CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND

In recent years, a number of South African companies have experienced problems with
accounting irregularities*, specifically referring to the manipulation of accounting records
in order to artificially adjust the financial statements. This causes damage to the financial
health† of a company. Among companies that have experienced such problems in the
past are: Macmed, NAIL, Beige, Masterbond, Saambou, Regal Bank, Unifer, Leisurenet
and NRB. Some of these companies have survived, but most of them collapsed after the
irregularities were discovered.

Internationally, two of the largest and most well-known bankruptcies in the 1990’s have
occurred as a result of accounting irregularities, namely those of Enron and WorldCom
(Altman & Hotchkiss, 2006:3). The cost of such activities is not borne by the
perpetrators, but by customers, investors, creditors, the government and insurance
companies. Apart from the financial losses incurred, there are also other losses, such as
decreased sales, decreased productivity, poor credibility and an adverse impact on
people’s professional ethics. The possibility is not excluded that, when one person gets
away with it, others may be inclined to believe that they will also be able to get away
with it.

As far back as 1995, the United States Chamber of Commerce already estimated that
the aggregate annual cost of fraud to companies in America exceeded $100 billion
(Glover & Aono, 1995:3). The 2012 Report to the Nations (ACFE, 2012:4) reports that
the impact of occupational fraud based on the estimated 2011 gross world product,

* This study makes use of the term “accounting irregularities”. The reason for this is that accounting irregularities encompass a wider
range of accounting misdemeanours that are perhaps not completely criminal and thus not included in the criminal activity called
financial statement fraud. Financial statement fraud refers to fraud incidences involving the intentional misstatement or omission of
material information in the organisation’s accounting system in order to cause changes to the financial reports with the goal to make
the company appear more, or less, profitable (ACFE, 2012:10).
† When reference is made to “financial health” in the study, the meaning is particularly aimed at the state of the company in terms of
the truthfulness, trustworthiness and transparency of its accounting data and published financial statements.

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translates to a potential projected global fraud loss of more than $3.5 trillion. Participants
in the survey estimated that the typical organization loses 5% of its revenues to fraud
each year.

According to the Federal Bureau of Investigation (FBI), white-collar crime is the fastest-
growing illegal activity in the USA (Martin, 1998:47). On the local front, the South African
Police Service (SAPS) reports that South Africa lost R3,4 billion due to commercial
crime in the first six months of 1999 (Minnaar-Van Veijeren, 2000c:38) and according to
more recent crime statistics, the incidence of commercial crime is on the increase.
(South African Police Service, 2011). A total of 88 388 cases of commercial crime was
reported in 2010/2011 compared to 84 842 cases reported in 2009/2010, an increase of
more than 4%. It is also important to consider that these figures reflect only the reported
cases. There may be many more instances of commercial crime that are never reported.

It may be difficult to determine whether accounting irregularities are increasing or

decreasing, because reliable statistics are not readily available. It is certain, however,
that they are changing their appearance because of greater transparency, faster and
more open communication, and the amounts appear larger because of inflation
(Du Plessis, 2001:4). Other reasons for their change in appearance include the
globalisation of trade and the use of technology. The two reasons last mentioned create
opportunities for crimes to be committed across borders. The speed and volume of
transaction handling have also increased thanks to changing technology. The Internet
and other networks make it easier to gain access to an organisation’s data. Records of
current assets, such as cash and inventory, are increasingly stored in computer systems
as electronic information. It is therefore becoming easier for criminals to manipulate
records and misappropriate such assets. No company is immune to the onslaught of
accounting irregularities and it is becoming the responsibility of all interested parties –
not only managers – to be aware of irregularities and how to prevent them, so as to
protect the financial health of the company they have an interest in.

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Governments and professional organisations around the world have started to devise
and implement laws and guidelines with the goal of preventing accounting irregularities
from occurring. These measures include, amongst others, the Sarbanes-Oxley Act from
America, the Turnbull Guide on corporate governance from the United Kingdom and the
King Report in South Africa. However, these may not be as effective as need be.
De Vay (2006) has proven in a doctoral study that the Sarbanes-Oxley Act is not
effective in detecting and thereby assisting with preventing irregularities in the
accounting system of a company.

Denis (2012:4) states that one of the only ways to reduce the occurrence of accounting
irregularities is by creating an expectation that there will be negative consequences for
failing to prepare and provide accurate financial reports. However, researchers claim
that legal and regulatory systems may be too “blunt” as an instrument to handle the
problems of inappropriate managerial behaviour. Debates about the nature and extent of
the role of legal and regulatory procedures are especially important in an era of
increasing calls for the regulation of corporations and markets.

