Study says that at least 10% of U.S. companies involved in fraudulent activity
From: Rotman at University of Toronto
February 17, 2023 -- Toronto
- To professor Alexander Dyck, corporate fraud is like an iceberg: a small
number is visible, but much more lurks below the surface.
How much more, he wondered? And, at what cost to investors?
Prof. Dyck and his team found that under typical surveillance, about
three percent of U.S. companies are found doing something funny with their
books in any given year. They determined that number by looking at financial
misrepresentations 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, all between 1997 and
2005.
However, the freefall and unexpected collapse of auditing firm Arthur
Andersen, starting in 2001, due to its involvement in the Enron accounting
scandal, gave Prof. Dyck, from the University of Toronto’s Rotman School of
Management, and other researchers the chance to see how much fraud was detected
during a period of heightened scrutiny. It represented “a huge opportunity,”
that rarely comes along, said Prof. Dyck, putting 20 percent of all U.S.
publicly traded companies – the slice that had been working with Andersen and
were forced to find new auditors -- under a higher-powered microscope due to
their previous association with the disgraced accounting firm.
Those companies did not show a greater propensity to fraud compared to
other companies in the 1998 to 2000 period. But that changed once the spotlight
was turned on beginning Nov. 30, 2001 – the date when Andersen client Enron
began filing for bankruptcy – until the end of 2003, the period the researchers
looked at. The new auditors, as well as regulators, investors and news media
were all looking much more closely at the ex-Andersen companies.
“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,” said Prof. Dyck, who holds the
Manulife Financial Chair in Financial Services and is the Director of the
Capital Markets Institute at the Rotman School.
The researchers used the finding to infer that the real number of
companies involved in fraud is at least 10 percent. That squares with previous
research that has pegged the true incidence of corporate fraud between 10 and
18 percent. While the researchers were looking at U.S. companies, Prof. Dyck
speculated that the ratio of undetected-to-detected fraud is not significantly
different in Canada.
Given those numbers, the researchers estimated that fraud destroys about
1.6 percent of a company’s equity value, mostly due to diminished reputation
among those in the know, representing about $830 billion in current U.S.
dollars.
The figures also help to quantify the value of regulatory intervention,
such as through the Sarbanes-Oxley Act, or SOX, introduced in 2002 in response
to Enron and other financial scandals. Its not hard to come up with the
compliance costs of SOX. What their study shows is that the legislation would
satisfy a cost benefit analysis, even if it only reduced corporate fraud by 10
percent of its current level.
The results should capture the attention of anyone with responsibility
for corporate oversight and research, Prof. Dyck says: “I spend a lot of time
running a program for directors of public corporations and I tout this evidence
when I say, ‘Do I think you guys should be spending time worrying about these
things? Yes. The problem is bigger than you might think.’”
The research was co-authored with Adair Morse of the University of
California at Berkeley and Luigi Zingales of the University of Chicago. It
appears in the Review of Accounting Studies.
Prof. Dyck will present his research during an event hosted by the
Capital Markets Institute on February 23, which will also include a discussion
with representatives from academia, the plaintiff’s bar, regulators, and
accountants. Further details are online.
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