MIUFaculty of Business Administration and International Trade
Department of Accounting
Techniques of Detecting and Preventing Fraud in Financial
StatementsGraduation Project
Prepared by Nour Ali Al Mohanad Emad Youstina Kout Nourhan
El-AgizyMirna Ismael
Supervised By: Professor Zakaria FaridProfessor of AccountingAin
Shams University
Spring 2015Dedication and Acknowledgment
This research is dedicated to our two accounting professors who
have defined a remarkable work in the field of accounting in Misr
International University from our point of view; Professor Zakaa
Khalifa and Professor Zakaria Farid.
Professor Zakaa Khalifa who is serving as the head of the
accounting department in Misr International University provided us
throughout our academic studies in the university with a prolific
knowledge in different fields of Accounting as well as providing a
constructive tips that helped us in our academic life.
Professor Zakaria Farid who is serving as the professor of
Accounting in Ain Shams University provided us with boundless
assistance in our project as well as fruitful and brand new ideas
in finalizing our project observing his academic contribution in
the field of Accounting and Financial Accounting in Egypt and
Abroad.Not to forget all the staff of Accounting and Teaching
assistants who has provided us with assistance through our academic
studies in the university and to everyone who might find our
project useful.
We designed this page to give our thanks for those who shaped
significant differences in our knowledge, personality and attitude
and we wish all readers to have the benefit from this humble work
of us.
Table of ContentPages1. Dedication and Acknowledgment 22. Table
of Content33. Chapter 1 (Introduction to Fraud in Financial
Statements)4 - 124. Chapter 2 (Literature Review)13 - 235. Chapter
3 (Reasons and Effects of Fraud in Financial Statements)24 - 426.
Chapter 4 (Indicators and ways to prevent Fraud in Financial
Statements)43 - 657. Chapter 5 (Case Study and Application in
Preventing Fraud in Financial Statements)66 - 848. Chapter 6
(Conclusion)85 - 869. References87 - 92
Chapter 1Introduction to Fraud in Financial StatementsI.
Introduction:Nowadays, Fraud in financial statements becomes mutual
as it causes a serious problem for everyone who is interested users
of financial data from any company, whether to invest in, a
competitor, or financial institutionsetc. Fraud has a direct impact
on business as companies who commit fraud shows a manipulation in
their financial statement in order to differentiate themselves from
others. Fraud can be caused by many factors to meet expectations of
the owners or creditors, or to obtain more favorable credit terms,
to meet performance criteria set by related companies, or to
maintain an impression of constant economic growth of the company.
Not all these are justifications to commit fraud in financial
statements, as fraud is extremely disastrous to any company, yet it
can be easily identified and prevented through auditing procedures
or analyzing the financial statements, which is very essential to
stop this insalubrious act to any company, to its stakeholders, and
to the whole community.
II. Background:1. Financial Statements:A companys financial
statements give a lot of financial information that business owners
and creditors use to estimate a companys financial performance.
Financial statements are very essential to a companys top
management because of spreading financial statements; management
can communicate with outside parties about its role to run the
company. Different financial statements focus on various fields of
financial performances. Financial statements are important for many
reasons, but here are three significant reasons (Eric Owen,
2013):a. Financial statements tell you the performance and the
value (sort of) of your company.b. Financial statements are what
others are using to measure your company. c. Financial statements
and other tools help you manage your company when you can no longer
be hands on with all the details.
2. Types of Financial Statements:There are three primary
financial statements: Balance Sheet, Income Statement and Cash Flow
Statement.a. Balance sheet: it is one of the most essential
statements used by accountants to provide the top management and
creditors with the information needed. The balance sheet presents a
company's financial situation at the end of a specified date.
Balance sheet consists of three main elements; they are assets,
liabilities and Equity. Assets are the resources of the
organization that have been gained through transactions, and have
economic value that can be measured and expressed in dollars, such
as cash, investments, inventories, land and equipments etc.
Liabilities (obligations of the company) are amounts owed to
creditors for a previous transaction such as accounts payable,
notes payable, salaries payable etc. Owner's equity is actually
means the book value of the company is equal to the reported asset
amounts minus the reported liability amounts.The Following is an
example of the balance sheet.
b. Income statement: it is one of the main financial statements
referred to as the profit and loss statement (P&L), statement
of operations, or statement of income. The income statement shows
the net results of a company and its operations during the period
specified in its heading.The Following is an example of the income
statement.c. Cash flow statement: it shows the cash generated and
used during a specific period of time. It consists from three main
categories. Operating activities converts the items reported on the
income statement from accrual basis of accounting to cash Basis,
investing activities (reports the purchases and sale of long-term
investments and property, plant and equipment) and financial
activities (reports the issuance and repurchases of the company's
own stock and bonds and the payment of the dividends) and the
supplemental information (reports the exchange of significant items
that did not involve cash and reports the amount of income taxes
paid and interest paid).The Following is an example of Cash Flow
Statement.
3. Users of the Financial Statements:There are internal and
external users of financial statements:
a. Internal Users: such as Management to analyze the
organizations performance and position and taking appropriate
measures to improve the company results, Employees to assess
companys profitability and its consequences on their future
compensation and job security and Owners for analyzing the
viability and profitability of their investment and determining any
future course of action.
b. External Users: such as Creditors for defining the credit
worthiness of the organization. Terms of credit are set by
creditors according to the assessment of their customers' financial
condition. Creditors include suppliers as well as lenders of
finance such as banks, Tax Authorities for determining the
reliability of the tax returns filed on behalf of the company,
Investors for analyzing the feasibility of investing in the
company, Investors want to make sure they can earn a reasonable
return on their investment before they commit any financial
resources to the company, Customers for assessing the financial
position of its suppliers which is necessary for them to maintain a
stable source of supply in the long term and Regulatory authorities
for ensuring that the company's disclosure of accounting
information is in accordance with the rules and regulations set in
order to protect the interests of the stakeholders who rely on such
information in forming their decisions.
4. Accounting Fraud:Accounting Fraud is one of the major
obstacles, which the companies face. It is a type of manipulation
in the financial statements in order to make the company looks
better in performance or in order to hide a theft process of the
assets, in other words accounting fraud can be described a
situation when an employee of a business entity steals,
misappropriate or misuse money or other resources. Anybody in the
position of stealing ranging from unit managers to accounting
clerks or chief financial officer can commit this kind of fraud.
Factors like elevating oneself, covering for errors, and covering
for loved one can be the motive behind the commission of accounting
fraud. The interesting stuff about accounting fraud is that small
discovery usually lead to massive exposure of fraud.
The accounting fraud, which happens in the financial statements,
is always high and is mostly prepared by top management staff. The
main motive behind this is to present a failing company being
profitable, as this will greatly influence the money that the
managers will collect at the end of the day. This type of fraud
could happens in the three types of the financial statements, they
manipulate the balance sheet in order to raise their earnings power
and assets .Justin Kuepper says in his article Spotting Creative
Accounting On The Balance Sheet at www.investopedia.com ''
Companies that manipulate their balance sheet are often seeking to
increase their earnings power in future periods (or the current
period) or create the appearance of a strong financial condition.
After all, financially-sound companies can more easily obtain lines
of credit at low interest rates, as well as more easily issue debt
financing or issue bonds on better terms''.
For the income statement, companies manipulate it for two
reasons; they maximize the net profit in order to make the company
looks like gaining more profits or minimize it for paying fewer
taxes. Fraud in the cash flow statement could happen by allocating
dividend and interest payments to financing rather than operating
cash flow and allocating dividends and interest received to
operating rather than investing cash flow.
5. Famous Accounting Scandals:According to Barry Ritholtz he
published on the big picture magazine about the most famous
scandalsa. The Global financial services firm Hided over $50
billion in loans hidden as sales. Lehman executives and the
company's auditors, Ernst & Young were the main players. :
Allegedly sold poisonous assets to Cayman Island banks with the
understanding that they would be bought back eventually. Created
the impression Lehman had $50 billion more cash and $50 billion
less in toxic assets than it did really did. They were caught
because of the bankrupt. This was one of the largest bankruptcies
in U.S. history. SEC did not sue due to lack of evidence. The funny
fact was that In 2007 Lehman Brothers was ranked the #1 "Most
Admired Securities Firm" by Fortune Magazine.
b. Madoff Investment Securities LLC was a Wall Street investment
firm founded by Madoff. They had tricked investors out of $64.8
billion through the largest Ponzi scheme in history. The main
players were Bernie Madoff, his accountant, David Friehling, and
Frank DiPascalli. Investors were paid returns out of their own
money or that of other investors rather than from profits. Madoff
told his sons about his arrangement and they reported him to the
SEC. He was arrested the next day. That has resulted in 150 years
in prison for Madoff + $170 billion repayment and prison time for
Friehling and DiPascalli. Madoff's fraud was revealed just months
after the 2008 U.S. financial collapse.
c. In the Indian IT services and back-office accounting firm,
Founder/Chairman Ramalinga Raju boosted revenue by $1.5 billion.
