Report of the National Commission on Fraudulent Financial Reporting October 1987 Copyright (c) 1987 by the National Commission on Fraudulent Financial Reporting National Commission on Fraudulent Financial Reporting COMMISSIONERS Chairman Hugh L. Marsh James C. Treadway, Jr. Director Executive Vice President and Internal Audit General Counsel Aluminum Company of America Paine Webber Incorporated Thomas I. Storrs William M. Batten Chairman of the Board (Retired) Chairman (Retired) NCNB Corporation New York Stock Exchange Donald H. Trautlein William S. Kanaga Chairman and Chief Executive Chairman of the Advisory Board Officer (Retired) Arthur Young & Company Bethlehem Steel Corporation STAFF Executive Staff G. Dewey Arnold, Executive Director Jack L. Krogstad, Research Director Catherine Collins McCoy, Deputy Executive Director and General Counsel Professional and Technical Staff Senior Consultants Joseph A. Adams Lawrence C. Best Angela L. Avant Allan Wear Louis Bisgay Mark P. Connelly Editorial Consultant Paul C. Curtis Carol Olsen Day George F. Daly Joseph J. Donlon Administrative Staff Michael Doyle Michael R. Funderburg Alma Fagan Laura S. Greenstein Catherine Fonfara John F. Harris Vicki Johnston Ellen Downey Hylas Sandra Ringer Joseph Janella Scott J. Ludwigsen Lawrence D. Morriss, Jr. Timothy G. O'Connor Gary A. Rubin Shirley Sunderland iii ADVISORY BOARD MEMBERS Donald W. Baker P. Norman Roy Vice President-Controller Executive Vice President Southwire Company Barry Wright Corporation (National Association of Accountants) (Financial Executives Institute) William G. Bishop, III Robert J. Sack Executive Vice President Chief Accountant Corporate Audit Department Division of Enforcement Shearson Lehman Bros., Inc. Securities & Exchange Commission (Institute of Internal Auditors) Philip B. Chenok A. Clarence Sampson, Jr. President & Chief Staff Officer Chief Accountant American Institute of Certified Securities & Exchange Commission Public Accountants Frank S, Sato William J. Duane, Jr. Inspector General General Auditor Veterans Administration Manufacturers Hanover Trust Company (Institute of Internal Auditors) Jerry D. Sullivan Partner James J. Leisenring Coopers & Lybrand Director of Research & (Chairman, Auditing Standards Board) Technical Activities Financial Accounting Standards Board Doyle Z. Williams Dean, School of Accounting Richard M. Phillips University of Southern California Kirkpatrick & Lockhart (American Accounting Association) (American Bar Association) iv TABLE OF CONTENTS Introduction 1 Summary of Recommendations 11 Chapter One: Overview of the Financial Reporting System and Fraudulent Financial Reporting 17 Chapter Two: Recommendations for the Public Company 31 Chapter Three: Recommendations for the Independent Public Accountant 49 Chapter Four: Recommendations for the SEC and Others to Improve the Regulatory and Legal Environment 63 Chapter Five: Recommendations for Education 79 Appendices 87 v LIST OF APPENDED MATERIAL Appendix A Biographies of Commissioners and Executive Staff 91 B Summary of External Research Program 95 C Summary of Research Reports and Briefing Papers Prepared by Commission Staff 109 D Persons Consulted by the Commission 121 E Composite Case Studies in Fraudulent Financial Reporting, Harvard Business School 125 F Good Practice Guidelines for Assessing the Risk of Fraudulent Financial Reporting 153 G Standards for the Professional Practice of Internal Auditing, The Institute of Internal Auditors 165 H New York Stock Exchange Listed Company Manual, Section 3, Corporate Responsibility-Audit Committee 177 I Good Practice Guidelines for the Audit Committee 179 J Good Practice Guidelines for Management's Report 183 K Good Practice Guidelines for Audit Committee Chairman's Letter 187 vi INTRODUCTION This report presents the findings, conclusions, and recommendations of the National Commission on Fraudulent Financial Reporting (the Commission), From October 1985 to September 1987, the Commission studied the financial reporting system in the United States. Our mission was to identify causal factors that can lead to fraudulent financial reporting and steps to reduce its incidence. Fraudulent financial reporting is indeed a serious problem. Infrequent though its occurrence arguably may be, its consequences can be widespread and significant. Although fraud in any form can be difficult to deter, fraudulent financial reporting can be reduced, perhaps substantially, if each party for whom we made recommendations takes the steps we recommend. The Commission's