According to Cressey (1986:195), there is a wide-spread belief that accounting

irregularities will decline in frequency and severity if more people know more about them
and if that knowledge is used to prevent them. Hussain, Kennedy and Kierstead
(2010:72) concur that employees need to be educated so that they can better
understand accounting irregularities, the internal controls and their role in the companies
they work in. They found in their research that companies should not only rely on a
yearly audit to detect accounting irregularities. It is thus imperative that more individuals
know what to look for. The problem of a lack of education in the field is also identified by
DeZoort, Harrison and Schnee (2012:289). They found that tax professionals face
increasing pressure to help manage the problem of irregularities but that tax literature
lacks clear guidance in the area.

It may be true that punishing and incapacitating violators of the law can perhaps help to
reduce accounting irregularities, but a better strategy may be to implement sufficient

3
measures to prevent irregularities from happening in the first place. Apart from
prevention, Martin (1998:49) claims that forensic accounting techniques are able to
reveal an irregularity before it becomes a large problem. The establishment of such
techniques, which can possibly be learnt by anyone with limited accounting knowledge,
may help employers and employees to detect irregularities sooner and prevent damage
to the financial health of a company. One upside is that there will always be evidence in
the accounting records, however hard perpetrators may try to hide their activities. It is
virtually impossible to destroy all evidence of inappropriate activities in the accounts.

A significant amount of research has been done on accounting irregularities, but most of
the existing literature on the occurrence of accounting irregularities emanates from the
USA. Works in which the detection and identification of accounting irregularities are
discussed tend to focus on auditors’ responsibility for detecting and identifying such
irregularities. Thus far, there has been little academic writing and research in South
Africa on the topic of accounting irregularities. More detail regarding some of the
researchers and authors who contributed to the field is available in Appendix A.

Most of the research articles on accounting irregularities in South Africa are published in
business magazines and not in accredited journals, for example Christophers (2005),
Colapinto (1998), Dawson (2001), De Souza (2006), Du Plessis (1997, 1999a, 1999b,
2001), Kirby (2005) and Minnaar-Van Veijeren (2000a, 2000b, 2000c). This
compromises the standard of such research done in South Africa, since research done
in other countries is mainly published in accredited scholarly journals. Only a few of the
South African studies about accounting irregularities deals specifically with the methods
of detecting irregularities that can damage the financial health of a company and
identifying its occurrence.

The characteristics of companies where managers and/or employees engage in

unethical and inappropriate activities tend to be similar in many respects, for example
characteristics relating to auditor relationships, debt, culture, liquidity and internal control
structures. But there are also inconsistencies between different studies, for example

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characteristics relating to profitability, debtors, inventory levels, the industry the
company operates in, the level of growth and the size of the company. Such
characteristics present one of the aspects of accounting irregularities that this study
aims to address and discuss. Other gaps in the literature result from the fact that little
attention has been paid to the detection of accounting irregularities and its identification
by all interested parties. The only study found in the course of this research that
addressed this problem directly was that of Du Plessis and Koornhof (2000). They
looked at the measures that creditors and investors could use to detect such
irregularities.

There are various ways to assess the soundness and usefulness of financial
statements. Auditors generally use such assessment methods when they carry out
audits. However, it may not be equally possible for other interested parties, such as
creditors and investors, to use these methods. This is because they may lack access to
the internal information available to internal parties such as managers. This study sets
out to determine whether the financial health of a company can be revealed by means of
possessing knowledge of the characteristics of vulnerable companies and by doing a
thorough analysis of the published financial statements of a company, which are
available to any interested party. If it is possible to use these means of detection,
investors, creditors and other interested parties will be able to reduce their risk of being
deceived.

1.2 IMPORTANCE OF THE STUDY

An upsurge in financial accounting irregularities in the current economic environment

ensures that the detection of financial accounting irregularities is a topic of great
importance for academics, researchers and industries (Sharma & Panigrahi, 2012:37).
Accounting irregularities have larger implications than many managers realise. In
addition to harming the financial health of the company in which the irregularities
happen, it can potentially also affect economic markets. An example in a South African
setting of the effect of accounting irregularities is illustrated in what happened to

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Saambou Ltd. early in 2002, when a rumour about accounting irregularities within the
company caused the share price to fall by twenty percent (Ngaujake, 2004).

