The effectiveness of federal regulations and corporate reputation in mitigating corporate accounting fraud
TABLE OF CONTENTS
Page
TABLE OF TABLES
................................ ................................ ................................ ....................
xi
TABLE OF FIGURES
................................ ................................ ................................ .................
xiii
TABLE OF APPENDICES
................................ ................................ ................................ .........
xiv
CHAPTER ONE: THE INTRODUCTION
................................ ................................ ....................
1
The Problem
................................ ................................ ................................ ................................ ....
1
Problem Background
................................ ................................ ................................ ......................
7
Purpose of the Study
................................ ................................ ................................ .....................
11
Research Question
................................ ................................ ................................ ........................
12
Research Hypotheses
................................ ................................ ................................ ....................
12
Limitations and Delimitations
................................ ................................ ................................ .......
13
Definitions of Terms
................................ ................................ ................................ .....................
15
Significance of the Study
................................ ................................ ................................ ..............
16
Organization of the Chapters
................................ ................................ ................................ ........
17
CHAPTER TWO: LITERATURE REVIEW
................................ ................................ ...............
19
The Purpose
................................ ................................ ................................ ................................ ..
19
Overview of Federal Regulations
................................ ................................ ................................ .
19
Policymakers: Standards Setters and Regulatory Bodies
................................ .........................
20
History of Major Federal Regulations
................................ ................................ ......................
23
The securities act of 1933.
................................ ................................ ................................ ....
24
The securities and exchange act of 1934.
................................ ................................ .............
24
The foreign corrupt practices o f 1977 (FCPA).
................................ ................................ ....
25
The statement of auditing standards 99 (SAS 99).
................................ ...............................
25
The Sarbanes - Oxley Act of 2002 (SOX).
................................ ................................ .............
26
The Dodd - Frank Wall Street Reform and Consumer Protection Act.
................................ ..
29
Overview of Corporate Reputation
................................ ................................ ...............................
30
Corporate Reputation: Connection to Name, Identity, and Image
................................ ............
3 1
History of Corporate Reputation
................................ ................................ ...............................
33
ix
Effects of Corporate Reputat ion
................................ ................................ ...............................
35
Overview of Corporate Accounting Fraud
................................ ................................ ...................
37
Categorization of Fraud
................................ ................................ ................................ ............
37
The Fraud Triangle, the Fraud Diamond, and Other Element of Fraud Occurrence
................
42
The fraud triangle.
................................ ................................ ................................ .................
42
The fraud diamond.
................................ ................................ ................................ ...............
43
Other element.
................................ ................................ ................................ .......................
44
Summary
................................ ................................ ................................ ................................ .......
45
CHAPTER THREE: METHODOLOGY
................................ ................................ .....................
49
The Purpose
................................ ................................ ................................ ................................ ..
49
The Research Design
................................ ................................ ................................ ....................
50
The Population and Sampling Procedures
................................ ................................ ....................
54
The Population
................................ ................................ ................................ ..........................
54
The Sampling Procedure
................................ ................................ ................................ ...........
57
Protection of Human Subjects
................................ ................................ ................................ ..
60
Instrumentation
................................ ................................ ................................ .............................
60
Methodological Assumptions and Limitations
................................ ................................ .............
67
Summary
................................ ................................ ................................ ................................ .......
69
CHAPTER FOUR: DATA ANALYSIS AND RESULTS
................................ ...........................
71
The Purpose
................................ ................................ ................................ ................................ ..
71
Respondents‘ Descrip tion and Distribution
................................ ................................ ..................
72
Data Analysis
................................ ................................ ................................ ................................
78
Cronbach‘s Alpha Statistics
................................ ................................ ................................ ......
78
Distribution of Responses on the Survey
................................ ................................ ..................
84
Research Question and Hypotheses Testing Results
................................ ................................ ..
100
Hypotheses One and Two
................................ ................................ ................................ .......
100
Hypotheses Three and Four
................................ ................................ ................................ ....
109
Hypotheses Five and Six
................................ ................................ ................................ .........
117
Analysis of Variance
................................ ................................ ................................ ...................
121
Combined Position Analysis
................................ ................................ ................................ ...
122
Response Differences Among Positions
................................ ................................ .................
