Fraud and bankruptcy go hand in hand

Bankrupt companies are three times more likely to have been cited for fraud by U.S. regulators, according to a new study released last week from Deloitte Financial Advisory Services LLP. The study also showed that fraud incidents were much more likely to land a company in bankruptcy court.

"Many of the companies that commit financial statement fraud are dealing with adverse performance issues and committing fraud to cover those up," said Toby Bishop, director of the Deloitte Forensic Center. "A significant proportion of them - 20 percent - will end up filing for Chapter 11 (bankruptcy protection)."

Fraud-linked bankruptcies like Enron, WorldCom, and Adelphia have kept U.S. courts busy for years, and the study revealed that companies that are cited for financial-statement fraud were twice as likely to file for bankruptcy as those that were not cited.

The study tracked companies with annual revenues of more than $100 million, comparing 519 bankrupt companies to a group of 2,919 non-bankrupt companies from about 2000 through 2007.

About 9 percent of the bankrupt companies were the subject of enforcement actions reported by the U.S. Securities and Exchange Commission, compared with 3 percent of the nonbankrupt companies.

"There are two distinct groups of people who are engaging in these frauds - people who are attempting to prop up the company in the hopes that the bank gives them more liquidity ... and those that are doing it more for their own personal benefit," said Sheila Smith, head of reorganization services at Deloitte.

Smith said it was not clear whether employees at bankrupt companies are more likely to commit fraud or whether the microscope of bankruptcy makes it easier for regulators to detect it.

The most common type of fraud detected at both bankrupt and nonbankrupt companies was improper revenue recognition.

"Generally revenue is monitored closely by analysts and investors," Bishop said, "and achieving expectations in that area is a high priority to management."

Improper disclosures and manipulation of expenses also showed up frequently in both groups.

In the study, consumer companies received the most SEC enforcement actions, at about 30 percent, followed by telecommunications, media and technology at about 27 percent.

Of those companies that received enforcement actions, about 50 percent of the consumer group filed for Chapter 11 bankruptcy protection, compared with about 30 percent of those in the telecommunications, media and technology sector.

History of Fraud

A long history of fraud at a company also had a strong link with bankruptcy, according to the study. Bankrupt companies were twice as likely as nonbankrupt ones to have more than 10 fraud schemes in their corporate history.

That was particularly true for bigger companies. Bankrupt companies with annual revenues of more than $10 billion had about 10.8 fraud schemes on average, while those with annual revenues between $100 million and $10 billion averaged 4.3, the study showed.

In fact, WorldCom and Enron, where top company executives were convicted of fraud, are among the five largest U.S. bankruptcy cases ever filed in the United States, according to tracking firm WorldCom held more than $100 billion in assets when it filed for bankruptcy in 2002, while Enron held more than $65 billion in assets at the time of its filing in 2001.

While it may be tempting for companies to cut back on support staff during tough economic times, Bishop said the link between fraud and bankruptcy showed that they could risk their whole business by loosening their focus on fraud detection efforts.

"This is the time when those efforts are more important than ever because of the heightened risk of people giving into the economic pressures and committing fraud," Bishop said. "Companies have to devote extra effort to that risk."

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