CHAPTER 14 increase in personal wealth.

Sometimes, the perpetrator does not seek direct

personal gain, but uses such fraud to “help” the organization avoid
FRAUD AND ERROR
bankruptcy or to avoid some other negative financial outcome.
INTRODUCTION
Three common ways fraudulent financial reporting can take place:
Corporate governance has been described as the process by which the owners
1. Manipulation, falsification, or alteration of accounting records or
and various of stakeholders of an organization exert control through requiring
supporting documents.
accountability for the resources entrusted to the organization.
2. Misrepresentation or omission of events, transactions, or other
Fraud is the intentional act using deception that causes material significant information.
misstatement of financial statements. Misstatements relevant to auditor’s 3. Intentional misapplication of accounting principles.
consideration of fraud:
THE FRAUD TRIANGLE
(1) Misstatements arising from misappropriation of assets
The Fraud Triangle characterizes incentives, opportunities, and
(2) Misstatements arising from fraudulent financial reporting
rationalizations that enable fraud to exist.
Intent to deceive is what distinguishes fraud from errors. Auditors routinely
The three elements of fraud triangle:
find financial errors in their client’s books, but those errors are unintentional.
1. Incentives or Pressures to Commit Fraud
TYPES OF MISSTATEMENTS
Incentives relating to asset misappropriation include:
A. Misstatements arising front misappropriation of assets
 Personal factors such as severe financial considerations.
Asset misappropriation occurs when a perpetrator steals or misuses an
 Pressure from family, friends, or the culture to live a more lavish
organization’s asset. This are dominant fraud scheme usually perpetrated
lifestyle than one’s personal earnings allow for
against small businesses where perpetrators are usually the employees.
 Addictions to gambling or drugs
Asset misappropriation can be accomplished by:
Incentives include the following for fraudulent financial reporting:
 Embezzling cash receipts
 Management compensation schemes
 Stealing assets
 Other financial pressures for either improved earnings or an
 Causing the company to pay for goods or services not received
improved balance sheet
Asset misappropriation commonly occurs when employees:  Pending retirement or stock option expirations
 Personal wealth tied to either financial results or survival of the
 Gain access to cash and manipulate accounts to cover up cash thefts.
company
 Manipulate cash disbursements through fake companies.
 Greed – example, backdating of stock options was performed by
 Steal inventory or other assets and manipulate the financial records individuals who already had millions of pesos in wealth through
to cover up the Fraud. stock
B. Misstatements arising from Fraudulent Financial Reporting
Fraudulent Financial Reporting is the intentional manipulation of reported 2. Opportunities to Commit and Conceal the Fraud
financial results to misstate the economic condition of the organization. The
perpetrator seeks gain through the rise in stock price and the commensurate
One of the most fundamental and consistent findings in fraud research is that  No help is available from outside
there must be an opportunity for fraud to be committed. The phrase  This is “borrowing”, and we intend to pay the stolen money back at
“everyone has an opportunity to commit fraud” conveys more as it means some point
that not only opportunity exists, but there is a lack of control or the  Something is owed by the company because others are treated better
complexity associated with a transaction are such that the perpetrator  We simply do not care about the consequences of our actions or of
assumes that the risk of being caught is low. accepted notions of decency and trust; we are for ourselves
Some of the opportunities to commit fraud that top management should For fraudulent financial reporting, the rationalization can range from “saving
consider includes: the company” to personal greed, and may include the following:
 Significant related-party transactions  This is one-time thing to get us through the current crisis and survive
 A company’s industry position (ability to dictate terms or conditions until things get better.
to suppliers or customers that might allow individuals to structure  Everybody cheats on the financial statements a little; we are just
fraudulent transactions) playing the same game.
 Management’s inconsistency involving subjective judgments  We will be in violation of all our debt covenants unless we find a
regarding assets or accounting estimates way to get this debt off the financial statements.
 Simple transactions that are made complex through an unusual  We need a higher stock price to acquire company XYZ, or to keep
recording process our employees through stock options and so forth.
 Complex or difficult to understand transactions, such as financial
derivatives or special-purpose entities Risk Factors Contributory to Misappropriation of Assets
 Ineffective monitoring of management by the board, either because Misappropriation of assets involves the theft of an entity’s assets and is often
the board of directors is not independent or effective, or because perpetrated by employees in relatively small and immaterial amounts. It can
there is a domineering manager also involve management who are usually more able to disguise or conceal
 Complex or unstable organizational structure misappropriation in ways that are difficult to detect.