They did it by fabricating revenues, margins and cash balances to
the tune of 50 billion rupees. They were caught by admitting the
fraud in a letter to the company's board of directors. Raju and his
brother charged with breach of trust, conspiracy, cheating and
falsification of records. They were released after the Central
Bureau of Investigation failed to file charges on time. In 2011,
Ramalinga Raju's wife published a book of his existentialist,
free-verse poetry.
III. Project Objective:The objective of this project is to: 1.
Examine the association between fraud in financial statements and
other variables: Employee salary, the economic situation of the
country, and rules and obligations of the organization through
conducting a survey and collecting opinions.2. Analyzing
manufacturing company financial statements in a certain area to
identify a margin of fraud that has occurred in their financial
statements.
IV. Research Methodology:The current research is an applied
research. Different types of qualitative methodologies will be used
in order to find out the causes, characteristics, the consequences
and the lessons learned from the fraud in the financial
statements.Data collection of the research depends on the
following: 1. Questionnaire.2. Professional Interview.3. Case
Study.The questionnaire is an important tool to understand and
collect different opinions from different cultures and environments
about fraud in financial statements and understand the impact of
fraud in other variables.
The professional interview will be very beneficial in order to
get in a direct contact with a professional who has been in a
company that committed a fraudulent act and understand his opinion
about fraud and how to prevent it.
The case study is one of the most important tools in this
project. It will show the margin of fraud in a financial statement
providing that the usage of financial statements analysis ratios is
necessary.
V. Limitations of the Study:The current research is limited to:
1. A technological manufacturing industry rather than service or
merchandising industries. That is because such industry has many
opportunities in its transactions to face fraud in its financial
statements. 2. Financial statements for years 2011, 2012, and 2013.
3. A South Korean company.
Chapter 2Literature Review1. Scott L. Summers and John T.
Sweeney Study (1998): Fraudulently misstated financial statements
and insider trading: an empirical analysis...In their abstract,
they stated, This study investigates the relationship between
insider trading and fraud. We find that in the presence of fraud,
insiders reduce their holdings of company stock through high levels
of selling activity as measured by either the number of
transactions, the number of shares sold, or the dollar amount of
shares sold. Moreover, we present evidence that a cascaded logit
model, incorporating insider trading variables and firm-specific
financial characteristics, differentiates companies with fraud from
companies without fraud.They also mentioned, The purpose of this
study was to analyze the relationship between financial statement
fraud and insider trading activity to determine whether auditors
could enhance financial statement fraud risk assessment by
including insider trading activity in their model. Using a matched
sample of fraud and no-fraud companies. They also stated, The
results of this study indicate that insider trading and financial
statement factors are useful in a model which distinguishes
companies where fraud is found from companies where fraud is not
found. This is a significant contribution to both auditors
attempting to detect fraud and to regulators monitoring insider
trading.At the end of their research, they stated the limitations
of the articles as they mentioned, There are a number of
limitations to this study. First, this study examines the
population of companies for which fraud was discovered after an
audit. Hence, two types of fraud are not included in the fraud
sample: undiscovered fraud and fraud discovered during the audit.
Second, this study may have a newsworthiness bias Third; this study
did not use a hold out sample to validate the models that are
presented. Further research with larger samples will be necessary
to validate these results. Finally. This study is limited in that
it does not address finer classifications of fraud. Turner (1980)
proposes classification of management fraud into four classes,
according to whether the distortion of the financial statements is
the vehicle for the fraud or a disguise of the fraud. In addition,
according to who benefits from the fraud: the company or the
perpetrator? Our model does not assess the likelihood of a
particular class of fraud.
2. Charalambos T. Spathis (2002): Detecting false financial
statements using published data: some evidence from Greece He
stated that This paper examines published data to develop a model
for detecting factors associated with false financial statements
(FFS) Most false financial statements in Greece can be identified
on the basis of the quantity and content of the qualifications in
the reports filed by the auditors on the accounts. A sample of 76
firms includes 38 with FFS and38 non-FFS. Ten financial variables
are selected for examination as potential predictors of FFS.
Univariate and multivariate statistical techniques such as logistic
regression are used to develop a model to identify factors
associated with FFS. The model is accurate in classifying the total
sample correctly with accuracy rates exceeding 84 per cent. The
results therefore demonstrate that the models function effectively
in detecting FFS and could be of assistance to auditors, both
internal and external, to taxation and other state authorities and
to the banking system.In the introduction of his paper, he
concluded by defining and explaining FFS, as References to false
financial statement (FFS) are increasingly frequent over the last
few years Falsifying financial statements primarily consists of
manipulating elements by overstating assets, sales and profit, or
understating liabilities, expenses, or losses.The data used in this
research is extracted from Books, newspapers and financial reports
from firms.Worth mentioning this is an applied research because he
used financial statement ratios analysis to apply FFS.
3. Niamh Brennan and Mary McGareth (2007): Financial statement
fraud: some lessons from US and European case studies. They stated
that '' This paper studies 14 companies, which were subject to an
official investigation arising from the publication of fraudulent
financial statements. The research found senior management to be
responsible for most fraud. Recording false sales was the most
common method of financial statement fraud. Meeting external
forecasts emerged as the primary motivation. Management discovered
most fraud, although the discovery was split between incumbent and
new management''.Fourteen companies are analyzed in the research
nine US and five European. The nine US companies were selected
following a search of the SECs Accounting and Auditing Enforcement
Releases (AAER) relating to violations of Rule 10-b of the
Securities and Exchange Act 1934 and Section 17(a) of the
Securities Act 1933.These are the main rules relating to financial
statement fraud. The AAER are available on-line at www.sec.gov.The
European cases are UK companies with the exception of Lernout and
Hauspie (L&H), a Belgian company. The main source for the
European cases was the financial press. The SFO website,
www.sfo.gov.uk, provided a summary of the results of successfully
prosecuted cases.The approach to assessing the case studies is that
suggested by Ryan et al (1992).Cases were deemed suitable for
inclusion in the research where information about methods and
motives was on the public record and where persons involved in the
fraud had been publicly identified. The main source was documented
evidence from SEC and SFO reports. Secondary evidence such as
newspaper reports and articles was also used.
4. Alfred Bridi reviewed by Robin Hodess 2010):Corruption in tax
administration and its effect on financial statements. The draft
project document does not fully integrate and analyze aspects
related to anti-corruption and how aspects related to
anti-corruption could be included in the different activities
proposed in the project and/or in the risk assessment. The main
components included in the project are (1) taxpayer services (2)
tax audit (3) efficiency in management (4) tax statistics.He stated
that in his summary '' Revenue administration is often ranked as
one of the poorest performing public sectors in terms of corruption
and, as Transparency Internationals latest Global Corruption
Barometer (TI 2009) illustrate, corruption continues to affect the
sector in 2009. This sector is very important to a states
development and economic health as it significantly affects its
capacity to spend on public projects and programs, thus making
problems of inefficiency and revenue leaking especially damaging.
Corruption in tax administration also dissuades honest taxpayers by
rendering them less competitive and making the black-market a more
attractive alternative. Tax administration is an attractive sector
for corruption to take place as the opportunities and incentives to
engage in illicit activity are numerous. The complexity of tax
laws, the high discretionary powers of tax officials, the low cost
of punishment are only some factors creating opportunities for
corruption in revenue administration''The author used the
qualitative method in this research, which is used to reveal a
target audiences range of behavior and the perceptions that drive
it with reference to specific topics or issues (tax corruption).The
author got most of his data from the internet and from several
books and by reviewing many on fraud financial statements.He used
many of samples as a case study for him; the Mexican experience,
The Bulgarian experience, The Tanzanian experience and The Bolivian
experience.