123
Co rrelation Analyses
................................ ................................ ................................ ...................
125
x
Years of Accounting Experience Analysis
................................ ................................ .............
125
Number of Organizational Employees Analysis ................................ ................................ .....
128
Summary
................................ ................................ ................................ ................................ .....
130
CHAPTER FIVE: DISCUSSION, CONCLUSIONS, AND RECOMMENDATIONS
............
133
The Purpose
................................ ................................ ................................ ................................
133
Summary of the Study
................................ ................................ ................................ ................
133
Study‘s Limitations
................................ ................................ ................................ .....................
136
Results‘ Discussion
................................ ................................ ................................ .....................
137
The Effectiveness of Federal Regulations Results
................................ ................................ ..
139
The Effectiveness of Corporate Reputation Results
................................ ...............................
142
Comparison of the Effectiveness of Federal Regulations and Corporate Reputation Results . 146
Conclusions
................................ ................................ ................................ ................................ .
149
Major Statements Rela ted to Federal Regulations
................................ ................................ ..
149
Major Statements Related to Corporate Reputation
................................ ...............................
150
Implications ................................ ................................ ................................ ................................ .
153
Implications for Practice
................................ ................................ ................................ .........
153
Implications for Research
................................ ................................ ................................ .......
155
Recommendations
................................ ................................ ................................ .......................
156
Recommendations for Practice
................................ ................................ ...............................
156
Recommendations for Research
................................ ................................ .............................
158
RE FERENCES
................................ ................................ ................................ ...........................
160
APPENDICES
................................ ................................ ................................ ............................
168
xi
TABLE OF TABLES
Table
Page
1 .
Seven Financial Shenanigans
................................ ................................ ................................ ...
3
2 .
Relationship among the Variables, Hypotheses, and Survey Items ................................ .......
54
3 .
The Sample Position Strata
................................ ................................ ................................ ....
58
4 .
Accounting Professionals' Sampling
................................ ................................ .....................
59
5 .
Responde nts and Non - Respondents' Composition
................................ ................................
73
6 .
Respondents' Gender Composition
................................ ................................ ........................
73
7 .
Respondents' Age Range Composition
................................ ................................ ..................
74
8 .
Respondents' Position Composition
................................ ................................ .......................
75
9 .
Respondents' Years of Accounting Experience Composition
................................ ...............
76
10
Respondents' Organization Type Composition
................................ ................................ ......
77
11 . Respondents' Organizational Number of Empl oyees Composition
................................ ......
78
12 . Cronbach's Alpha Statistics
................................ ................................ ................................ ..
81
13 . Cronbach's Alpha Statistics without Statements 7 and 14
................................ ....................
81
14 . Cronbach's Alpha Statistics for State ments 1 T hrough 7
................................ .....................
82
15 . Cronbach's Alpha Statistics for Statements 8 T hrough 13
................................ ...................
83
16 . Cronbach's Alpha Statistics for Statements 14 T hrough 16
................................ .................
83
17 . Distribu tion of Responses to Statement 1
................................ ................................ .............
85
18 . Distribution of Responses to Statement 2
................................ ................................ .............
86
19 . Distribution of Responses to Statement 3
................................ ................................ .............
87
xii
20 . Distribution of Response s to Statement 4
................................ ................................ .............
88
21 . Distribution of Responses to Statement 5
................................ ................................ .............
89
22 . Distribution of Responses to Statement 6
................................ ................................ .............
90
23 . Distribution of Responses to Statement 7
................................ ................................ .............
91
24 . Distribution of Responses to Statement 8
................................ ................................ .............
92
25 . Distribution of Responses to Statement 9
................................ ................................ .............
93
26 . Distribution of Responses to Statement 10
................................ ................................ ...........
94
27 . Distribution of Responses to Statement 11
................................ ................................ ...........
95
28 . Distribution of Responses to Statement 12
................................ ................................ ...........
96
29 . Distribution of Responses to Statement 13
................................ ................................ ...........
97
30 . Distribution of Responses to Statement 14
................................ ................................ ...........
98
31 . Distribution of Responses to Statement 15
................................ ................................ ...........
99
32 . Distributi on of Responses to Statement 16
................................ ................................ ..........
100
33 . Combined Position Analysis
................................ ................................ ...............................
