The equity and credit markets (capital markets) in the United States are considered to be among the most efficient in the economically developed world. One reason for the efficient operation of these markets is the public availability of creditable financial statements to individuals and institutions and the confidence in these statements by those using them as a basis for their investment and credit decisions. A potential serious threat to the efficient functioning of these markets is the incidence of fraudulent financial reporting.

Fraudulent financial reporting is intentional or reckless conduct, acts, or omissions, that result in materially misleading financial statements. Confidence in the operation of capital markets is diminished when the system of public disclosure is eroded by reported instances of fraudulent reporting.

In the mid-1980s, the failure of a number of financial institutions led various groups to deter mine possible causes, including the extent of fraudulent reporting involved in the failures. The Subcommittee on Oversight and Investigations of the U.S. House of Representative's Committee on Energy and Commerce held hearings concerning the accounting profession. The subcommittee's intent was to determine whether the system of public disclosure and reporting needed corrective action. In opening the hearings, the chairman, Representative John Dingell, questioned whether the public disclosure and audit system then in effect was meeting public expectations. In August 1986, Congressman Dingell and other members of the committee proposed legislation to amend the Securities and Exchange Act of 1934 to require independent public account ants (auditors) to include procedures for material financial fraud detection, to require reporting on internal control systems, and to require the reporting of fraudulent activities to appropriate enforcement and regulatory authorities. The legislative proposals were not accepted. There persisted the belief that the profession could respond successfully to the challenges without further legal requirements.

A private-sector response to these hearings, the National Commission on Fraudulent Financial Reporting (Treadway Commission)—jointly sponsored and funded by the American Institute of Certified Public Accountants (AICPA), the American Accounting Association (AAA), the Financial Executives Institute (FEI), the Institute of Internal Auditors (IIA), and the National Association of Accountants (NAA) (now the Institute of Management Accountants)—was formed in 1985 to identify factors contributing to fraudulent financial reporting and to develop recommendations to reduce its future occurrence. The Treadway Commission issued its report in October 1987.

TREADWAY COMMISSION REPORT

The Treadway Commission concluded that the responsibility for fraudulent financial reporting was not vested in one group. While the commission conceded that financial statements are the responsibility of a company's management, it issued a series of recommendations for the public company, the independent public accountant, the Securities and Exchange Commission (SEC), and the educational community.

The report identified a number of factors that might contribute to fraudulent financial reporting, including a number of environmental, institutional, and individual personal incentives to engage in fraudulent financial reporting. Institutional incentives include falsely improving financial appearances in financial statements for the purpose of maintaining market stock prices or to meet investor expectations as well as delaying the reporting of financial difficulties in order to avoid failure to comply with covenants in debt agreements. Individual incentives include falsely reporting results in order to achieve targeted results for bonus or incentive compensation purposes, as well as to avoid penalties for poor performance in achieving targeted profit objectives.

The commission indicated that the oversight bodies that establish auditing standards and those that monitor compliance have a continuing responsibility to uphold the integrity of the public disclosure and reporting system. The Commission also concluded that many of the Securities and Exchange Commission's fraudulent financial reporting cases against auditors' alleged failure to conduct the audits in accordance with generally accepted auditing standards.

RECOMMENDATIONS FOR THE PUBLIC COMPANY

The commission made a number of recommendations affecting public companies. These included proposals that companies develop and vigilantly enforce written codes of corporate conduct because such codes foster a positive ethical climate and discourage incidences of fraudulent financial reporting by positively affecting behavior throughout the public company.

The commission noted that company audit committees (those members of a company's board of directors who have responsibility for oversight of the financial reporting process) have historically been generally successful in exercising their oversight responsibility regarding financial reporting. However, it offered a number of recommendations that would improve this system. The commission proposed that boards of directors of all public companies be required by SEC rule to be composed of independent (outside, nonemployee) directors. Other specific recommendations included proposals to expand the authority of the audit committee and to enhance communications with the company's internal auditors and independent public accountants.

RECOMMENDATIONS FOR THE INDEPENDENT PUBLIC ACCOUNTANT

The commission issued a number of specific recommendations designed to improve the auditor's ability to detect fraudulent financial reporting. One significant proposal was a recommendation that the Auditing Standards Board (ASB) of the AICPA revise standards to restate the independent public accountant's responsibility for the detection of fraudulent financial reporting. The commission recommended that the independent public accountant be required to take proactive steps to assess the potential for fraudulent financial reporting and design audit tests to provide reasonable assurance of detection. Other recommendations included suggestions for improved detection capabilities through required analytical review procedures in all audit engagements and improvements to peer review processes and other intra-accounting firm review procedures. The commission also suggested that the SEC strengthen the civil and criminal sanctions affecting registrants and the independent public accountant.