5. Javiriyah Ashraf (2011): The Accounting Fraud @ WorldCom: The
Causes, The Characteristics, The Consequences, and The Lessons
LearnedHe stated that '' The economic prosperity of the late 1990s
was characterized by a perceived expansive growth that increased
the expectations of a company's performance. WorldCom, a
telecommunications company, was a victim of these expectations that
led to the evolution of a fraud designed to deceive the public
until the economic outlook improved. Through understanding what led
to the fraud, how the fraud grew, and what its effects were,
lessons can be derived to gain a better understanding of the
reasons behind a fraud and to prevent future frauds from occurring
or growing as big as the WorldCom fraud did''.This is a web based
research by using the applied method which he made not for just be
an informative research but to find out the causes ,
characteristics, the consequences and the lessons learned from the
fraud in the financial statements.The author also used the case
study analysis as purpose of the study involves in depth,
contextual analysis about WorldCom as it was provider of long
distance phone services to businesses and residents. It started as
a small company known as Long Distance Discount Services (LDDS)
that grew to become the third largest telecommunications company in
the United States.As was mentioned before the source of his
collected data was from the internet and by reviewing some of the
company financial statements reports. Gene Morse, the internal
auditor at WorldCom when all this happened, for his internal
insight into the case, which was a face-to-face interview.
6. Mariana vlad, Mihaela tulvinschi and Irina Chirita (2011):
The consequences of fraudulent financial reportingThey stated,
Financial reporting frauds are a serious threat for the investors
confidence in the financial information. The side effects of the
financial frauds are affecting the integrity, quality and
confidence in published financial reporting. Criminals who carry
out such fraud, from management to employees, must understand that
the interference of records is a crime that will be judged.
Qualitative financial reporting, including reliable financial
statements without mistakes, can be made when there is well-planned
corporate governance. Although participants in corporate governance
responsibilities vary depending on their level of preparation and
on the presentation form of financial reporting, a well-defined
working relationship among these participants should reduce the
probability of financial fraud.After conducting their research they
concluded by saying that Although the achievement of financial
reporting by so-called "fraudulent scheme" refers to short-term
achievement of "management earnings ", they may draw the following
consequences in time: undermines the credibility, quality,
transparency and integrity of financial reporting process;
endangers the integrity and objectivity of the auditing profession,
especially auditors and audit firms; diminishes the confidence in
the capital markets, as well as in market participants and in the
reliability of financial information; makes capital markets less
efficient; adversely affects economic growth; huge lawsuit costs;
destroys the careers of people involved in fraudulent financial
statements; they cause bankruptcy or substantial economic losses
for companies involved in financial statement fraud; encourages
regulatory intervention; erodes public confidence and trust in
accounting and auditing profession.
7. Ovidia Doinea and Gheorghe Lapadat (2012): Deterring
Financial Reporting Fraud .They stated that The mainstay of the
paper is formed by an analysis of the relationship between the
importance of RPTs in auditing and in detecting fraud, the
widespread adoption of Web-based financial and business reporting,
the risk of fair value accounting fraud, the process of detecting
fraud, and opportunities for fraudulent financial reporting based
on misapplication of fair value accounting concepts. This research
makes conceptual and methodological contributions to the role of
the external auditor in detecting and deterring fraudulent or
misleading financial reporting, increased globalization of
financial and product markets, the pervasiveness of technology
within the corporate financial data transmission structure, and
managements involvement in the fraudulent financial reporting
activity.They Concluded by saying that This paper seeks to fill a
gap in the current literature by examining different aspects of the
relationship RPTs conditional on the existence of fraud, the
importance of accurate and credible financial reporting, the
prevention or executive of fraudulent financial reporting, the
flexibility of the Web as a medium for corporate disclosure, and
the risk of financial reporting fraud. Our paper contributes to the
literature by providing evidence on top managements ability to
override internal controls, the content and presentation attributes
of Web-based financial information, the likelihood of fraudulent
financial reporting, industry as a potential inherent risk
indicator in a financial statement audit, and properties of
reported financial information.
8. Rajan Jupta and Nasib Singh Gill (2012): "Financial statement
fraud detection using text mining". They stated that Data mining
techniques have been used enormously by the researchers community
in detecting financial statement fraud. Most of the research in
this direction has used the numbers (quantitative information) i.e.
financial ratios present in the financial statements for detecting
fraud. There is very little or no research on the analysis of text
such as auditors comments or notes present in published reports. In
this study we propose a text mining approach for detecting
financial statement fraud by analyzing the hidden clues in the
qualitative information (text) present in financial
statements".They presented a text mining approach for detection of
financial statement fraud. Fraud detection model presented in their
paper begins with collection of financial statements for both fraud
and non-fraud organizations followed by preprocessing which
involves lexical analysis of text present in financial statements.
At the next step, bag of words approach has been selected for
extracting information hidden in the text that results in vector
spaces for both fraudulent and non-fraudulent organizations.They
stated, Companies may present a rosy picture to the investors by
manipulating the financial measurements and qualitative narratives
of financial statements. These disclosures (qualitative narratives)
may not contain fraud indicators explicitly; however, indicators of
fraud can be constructed by understanding the syntactic as well as
semantics of any natural language because perpetrators of fraud may
camouflage the indicators by using semantic arsenal of the
language. Therefore, in order to detect fraud, it is necessary to
examine the qualitative disclosures in the footnotes in the
financial statements, as well as the numbers (quantitative
information) associated with financial statements.
9. Anuj Sharma and Prabin Kumar Panigrahi (2012): A Review of
Financial Accounting Fraud Detection based on Data Mining
Techniques. They stated that With an upsurge in financial
accounting fraud in the current economic scenario experienced,
financial accounting fraud detection (FAFD) has become an emerging
topic of great importance for academic, research and industries.
The failure of internal auditing system of the organization in
identifying the accounting frauds has led to use of specialized
procedures to detect financial accounting fraud, collective known
as forensic accounting. Data mining techniques are providing great
aid in financial accounting fraud detection, since dealing with the
large data volumes and complexities of financial data are big
challenges for forensic accounting. This paper presents a
comprehensive review of the literature on the application of data
mining techniques for the detection of financial accounting fraud
and proposes a framework for data mining techniques based
accounting fraud detection. The systematic and comprehensive
literature review of the data mining techniques applicable to
financial accounting fraud detection may provide a foundation to
future research in this field. The findings of this review show
that data mining techniques like logistic models, neural networks,
Bayesian belief network, and decision trees have been applied most
extensively to provide primary solutions to the problems inherent
in the detection and classification of fraudulent data.
10. Rajan Jupta and Nasib Singh Gill (2012): A Data Mining
Framework for Prevention and Detection of Financial Statement Fraud
.They stated that Financial statement fraud has reached the
epidemic proportion globally. Recently, financial statement fraud
has dominated the corporate news-causing debacle at number of
companies worldwide. In the wake of failure of many organizations,
there is a dire need of prevention and detection of financial
statement fraud. Prevention of financial statement fraud is a
measure to stop its occurrence initially whereas detection means
the identification of such fraud as soon as possible. Fraud
detection is required only if prevention has failed. Therefore, a
continuous fraud detection mechanism should be in place because
management may be unaware about the failure of prevention
mechanism. In this paper we propose a data mining framework for
prevention and detection of financial statement fraud.They assumed
the framework to conduct their research as collecting data from
financial statements about a certain financial ratios 62 financial
ratios.They also reprocessed data through data reprocessing
techniques including normalization of the input variables and
resolving inconsistencies in the dataset, now data are ready to be
mined.
11. Rajan Jupta and Nasib Singh Gil (2012): A Solution for
Preventing Fraudulent Financial Reporting using Descriptive Data
Mining Techniques.They stated that In the present age of scams,
financial statement fraud represents enormous cost to our economy.
The deliberate misstatement of numbers in the accounting books with
the help of well-planned scheme by an intelligent squad of
knowledgeable perpetrators in order to deceive the capital market
participants is termed as financial statement fraud. In order to
reduce fraud risk which comprehends both detection and prevention
of financial statement fraud, this paper implements descriptive
data mining techniques such as Association rules and clustering as
opposed to predictive data mining techniques used in the
literature. Each of these techniques is applied on dataset obtained
from financial statements namely balance sheet, income statement
and cash flow statement of 114 companies.They collected data about
the 114 companies in their research coming from www.wikinvest.com
In order to identify companies accused of financial statement
fraud, Accounting and Auditing Enforcement Releases published by
S.E.C. (U.S. Securities and Exchange Commission) between 2007 and
2012, they also have removed all incidents of violation of the
Foreign Corrupt Practices Act (FCPA) from their sample because FCPA
prohibits the practice of bribing foreign officials and most of the
AAERs issued because of FCPA do not reflect which financial
statement, balance sheet or income statement, is affected.They also
identified 29 fraudulent organizations by analyzing AAERs. Out of
these 114 firms, 85 firms have not reported their financial
statements fraudulently, however, absence of any proof does not
guarantee that these firms have not falsified their financial
statements or will not do the same in future. In order to identify
organizations with probability of fraud.
