where markets would expect to find these kinds of financial shenanigans. Renowned value investor Warren Buffett, who had a 4.1% stake in the retailer, said he’d made a “huge mistake” in placing Tesco stock in his portfolio. (See Warren Buffett: ‘Tesco was a huge mistake,’ by Julia Kollewe, The Guardian, Oct. 2, 2014.)

As the Tesco scandal attests, it isn’t necessarily corporations on the verge of bankruptcy that are most likely to cook their books, as some might think. Prestigious firms that are held in high regard are in fact the ones more prone to financial accounting fraud.

That at least is one of the conclusions academics at Washington State University (WSU), Pennsylvania State University and Miami University reached in a study released earlier this year. (See Financial Prominence and Financial Conditions: Risk Factors for 21st Century Corporate Financial Securities Fraud in the United States, by Jennifer Schwartz, Darrell Steffensmeier, William J. Moser and Lindsey Beltz, Jan. 9, 2021.)

“We thought it would be companies that were struggling financially, that were nearing bankruptcy, but it was quite the opposite,” Jennifer Schwartz, WSU sociologist and lead author on the study, was quoted saying on the WSU website earlier this year. (See Big name corporations more likely to commit fraud, WSU, Feb. 5, 2021.)

“It was the companies that thought they should be doing better than they were, the ones with strong growth imperatives — those were the firms that were most likely to cheat,” Schwartz says.

The Tesco case backs some of the survey’s findings and illustrates why blue-chip firms might resort to financial statement fraud, not to mention the legal difficulties in assigning blame in such cases. (See Proving intent proves to be tricky, by Gerry Zack, CFE, Fraud Magazine, March/April 2015.)

After the company had flagged the accounting problems, forensic accountants went on to discover the amount Tesco had inflated was closer to 263 million pounds and that financial misstatements went back to prior years. This further cut confidence in the once admired retailer. An investigation ensued.

The case was far from cut and dried, though. The three Tesco executives accused of fraud were acquitted after the U.K.’s Serious Fraud Office failed to prove that any of them knew of the crime — the “directing mind” threshold required by U.K. law to establish corporate criminal liability in fraud cases. Two were cleared of fraud charges in late 2018, and the third was acquitted in January the following year. (See Former Tesco executive acquitted over £250m accounting scandal, by Jane Croft, the Financial Times, Jan. 23, 2019 and Tesco trial failure is another setback for SFO, editorial board of the Financial Times, Dec. 9, 2018.)

And while that ruling acquitting the executives raised questions over why the company should submit to any sort of punishment, Tesco signed a three-year deferred prosecution agreement to avoid corporate prosecution and agreed to pay a 129 million pound fine. (See SFO confirms end of Deferred Prosecution Agreement with Tesco Stores Ltd, SFO, April 10, 2020.) 

The U.K. Financial Conduct Authority (FCA) also said that the company had committed market abuses and ordered Tesco PLC to pay about 85 million pounds to investors who’d bought its shares and bonds during the time of the misstatement. (See Tesco to pay redress for market abuse, FCA press release, last updated Aug. 23, 2017.)

Precursors to securities fraud

As the Tesco example shows, when a business that’s a household name manipulates its financial statements, the impact can be significant and long-lasting. Yet while white-collar crime continues to attract the attention of academics, including extensive study of the individual perpetrators by criminologists, there’s limited understanding of the precursors to securities fraud from an organizational perspective.

By conducting the survey for the “Financial Prominence and Financial Conditions” study, researchers sought to fill the gap in this type of analysis and “link [the] likelihood of U.S. public firm involvement in securities fraud to firm prominence and to financial performance indicators.”

The researchers gathered information on more than 250 U.S. public companies involved in corporate securities fraud as identified in Securities and Exchange Commission (SEC) filings between 2005 and 2013. To create a control group, the team randomly selected over 500 U.S. public companies that hadn’t engaged in fraud.

They created four hypotheses related to a firm’s profitability, bankruptcy risk, growth opportunities and risks, and the effects of the firm’s reputation. (See sidebar at the end of the article). And the analysis of the data identified three risk factors for firms that engaged in securities fraud:

• A firm’s prominence, as indicated by its central market position and Fortune 500 status, rendered it significantly more prone to financial accounting fraud.
• Failing financial conditions weren’t associated with financial fraud, although posting marginal (albeit positive) profits was a significant risk factor for financial fraud.
• A strong future growth orientation and correspondent risk profile exerted significant effects on fraud risk, controlling for a firm’s financial well-being during the prior year, its marketplace position, industry and other factors.

Tesco turnaround

In varying degrees, Tesco qualified under all three categories. In the run-up to the accounting scandal, cheaper discount chains had started to bite into the U.K. grocer’s dominant market share and profits after it had carried out an aggressive foreign expansion in the 1990s and ultimately failed in its attempt to gain a foothold in the U.S.