 Weak or nonexistent internal controls
Misappropriation of assets can be accompanied by:

 Embezzling receipts (collections of A/R, or written-off receipts)

 Stealing physical assets or intellectual property (inventory for
3. Rationalizing the Fraud – the mindset of the fraudster to justify
personal use or sale, stealing scrap for sale, colluding with
committing the fraud
comepetitor by disclosing tech data for payment)
For asset misappropriation, personal rationalizations revolve often around  Causing an entity to pay for goods and services not received
either from company mistreatment or a sense of entitlement (“the company (payments to fictitious vendors, kickbacks paid by vendors to entity’s
owes me!”) by the individual perpetrating the fraud. purchasing agents in return for inflating prices, payments to fictitious
employees)
Some common rationalizatins for asset misappropriation:
 Using entity’s asset for personal use (using the entity’s assets as
 Fraud is justified to save a family member or loved one from collateral for a personal loan or a loan related to a party)
financial crisis
 We will lose everything (family, home, car, etc.) if we don’t take the
money
Misappropriation of assets is accompanied by false or misleading records or (g) Inadequate physical safeguards over cash, investments,
documents to conceal the fact that assets are missing or have been pledged inventory or fixed assets
without proper authorization. (h) Lack of complete and timely reconciliation of assets
(i) Lack of timely and appropriate documentation of
A. Incentives/ Pressures
transactions (credits for merchandise returns)
1. Personal financial obligations may create pressure on
(j) Lack of mandatory vacations for employes performing key
management or employees with access to cash or other assets
control functions.
susceptible to theft or misappropriate those assets
(k) Inadequate management understanding of information
2. Adverse relationships between the entity and employees with
technology, which enables information technology
access to cash or other assets susceptible to theft may motivate
employees to perpetrate a misappropriation.
those employees to misappropriate those assets.
(l) Inadequate access controls over automated records,
Adverse relationships may be from:
including controls over and review of computer systems
(a) Known or anticipated future employee layoffs
event logs.
(b) Recent or anticipated changes to employee compendation
C. Attitudes/ Rationalizations
(c) Promotions, compensation, or other rewards inconsistent
1. Disregard for the need for monitoring or reducing risks related to
with expectations
misappropriation of assets
B. Opportunities
2. Disregard for internal control over misappropriation of assets by
1. Certain characteristics or circumstances may increase the
overriding existing controls or by failing to correct known internal
susceptibility of assets to misappropriation.
control deficiencies.
Opportunities to misappropriate assets increase when:
3. Behavior indicating displeasure or dissatisfaction with the entity or
(a) Large amounts of cash are on hand or processed
its treatment of the employee.
(b) Inventory items that are small in size, of high value, or in
4. Changes in behavior or lifestyle that may indicate assets have been
high demand
misappropriated
(c) Fixed assets which are small in size, marketable, or lacking
5. Tolerance of petty theft
observable identification of ownership
2. Inadequate internal control over assets may increase the
susceptibility of misappropriation of those assets.
Risk Factors Contributory to Fraudulent Financial Reporting
Misappropriation of assets occur because:
(a) Inadequate segregation of duties or independent checks Fraudulent financial reporting may be accomplished by:
(b) Inadequate oversight of senior management expenditures,
such as travel and other reimbursements  Manipulation, falsification (including forgery), or alteration of
(c) Inadequate management oversight of employees responsible accounting records or supporting documentation from which the
for assets (inadequate supervision or monitoring remote financial statements are prepared
locations)  Misrepresentation in, or intentional omission from, the financial
(d) Inadequate job applicant screening of employees with access statements of events, transactions or other significant information.
to assets  Intentional misapplication of accounting principles relating to
(e) Inadequate record keeping with respect to assets amounts, classification, manner of presentation, or disclosure.
(f) Inadequate system of authorization and approval of
transactions (purchasing)
Fraudulent financial reporting involves intentional misstatement including  Omitting, advancing or delaying recognition in the financial
omissions of amounts or disclosures in financial statements to deceive statements of events and transactions that have occurred
financial statement users which can be caused by management trying to during the reporting period.
manage earnings in order to deceive financial statement users by influencing  Concealing, or not disclosing, facts that could affect the
their perceptions as to the entity’s performance and profitability. amounts recorded in the financial statements.
 Engaging in complex transactions that are structured to
Such earnings management may start out with small actions or inappr
adjustment of assumptions and changes in judgment by management. misrepresent the financial position or financial performance
of the entity.