According to Rezaee (2002:7), the potential harmful effects of accounting irregularities

include, but are not limited to: undermining the quality and integrity of the financial
reporting process and jeopardising the integrity and objectivity of the accounting
profession. Ryan, Scapens and Theobald (2002:99) claim that the use of accounting
models for decision-making are already of limited use because of their historical
information content and their strict recognition and measurement rules. The existence of
irregularities in accounting systems makes accounting information even less useful for
decision making. Accounting irregularities therefore diminish the confidence of capital
markets and market participants in the usefulness of financial information and therefore
these irregularities make the capital market less efficient. This in turn, has the potential
to affect a nation’s growth and prosperity adversely. If the parties affected by the
accounting irregularities decide on legal action, this action can possibly result in litigation
losses. If discovered, the careers of the individuals involved in perpetuating the
accounting irregularities will inevitably be destroyed. In severe cases, accounting
irregularities can even lead to the destruction of the normal operations and performance
of companies allegedly involved and therefore can result in economic losses or even the
bankruptcy of the company. For the rest of the industry, occurrences of accounting
irregularities will encourage a higher level of regulatory intervention.

For the above reasons, it is essential to attempt to prevent the incidence of accounting
irregularities or at least attempt to detect incidences as soon as possible. The
identification of specific characteristics that can perhaps be used to earmark and then
analyse a company for accounting irregularities will assist interested parties in protecting
their interests in a proactive way.

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1.3 PROBLEM STATEMENT

As indicated in preceding paragraphs, literature on the ability of a financial analysis in

order to reveal the financial health of a company in a South African setting is limited.
This is especially the case if one looks at the presence of possible irregularities in the
accounting system. Most of the research material that is available only discusses the
theory behind accounting irregularities, while very few studies relate to the identification
of the irregularities. A few studies from other countries have investigated the use of a
financial analysis in revealing the financial health of a company when it comes to
possible accounting irregularities. However, many of these studies recognise the need
for further research. Few studies have thus far been done about the use of financial
analysis to reveal financial health and the possibility of accounting irregularities in South
African companies, specifically with reference to interested parties such as creditors and
investors who may not have access to internal company information.

As a result of the limited research that is available in the field of accounting irregularities,
this study is firstly an exploration into the broad subject area of accounting irregularities.
It aims to break new ground in a largely unknown field because the emphasis falls on
those interested parties that do not have access to all the company information and also
do not have access to or knowledge of auditing and analytical techniques. This makes it
an explorative study as it investigates an area that has not been researched much in the
past. It will include investigations into previous research of accounting irregularities.

The study does not aim to create a forensic process or an audit, but establishes the
means for interested parties outside a company to analyse the published financial
statements of a company to assess the possibility of the presence of irregularities in a
company’s accounting system.

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The decision-usefulness of published financial statements can be impaired by
accounting irregularities. The research problem can be expressed in the following
statement: Certain interested parties of a company have limited access to the
necessary resources needed in order to evaluate the financial health of a
company. The use of financial analysis and interpretation in conjunction with
clear characteristics or indicators from published financial statements can make it
possible to investigate and comprehend the financial health of a company.

1.4 RESEARCH OBJECTIVES

The research objectives of the study are to answer the research problem by means of
the following:

• An investigation into the characteristics, as identified by researchers locally and

abroad, that are displayed by companies with a higher risk of suffering from the
occurrence of accounting irregularities.

• A survey of the media by means of a literature review to identify case studies of

companies that had allegations of accounting irregularities made against them.

• The analysis of the case study companies in a quantitative and qualitative way to
determine whether the characteristics that are displayed by companies with a
higher risk of suffering from the occurrence of accounting irregularities (refer to
the first objective), hold true in practice.

• Statistical analyses of the share price data of the case study companies in the
form of an event study, a regression analysis and a structural break analysis, in
order to determine when and under what circumstances significant changes
happened.

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 • Conduct a survey involving the creators and the users of financial statements in
order to observe their experience regarding the usefulness of financial statements
to reveal financial health. This is done by means of questionnaires that are
designed to derive conclusions of what practitioners tend to experience in
practice and what their feelings are regarding the use of financial statements and
accounting data in an analysis of the financial health of a company. The results of
the questionnaire are analysed statistically to indicate the value of the hypotheses
that flows from this objective (the hypotheses is discussed in more detail in
Chapter Four).

The research objectives are discussed in detail in Chapter Four.