123
34. ANOVA on Responses to Survey Statements
................................ ................................ ....
124
35. Spearman Correl ation Coefficients for Years of Accounting Experience
.........................
127
36. Spearman Correlation Coefficients for
Number of Organizational Employees
.................
129
xiii
TABLE OF
FIGURES
Figure
Page
1 .
General Framework of this Study
................................ ................................ ............................
7
2 .
Breakdown of Percentage of Response Categories to Statement
1
................................ .....
102
3 .
Breakdown of Percentage of Response Categories to Statement 2
................................ .....
103
4 .
Breakdown of Percentage of Resp onse Categories to Statement 3
................................ .....
104
5 .
Breakdown of Percentage of Response Categories to Statement 4
................................ .....
105
6 .
Breakdown of Percentage of Response Categories to Statement 5
................................ .....
106
7 .
Breakdown of Percentage of Response Categories to Statement 6
................................ .....
107
8 .
Breakdown of Percentage of Response Categories to Statement 7
................................ .....
108
9 .
Percentages of Strongly Agree and Agree Responses to Statements 1 Through 7
...............
109
10 Breakdown of Percentage of Response Categories to Statement 8
................................ .....
110
11 . Breakdown of Percentage of Response Categories to Statement 9
................................ ....
111
12 . Breakdown of Percentage of Response Categories to Statement 10
................................ ..
112
13 . Breakdown of Percentage of Response Categories to Statement 11
................................ ..
113
14 . Breakdown of Percentage of Response Categories to Statement 12
................................ ..
1 14
15 . Breakdown of Percentage of Response Categories to Statement
1 3
................................ ..
115
16 . Percentages of Strongly Agree and Agree Responses to Statements 8 Through 13
............
116
17 . Breakdown of Percentage of Response Categories to Statement
1 4
................................ ..
118
18 . Breakdown of Per centage of Response Categories to Statement
1 5
................................ ..
119
19 . Breakdown of Percentage of Response Categories to Statement
1 6
................................ ..
120
20 . Percentages of Strongly Agree and Agree Responses to Statements 14 Through 16
.........
121
xiv
TABLE OF APPENDICES
Appendix
Page
A . IRB Certification
................................ ................................ ................................ ..................
169
B . Informed Consent (Email Invitation)
................................ ................................ ...................
172
C . Survey Instrument
................................ ................................ ................................ ...............
174
D . Survey's Introductory Paragraph
................................ ................................ ..........................
178
E . Pilot Testing Participation Email ................................ ................................ ..........................
180
F . First Reminder
................................ ................................ ................................ ......................
182
G . Second Reminder
................................ ................................ ................................ ..................
184
H . Cronbach Coefficient Alpha
................................ ................................ ................................
187
I . Cronbach Coefficient Alpha - Aggregate With Statements 7 and 14 Removed
.....................
189
J . Cronbach Coefficient Alpha for Subscale Including Statements 1 Through 7
.....................
191
K . Cronbach Coefficient Alpha for Subscale Including Statements 8 Through 13
...................
193
L . Cronbach Coefficient Alpha for Subscale Including Statements 14
Through 1 6
................
195
1
CHAPTER ONE : THE INTRODUCTION
1.1
The
Problem
The recent series of accounting frauds of major American corporations include Enron, WorldCom, and Tyco, among others . The rest of the world was not exempt ,
as many nations experienced similar accounting frauds . Hollinger International and Norte l Networks Corp (Canada ), Parmalat (Italy ), Royal Ahold (Netherlands ), Vivendi (France ), YGX (China ), Livedoor Co . (Japan ), and Satyam (India) are infamous examples . Those high - profile accounting frauds since the beginning of the 21st
century and the subs equent bankruptcies, collapses, delisting from stock exchange s , material asset sales, and restatements have also resulted in loss of lifetime savings, investments, pension benefits, and other accumulated assets .
Unsurprisingly, the public has shown anger
at those persons behind the scandals because the frauds undermined public confidence and trust in corporations, executives, and the accounting profession . Hwang and Staley (2006) even suggest that the accounting and auditing scandals have negatively affe cted several executive and financial management professional
position s ranging from chief executive officers (CEOs), chief financial officers (CFOs), accountants,
controllers, auditors, accounting a nd auditing firms, lawyers, to investment analysts and bankers due to their participations in the scandals . Accordingly, congress passed laws i ncluding the Sarbanes - Oxley Act of 2002 (SOX) to curtail recurrences .