In 2013, Tesco announced its first profit drop in 20 years. The following year it released a string of profit warnings that culminated in the ousting of the then-CEO Phil Clarke. (See Tesco timeline – the retail giant’s rise and fall, The Guardian, April 23, 2015.)

Some accounting experts thought those circumstances pushed the retailer to overbook income from suppliers that was based on sales targets that Tesco could no longer achieve. The result was inflated profits and the SFO’s accusations of fraud. (See Tesco scandal – the perils of aggressive accounting, by Alex Miller, Association of Chartered Certified Accountants.)

Tesco has since enjoyed a turnaround in its finances and reputation under the leadership of Dave Lewis, who took over as CEO in 2014 and stepped down last year.

The group went from reporting an annual loss in 2015 of 6.4 billion pounds — one of the largest in British corporate history — to declaring a 3-billion-pound profit in April last year. (See Finance chief who guided Tesco from scandal to turnaround to retire, James Davey, Reuters, June 2, 2020.)

Prevailing pressures

Some experts see Tesco’s accounting scandal as a classic case of the pressures endured by many publicly traded companies seeking to please the short-term demands of the market. (See Tesco scandal – the perils of aggressive accounting.)

ACFE Regent Emeritus Bruce Dubinsky, CFE, a senior advisor in the governance, risk, investigations & disputes practice of Duff & Phelps LLC, is an expert in fraud and financial investigation. He says from his experience the pressure to hit earnings targets plays a major role in financial fraud.

“When I was a kid … if companies held their dividend payout stable and missed their earnings projection, they missed it,” he says. “They didn’t get crucified by the market and by analysts … [Today] if a company misses its projections by as little as a penny, it gets punished severely.

“When companies are in growth mode and need to make their earnings as a public company, there is a lot of pressure from the analyst community."

This type of environment creates a perplexing and all too familiar problem. “How do you incentivize management to have a vested interest to grow a company, yet not entice them to go down that slippery slope and do something they shouldn’t?” Dubinsky asks.

Given those pressures on big public companies, it may not be surprising that the survey conducted by the university researchers found that firms that were part of the Fortune 500, were listed on the New York Stock Exchange and/or had strong growth expectations were more likely to commit fraud. (See Fortune 500 companies are more likely to commit this type of crime, by John Anderer, LADDERS, Feb. 22, 2021.)

The findings, the researchers say, are consistent with other research on corporate fraud derived from American sociologist Robert Merton’s strain and anomie theories, which state that social structures and pressures may push individuals and corporations to commit crimes.

“Conditions of economic growth may create greater expectations and pressures toward financial fraud as firm officials assume continuous profitability or growth, when in practice markets shift and competitors innovate,” the researchers wrote.

The researchers suggest those financial pressures are greater for high-status firms that rely on receiving positive market valuations and worry more about reputational risk caused by high-profile financial failures than the negative publicity brought on from SEC detection.

Robert Davidson, an associate professor at Virginia Tech who studies executive behavior and its effects on firms, sees merit in the survey’s conclusions and says a fair number of the prominent and larger firms have been engaged in fraud.

“That might be because they’re the ones that had a long period of legitimate growth before performance declined. And those managers are a little more overconfident or aggressive,” he says. “Maybe they’d succeeded because they were aggressive risk takers, so they figured that this is just another calculated risk they can take.”

Studying individual perpetrators

Yet while Davidson understands the need to research the characteristics of the firms that engage in fraud, he also sees compelling reasons to study the individual perpetrators.

“There are probably hundreds or maybe thousands of firms that have similar shortcomings. To the best of our knowledge, only a very tiny handful of them ever go so far as to fraudulently manipulate their financial statements,” he says.

This suggests to Davidson that there’s a need to understand the individual perpetrators and how they make decisions.

Brad Preber, CEO at advisory firm Grant Thornton, LLC, agrees that it’s critical to understand the psyche of individuals who commit fraud at corporations. “Put the Freud in ‘fraud’ and figure out exactly what it is that causes human beings to believe they need to commit a crime in order to relieve an insurmountable pressure,” he says.

He says Donald R. Cressey’s Fraud Triangle is a useful model to study individual behavior under these circumstances. It incorporates three variables for fraud to occur: “pressure” such as a financial pressure to meet market expectations, “perceived opportunity,” and a way to “rationalize” the fraud. (See The Fraud Triangle, ACFE.)

The pressure component plays a particularly prominent role in financial statement fraud schemes, Preber says. Poor financial numbers can increase the cost of capital, prevent access to the capital markets and could raise concerns about a breach in debt covenants. Once such pressures become seemingly insurmountable, executives may exercise poor judgment.

And when it comes to the rationalization component of The Fraud Triangle, it’s relatively easy for Preber to put himself in the would-be perpetrator’s position and come up with the justification to manipulate the financial statements, especially during the time of the COVID-19 pandemic.