1.5 RESEARCH METHODOLOGY

In order to conduct structured research that adds value, one needs to establish and
follow an appropriate methodology. In order to give structure and meaning to a research
project, it is necessary to make use of a research model. Such a model can be
developed from scratch, or an existing research model can be adapted and applied to a
new study. The last-mentioned option is applied in this study, making use of a model
developed by Mitroff, Betz, Pondy and Sagasti (1974) in a research project. Mitroff et al.
(1974:46) indicated that there are certain aspects of science which can only be studied
from a whole systems perspective and that anything less than a holistic view will fail to
pick up some of the most essential characteristics. The model was again mentioned and
discussed by Mitroff and Kilmann (1977:114), where they referred to the model as a
“whole systems model of science”. In the rest of this study the model is referred to as
the “Mitroff model”.

Koornhof (2001:255) found that the model by Mitroff and Kilmann has an element of
flexibility that makes it appropriate to a wide spectrum of research, especially in less
formal, experimental and naturalistic research. This makes the model ideal for this
research.

9
The Mitroff model guides the researcher through the necessary research inquiry
procedures that ought to be followed to solve a particular problem. The model can be
used in a wide spectrum of research beyond the realm of systems theory.

Figure 1.1: The “whole systems model of science” or the “Mitroff model”

Source: Adapted from Mitroff and Kilmann (1977:114)

The diagram is interpreted as follows:

• Each circle represents what is referred to as a “phase”
• The lines connecting the circles are referred to as “steps”

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As observed in a study by Koornhof (2001:260), the model is a valuable tool in
accounting research, especially in areas where there is a range of research approaches
and methods:
• its circles and activities help to delineate the scope of research;
• the circles also assist the researcher with segmenting the research project into
chapters;
• the various research activities suggest an appropriate and logical sequence of
chapters;
• the model prompts appropriate thought processes at various stages in the
research project; for example, lateral thinking during conceptualisation and logical
reasoning during modelling;
• it encourages a holistic approach to scientific endeavour;
• it supports a process-related approach, because the model has no specific
beginning or end and provides for continuous feedback;
• it provides legitimacy to an exploratory and non-formal research topic;
• it dispels misconceptions about research; such as that
o research should cover all activities identified in the model;
o research must be validated;
o research must be implemented; and
• it highlights alternative research approaches and styles that can be adopted.

For the purposes of this study, the Mitroff model is used to structure and divide the
document as described below.

Phase One of the model (Phase I: Reality, Problem situation), explains the background
and the motivation behind the study. Phase I is comprised of Chapter One (my
introduction), as well as Chapter Two and Chapter Three of this dissertation.
Chapter Two takes the form of a literature review about accounting irregularities and
Chapter Three is a literature review on corporate finance techniques and theories on the
detection and identification of accounting irregularities. These chapters explain the
problem situation and state the reasons why such a study is necessary.

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Step One (Conceptualisation) is the activity involved in preparing a research
methodology for the empirical research, which is presented in the next Phase. Therefore
Phase Two of the model (Phase II: Conceptual model) is the presentation of the
research methodology developed in Step One and is presented in this document in
Chapter Four, which is concerned with the research methodology used for the empirical
research. Chapter Four sets out the idea of the study, how the research will be
conducted and the ultimate aim or model that is to be the outcome of the research.

Step Two (Modelling) is the activity involved in the actual research as described in
Chapter Four. Phase Three of the model (Phase III: Scientific model) relates to the
actual empirical research and is described in Chapters Five, Six, Seven and Eight. The
chapters contain the following:
1. an identification of the characteristics that are prevalent in companies with a risk
for accounting irregularities;
2. the identification of case study companies that are to be analysed;
3. an analysis of the case study companies in a quantitative and qualitative way as
well as a statistical analysis of the companies by means of event studies and
regression and structural break analyses; and
4. a survey of the experience of people involved in the preparation of annual reports
as well as the users of annual reports.

Step Three (Model solving) is the activity involved in describing the empirical research
results so as to present it in a way that can be understood and used by the readers of
the study. Phase Four (Phase IV: Solution) is represented at the closure of the study in
Chapter Nine, where the outcome of the empirical research is discussed and
recommendations are made regarding the ability of financial statements to reveal the
financial health of a company.

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Step Four (Implementation) is the activity involved in analysing the actual research
results and stating how they can be implemented in practice. It relates the results of the
research back to the original problem situation.

Step Five (Feedback) and Step Six (Validation) fall outside the scope of this study.

In the rest of the document an indication is given in each chapter as to which part of the
Mitroff model is being addressed.

1.6 NATURE AND FORM OF RESULTS

1.6.1 Outcomes of the study

The interim findings of each section of the study are presented at the end of the relevant
chapter. Descriptions are included to support the findings. The integrated findings from
all the sections and possible solution(s) to the research problem are discussed in detail
in the final chapter.

