Two out of three corporate frauds go undetected, research finds

For the University of Toronto’s Alexander Dyck, corporate fraud is like an iceberg: a small number is visible, but much more lurks below the surface.

But how much more? And at what cost to investors?

Dyck, a professor of finance and economic analysis and policy at the Rotman School of Management, and his team found that under typical surveillance, about three per cent of U.S. companies are found doing something funny with their books in any given year. They arrived at the number by examining 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 Dyck and his colleages the chance to see how much fraud was detected during a period of heightened scrutiny.

Arthur Anderson had been working with 20 per cent of all U.S. publicly traded companies. Forced to find new auditors, those companies found themselves under a microscope due to their previous association with the disgraced accounting firm – presenting a “huge opportunity,” Dyck says.

While those companies didn’t show a greater propensity to fraud in the runup to the scandal, it was a different story once the spotlight was turned on between Nov. 30, 2001 – the date when Andersen client Enron began filing for bankruptcy – until the end of 2003. During that period, 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,” says 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, which included Adair Morse of the University of California, Berkeley and Luigi Zingales of the University of Chicago, used the findings to infer that the real number of companies involved in fraud is at least 10 per cent – about three times greater than their previous estimates. That squares with previous research that has pegged the true incidence of corporate fraud between 10 and 18 per cent. While the researchers were looking at U.S. companies, Dyck speculated that the ratio of undetected-to-detected fraud is not significantly different in Canada.

The findings were published in the Review of Accounting Studies. Dyck is scheduled to present his research during an event hosted by the Capital Markets Institute on Feb. 23. 

The researchers estimate 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 the Sarbanes-Oxley Act, or SOX, introduced in 2002 in response to Enron and other financial scandals. The study shows the legislation would satisfy a cost benefit analysis even if it only reduced corporate fraud by 10 per cent of its current level.

The results should capture the attention of anyone with responsibility for corporate oversight and research, 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.’”