2
Despite the many publicized accounting frauds, Albrecht, Albrecht, and Albrecht (2008) and Beasley, Carcello, Hermanson, and Neal ( 2010)
affirm that most organizations‘ executive s and employees are ethical, conduct business with integrity , and provide financial reports that are free of material misstatements due to fraud . However, some ,
such as the aforementioned examples ,
distort their companies‘ financial statements to make the compa nies look better financially than they really are . Riahi - Belkaoui (2003) delineates that the pressure to achieve a certain result may be due to an attempt to report positive profits , to sustain recent performance , or to meet financial analysts‘ forecasts for financial performance .
Giroux (2008)
points out that e arnings manipulation is common in most financial statement frauds . Earnings manipulation usually starts from management‘s choice from various accounting methods and procedures under the generally
accepted accounting principles
(GAAP) . Since preferences and the economic consequences of the choices vary, executives may choose a method or procedure based on desired
results . A study revealed that about o ne - third of CFOs declared they would manipulat e report ed earnings rather than allowing
their companies to miss analysts‘ expectations (Durfee, 2006) . These manipulations may be allowable under GAAP ,
but they may be questionable . Hence, good judgment may mean not exercising such discretions that may eventually
lead to
financial statements
distortion
(Riahi - Belkaoui, 2003 ; Schilit, 2002 ) .
The schemes management uses to execute manipulation or fraudulent financial reporting include improper revenue recognition ( manipulation of revenue accounts and acc ounts receivables ), improper application of inventory method s, fictitious assets amounts , failure of loss recognition , improper capitalization , improper change of
3
accounting practices to increase earnings , improper disclosure of significant information, an d
falsification or alteration of records (Riahi - Belkaoui, 2003) . I mproper revenue recognition is the most common of all fraudulent financial statement schemes . Although the Deloitte Forensic Center (2008 , 2009 ) report s
that it occurs an average of 38 %
of
the time , the Deloitte Forensic Center (2009) notes that it only occured 30 %
of the time in 2008 .
Schilit (2002) uses the term financial shenanigans ,
which he defines as ― techniques companies employ to defraud stakeholders ‖
(p . v) . His discussions are based on the Center for Financial Research and Analysis‘ identification of such schemes as shown in Table 1 .
Table 1
Seven Financial Shenanigans
________________________________________________________________ ________
Shenanigan
Scheme
number
description
________________________________________________________________ ________
1
Recording revenue too soon or of questionable quality
2
Recording bogus revenue
3
Boosting income with one time gains
4
Shifting current expenses to a later or earlier period
5
Failing to record or improperly reducing liabilities
6
Shifting current revenue to a later period
7
Shifting future expenses to the current period as a special charge
___________________________________ _____________________________ ________
Note . The descriptions are compiled from Financial Shenanigans:
How to Detect Accounting Gimmicks
and Fraud in Financial Reports
(pp . 24 - 25), by H . Schilit, 2002, New York, NY : McGraw - Hill . Copyright 2007 by McGraw - H ill.
4
Enron had effective internal controls and mostly correct financial reporting , but management overrode internal controls to create ―periodic and selective financial statement falsifications‖
(Hurley & Boyd, 2007,
p. 20) . The example shows that intern al controls may not prevent financial statement fraud if there is collusion to defraud . Federal regulations impose on corporations and individuals to do what they are supposed to do
because
regulations control tendency to act only for self - interest (Micha el, 2006) . They also help to guide behaviors because people have different perceptions of themselves, situations, and views of what is ethical (Michael, 2006) . For instance, the Securities Act of 1933 and the Securities and Exchange Act of 1934
contain p rovisions for fair dealings with companies‘ stakeholders . Therefore, regulations may deter selfish and unwise judgments that can result in misleading financial statements .