The aim of this exploratory study is to identify whether there is any benefit to be had
from an analysis of published financial statements. If such a benefit exists, it can help
parties other than internal management, such as the board of directors, investors,
creditors, the Receiver of Revenue and the government to detect and identify
accounting irregularities that may harm the financial health of a company.

Beneish, Lee and Nichols (2012:25) state that efforts to prevent accounting irregularities
involve both public and private initiatives. On the public side, accounting and security
market regulators can help prevent them by means of legislation and enforcement
actions. On the private side, parties such as investors can play a role by identifying
organisations that are likely to have manipulated earnings and hold them accountable
through market-based disciplinary mechanisms.

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1.6.2 Outline of the thesis

Following on from this chapter, the rest of the study follows the format set out below.

Chapter Two is a literature review with a detailed background of irregularities of various

kinds. The study looks at accounting irregularities that may impact on the financial
health of a company. Other types of irregularities are also discussed in order to make
the distinction between different types of irregularities clear. Since the study is an
exploratory one, looking at a relatively new area of research, the aim of the literature
review is to integrate the observations and findings that other researchers have made,
rather than critically appraising other researchers’ work.

Chapter Three looks at the use of financial analysis as a method to detect and identify
irregularities. This is discussed with reference to previous research.

Chapter Four gives a detailed account of the research methodology and research
methods that are applied in the study.

Chapter Five looks at characteristics displayed by companies that pose a greater risk for
accounting irregularities. The information comes from the work of various researchers
and writers from around the world, including South Africa. There appears to be a
number of quantitative and qualitative characteristics that are displayed by companies
with a higher possibility of having accounting irregularities.

Chapter Six discusses five companies that, through media searches, have been
identified as having had allegations of accounting irregularities against them.

Chapter Seven contains the results of the empirical analyses of the identified case
studies. Firstly, the annual reports of the companies that were identified are analysed.
Secondly, the annual reports of the companies are compared to the weighted average
total of all the companies in the sector and to individual companies without known

14
accounting irregularity allegations in the same sector. This forms part of a quantitative
analysis and a qualitative analysis. Thirdly, statistical analyses, specifically event studies
and structural break analyses are performed on the share price data of the identified
case study companies.

Chapter Eight contains details about the results of a questionnaire survey distributed to
a random selection of compilers and users of financial statements.

Chapter Nine summarises the findings from the analyses of the case studies and the
survey results and sets the stage for further research.

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 CHAPTER TWO
CORPORATE MISCONDUCT AND ACCOUNTING IRREGULARITIES

2.1 INTRODUCTION

This chapter forms part of Phase One of the Mitroff model as described in Chapter One.
The aim of this chapter is to give the reader an idea of the reality of the problem by
means of a literature review.

The study deals with the means available to interested parties to reveal the financial
health of a company, specifically relating to the presence of possible accounting
irregularities in the accounting system and the published financial statements of a
company. In order to provide background to the reader, this chapter explains how
accounting irregularities manifest in the financial statements. This is best done by
means of a literature review about the end result of accounting irregularities, namely
fraud. The chapter therefore commences with general definitions of fraud and the
different terms that are used when fraud is discussed. This is followed by information
about the different types of fraud, why fraud occurs, how fraud is perpetrated, who is
responsible for fraud detection and control and finally how fraud is detected and
identified.

In extreme cases accounting irregularities can evolve into financial statement fraud,
which has the potential to cause the downfall of a company. However, even if a worst-
case scenario like that does not realise, it may still cause damage to the reputation of a
company and result in unnecessary monetary losses for not only the company, but also
its investors and other related parties.

For the reasons mentioned above, it is important that everyone with a stake in a
company knows what accounting irregularities are, what they look like and how they can
possibly be prevented. This chapter gives an overview of the different kinds of fraud with
specific attention given to accounting irregularities. The aim is not only to familiarise the

16
reader with accounting irregularities and fraud, but also to give reference to studies that
have been conducted in this field.

2.2 WHAT IS FRAUD?

Robertson (2002:5) defines fraud as “all the means that human ingenuity can devise,
and which an individual may resort to in order to get an advantage over another person
by false suggestions or the suppression of the truth.” It includes the following: surprises,
tricks, cunning, dissembling and any other unfair way through which another person is
cheated.

Locally, Ernst and Young South Africa (2003) define fraud differently, namely as a crime
that has elements of intentional and unlawful misrepresentation which cause prejudice,
most often taking the form of misappropriation or false accounting. The South African
legal definition of fraud, according to the Prevention and Combating of Corrupt Activities
Act, Act 12 of 2004, is a crime of deliberately misleading or deceiving someone to cause
that person financial loss or other harm.

