NEW YORK (AP) -- When it comes to cooking the books, small companies are the biggest culprits, a new study reports.
And while the financial finagling is small, the damage often isn't. Half the companies in the fraud study wound up either closing their doors or reorganizing in Bankruptcy Court.Investors should watch for red flags, such as a chief executive who is also the company founder and has a weak or inexperienced board of directors that has an unusually large stake in the company's stock, according to the findings released Friday.
That "fits the profile of a company that may be involved in fraudulent financial reporting," said John Flaherty, chairman of the Committee of Sponsoring Organizations of the Treadway Commission, which is a consortium of five accounting groups.
The study comes as the Securities and Exchange Committee is considering measures to increase the power and independence of corporate audit committees following a series of high-profile financial fiascoes.
In the 300 cases of fraudulent financial reporting that the SEC tackled between 1987 and 1997, and the chief executive was involved almost three-quarters of the time, the study said.
In those cases, about 60 percent of the directors were either company executives, family members, or had special ties to the company that could influence their votes.
"Investors tend not to look at who's on the board of directors of the companies they invest in," Flaherty said.
Because executives, directors and even suppliers were in cahoots, the crime was hard for outside accountants to detect. Especially because the numbers were carefully doctored over an average of two years before regulators caught on.
"The fraud didn't happen overnight," said Alan W. Anderson, a senior vice president for the American Institute of Certified Public Accountants, and a member of the committee. "It wasn't like turning on a light switch."
While the study released Friday found that the biggest problem lies in companies with market values under $100 million, the SEC is expected to focus on companies valued at more than $200 million because they have more investors with more at stake.
"The bigger risk is with the bigger companies," said Flaherty, who also is the former general auditor for PepsiCo Inc.
That means the responsibility, at least for now, falls on investors who put their money in small companies to look for warning signs.
Among the companies hit by fraud, computer and software businesses were in almost one out of every six cases studied.
Many startup high-tech businesses, which are attracting a cultlike following on Wall Street, fit the profile of having a founder-CEO, with high stock ownership among board members and top executives. Plus, many of them are losing money -- another common trait in the study group.
That's important because the main reasons executives said they cooked the books was to avoid posting a loss, or having their stock removed from an exchange for failure to meet minimum financial standards.
A strong temptation to cheat comes from the pressure many chief executives face to meet Wall Street's profit estimates.
Computer and software companies accounted for 15 percent of the fraud cases, other manufacturing an additional 15 percent, followed by financial services with 14 percent, and health care and health products, 11 percent. The other categories accounted for 8 percent or less of the cases.
The companies misstated or misappropriated their financial assets by an average of $25 million, though the median was $4.1 million, but one out of two businesses failed.
"Financial reporting fraud is a serious problem and we regularly take action against it, regardless of whether it's a small company or a big company." said SEC spokesman John Heine.
The study was conducted by professors at North Carolina State University, University of Tennessee and Kennesaw (Ga.) State University. The professors took a random sample of 200 of the 300 cases in which the Securities and Exchange Commission took action.