Scandalous companies such as Enron and Royal Ahold besmirched and lost their po sitive reputations even though they previously had excellent reputational records . Harris Interactive ® and the Reputation Institute‘s ranking of Royal Ahold as the most repu table
company in 2001 and Fortune Magazine‘s ranking of Enron as America‘s Most In novative Company for 6
consecutive years and 25 th
most admired company in America just months before it collapsed provide instances of how companies enjoy false
positive reputations
( Alsop, 2004; Dowling, 2004) . Enro n‘s code of ethics that its executives and employees supposedly followed may have contributed to the boost in ranking by Fortune Magazine .
Some excerpts from the code include
the following :
We want to be proud of Enron and that it enjoys a reputation for
fairness and
honesty.…Let‘s keep that reputation high….We are dedicated to conducting
business according to all applicable local and international laws and
5
regulations…and with the highest professional and ethical standards .
(Alsop,
2004, pp . 58 - 59)
Since Enron‘s collapse, it is evident that the company‘s code of ethics consisted of empty words ,
as Enron applied only some, if any, of the words in its business dealings . Enron also used the formerly positive reputation of associated companies to give the impression of a repu table
company . For instance, many people believed that if Arthur Andersen, one of the big five accounting firms at the time, certified Enron‘s financial statements then it must be a good corporation
(Dowl ing, 2004) . Also, McKinsey & Company, a renowned management consulting firm, performed 20 projects for Enron while its director regularly attended Enron‘s board meetings
(Dowling, 2004) .
Dalton and Croft (2003)
suggest tha t reputation is a natural part of human lives and an integral part of the society . A reputation is others‘ perception of someone ,
or of an organization ,
over time . E very organization as well as every individual has a reputation . The difference is whethe r one has a positive (good) or negative (bad) reputation . Corporate reputation is the perception of a company‘s attributes by its stakeholders
and the public,
and it is earned over time . A company‘s track record in terms of its community and marketplace standing and integrity contribute to its reputation
(Dalton & Croft, 2003) . Hence, the topic of corporate reputation and related issues such as corporate social responsibility (CSR) has gained popularity in recent years .
Cor porate reputation is an important measure of a corporation‘s success and sustainability . Corporations with positive reputations have reputational capital, an intangible asset . Preston (2004) suggests that a corporation with a positive reputation has an i ntegral and distinct asset ,
while one with a negative reputation carries an inherent liability . Since several companies constantly compete for the support of key
6
stakeholders, good reputation gives a company strategic advantage over its competitors ,
there by influencing its performance
(Fombrun, 1996 ; Schwaiger, 2004) . In other words, stakeholders positively reward companies with good reputations and negatively reward those with bad reputations . Nevertheless, Alsop (2004) warns that corporations with posi tive reputations must not be complacent , but must aspire to exceed compliance with federal regulations if they want to maintain outstanding reputations . The main reason is that the public expects more from repu table
companies than just compliance with app licable legislations and standards.
A corporation‘s reputation is usually dependent on its top management, especially the CEO or someone with an equivalent title . Since the CEO is the ultimate spokesperson and embodiment of the organization, people‘s perc eption of him or her can reflect on the organization . For example, reputations of CEOs ,
such as Bill Gates of Microsoft and Meg Whitman of e Bay ,
have helped improve their companies‘ positive reputation s,
while Martha Stewart‘s reputation has had a devasta ting effect on her company‘s reputation
(Alsop, 2004) . A culture of morality in an organization is important for building and maintaining positive reputation because accounting fraud can cause collateral damage to corporate re putation.
Since regulatory policies and bodies typically compel companies to be transparent and honest , compliance with the
regulatory
process improves corporate reputation
(Alsop, 2004) . Also, f ederal regulations and corporat e reputation involve working in the best i nterest of stakeholders . R egulations
protect stake holders ,
and stakeholders ‘ perceptions
are usually
positive if a corporation holds
its stakeholders at high
esteem . Thus , federal regulations and corporate reputa tion
are connected . As Figure
1 shows ,
the
7
framework of the study
was to explore the relationship between
the effectiveness of federal regulations and corporate reputation on reducing accounting fraud .
Figure
1 . General framework of this study to illustrate the connection between federal regulations and corporate reputation
in the reduction of corporate accounting fraud.