In this study, the focus is mostly on occupational fraud, which refers to fraud that takes
place in the workplace. This is formally defined by ACFE’s Report to the Nation (2012:6)
as “the use of one’s occupation for personal enrichment through the deliberate misuse
or misapplication of the employing organisation’s resources or assets.” This definition is
very broad, including any form of misconduct by employees, managers, and executives.
Occupational fraud schemes range from occurrences as simple as the theft of company
supplies to actions as complex as sophisticated accounting fraud.

2.2.1 The fraud triangle

Even though there are different versions of the definition for fraud, the essence of fraud
remains the same in that it encompasses all activities that are intended to deceive those
that are not involved in the fraudulent activities, with the end result of unduly benefiting

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those that perpetrate the crime. The fraud triangle (as depicted in Figure 2.1) explains
the elements of fraud. In order for fraud to occur, all three these elements are usually
present.

Figure 2.1: The fraud triangle

Opportunity

Rationalisation Motivation

Source: Adapted from Wells (1997:11)

Robertson (2002:185) explains how the three elements from the fraud triangle make
fraud possible. The three elements work together in the following way:
• Motive (incentive) is the pressures that a person experiences. These are to be
“psychotic” (related to habit), egocentric (related to personal prestige), ideological
(believing that the cause is morally superior) or economic (related to a need for
money). When a person who is involved in an organisation acts in a different way
than he/she normally would, it may be an indication that the person is experiencing
difficulties. Such difficulties may act as motivation to use fraudulent means to get out
of the situation.
• Opportunity is an open door to solve a problem by violating a trust. It is important that
interested parties in a company do what they can to ensure that the opportunity to
commit fraud is limited. This is mostly done by means of control measures.
Normally, the higher the position of a person in the organisational hierarchy, the
more trust is placed in him/her and the greater his/her opportunity to commit fraud.
• Rationalisation refers to the ability to convince oneself that an act is acceptable
according to moral and ethical values even if it is not. Fraudsters find a way to
rationalise their actions and make it acceptable to themselves. This will, however,

18
 only come out if and when a case of fraud is detected and identified. While the
perpetrator is involved in a case of fraud, rationalisation will act as a further means
to hide the fraud.

Kassem and Higson (2012:195) find that researchers interpret the fraud triangle
differently, especially the motive-section. The model developed by them is displayed in
Figure 2.2

Figure 2.2: An updated fraud triangle

Source: Adapted from Kassem and Higson (2012:194)

The contribution made to the fraud triangle by Kassem and Higson (2012: 194) is
evident in the mention of a model called “MICE” to define motivation. It stands for the
following: money, ideology, coercion, and ego. Ideological motivators justify the means
where perpetrators act inappropriately to achieve some perceived greater good that is
consistent with their beliefs. Coercion happens when individuals may be unwillingly
pulled into a scheme. Ego can also be a motive in cases where individuals do not want
to lose their reputation or position of power in front of their society or families and resort

19
to inappropriate means to keep up appearances. Kassem and Higson also added
another element; namely, a fraudster’s capabilities to commit a crime.

The fraud triangle, whether looking at the old or the new model, helps one to understand
why fraud is committed in the first place. It also gives interested parties a guideline as to
what they have to look out for. It is important that people realise fraud is a reality and
that most people are capable of committing fraud or run the risk of being defrauded.

2.2.2 White-collar crime and its perpetrators

Fraud is often referred to as white-collar crime, but Minnaar-Van Veijeren (2000c:38)

explains that fraud is a separate crime found within the ambit of white-collar crime.
White-collar crime in general is also referred to as commercial or economic crime. While
white-collar crime includes fraud, it includes other elements as well, such as bribery and
corruption, industrial espionage, insider trading, conflicts of interest and money
laundering (Du Plessis, 1997:11). Minnaar-Van Veijeren (2000a:37) states that there are
a number of characteristics that are inherent to white-collar crime and that distinguish it
from other crimes like robbery and assault. The crime usually involves premeditation, as
well as careful planning and deception because of its complexity. There is normally a
concealed misappropriation or deception, meaning that it is not openly visible. There
may be a diffusion of responsibility and a diffusion of victimisation. Other characteristics
indicate towards a lack of violence and the presence of an element of fraud and/or
corruption, forgery, theft, money laundering and other elements. These characteristics
prove that white-collar crime is different from other types of crime and they make it more
difficult to detect and identify the crime. These crimes are often seen to be "rational" and
the criminal often has the opportunity to commit such crimes through his/her working
conditions.

