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Real - Fraud and Error

This chapter discusses fraud and error in corporate governance. It defines fraud as an intentional act involving deception to misstate financial statements. There are two types of misstatements: those from misappropriating assets and those from fraudulent financial reporting. The fraud triangle characterizes the incentives, opportunities, and rationalizations that enable fraud. Incentives can include financial pressures, management compensation schemes, or greed. Opportunities arise from weaknesses in internal controls or complex transactions. Rationalizations allow fraudsters to justify committing fraud, such as claiming the company owes them or fraud is temporary.

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Rhea May Balute
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164 views5 pages

Real - Fraud and Error

This chapter discusses fraud and error in corporate governance. It defines fraud as an intentional act involving deception to misstate financial statements. There are two types of misstatements: those from misappropriating assets and those from fraudulent financial reporting. The fraud triangle characterizes the incentives, opportunities, and rationalizations that enable fraud. Incentives can include financial pressures, management compensation schemes, or greed. Opportunities arise from weaknesses in internal controls or complex transactions. Rationalizations allow fraudsters to justify committing fraud, such as claiming the company owes them or fraud is temporary.

Uploaded by

Rhea May Balute
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 14

FRAUD AND ERROR

INTRODUCTION
In the previous chapters, corporate governance has been descri bed as the process
by which the owners and various of stakeholders of an organization exert control
through requiring accountability for the resources entrusted to the organization.

This chapter introduces fraud risk and errors and how they can be reduced if not
totally avoided by having effective internal control — a tool of good corporate
governance.

Fraud is an intentional act involving the use of deception that results in a


material misstatement of the financial statements. Two types of misstatements
are relevant to auditors' consideration of fraud: (a) misstatements arising from
misappropriation of assets, and (b) misstatements arising from fraudulent
financial reporting.

Intent to deceive is what distinguishes fraud from errors. Auditors routi nely find
financial errors in their client's books, but those errors are not intentional.

TYPES OF MISSTATEMENTS

a Misstatements arising front misappropriation of assets


. Misstatements arising from fraudulent financial
b reporting

Misstatements arising from misappropriation of assets

Asset misappropriation occurs when a perpetrator steals or misuses an


organization's assets. Asset misappropriations are the dominant fraud scheme
perpetrated against small business and the perpetrators are usually
employees. Asset misappropriations can be accomplished in various ways,
including embezzling cash receipts, stealing assets, or causing the company
to pay for goods or services that were not received.
Fraud and Error 219
Asset misappropriation commonly occurs when employees:

-Gain access to cash and manipulate accounts to cover up cash thefts.


Manipulate cash disbursements through fake companies.
Steal inventory or other assets and manipulate the finarmial records to
cover up the Fraud.

Misstatements arising from Fraudulent Financial Reporting

The intentional manipulation of reported financial results to misstate the


economic condition of the organization is cal led fraudulent financial
reporting. The perpetrator of such a fraud generally seeks gain through the
rise in stock price and the commensurate increase in personal wealth.
Sometimes the perpetrator does not seek direct personal gain, but instead
uses the fraudulent financial reporting to "help" the organization avoid
bankruptcy or to avoid some other negative financial outcome. Three
common ways in which fraudulent financial reporting can take place include:
1. Manipulation, falsification, or alteration of accounting records or
supporting documents.
2. Misrepresentation or omission of events, transactions, or other
significant information.
3. Intentional misapplication of accounting principles.

THE FRAUD TRIANGLE


incentives, opportunities and rationalizations
The Fraud Triangle characterizes that
enable fraud to exist.

The three elements of the fraud triangle are:


Incentive to commit fraud
Opportunity to commit and conceal the fraud
committing
Rationalization — the mindset of the fraudster to justify
The fraud
220 Chapter 1 4

Incentives or Pressures to Commit Fraud

Incentives relating to asset misappropriation include:

Personal factors, such as severe financial -considerations


Pressure from fami ly, friends, or the culture to l ive a more lavish
lifestyle than one's personal earnings allow for
Addictions to gambling or drugs

The incentives include the fol lowing for fraudulent financial reporting:

Management compensation schemes


Other financial pressures for either improved earnings Or an
improved balance sheet
Debt covenants
Pending retirement or stock option expirations
Personal wealth tied to either financial results or survival of the
company
Greed — for example, the backdati ng of stock options was
performed by individuals who already had mi ll ions of pesos of
wealth through stock

Opportunities to Commit Fraud

One of the most fundamental and consistent findings in fraud research is that
there must be an opport unity for fraud to be committed. Although this may
sound obvious — that is, "everyone has an opportunity to commit fraud" —
it really conveys much more. It means not only that an opportunity exists, but
either there is a lack of controls or the complexities associated with a
transaction are such that the perpetrator assesses the risk of bei ng caught as
low. Some of the opportunities to commit fraud that the top management
should consider incl ude the following:
Significant related-party transactions
A company's industry position, such as the ability to dictate terms or
conditions to suppliers or customers that might al low individuals to
structure fraudulent transactions
Fraud Error 221

Management's inconsistency involving subjective judgments regarding assets or


accounting estimates

Simple transactions that are made complex through an unusual recording process

Complex or difficult to understand transactions, such as financial derivatives or


special-purpose entities

Ineffective monitoring of management by the board, either because the board of


directors is not independent or effective, or because there is a domineering
manager

Complex or unstable organizational structure Weak or non existentintemal


controls
Rationalizing the Fraud

For asset misappropriation, personal rationalintions often revolve around


mistreatment by the company or a sense of entitlement (such as, "the company
owes me! by the individual perpetrating the fraud. Following are some common
rationalizations for asset misappropriation:

Fraud is justified to save a family member or loved one from financial crisis.

We will lose everything (family, home, car and so on) if we don't take the money.
No help is available from outside.

This is "borrowing", and we intend to pay the stolen money back at some point.
Something is owed by the company because others are treated better.

We simply do not care about the consequences of our actions or Of accepted


notions of decency and trust; we are for ourselves.

For fraudulent financial reporting, the rationalistic can range from "saving the
company" to personal greed, and may include the following:

This is one-time thing to get us through the current crisis and survive until things
get better.
Everybody cheats on the financial statements a little; we are just playing the same
game.

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