12. Holger Rootzn (2012): The Enron Scandal.He stated that From
the 1990's until the fall of 2001, Enron was famous throughout the
business world and was known as an innovator, technology
powerhouse, and a corporation with no fear. The sudden fall of
Enron in the end of 2001 shattered not just the business world but
also the lives of their employees and the people who believed that
their soar to greatness was genuine. Their collapse was followed by
a series of revelations on how they manipulated their
success.Showing up some recommendations such as Incentives must be
paid after a project is done or at least when the company is really
profiting from that certain project, Operational Risk should be
minimized and there should be some sort of checkup, Careful
selection of accounting approach and financial structures to use,
Minimized payment in stocks.
13. Hawariah Dalnial, Amrizah Kamaluddin, Zuraidah Mohd Sanusi,
and Khairun Syafiza Khairuddin (2014): Detecting Fraudulent
Financial Reporting through Financial Statement Analysis.They
stated that Fraudulent financial reporting is a major concern for
two primary regulators of Malaysias capital market - the Securities
Commission (SC) and Bursa Malaysia. Both authorities continue to
refine the parameters that will ensure rigorous surveillance over
public listed firms. The objective of current study is to examine
the association between financial statement analysis and fraudulent
financial reporting. Many researchers found indication of financial
ratios to detect fraudulent financial reporting but others also
have concluded otherwise. Most of these studies were conducted
outside of Malaysia. The sample comprises of the Malaysian Public
Listed firms and data used ranged between year 2000 to 2011. The
result indicated that several financial ratios such as total debt
to total asset, and receivables to revenue were found to be
significant predictors to detect fraudulent financial reporting.
This reflects that, financial ratios maybe helpful in the detection
of fraudulent financial reporting. These findings add to the extant
literature on the ability of financial ratios to detecting fraud.In
their study, they used a sample method as they stated, This study
examined 130 samples consisting of 65 samples for fraudulent firms
and 65 samples of non-fraudulent firms from the Malaysian Public
Listed Firms available between the years 2000 and 2011 with
financial data collected from DataStream. Moreover, they used a
selection of fraudulent financial reporting firms as stated, Firms
involving in fraudulent reporting are obtained from the Bursa
Malaysia media center. This list summarizes firms according to the
offences made against the Listing Requirements of Bursa Malaysia
Securities Berhad, most of which were reporting material
misstatements in the financial reports. This assessment resulted in
91 preliminary sample firms.
14. Anita R. Morgan and Cori Burnside (2014): Olympus
Corporation Financial Statement Fraud Case Study: The Role That
National Culture Plays On Detecting And Deterring Fraud.They stated
that Recent cases provide insight into the role that an unethical
corporate culture plays in financial statement fraud. The case of
financial statement fraud in Olympus Corporation, a Japanese firm,
provides the opportunity to examine how national culture plays a
role in corporate governance and fraud detection. This case study
focuses on the impact of Japanese culture on the corporate culture
of The Olympus Corporation, and how that corporate culture resulted
in financial statement fraud.
Chapter 3Reasons and Effects of Fraud in Financial
Statements
I. Types of financial statement frauds and technical
solutions:There are three types of the businesses fraud;
corruption, asset misappropriation, and financial statements fraud.
Corruption means dishonest behavior by those in positions of power,
such as managers or government officials. Corruption can include
giving or accepting bribes or inappropriate gifts, double dealing,
under-the-table transactions, manipulating elections, diverting
funds, laundering money and defrauding investors. Asset
misappropriation involves third parties or employees abusing their
position to steal from an organization through fraudulent activity.
Finally the financial statements fraud, which will be discussed in
the current study. It means intentional misrepresentation,
misstatement or oversight of financial statement in order to
mislead the reader and to create a wrong impression of an
organization's financial position.
Public and private businesses do financial statement fraud in
order to secure investor interest or obtain bank agreements for
financing, as good reason for bonuses or increased wages and
salaries or to meet expectations of the owners. Top management is
usually the responsible of financial statement fraud because
financial statements are made at the management level. The
financial statement fraud will be divided into two types;
overstatements and understatements according to the following
diagram:
1. The over statements means that recording the assets and the
revenues of the company more than its main value in order to show
that the company is gaining profits to raise the price of its
stocks in the stock market. As an example if an asset is
overstated, the balance sheet shows assets as higher as they should
be. For example, a bank might value a mortgage-backed security at
$1M when it properly should be evaluated at $750K. There are also
many types of the over statements including timing differences,
fictitious revenues, cancelled liabilities and expenses, improper
asset valuation and improper disclosures.
Everette Colby stated that "Financial statement fraud can take
many different forms, but there are several methods that are
considered most common. These include fictitious revenues, timing
differences, concealed liabilities or expenses, improper disclosure
of related-party transactions, and improper asset valuations. From
an accounting perspective, revenues, profits, or assets are
typically overstated Overstating revenues, profits, or assets
reflects a financially stronger company".2. Fictitious revenues
mean that recording sales that did not happen in real. Colby stated
that '' fictitious revenues involves the creation or manipulation
of transactions to enhance the organizations reported earnings.
Fabricating revenue typically involves creating fake or phantom
customers and sales. Artificial sales can also involve legitimate
customers by creating phony invoices or increasing quantities or
prices''.
Fictitious revenues could be done by making many of fake
customers' accounts in the company system, which deceives any
auditor by thinking that this company has many customers so it
makes big revenues. Actually the purpose of this type of fraud is
to have a big number of the net income in order to raise the
company stock market shares. Another reason for the top management
they do the fictitious revenue in order to prove that for the
business owners that they are performing well so they keep their
position. For the person who is concerned about the matter he
should compare the sales invoices with the real one to be sure that
everything is okay.
Colby also mentioned that '' there are several questions should
the examiner ask himself such as: Can sales be confirmed with the
customers? Were invoices at year end unusually high? Were there any
sales to related parties in the last quarter? Related-party
transactions are much more prone to manipulation. Have any
documents been altered or forgeted and are they originals or
photocopies? If management has created fictitious sales, they
usually have to create phony documents (type of business papers
which are fabricated to proof a kind of a fraud as it is real) to
support those sales or alter legitimate documents to reflect the
increased sales amount''.
We should also examine the latest transactions and adjustments
because they have a big potential possibility of manipulation.
Making gross margin ratio analysis (a profitability ratio that
compares the gross margin of a business to the net sales, gross
margin ratio = gross margin / net sales) will help also to prevent
the fictitious revenues. Colby says that this ratio will often be
out of line with other periods if this is the first year fictitious
revenues were created. One of the most known cases of fictitious
revenues is Cendant Corp.
Jamal Ahmad, David Jansen and Jonny J. Frank stated that ''
Created $35 million in inappropriate restructuring reserves in 1996
that were reversed in 1997 to inflate income thus creating the
illusion of a rapid turnaround. In 1997, reported over $70 million
of revenue from bill and hold sales, channel stuffing and other
inappropriate accounting practices. That's resulted in restating
1997 income from $109 million to $38 million. CEO charged with
violating federal securities laws by misrepresenting material
information about the company. CEO settled by paying a piece of a
$141 million fine. Former controller and chief accounting officer
each agreed to pay $100,000 in fines. Former Arthur Anderson
partner also settled for undisclosed amount''.
3. Timing differences, (overstatement) is another way of
creating overstatement revenues. It involves the recording of
revenue and/or expenses in the wrong period. Recording revenue
early, before it is made, will immediately increase the enterprises
income using lawful sales, rather than making fake sales. The top
management has several methods for using the time differences
method to capitalize the revenue.
Colby also stated that '' Recording expenses in the wrong period
is another way of increasing the organizations income. Expenses
would typically be capitalized or recorded in the subsequent period
so the effects are not taken into account on the income statement.
Depreciating or amortizing assets too slowly is another method of
delaying expense recognition". There are many methods to stop the
timing differences fraud, one of them is to examine if the invoices
are made in the true period or not. Examine the real time of
purchases from the suppliers and the real time of selling from the
clients. Examine the organizations capitalization policies. Examine
changes in depreciable assets lives. Re-compute the depreciation
and amortization for all assets. One of the most known cases of
timing differences is Xerox company which Overstated revenue for
over 4 years by accelerating the recognition of $3 billion in
revenue and inflating earnings by about $1.5 billion. That's
resulted in Co. agreed to pay $10 million in fines and restate its
income for the years 1997-2000.
4. Concealed liabilities or expenses are made in order show that
company has a big net profit and a stable financial position
condition. Colby mentioned that '' Users of financial statements
tend to look unfavorably at companies with significant amounts of
debt. When liabilities or expenses are concealed, the companys
equity, assets, and/or net earnings are inflated. Understating
liabilities involves not recording accounts payable or accrued
liabilities, recording unearned revenues as earned, not recording
warranty or service liabilities, not recording loans or keeping
liabilities off the books, and not recording contingent liabilities
".