RECOMMENDATIONS FOR THE SECURITIES AND EXCHANGE COMMISSION

The commission acknowledged that strong and effective deterrence is essential in reducing the incidence of fraudulent financial reporting. The commission's recommendations to the SEC included increasing deterrence by issuance of new SEC sanctions, greater criminal prosecution, improved regulation of the public accounting profession, adequate SEC resources, improved federal regulation of financial institutions, and improved oversight by the state boards of accountancy.

RECOMMENDATIONS FOR EDUCATION

The commission concluded that education could influence present and future participants in the financial reporting system. Therefore, recommendations were made related to curricula, professional certification examinations, and continuing professional education.

The commission recommended that the business and accounting curricula should convey a deeper understanding of internal controls and the overall control environment within which financial reporting takes place. Students need to be taught the complex regulatory and law enforcement framework that government and private-sector bodies have developed to provide safeguards to protect the public interest. Students also need to develop skills that will help prevent, detect, and deter fraud in financial reporting. The ethical dimension of financial reporting should be given more emphasis in college and university programs.

The commission recommended that certification examinations and continuing education programs give greater attention to the knowledge, skills, and ethical values that would produce a better understanding of fraudulent financial reporting and possibly promote a reduction in the incidence of such fraud.

RESPONSE OF THE AUDITING STANDARDS BOARD

In response to the Treadway Commission report and to other influences, the Auditing Standards Board issued ten new auditing standards in April 1988. These Statements on Auditing Standards (SASs) include requirements affecting the auditor's responsibility to detect and report errors and irregularities, consideration of internal control structure in a financial statement audit, and communication with a company's audit committee.

SAS No. 53, "The Auditor's Responsibility to Detect and Report Errors and Irregularities," stated auditor responsibility more clearly than had the earlier statement with the same title. SAS No. 53, however, was superseded in 1997 with a new SAS, No. 82, "Consideration of Fraud in a Financial Statement Audit." This revised Statement clearly identified the responsibility of the auditor to provide reasonable assurance that the two types of misstatements are detected: those arising from fraudulent financial reporting and those arising from misappropriation of assets.

Another SAS, No. 61, "Communication with Audit Committees," was issued to enhance the role of the audit committee of the board of directors in understanding the scope and results of the audit so that the committee members would be more effective in overseeing the financial reporting and disclosure process for which the company's management is responsible. In complying with this Statement, the auditor is required to communicate to the audit committee such matters as the company's management's significant accounting policies, judgments, and accounting estimates, and disagreements with the auditors. The audit committee is to be informed of any consultation that management had with other accountants and of difficulties the auditors encountered while performing the audit.

SAS No. 55, "Consideration of Internal Control in a Financial Statement Audit," changed the responsibility of the auditor for internal control. The new Statement required the auditor to develop an understanding of internal control sufficient to plan the audit and to document the understanding. Prior to the issuance of the new Statement, the auditor was not required to develop such an understanding. SAS No. 55 was amended with the issuance of SAS No. 78 in 1997, which redefined internal control. Control environment and risk assessment, among the concerns of the Treadway Commission, were more clearly described in SAS No. 78 and the auditor's responsibility for both factors clearly specified.

CONTINUING ATTENTION TO THE PROBLEMS OF FRAUDULENT FINANCIAL REPORTING

Attempts have continued to enhance understanding of fraudulent financial reporting in the United States. In early 1999, for example, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) issued the results of a study of Accounting and Auditing Enforcement Releases issued by the SEC between 1987 and 1997. This study attempted to improve ways of determining who participated in a fraud as well as the size and duration of the fraudulent behavior.

The Blue Ribbon Committee, formed at the request of the SEC chairman, the New York Stock Exchange, and the National Association of Securities Dealers, was charged with recommending ways to enhance the effectiveness of audit committees. The committee reported its recommendations in early 1999. The focus of the recommendations was related to audit committee oversight responsibilities relating to financial reporting.

The SEC, with its oversight responsibility for financial reporting, continues to provide leadership in cooperation with other groups for the reduction of fraudulent financial reporting.