Pressures and incentives may lead these actions to increase to the extent that  Altering records and terms related to significant and unusual
they result in fraudulent financial reporting. Situations as such occur due to transactions.
pressure to meet market expectations or a desire to maximize compensation C. Rationalizations
based on performance; management intentionally takes positions that lead to
fraudulent financial reporting by materially misstating the financial Individuals can rationalize committing a fraudulent act. Some individuals
statements (they may reduce earnings by a material amount to minimize tax possess an attitude, character or set of ethical values that allow them
or inflate earnings to secure bank financing). knowingly and intentionally commit a dishonest act. Even honest
individuals can commit fraud in an environment that imposes sufficient
Fraud (fraudulent financial reporting or misappropriation of assets) involves pressure on them.
incentive or pressure to commit fraud, a perceived opportunity to do so and
some rationalization of the act. Material Weakness in Internal Control

A. Incentive/ Pressure – fraudulent financial reporting may exist when A material weakness is a deficiency, or a combination of deficiencies in
management is pressured from sources outside or inside the entity, to internal control over financial reporting, that there is a reasonable possibility
achieve an expected (or unrealistic) earnings target or financial that a material misstatement of the company’s annual or interim financial
outcome – if there is significant consequences for failing to meet statements will not be prevented or detected on a timely basis and the
financial goals. likelihood and magnitude of potential misstatement are such that the
B. Opportunities – opportunity to commit fraud exist when an company cannot conclude that its internal control over financial reporting is
individual believes that an internal control can be overridden (the effective.
individual is in position of trust or has knowledge of specific A material weakness does not mean that the control deficiency resulted in a
weaknesses in internal control) material, or immaterial, misstatement in the financial statements. A
Fraudulent financial reporting often involves management override reasonable possibility is that this type of control deficiency could lead to a
of controls that otherwise may appeart to be operating effectively. material misstatement.
Fraud can be committed by management overriding controls using
techniques such as: Responsibility for the Prevention and Detection of Fraud
 Recording fictitous journal entries close to the end of an The primary responsibility for detecting and preventing fraud depends on
accounting period to manipulate operating results or achieve those charged with governance of the entity and management. Management
other objectives. with the oversight of those charged with governance, place a strong emphasis
 Inappropriately adjusting assumptions and changing on fraud prevention, which may reduce opportunities for fraud to take place,
judgments used to estimate account balances. and fraud deterrence, which could persuade individuals not to commit fraud
because of the likelihood detection and punishment.
This involves committing to creating a honest culture and ethical behavior 2. Meet external expectations
which can be reinforced by an active oversight by those charged with 3. Provide income smoothing
governance. In exericising oversight responsibility, those charged with 4. Provide window dressing for an IPO or a loan
governance consider the potential for override of controls or other
Meet Internal Targets
inappropriate influence over the financial reporting process, such as efforts
by management to manege earnings in order to influence the perceptions of Internal earnings target represent an important means or tool in motivating
analysts as to entity’s performance and profitability. managers to increase sales efforts, control costs and use resources more
efficiently. Research has confirmed that the existence of earnings based
FRAUDULENT FINANCIAL REPORTING THROUGH EARNING
internal bonuses contributes to the incidence of earning’s management.
MANAGEMENT
Managers with earnings based bonus plan manage earnings upward if they
Income smoothing/ earnings management/ cooking the books/ paper
are closed to the bonus threshold and manage earnings downward if the
entrepreneurialism refers to choosing accounting methods and making
earnings are substantially in excess of the maximum bonus level. Latter
accounting principle changes to produce a specified income level or trend.
tendency means that managers have a tendency to defer some earnings “for a
Reducing volatily of income and reporting relatively gradual or continual
rainy day”.
increases in income are alleged to be common company goals. The implicit
assumption is that the investing public, values a smooth and predictable Meet External Expectations
income trend. Investors perceive erratic earnings trend risky than smooth
trend. External stakeholders have interest in a company’s financial performance.