“People who I know and care about are going to lose their jobs if we don’t fudge the numbers. My career will be ruined if the business isn’t managed in a way that it can successfully navigate the recession caused by COVID,” Preber says. “In my experience, fraud risk is significantly enhanced when you have an individual with limited controls and a very large personality, someone who is outgoing, egocentric, and really thinks themselves above the organization.”

Responsibility across the board

Ultimately, preventing corporate securities fraud requires alignment from the board to frontline employees. “The board is responsible for governance and oversight over management. They will own the governance of the risk related to fraud,” Preber says.

It’s also important to have an independent internal auditor to test the organization’s internal controls and report on their effectiveness to the board, not to mention a culture that fosters fraud prevention, he adds.

“I once heard an executive tell his employees that we don’t have a lot of rules here, because we hire people who don’t need them,” Preber says. “That is what I call a strong ethical fiber in the culture that allows individuals to know the difference between what is right and what is wrong, and for the gray areas, who to consult with on a timely basis so that mistakes aren’t made."

That human element is key, especially when it comes to prevention, says Dubinsky, who recalls a University of Maryland program that required executive MBA students to interview white-collar criminals in federal prison. Such a program could act as an early deterrence for any executives who might later be tempted to cook the books.

“If you took a C-suite into a prison and had them interview white-collar criminals convicted of securities fraud who are dressed in a green or orange jumpsuit, answering to guards all day long, I do believe that would have a huge effect,” Dubinsky says.

See sidebar: Testing the antecedents for corporate fraud.

Paul McCormack, CFE, is a freelance writer specializing in fraud, security and compliance. He previously worked for SunTrust, EY, PricewaterhouseCoopers and Delta Airlines. Contact him at paul@mccormackwrites.com.

Testing the antecedents for corporate fraud

In a study released earlier this year, researchers at the sociology departments at Washington State University, Pennsylvania State University and Miami University set out to test certain hypotheses about financial-market antecedents and whether they were more prevalent in corporations that commit fraud. (See Financial Prominence and Financial Conditions: Risk Factors for 21st Century Corporate Financial Securities Fraud in the United States, by Jennifer Schwartz, Darrell Steffensmeier, William J. Moser and Lindsey Beltz, Jan. 9, 2021.)

The hypotheses were:

• Profitability — Firms that have recently experienced marginal profits will be more prone to corporate securities fraud than firms with solid profitability (or losses) during the past year.

Profitability was measured as return on assets (ROA), with negative profitability being an ROA of 0% or less, marginal profitability being 0% to under 2.5%, and solid profitability being 2.5% and higher.

• Bankruptcy risk — Firms in the gray zone of bankruptcy risk will be more prone to corporate securities fraud than firms that are safe from imminent bankruptcy.

To measure bankruptcy risk, researchers used the Altman Z-score, a standardized measure of the likelihood of bankruptcy within several years based on the sum of coefficient-weighted financial ratios that evaluate corporate insolvency versus financial strength. A standardized z-score below 1.8 indicates high bankruptcy risk, whereas scores above 3 demonstrate very low bankruptcy risk.

• Growth opportunities and risks — Firms under strong expectations of future growth will be more prone to corporate securities fraud than firms under more modest or nonexistent future growth expectations.

Researchers used a Tobin Quotient — equity market value divided by equity book value — to measure growth risk profiles. No or slow growth risk is a quotient of less than one, while strong growth risk is over 1.3. A ratio of 1 means stable cash flows with little opportunity for growth.

• Conditional effects of a firm’s reputation — Prominent firms with Fortune 500 status will be more susceptible than less prominent firms to financial risk factors of corporate securities fraud.

Findings

Researchers found that financial distress and weak financial performance were more characteristic in non-fraud firms. Fraud firms, on the other hand, were well-positioned in terms of profitability, bankruptcy risk and growth potential. Fraud firms were also more likely to have a large market share, have stocks that trade on a major exchange and carried some sort of Fortune 500 status.

Here are some of the findings for each hypothesis. (See chart below.)

• Profitability — Firms experiencing marginal profitability were at significantly higher odds of fraud — twice that of the reference group.

• Bankruptcy risk — Bankruptcy risk was less overall among fraud firms — one-quarter were at imminent risk of bankruptcy compared to over 40% of non-fraud firms. Firms safe from imminent bankruptcy risk, and those at modest risk in the gray zone, had higher odds of fraud than firms at high-risk of bankruptcy, all else equal.

• Growth opportunities and risks — Firms with stronger growth-risk profiles exhibited significantly increased odds of financial securities fraud in the following year compared to undervalued firms. Firms with positive growth expectations had odds of fraud that were two to three times those of stable firms operating under static expectations of growth.

• Conditional effects of a firm’s reputation — Fraud is more likely among prestigious firms, such as Fortune 500 firms.

The researchers concluded that a combination of the above conditions made companies even more susceptible to fraud — for example, a Fortune 500 firm with marginal profitability and/or strong future growth/risk expectations. During boom times when competitors are also thriving, such companies may be under more pressure to demonstrate profitability and growth.