Just How Common Is Corporate Fraud?

The end of every bull market brings with it revelations of corporate fraud (think Enron, Maddoff, Satyam and now the crypto blowups). Our forensic accounting research on the Indian stockmarket has suggested that over the past decade a third or so of listed Indian companies have done naughty things with their accounts – see https://marcellus.in/newsletter/little-champs/the-importance-of-accounting-quality/

In the American context, this NYT piece (based on this academic article https://link.springer.com/article/10.1007/s11142-022-09738-5#Sec9) says something very similar to what we find in India: “Only about a third of frauds in public companies actually come to light, and that fraud is disturbingly common. Mr. Dyck and his co-authors estimate that about 40 percent of companies are committing accounting violations and that 10 percent are committing what is considered securities fraud, destroying 1.6 percent of equity value each year — about $830 billion in 2021.”

This is stunning. Basically, the academic paper which has been authored by three heavy hitters – Alexander Dyck (Univ of Toronto), Adair Morse (UC Berkeley) & Luigi Zingales (Univ of Chicago) – is saying that FTX, Theranos, Nikola, etc are not exactly aberrations in American corporate life. In fact, for anyone who is invested in unlisted stocks (whether in India or in America) the fraud risk is even higher than the 40% figure mentioned above: “Mr. Dyck and his colleagues wanted to scratch the surface of misconduct in public companies to figure out how much of it goes undiscovered normally. To do this, they first examined a period of unique scrutiny in accounting history, the 2001 demise of the auditing firm Arthur Andersen following the collapse of Enron.

At that time, the firm’s former clients were in the spotlight and new auditors were far more motivated to uncover wrongdoing, given the suspicions looming over companies that had worked with Arthur Andersen. That should make the rate of fraud they found more accurate than other measures. But the probes didn’t uncover more wrongdoing among Arthur Andersen’s clients than at other businesses reliant on other auditors. The same ratio of fraud appeared in a set of comparisons with other research, which led them to conclude it is consistent. They used this rate of fraud to conclude that about a third of corporate fraud goes unnoticed.

Given how common fraud is at audited public companies, Mr. Dyck said, misconduct is likely even more pervasive in privately held businesses, particularly in crypto, which is only loosely regulated”

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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.