recommendations embrace the top management and boards of directors of all public companies, independent public accountants and the public accounting profession, the SEC and other regulatory and law enforcement bodies, and the academic world. As background to the Commission and its work, this introduction discusses the Commission's sponsors, members, and advisors, the definition of fraudulent financial reporting that the Commission used, the Commission's objectives, the scope of the study, and the research program. Following this background information is a discussion of the major conclusions that guided the Commission in developing the recommendations presented in this report. I. The Commission Sponsors, Members, and Advisors The Commission was a private-sector initiative, 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). The six-member Commission was independent of the sponsoring organizations. The chairman of the Commission was James C. Treadway, Jr., formerly a Commissioner of the Securities and Exchange Commission (SEC), and presently Executive Vice President, General Counsel, member of the Executive Group, and a Director of Paine Webber Incorporated. William M. Batten is the immediate past Chairman of the New York Stock Exchange and the former Chief Executive Officer (CEO) of J.C. Penney Co. William S. Kanaga is Chairman of the Advisory Board of Arthur Young & Company, and served as Chairman of that firm and of the AICPA. Hugh L. Marsh is the Director-Internal Audit for ALCOA, responsible for its worldwide audit activities. He also is a past Chairman of the IIA. Thomas 1. Storrs is the immediate past Chairman and CEO of NCNB Corporation, a bank holding company, and continues to serve as a Director of NCNB. Donald H. Trautlein recently retired as Chairman and CEO of Bethlehem Steel and was formerly a partner with the accounting firm of Price Waterhouse. Appendix A includes biographies of the Commissioners and the Executive Staff. 1 An Advisory Board, representing a broad spectrum of experience and points of view, assisted the Commission. Definition of Fraudulent Financial Reporting For purposes of this study and report, the Commission defined fraudulent financial reporting as intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements. Fraudulent financial reporting can involve many factors and take many forms. It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders. It may entail the misapplication of ac- counting principles. Company employees at any level may be involved, from top to middle management to lower-level personnel. If the conduct is intentional, or so reckless that it is the legal equivalent of intentional conduct, and results in fraudulent financial statements, it comes within the Commission's operating definition of the term fraudulent financial reporting. Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors. The Commission also distinguished fraudulent financial reporting from other corporate improprieties, such as employee embezzlements, violations of environmental or product safety regulations, and tax fraud, which do not necessarily cause the financial statements to be materially inaccurate. Objectives The Commission had three major objectives: 1. Consider the extent to which acts of fraudulent financial reporting undermine the integrity of financial reporting; the forces and the opportunities, environmental, institutional, or individual, that may contribute to these acts; the extent to which fraudulent financial reporting can be prevented or deterred and to which it can be detected sooner after occurrence; the extent, if any, to which incidents of this type of fraud may be the product of a decline in professionalism of corporate financial officers and internal auditors; and the extent, if any, to which the regulatory and law enforcement environment unwittingly may have tolerated or contributed to the occurrence of this type of fraud. 2. Examine the role of the independent public accountant in detecting fraud, focusing particularly on whether the detection of fraudulent financial reporting has been neglected or insufficiently focused on and whether the ability of the independent public accountant to detect such fraud can be enhanced, and consider whether changes in auditing standards or procedures -- internal and external -- would reduce the extent of fraudulent financial reporting. 3. Identify attributes of corporate structure that may contribute to acts of fraudulent financial reporting or to the failure to detect such acts promptly. Scope: Public Companies