To smooth income, firms increase reported earnings during a downturn and Employee and customers wants company to do well that it can surviver in the
decrease it during prosperous times. Excessively high income invites long run and make good on its long-term pensions and warranty obligations.
unwanted attention from unfriendly press coverage, government intervention Suppliers want assurance that they will be paid and that purchasing company
and increased demand for dividends. Large income increases are difficult to will be a reliable purchaser.
sustain and create increased expectations. Reporting negative earning and signs of financial weakness provide strong
By choosing method that increase income, firms seek to avoid the evidence that companies manage earnings to avoid reporting losses and
unfavorable economic consequences of lowered earnings (reduced stock disappointing external stakeholders.
prices, higher borrowing costs, and noncompliance with debt covenants). Financial analysts are important external financial statement users because
Many firms continue to manage income to avoid earnings reduction. other than making buy and sell recommendations about shares of company
Motivations for Earnings Management stocks, they also generate forecasts of company earnings. Announcing ent
income less than net income forecast by analysts results in drop in stock price
Numbers are important in framins people’s opinions. We rarely question how where companies have incentive to manage earnings expected by analysts.
numbers are computed. Managers manage earnings to make sure they meet analysts’ forecasts and
provide overy pessimistic “guidance” to analysts to ensure that forecasts
Reported numbers have power to frame opinions in the corporate arena, and
made are not too high to reach.
reported net income is the number that receives most attention which makes
it the number that corporate managers mostly tempered to manipulate. Provide Income Smoothing
Four reasons that push managers to manipulate reported earnings:
1. Meet internal target
Income Smoothing is the practice of carefully timing the recognition of Operating results with great gap between expectations and actual results is
revenuew and expenses to even on the amount of reported earnings from one great that cannot be closed by any accounting assumption, manager fixated
year to the next. on making target number resort to out-and-out fraud by inventing
transactions and customers.
By making a company appear to be less volatile, income smoothingcan make
it easier for a company to obtain a lona on favorable terms and easier to Forces encouraging managers and accountants to earnings management are
attract investors. real and that if one is not aware of those forces, it is easy to slip from left side
of the continuum to the right side.
By carefully timing the recognition of gains and losses, a company can avoid
reporting earnings that bounce up and down from year to year, which is A. Strategic Matching – Certain key transactions are completed
applying income smoothing. quickly or delayed so they are recognized in the most advantageous
period (delay in recording operating expenditures by temporarily
Provide Window Dressing fro a Loan or Initial Public Offering (IPO) of
deferring them using asset accounts).
Equity Share
B. and C. Change in Methods or Estimates with Full or Little or NO
Company applying for a large loan or before IPO of stock, it is critical that
reported earnings look good. Managers have the tendency to boost their
reported earnings using accounting assumptions that can result to artificially
inflate earnings.
EARNING MANAGEMENT TECHNIQUES
Earnings management involves a series of increasingly aggressive steps
including recording fictitious transactions, strategic matching of one-time
gains and losses, change in accounting methods with either full, littler or no
disclosure or applying accounting method which is n violation of Financial
Accounting Standards. The importance and economic significance of the
Disclosure – Frequently changing accounting estimates related to
catastrophic reporting failures associated with companies that engage in more
bad debts, income on pension funds, depreciation lives, to manage
elaborate earnings management, the continuum is important.
the amount of reported earnings.
The continuum mirror the progression in earnings management strategies
D. Fradulent Reporting (applying accounting method that is not in
followed by individual companies. These activies start small and legitimately
accordance with Financial Reporting Standards) – Deliberate
reflect strategic timing of transactions to smooth reported results.
omission of impairment losses on assets financial statements are
Operating results that fall short of targets, companies might make changes in prepared.
accounting estimates to meet earnings expectations but will fully disclose
E. Fictitious Transactions (to reflect a more favorable financial
these changes in accounting to avoid deceiving serious financial statement
condition and operating results, a company may record a fictitious
user.
payment of a loan by debiting Loans Payable and crediting Revenue
Operating results far short of expections causes an increasingly desperate account).
management to cross the linto into deceptive accounting by making changes
Is Earnings Management Ethical?
not disclosed or violates Financial Reporting Standards completely.
No. Universal agreement, however, ends with respect to what is and what
is not ethical. Users and preparers of financial statements should insist on
transparency in reporting to reduce information risk and lower the cost of
capital.
Earnings management can and occurs without any violation of the
accounting rules but intentionally trying to deceive others is wronf
regardless of the economic consequences.
Companies that manipulated reported earnings can have huge loss of
credibility which can harm all the company relationship and drastically
impair its economic value.
The more reliable information provided by company, the more
confidence potential investors can place in that information. High quality
information allows for better decision-making. The ability to make better
decisions reduces the risk to potential investors and creditors and reduces
the cost of capital to a company.
A high value of company reputation, ethical behavior is the best long-run
business practice.