In order to discover the concealed liabilities or expenses the
auditor should examine the all liabilities and record the
unrecorded liabilities by using the cut-off method including
vendors invoices, receiving documents, and cash disbursements to
know if these liabilities are recorded or not. Using the current
ratio is also so helpful to detect the concealed liabilities or
expenses (liquidity ratio that measures a company's ability to pay
short-term liabilities, current ratio = current assets / current
liabilities). If it is unordinary has high volume, it may be a sign
of hidden liabilities.
In July 2002, the SEC filed suit against the Rigas family.
Founders of Adelphia Communications, the suit alleged that between
mid-1999 and the end of 2001, Adelphia fraudulently excluded from
the Companys annual and quarterly consolidated financial statements
over $2.3 billion in bank debt by deliberately shifting those
liabilities onto the books of Adelphias off-balance sheet,
unconsolidated affiliates. Failure to record this debt violated
GAAP requirements and laid the foundation for a series of
misrepresentations about those liabilities, including the creation
of: (1) sham transactions backed by fictitious documents to give
the false appearance that Adelphia had actually repaid debts when,
in truth, it had simply shifted them to unconsolidated
Rigas-controlled entities, and (2) misleading financial statements
by giving the false impression through the use of footnotes that
liabilities listed in the Companys financials included all
outstanding bank debt.
5. Improper disclosure is actually based on not real presenting
of the company and making wrong representations in documents and
other company filings. Making wrong information in the attachment
sections of annual reports of other filings are another purpose for
improper disclosures. Many of wrong disclosures are intentionally
made by top management and other improper disclosures are just
errors and don't have prior intention to be made with illogical
reasons. Examples of improper disclosure would include liability
omissions, failure to disclose loan covenants, loan defaults or
contingent liabilities, significant events; related-party
transactions (include inflating inventory by purchasing from an
affiliate at a price that is higher than market. Companies can also
transfer liabilities to a related affiliate. Some of the methods to
detect improper related-party transactions are to examine minutes
of the board meetings), and changes in accounting policy
methods.
6. Improper asset valuation (overstatement) simply it is
maximizing the assets in the balance sheet of a company. The
enterprises are usually use assets to pay their debts and their
expenses that they are actually valued as inventory, accounts
receivable, and fixed assets.
7. Manipulating in inventories is a well-known improper asset
valuation.
Colby said that '' Inventory is also typically dispensed from
several locations and is normally comprised of a large number of
items. This makes it easier to create improper estimates for
obsolete or slow-moving goods, to manipulate physical inventory
counts, to create fictitious inventory, to fail to record the
purchase of inventory, and for improper inventory capitalization
''.
Detecting inventory fraud needs the auditor to be more
experienced. He can detect it by using several methods, Identify
changes in organization operations that might have led to the
neglected or slow-moving inventory. Watch the inventory itself.
Examine the inventory detail in purchase and other inventory
papers. Inventory turnover ratio (A ratio showing how many times a
company's inventory is sold and replaced over a period, inventory
turnover = sales / inventory) analysis to determine if the results
are what is expected. Any variances should be followed up for
explanation. One of the most noticeable red flags of unrecorded
inventory is that the cost of goods sold is too low in relation to
recorded revenues. This can be detected by using gross margin ratio
analysis. The gross margin will typically be too high. Search for
unrecorded liabilities that relate to inventory purchases and
perform tracing from physical inventory count to inventory
records.
8. Accounts receivable are typically falsified or manipulated in
the same manner as revenue and inventory. MR Cobles says that
accounts receivable fraud includes fabricated receivables and the
failure to write off accounts receivable for bad debts. Accounts
receivable are also prone to manipulation as a result of fraudulent
revenue schemes because the fraudster will often create fictitious
accounts receivable when creating fictitious revenues. Methods for
detecting fictitious accounts receivable are to examine the
accounts receivable aging report compare the yearend balance with
the rest of the year and the previous month for unusual changes.
Examine unusual sales and adjustments as well as subsequent period
credit memos. Examine previous write-offs. Confirm accounts
receivable with the purchasers. Calculate the accounts receivable
turnover ratio (An accounting measure used to quantify a firm's
effectiveness in extending credit as well as collecting debts,
accounts receivable turnover = net credit sales / average accounts
receivable ) . A slow turnover rate would be indicative of amounts
that are uncollectible.
9. Fixed assets improper: valuation of fixed assets can occur in
several ways. These include booking fictitious fixed assets,
misrepresenting the asset value, improper capitalization, or the
misclassification of assets.
Colby stated that '' The most common offset account when booking
fictitious assets is owners equity. Land and building flips between
related parties are often used to increase the value of the assets.
Misclassification or the improper capitalization of fixed assets
occurs when non- asset items are included in the fixed asset
total''. Detecting the improper valuation of fixed assets can be
accomplished using several techniques. You can see the
documentation supporting the asset having, examine the title of
assets, examine appraisers reports on value, trace assets on the
floor to those in the books, and compute the current ratio since
misclassification is typically done to improve current ratio. As an
example for improper asset valuation In August 2002, it was
revealed that the rot at WorldCom went even deeper than previously
thought. The company reported that an internal audit had discovered
that US$3.3 billion in profits were improperly recorded on its
books from 1999 to the first quarter of 2002. That was in addition
to the US$3.8 billion in expenses that had been improperly reported
as capital investments in 2001.
10. The second type of the accounting fraud is the
understatements means that recording the assets and the revenues of
the company less than its main value in order to minimize the taxes
which the company pay to the government. The IRS has detected the
fraudulent activities that companies stating that underreporting or
omitting income, Overstating the amount of deductions, Keeping two
sets of books, Making false entries in books and records, Claiming
personal expenses as business expenses, Claiming false deductions
and Hiding or transferring assets or income are considered as
criminal activities in violations of tax low. As an example if an
asset is understated, the balance sheet shows assets as lower as
they should be. For example - a bank might value a mortgage-backed
security at $750K when it properly should be evaluated at $1M.
There are also many types of the understatements including timing
differences, understated revenues, overstated liabilities and
expenses, improper asset valuation.11. Understated revenues mean
that lowering the revenues of the company in order to reduce their
tax liability or keep some money for the bad performance years that
expected to happen in the future which is known as cookie-jar
accounting.Arthur Pinkasovitch stated that '' cookie-jar accounting
is disingenuous accounting practice in which periods of good
financial results are used to create reserves that shore up profits
in lean years. A company to smooth out volatility in its financial
results, thus giving investors the misleading impression that it is
consistently meeting earnings targets, uses Cookie jar accounting.
Investors, who assign the company a premium valuation, generally
reward this reliable earnings performance. Regulators frown on the
practice since it misrepresents a companys performance, which may
be very different in reality from what it purports to be''
One of the best-known cases of cookie jar accounting in recent
years was that of computer giant Dell, which in July 2010 agreed to
pay a $100 million penalty to the Securities and Exchange
Commission (SEC) to settle SEC allegations that it used cookie jar
reserves. The SEC maintained that Dell would have missed analysts
earnings estimates in every quarter between 2002 and 2006 had it
not dipped into these reserves to cover shortfalls in its operating
results. The cookie jar reserves were created through undisclosed
payments that Dell received from chip giant Intel in return for
agreeing to use Intels CPU chips exclusively in its computers.
(Intel made these payments to Dell to lock out rival chipmaker
Advanced Micro Devices from Dell computers.). For the person who is
concerned about the matter he should compare the sales invoices
with the real one to be sure that everything is okay.
12. Timing differences (understatement), Expenses would
typically be capitalized or recorded in the subsequent period so
the effects are not taken into account on the income statement. If
the objective is to decrease income to minimize the organizations
taxes payable, it might accelerate expenses into the current
period. This could involve increasing the rate of depreciation or
amortization on assets. It can also include expensing capital
expenditures. There are many methods to stop the timing differences
fraud, one of them is to examine if the invoices are made in the
true period or not. Examine the real time of purchases from the
suppliers and the real time of selling from the clients. Examine
the organizations capitalization policies.
13. Overstated liabilities and expenses the flusters use this
method by maximizing the liabilities and expenses in order to do
the tax evasion (Tax evasion is the illegal act of not paying the
taxes that you owe, Tax evasion carries stiff penalties in
practically every country in the world. In many countries, tax
evasion will result in prison time and/or stiff penalties) so at
the end of the day the company has a low net profit in its income
statement. In addition, the Australian Taxation office stated, Tax
evasion generally occurs when companies don't report all of their
income, or they overstate their deductions. Companies do this to
reduce the amount of tax they need to pay to gain a personal
benefit''. . In order to discover the understated liabilities or
expenses the auditor should examine the all liabilities and
unrecorded the recorded liabilities. Using the current ratio is
also so helpful to detect the understated liabilities or expenses.