Additional to the inherent characteristics of white-collar crime, it seems as if the criminals

involved in such crimes display behaviour different from that of other criminals. In Elliot
and Willingham (1980:214), it is noted that criminals who perpetrate white-collar crime

20
are often older, have no tattoos, have higher IQ scores, are mostly female, have a
higher education qualification, do not use drugs and have fewer entries on their arrest
and conviction records. Robertson (2002:182) additionally found that most fraudsters
are married, are members of a church, are educated beyond high school, have no arrest
record, range in age from their teens to over 60 years, are generally socially conforming,
tend to have an employment tenure of one to 20 or more years and usually act alone.

Research has shown that fraud is more likely to be perpetrated by those in positions of
trust (Mitchell, 1997:104) – thus by employees that have been part of the company for a
long time, or by managers. It was also found that fraudsters score higher in tests of self-
esteem, self-sufficiency and motivation for achievement, social conformity, and self-
control, kindness, empathy, optimism and family harmony. It seems that white-collar
criminals are more like the average person than other criminals.

Other factors that provide further proof of the ordinariness of fraud perpetrators are
related to the size of the frauds committed by different perpetrators. These have been
established by ACFE, based on research figures from around the world (2012:39-60):
• losses due to fraud by managers and executives are generally greater than those by
non-managerial employees;
• however, more occurrences of occupational fraud result from activities by employees
and managers;
• more frauds are committed by those who have worked for the organisation between
one and five years;
• the longer the time period that the perpetrator has worked for the victim organisation,
the larger the loss;
• males account for more fraud cases than women;
• losses caused by men tend to be higher than the losses caused by women;
• more frauds are committed by employees in the age group of 45 to 55 years;
• when looking at median loss per age group, the highest median loss is caused by
perpetrators in the age group of 50 to 55 years;
• the more educated the perpetrator, the higher the loss from the fraud tends to be;

21
• the most frauds happen in the accounting department, followed by operations and
sales; and
• the largest frauds happen with executive management, the finance department and
the board of directors.
If these observations are true, it provides proof that white-collar crime can perhaps be
more difficult to detect and identify than other crimes, since the perpetrator is likely to be
an ordinary citizen who appears to be the same as any other. It is rumoured that most
people are shocked when they hear someone was involved in white-collar crime. It is
normally a person that one would least likely suspect.

Wells (1990:82) uncovered six myths that people tend to believe about fraud. The main
points are summarised as follows:
• Myth 1: Most people will not commit fraud. This is untrue because fraudsters come
from all walks of life. The research by the ACFE shows that it tends to be the person
least suspected. Those in top positions and pillars in the community are often
believed to be innocent, but it must be borne in mind that they occupy the best
positions and have the best opportunities to commit fraud without being caught.
• Myth 2: Fraud is not material. Small frauds have the potential to quickly become
material. A lot of small incidents also quickly add up to a lot. For these reasons all
types and sizes of fraud need to be considered as important.
• Myth 3: Most fraud goes undetected. Fraudsters generally become overconfident in
their actions and their frauds become too large. It has the consequence that the
fraud becomes easier to detect.
• Myth 4: Fraud is usually well concealed. After being detected it is often found that
most frauds were not well concealed in the first place and could have been detected
easily through the careful observation of people and records.
• Myth 5: Prosecution deters others. It has been found that fraud detection provides
others with pointers on how to perpetrate a fraud without being caught rather than to
deter fraudsters from committing the crime.
Through these myths, it becomes apparent that people tend to misjudge not only the
extent of fraud but also who commits it and how it can possibly be detected and

22
identified. If one accepts that fraud is always a possibility, it becomes clear why
everyone, including parties external to the operations of a company, should make an
effort to prevent, detect and identify cases of fraud.

2.3 FRAUD WITHIN A COMPANY – CORPORATE FRAUD

In South Africa corporate fraud is as serious a problem as it is in any other country.

Corporate fraud cost the economy R40 billion per year around 2001 (Dawson, 2001:14).
Fraud within a company is seen as a more serious problem than fraud committed
against a company by outsiders. This has led to a growing awareness of the dangers of
corporate fraud and of methods to detect and prevent its occurrence. Improved
governance systems and increased disclosure have resulted, but it remains to be seen
whether these do in fact reduce the occurrence of fraud.