1.2
Problem Background
Fraud is not a new phenomenon; history and anecdotal reco rds indicate that dubious dealings of land exchange occurred as early as the American colonial era . Nott and Adjibolosoo (2005) assert that for centuries business leaders and their subordinates have experienced varying levels of integrity crises and corru ption in their business dealings . Fraud has dire consequences for individuals, organizations ,
and governments as any perpetrated fraud directly or indirectly affects these . Corporate accounting fraud, for example, affects many individuals ‘ financial stat es
as well the organization ‘ s
well - being , regardless of size, location, or industry .
A recent survey reveals that about 30%
of organizations worldwide experienced one or more incidents of fraud the previous year (PricewaterhouseCoopers, 2009) . Of Reduction of Corporate Accounting Fraud
Federal Regulations
Corporate Reputation
8
those 30 % , 38 %
reported experiencing accounting fraud (PricewaterhouseCoopers, 2009) . The result indicates that accounting fraud has more than tripled since a similar survey was conducted in 2003 . Another survey estimates that organizations
throughout the worl d
lose 5%
of their annual revenues to fraud
(Association of
Certified Fraud Examiners, 2010 ) . This translates to fraud losses of approximately $ 2.9 trillion
based on th e
2009 Gross World
Product (Association of
Certified Fraud Examiners, 2010 ) .
Even tho ugh fraud has a variety of definitions, each definition has two common elements . The two elements are intent and deception
(American Institute of Ce rtified Public Accountants, 2002 ) . The first element implies that no unintentional fraud exists . The Amer ican Institute of Certified Public Accountants ( 2002 ) affirms this by stating in Statement of Auditing Standards 99 (SAS 99) that ― the primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement of t he financial statements is intentional or unintentional‖ (p. 16 9) . The second element, deception, implies that the perpetrator lied or withheld the truth
about a situation .
Corporate accounting fraud (also known as financial statements fraud or fraudule nt financial reporting) involves intentional material misstatement or misrepresentation of an organization‘s financial statements
(National Commission on Fraudulent Financial Reporting, 1987) . This type of fraud is als o called management fraud
because management or an executive in the organization usually perpetrates or gets involved before such a fraud can be successful . Badawi (2005)
posits that (a) senior management (CEOs and CFOs) conceal true organizational busine ss performance , (b) mid - and lower - level management conceal poor performance in their areas of responsibility , and (c) organizational criminals falsify financial statements to obtain loans
9
or to inflate stock prices to commit corporate accounting fraud . In
addition to the involvement of an employee or management, it is usually the case that an accountant, accounting firm, or auditing firm usually aid s
and abet s
corporate accounting fraud.
Accounting fraud
is closely related to securities fraud as most accou nting frauds affect publicly - traded companies . Such fraud involves a deliberate strategy to deceive by distorting financial information along with related records
(Riahi - Belkaoui, 2003) . Furthermore, corporate accounting frau d can either be an inclusive or exclusive fraud . As the name implies, an inclusive accounting fraud means the perpetrator includes what should not have been included ,
thereby causing overstatements of assets and understatements of liabilities (Dooley, 200 2) . An exclusive accounting fraud, therefore, is an intentional omission of liabilities or other obligations from the financial statements (Dooley, 2002) . A typical fraud perpetrator conceals his fraud for as long as possible, so fraud schemes usually go
undetected for months . Whereas the median number of months before all t ypes of fraud are detected is 18
months, fraudulent financial statements ha ve
gone for as long as
27
month s
before detection (Association of
Certified Fraud Examiners, 2010 ).
To mitig ate corporate accounting frauds over the years, several federal legislations and standards have been passed and enhanced . Some of the legislations include the Securities Act of 1933, the Securities and Exchange Act of 1934, and SOX .
S tandards include the GAAP and Statement of Accounting Standards (SAS) . The main purpose of these federal regulations is the protection of corporate beneficiaries (stakeholders) . Companies these days, perhaps more than ever, have to work hard to protect their reputations cons idering several accounting frauds, collapses, and
10
restatements that have plague d
corporations and industries . Bonini, Court ,
and Marchi (2009)
contend that ―people have unprecedented access to information now and may therefore concern themselves with a su rprisingly wide array of issues‖ (p . 78) pertaining to companies they care about or know . The information can give people an impetus to act .
The energized public and other stakeholders are more alert to and less tolerant of corporate misdeeds . Bonini e t al.