If it is unordinary has low volume, it may be a sign of capitalized
liabilities.
14. Improper asset valuation (understatement) simply it is
minimizing the assets in the balance sheet of a company to pay low
taxes. As we said before any type of lowering the taxes is called
tax evasion, which is illegal act arises when companies whether
overstating their expenses and underestimating their assets to gain
personal benefit that is faced by governments through penalties
that might lead to prison or paying high damages. As a result of
the assets could be converted to cash, lowering it would low the
cash also. This could be done by minimizing the number of its
inventories, receivables and fixed asset values.
15. Detecting inventory fraud needs the auditor to be more
experienced. He can detect it by using several methods, Identify
changes in organization operations that might have led to the
capitalized or fast-moving inventory. Watch the inventory itself.
Examine the inventory detail in purchase and other inventory
papers. Auditors should do inventory turnover r ratio analysis to
determine if the results are what is expected. Any unexpected high
amounts should be followed up for explanation. About the
receivables they should examine unusual sales and adjustments as
well as subsequent period credit memos. Confirm accounts receivable
with the purchasers. Calculate the accounts receivable turnover
ratio. A fast turnover rate would be indicative of amounts that are
highly collectible.
16. Detecting the improper valuation of fixed assets can be
accomplished using several techniques. You can see the
documentation supporting the asset having, examine the title of
assets, examine appraisers reports on value, trace assets on the
floor to those in the books, and compute the current ratio since
misclassification is typically done to decrease current ratio.
II. The role of government to reduce tax fraud:Governments
should act together to stop the immoral tax evasion done by
taxpayer in different jurisdictions in the world, so we decided to
give different solutions to minimize tax evasion and also that will
not affect the profitability of governments and will be sensibly
with the taxpayer not to make tax fraud in order to evade taxes and
here are some recommendations:
1. Government should require companies and individuals to
provide transparent country-by-country accounts. In addition, the
accounting and tax deduction for the assessment and validity of
charges would be strict sharing of national sales and actual
costs.2. Government should automate information exchanges with
other countries.3. Government should Change the strict culture.
Leaders and government should be taking vital action. Not paying
proper taxes and reconciling avoidance should cause explicit
censure and sanctions.
III. Famous Tax Evaders:Daniel Bukszpan prepared a short list
for famous celebrities who evaded taxes. This list includes::
1. Wesley Snipes: He failed to file tax returns between 1999 and
2006, and prosecutors claimed that during those years, $38 million
worth of income had gone unreported. Snipes justified the
nonpayment in a 2006 statement in which he claimed he was a
nonresident foreign of the United States. In reality, he was born
in Florida. He also stated the U.S. government had "no legal
authority to impose any kind of criminal sanctions" and that he had
no income for the U.S. government to legitimately tax. The courts
did not see it that way, and on Feb. 1, 2008, he was convicted of
three crime charges of failure to file income tax returns.
2. Richard Hatch: In September 2005, IRS accused him on charges
of failing to report the money he had won in his 2000 tax return.
The accusation was not only listed his unreported revenues but also
unreported money from rental properties he owned, the car he won on
a show and false statements that he had knowingly given about all
of the above. In 2006, he was found guilty of tax evasion and
sentenced to 51 months in prison.3. Leona Helmsley: Leona Helmsley
and her husband, Harry, were New York real estate tycoons whose
huge hotel empire included the Helmsley Palace on Madison Avenue in
Manhattan. They had their Connecticut mansion; five years later,
they were accused on charges of evading $4 million in income taxes
for fraudulently billing work on the mansion to their hotels as
business expenses. Leona Helmsley was finally convicted of evading
$1.2 million worth of federal income taxes. Her husband was found
not mentally competent to stand trial. They both have since died.4.
Pete Rose: In 1990, Rose was sentenced to five months in prison and
fined $50,000 for tax evasion, according to The Associated Press.
He had failed to report more than $350,000 of income from autograph
signings, sales of souvenirs and even the gambling that had cost
him his career5. Kwame Kilpatrick: The youngest person ever elected
mayor of DetroitKilpatricks durationwas famous for its many
scandals and corruption claims, according to The New York TimesThe
former mayor had created a charitable organization that received
tax-exempt status, but authorities accused him of using the fund to
pay for personal expenses, political consulting, On June 23, 2010,
Kilpatrick was accused on multiple federal charges, including
filing false tax returns. Each of the five tax amounts carried a
possible sentence of five years and a $250,000 fine. The former
mayor has arguednot guilty, and his case goes to trial in September
2012.6. Willie Nelson: In 1990, the IRS had served Nelson with a
bill for $32 million in back taxes, one of the largest ever
presented to an individual, because his accounting firm,
PriceWaterhouse, had put his money into tax shelters of suspicious
validity instead. The singer settled his debt with the IRS in
1993.
IV. Reasons of Financial Statement Fraud:There are many reasons
leads to the financial statements frauds including many indicators.
Fraud triangle, human greed, lack of transparency, company culture,
lack of the internal controls and the Non-independent internal
audit department are the most common reasons for the financial
statement fraud.
Fraud triangle is a model for knowing the indicators that cause
someone to do intentional fraud it is originated from Donald
Cressey's hypothesis in 1973. It consists of three main important
components, which, together, lead to fraudulent behavior. According
to Romney & Steinbart (2008), three conditions exist in the
occurrence of fraud: pressure, opportunity, and rationalization.
Albrecht & Albrecht (2004) state that auditors focus more on
the elimination of opportunity by ensuring strong internal
controls, however, they often fail to focus on the motivation or
rationalization of the perpetrators.
1. Rationalization is a crucial component in most frauds.
Rationalization involves a person reconciling his/her behavior
(stealing) with the commonly accepted notions of decency and trust.
Some common rationalizations for committing fraud are:a. The person
believes committing fraud is justified to save a family member or
loved oneb. The person believes they will lose everything family,
home, car, etc. if they do not take the Money; the person believes
that no help is available from outside.c. The person labels the
theft as borrowing, and fully intends to pay the stolen money back
at some point; the person, because of job dissatisfaction
(salaries, job environment, treatment by managers Believes that
something is owed to him/her).d. The person is unable to understand
or does not care about the consequence of their actions or of the
accepted notions of decency and trust are also one of them.
2. Pressure or motivation is what makes a person to commit
fraud. Pressure can include almost everything or anything including
medical bills, expensive tastes, addiction problems, etc. always
and most of the time; pressure comes from a significant financial
need/problem. Often this need/problem is non-sharable in the eyes
of the fraudster. That is, the person believes, for whatever
reason, that their obstacle must be solved in secret. However, some
frauds are committed simply out of greed alone.
Denise R. Tessier, regarding the fraud triangle theory, stated
that '' Motivation or pressure is the second angle in examining
what is driving the individual to commit the act. Just as with
rationalization, the perception of a need or a pressure is the key
factor, and it does not matter whether or not the motivation makes
sense to others or is based in reality. Individuals may be facing
financial or other personal problems such as gambling, drugs,
alcohol addiction, or extreme medical bills. Pure greed also can
factor into the equation but may be flavored with a sense of
injustice. For example, the perpetrator may feel like the company
should have paid me what my car was worth.
3. Opportunity is the ability to commit fraud. Because
fraudsters do not wish to be caught, they must also believe that
their activities will not be detected. Opportunity is created by
weak internal controls, poor management oversight, and/or through
use of ones position and authority. Failure to establish adequate
procedures to detect fraudulent activity also increases the
opportunities fraud for to occur. Of the three elements,
opportunity is the leg that organizations have the most control
over. It is essential that organizations build processes,
procedures and controls that do not needlessly put employees in a
position to commit fraud and that effectively detect fraudulent
activity if it occurs.
Denise R. Tessier also said that "Finally, fraudsters must find
an opportunity. This is defined as an environment or temporary
circumstance that allows the fraud to be committed, typically with
little perceived chance of being caught or penalized. Windows of
opportunity exist for wrongdoing when companies have poor internal
controls, weak processes and procedures, unauthorized or unchecked
access to assets by employees, or a lack of management review and
oversight.''
The second indicator of the financial statement fraud is the
human greed and arrogance. Human greed is excellent old-fashioned
human nature have hand when an individual, or group of individuals,
sees an opportunity to make a fast buck. A wonderful example being
those cases where people adjust their expense claims upwards.
Arrogance is when some people believe that they are better than the
system, and that they can get away with anything. The late Robert
Maxwell (was a Czechoslovakian-born British media proprietor and
Member of Parliament (MP). He rose from poverty to build an
extensive publishing empire. His death revealed huge discrepancies
in his companies' finances, including the Mirror Group pension
fund, which Maxwell had fraudulently misappropriated) plundered his
company pension scheme, arrogantly assuming that since he was
chairperson of the company he could get away with it; he almost
did!
Lack of transparency leads to direct financial statement fraud.
Transparency term is the extent to which investors have ready
access to any required financial information about a company such
as price levels, market depth and audited financial reports.
Classically defined as when "much is known by many", transparency
is one of the silent prerequisites of any free and efficient
market. Transparency helps to prevent the corruption that
inevitably occurs when a select few have access to important
information, allowing them to use it for personal gain. Reduced
price volatility also tends to be a byproduct of a transparent
market because all the market participants can base decisions of
value on the same idea. Complex financial transactions that are
difficult to understand are an ideal method to hide a fraud. The
Barings fraud was perpetrated by use of an accounting dump account
that no one understood.
Lack of the internal controls of the company is one of the most
famous reason leads to the financial statement fraud. Internal
controls are policies and procedures that will protect your
business assets and reduce the risk of fraud. They can be simple,
little to no cost ways that may prevent or minimize financial
problems. Where are the accounting controls, such as a monthly
reconciliation (Reconciling an account often means proving or
documenting that an account balance is correct. For example, we
reconcile the balance in the general ledger account Cash in
Checking to the balance shown on the bank statement) of the bank
account, are lapse the signals that a fraud has occurred will be
missed.
The corporate governance is one of the important tools of the
internal controls. The system by which companies are directed and
controlled, it is also the process by which corporations are made
responsive to the rights and wishes of stakeholders. Corporate
governance is also the manner in which management and those charged
with oversight accountability meet their obligations and fiduciary
responsibilities to stakeholders.
Company culture can lead to the frauds in several ways. Managers
can unknowingly create an environment where fraud runs highly. To
protect the organization from the fraud, it is important that
management understands their role in fostering an ethical, healthy
work environment.
Robyn Barrett says in her article how company culture can lead
to fraud '' Establishing a positive company culture is a key
component in keeping fraud at bay. It begins with cultivating a
company culture that fits the values most vital to the companys
success. This can be achieved by clearly defining what behaviors
will be accepted and encouraged within the company and which will
not.''
According to the CPAs Handbook of Fraud and Commercial Crime
Prevention, a guide published by the American Institute of
Certified Public Accountants, there are certain elements of a
companys culture that can make it more susceptible to fraud.
Amongst these are autocratic management styles, centralized
distribution of authority and overwhelmingly negative feedback.
Autocratic managers often make decisions without involving the
employees in the decision-making process and put unnecessary
pressure on employees to perform. According to the AICPA, this
pressure can lead to internal fraud.
Robyn Barrett stated that '' Much like companies with autocratic
managers, companies who implement a centralized distribution of
authority harbor an environment for fraud by taking power away from
employees and allowing all decisions to be made by higher-ups.
Stripping employees of their ability to offer any insight or
feedback makes it easier for employees to rationalize internal
fraud''.
Lack of clear moral direction from senior management where the
senior management indulges them in semi corrupt behavior, e.g. This
won't give the employees the green light to work in environment
full of the morals and ethics. This will make them more liable to
the fraud behavioral more than other organizational environment
which have clear moral and ethical standards from the high
management staff.
The last reason of the fraud is the Non independent internal
audit department where an organization's internal audit department
is not independent, e.g. where it does not report to a truly
independent audit committee but to the Finance Director, the more
likely that when there are signals that a fraud is occurring the
more likely they will be ignored. It is indeed interesting to note
that Cynthia Cooper (Head of Internal Audit at WorldCom) had to
bypass her boss (the CFO) and go directly to the audit committee to
report the discovery of the capital expenditure fraud.
V. Consequences and Effects of Financial Statement
Fraud:Financial statement fraud will have an effect on the
employees or the organization that includes a monetary interest
within the success or failure of an organization. A manipulation of
the corporate reported earnings or assets will have an effect on a
bank that extends credit to the company, a shareowner who invests
cash within the company, and the employees who actually work in the
company.
1. Banks lose lots of money, which affects other bank customers
and clients who always make up for those losses and affects the
banks investors. Creditors can lose large sums of money, which may
not have been risked if the creditors knew the true financial
condition of the company. Many of top management who make frauds
leads their companies to collapse at the end of the day, those
companies after collapsing can't pay back their loans to the banks
and this has a dangerous effect on the national economy itself.
2. Financial statement fraud will cause shareholders to overpay
for their investment in the company and they will get less value
for their money than they are aware. They may lose part or all of
their investment if the company ultimately fails or has to go
through some sort of reorganization in order to remain viable.
Shareholders also lose the opportunity to invest their money in
other companies which may have better actual financial results or
which may be more honest in their operations.
3. The manipulation of financial statements additionally affects
staff. It is the ability to place staff out of work once the fraud
is exposed or collapses. It additionally has the ability to
complement staff principally those concerned with in the fraud,
however probably people who are not. Sensible financial results
(actual or fabricated) will be coupled to promotions, raises,
increased profit packages, bonuses, and therefore the value of
stock option awards. Another important effect that the employees
will lose their moral and ethics towards to their company and this
will badly affect the organization itself.
There are also many other effects of the financial statement
frauds have a direct effect on the company itself including
financial loss, External Confidence, Company Morale and increased
audit costs according to John Freedman, Demand Media in their
article How Fraud Hurts You & Your Organization.
1. Financial Loss: Financial loss is an obvious effect of both
types of fraud. When someone misappropriates company assets, the
loss is easy to quantify. For example, if a cashier takes $60 from
the cash register, the company loses $60. The costs of fraudulent
financial reporting are harder to determine. If a small-business
owner perpetrates financial statement fraud, an explicit dollar
figure might not be obvious. However, fines assessed for misleading
investors, civil suits to recoup investor and creditor losses and
the unwillingness of companies to extend credit to the business in
the future all add up to a severe financial loss for the
company.
2. External Confidence: Once a fraud has been uncovered, the
company faces an ongoing problem of public trust in the
organization. While a small business scandalized by fraud might
never be the victim or perpetrator of another fraud, its public
image might be irreparably tainted. Consequently, the company may
have to pay a higher price for credit, may be refused membership in
trade associations or might not be considered for a strategic
alliance.
3. Company Moral: The effect of fraud on a company's culture and
morale can be shattering. Any association with a company that has
perpetrated or suffered fraud can be troubling and embarrassing for
the people who work there. This may be especially true in a
small-business setting where workers feel more connected with one
another. Even if employees leave the company, they may carry an
association with a fraudulent company into their next place of
employment, even if they were not involved with the fraud at
all.
4. Increased Audit Costs: Small businesses that are subject to
audit and have experienced fraud, especially if the fraud was
perpetrated by company management, are likely to be assessed as a
high audit risk. That means auditors will more closely scrutinize
company books before signing off on a company's financial
statements. When an auditor is required to perform more procedures,
the cost of the audit will increase. This can often be mitigated by
demonstrating that the offending managers or employees have left
the company and the company has instituted strict procedures to
thwart future attempts at fraud.Chapter 4Indicators and ways to
prevent Fraud in Financial StatementsAs Albert Einstein has said
meanwhile We cannot solve our problems with the same thinking we
used when we created them. We will adopt this approach in trying to
understand the indicators and ways to solve the existing problem of
fraud and to understand the behavioral aspects of fraudsters
through understanding the behavioral red flags and business
indicators and reviewing ingenious solutions to this problem.I.
Behavioral Red Flags:Behavioral red flags; means there are many
attitudes done by the fraudster when these attitudes happen it make
doubts about the fraudster.
According to the article "Theft, Fraud and Dishonest Employees
Do you really know whats happening in your business?" By Erika
Lucas, stated, "Of course the vast majority of employees are
upstanding, honest citizens. However, if you are concerned that
there might be some rogues in the pack, there are some red flags to
look out for. Warning signs include people who appear to be living
beyond their means (flash cars, big houses, five star holidays)
although there can of course be rational explanations for this,
such as a family inheritance or win on the lottery! Other signs to
look out for are people who are always first and last in the
office, rarely take holiday and are overly protective of their
workload. An unhealthy closeness with customers, suppliers or
competitors is another sign that something may be amiss. None of
these mean that anything untoward is definitely taking place but
they are signs that can indicate you ought to be taking a closer
look at whats happening ".
Another warning signs to look for is when the person who is the
first one who goes to the office and also he is the last one who
leaves it, he goes first one and leaves last one in order not to
give a chance to get doubted.
In addition, when the person rarely takes holidays, the
perpetrator will often exhibit unusual behavior, which is one of
the strongest indicators of fraud. The fraudster may not ever take
a vacation or call in sick in fear of being caught. He or she may
not attribute out work even when overloaded. That individual does
not want anyone of his employees nor manager to identify how the
discs are being manipulated, by granting others the chance to over
review his own study in this absence. There are other signs to look
for like:1. Refuses or does not seek promotion or rotation and
gives so reasonable explanation: Career progression or work
rotation is highly desirable for the majority, but if an employee
refuses this on more than one occasion, it could be another
indicator that something is going on. Management must take the time
to see how their employees play with others in the department, if
an employee insists on playing in isolation when this is not always
appropriate this is a solid indicator of fake.
2. Suspected to have over-extended personal finances or
excessive lifestyle: Selfishness and greed is one of the key
motivations for committing fraud. Management should be alert to the
fact that overnight inheritances, newly established luxury
lifestyles and excessive personal consumption may all point to
fraudulent conduct. Most people who perpetrate fraud are under
fiscal pressure and sometimes these pressures are real. The
minority of the perpetrators steals and save most immediately
spends everything they steal or in better language, everything they
embezzle. As they become more positive in their fraud schemes, they
slip and spend increasingly larger amounts until they are living
lifestyles far beyond what they can reasonably afford, for examples
getting new cars, exotic vacations, home improvements or they even
move into a more expensive home, purchase of expensive jewelers or
clothes.
3. Defensive Mechanism: Perpetrators use the defense mechanisms,
or manners in which they behave or think in certain ways to better
protect or defend themselves. Although this is an area slightly
controversial, managers should be able to utilize their best
assessment. There have been many examples of employees inventing
illnesses as a mechanism to behave as a buffer to question. If an
employee is creating defense mechanisms to prevent questioning over
transactions or performance, there may be reason to be extra
careful and observant. This is especially the case where answers to
straightforward questions are ever shifting and inconsistent.
4. Senior managers with unusual spheres of influence: When the
CFO Banks cash takings or a senior manager is required in
purchasing decisions outside of his function, ask the question:
Why? In recounting to the first of these, it is important that all
businesses can trace all fund inflows from source to bank with
appropriate segregation of responsibilities.
II. Business Indicators:1. Accounts not reconciled to underlying
records: The most recent Fraud Barometer attests, that 55% of the
management fraud were performed at senior levels. One of the common
management frauds is introducing the business as performing in the
best image and better than it is truly is. It is frequently the
case in such situations that key accounting reconciliations are set
aside to enable the manipulation to pass undetected.
2. Elsewhere in the industry: As mentioned or as known that
complete performance against peers is generally good news, however,
independent directors and the board must get comfortable as to
estimate how this has been accomplished.
3. Excessive secrecy about a role and its operations: Certain
business leaders deliver a mysterious habit of avoiding or
postponing scrutiny, such as internal audit reviews, for credible
reasons. Such avoidance activity should not be accepted on a
repeated or continuous basis.
4. Posting to vulnerable balance sheet accounts: When funds are
stolen or accounts are manipulated the perpetrator will need to
process an accounting entry to cover the underlying transaction. In
every lawsuit or on every social function, certain balance sheet
accounts are utilized such as suspense accounts or other histories
(such as VAT or PAYE) that are rarely fully reconciled. Unexpected
buildup of balances on such accounts requires a challenge.
III. Other miscellaneous indicators: As mentioned in studies
done by PwC "A business is placed at risk for fraudulent activity
if an in-house accountant works without proper supervision on every
aspect of the businesss financial operations, e.g. payroll,
receivables, deposits, payments etc.
In house accountant works without supervision : if the
accountant takes his work to do it in his house without supervision
in his work so it is high risk to do fraud and also if the
accountant does his job in his office but without supervision there
is also high risky.
Accountant insists on handling activities that other department:
other cases shows that the accountant can be handling more than one
jobs on accounting department and on another department and this
increase the doubts towards this person.
IV. Internal Auditor Responsibility:The internal audit
activities inside a firm should be done in a professional way, and
according to recognized standards of practice within the internal
audit industry. To make sure that the level of performance is
achieved all auditors in the internal audit department must share
responsibility for the accomplishment of all delegated jobs in a
professional manner.
1. Main Internal Auditor Responsibility:a. Declaring any
deficiency to independence or objectivity that may exist.b.
Performing assigned jobs in an independent and self-directed way.c.
Completing assigned jobs in a timely, detailed, accurate and
well-documented way.d. Submitting all completed work papers to the
Director of Internal Audit for final evaluation and approval.e.
Conducting oneself in a professional manner at all times; evading
those situations that would lead to criticism by the area being
audited, or by the public.f. Assuming a friendly and cooperative
behavior with the audited areas staff. Disagreements should be
reported to the Director of Internal Audit.g. Conducting work to
reduce disruption of the audited areas workflow or ability to
service their customers.h. Advising oneself with the premises,
responsible employees, and the location of records early in the
audit.i. Requesting any documents that may be needed. Management of
the audited area should be made conscious that the Internal Auditor
has those documents.j. Protecting all files / records that have
been assigned to the Auditors control.k. Returning all files /
records to the person or area, they were obtained from.l.
Maintaining all records in the same or better condition than that
in which they were found.m. Retaining all records on premises -
never removing vital documents from the premises.n. Returning all
documents taken to the Internal Auditors work area to the records
custodian by the end of the day if such return is requested.2.
Additional Internal Auditor Responsibility:a. Developing a
knowledge with the organization and functions of the unit to be
audited.b. Pre-planning the audit in accordance with the
opportunity and difficulty of the area under review.c. Guaranteeing
that an assessment of risks is combined into, or forms the basis of
all audit work planned and performed.d. Accepting responsibility
for the audit work performed on assigned assignments.e. Managing
the audit in relation to time and resource budgets.f. Ensuring that
audit results and recommendations made during the course of the
audit are on time communicated to management.g. Ensuring that all
Worksheets issued are correctly constructed, supported, and
communicated.h. Ensuring that all objectives have been accomplished
and all conclusions are properly supported.i. Ensuring that the
audit or review is conducted with the least amount of disturbance
to the audited area as is possible.j. Conducting an Exit Review or
briefing at the conclusion of fieldwork.k. Drafting and seeking
approval for a formal Audit Report.l. Finalizing the audit files
and ensuring that all supporting documentation is properly taken.m.
Performing follow-up work as necessary successive to the audit.
3. The Auditors Responsibility to consider Fraud and Error in an
audit of financial statement:After reading a report called The
Auditors Responsibility to Consider Fraud and Error in an Audit of
a Financial Report, we discovered that there are some essential
limitations of audit the report stated, An audit does not guarantee
all material misstatements will be detected because of such factors
as the use of judgement, the use of testing, the inherent
limitations of internal control and the fact that much of the
evidence available to the auditor is persuasive rather than
conclusive in nature.
For these reasons, the auditor is able to obtain only reasonable
assurance that material misstatements in the financial report will
be detected. And The risk of not detecting a material misstatement
resulting from fraud is higher than the risk of not detecting a
material misstatement resulting from error because fraud may
involve sophisticated and carefully organized arrangements designed
to hide it, such as forgery, deliberate failure to record
transactions, or intentional misrepresentations being made to the
auditor. Such attempts at concealment may be even more difficult to
detect when accompanied by complicity.
Complicity may cause the auditor to believe that evidence is
persuasive when it is, in fact, false. The auditors ability to
detect a fraud depends on factors such as the skillfulness of the
perpetrator, the frequency and extent of manipulation, the degree
of collusion involved, the relative size of individual amounts
manipulated, and the seniority of those involved. Audit procedures
that are effective for detecting an error may be ineffective for
detecting fraud.
The risk of the auditor not detecting a material misstatement
resulting from management fraud is greater than for employee fraud,
because those charged with governance and management are often in a
position that assumes their honesty and enables them to prevail the
formally established control procedures. Certain levels of
management may be in a position to prevail control procedures
designed to prevent similar frauds by other employees.
The report includes by stating that The auditors opinion on the
financial report is based on the concept of obtaining reasonable
assurance; hence, in an audit, the auditor does not guarantee that
material misstatements, whether from fraud or error, will be
detected. Therefore, the succeeding discovery of a material
misstatement of the financial report resulting from fraud or error
does not, in and of itself, indicate: a failure to obtain
reasonable assurance, inadequate planning, performance or
judgement, the absence o