The ISA 240 (IAASB, 2012) defines corporate fraud as "an intentional act by one or
more individuals among management, those charged with governance, employees or
third parties, involving the use of deception to obtain an unjust or illegal advantage".
Robertson (2002:59) calls corporate fraud an occupational crime, meaning that it is a
crime committed by individuals within an organisation while they are engaged in their
occupations. The categories which he uses for occupational crime are; first, crime
committed for the benefit of an employing organisation; second, fraud committed by
state officials through the exercise of their authority; third, fraud by professionals as
professionals; and fourth, fraud committed by individuals as individuals.

2.3.1 The fraud triangle in corporate fraud

The elements of the fraud triangle are visible in corporate fraud. Moyes and Hasan
(1996:41) have identified the factors of the fraud triangle that apply to corporate fraud as
situational pressures from management or the corporation (motivation); opportunities
that allow and encourage fraud to be committed (opportunity) and management that
justifies conduct as acceptable with plausible but untrue reasons (rationalisation).

23
Rationalisations that are often heard is that "everybody does it", "it is worth the risk", "it
is only temporary" and "the company makes substantial contributions to society that will
be lost if the company goes under". When considering crimes such as tax evasion, the
rationalisations can perhaps be that it is all right to steal from the government because
"it is socialistic", "it is large enough to handle it", "laws are counterproductive" and "the
laws were set by an opposition political party to reduce competition".

2.3.2 Measures that are put in place to prevent corporate fraud

Fraud, especially on behalf of the company, comes with a certain organisational culture.
It does not mean that a company engaging in unethical or fraudulent activities has to
have a negative culture. In many cases, it is a positive one where individuals identify
with the goals and well-being of a company and want what they believe is best for the
company and for themselves. Characteristics associated with fraud include loyalty,
cohesiveness, trust, aggressiveness and other attributes that are mostly valued by
companies as traits they prefer in their employees (Elliot & Willingham, 1980:177).
Corporate fraudsters may therefore act with the best intentions and often do not realise
that they are acting fraudulently. Robertson (2002:55) is of the opinion that management
behaviour is the main cause behind corporate fraud, as managers are the primary
influence in unethical decision-making. They “set the tone at the top” and create what
becomes the ethical norm.

It is an indication of the seriousness of the crime that several statements and

suggestions have been introduced in the USA on how to prevent corporate fraud
(National Commission of Fraudulent Financial Reporting, 1987). In the period from 1985
to 1987 alone, the Financial Accounting Standards Board (FASB) issued nine
statements to enhance the quality of generally accepted accounting practice (GAAP);
the Securities and Exchange Commission (SEC) issued eleven financial reporting
releases; and the National Commission of Fraudulent Financial Reporting released
49 recommendations to prevent and detect fraud.

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In South Africa, the King III report on corporate governance (Institute of Directors, 2009)
gives clear guidelines on the internal control measures required to assist in the
prevention of fraud. Reporting on internal controls has become compulsory (Cameron-
Ellis, 2000:66) in order to increase the awareness of directors and thus reduce the
incidence of fraud. However, it remains difficult to prevent fraud and to measure its
scope – it is a crime that is difficult to trace because people do their best to hide their
actions. Measurement is made more difficult because fraud is often not reported and/or
the perpetrators are not prosecuted.

Krambia-Kapardis (2002:267) suggests that corporate fraud is difficult to detect because

the people who commit the crime are often familiar with accounting procedures and thus
know how to cover it up. Peter, Jerry and Danjuma (2012:153) find from various studies
that external auditors rarely detect fraud perpetrated by management in the course of
their audit assignment because management is in an ideal position to override internal
controls and to conceal the accounting irregularities perpetrated by them. There is also
often a built-in conflict of interests because the managers who hire the auditors are the
ones being investigated; therefore they are able to hide those specific things they do not
want to be detected. If these observations hold true for a company, fraud is likely to go
by undetected. Therefore it is helpful if parties other than managers are aware of fraud
and realise that its occurrence is not as unlikely as one may believe.

2.3.3 Types of corporate fraud and its impact

ISA 240 (IAASB, 2012) places fraud in companies into two main categories. The first is
misstatements in the accounting system of an organisation and the other refers to
misstatements resulting from a misappropriation of assets. The misappropriation of
assets falls under employee fraud, while misstatements from fraudulent financial
reporting are also called accounting, financial statement or management fraud. These
types of fraud are discussed below.

25
The Institute of Internal Auditors (IIA, 2001) Practice Advisory 1210.A2-1 identifies some
examples of fraud that are aimed at benefitting the organisation. They are the sale or
assignment of fictitious or misrepresented assets, improper payments (bribes) to
government officials, the intentional improper representation or valuation of assets,
liabilities or income, intentional improper transfer pricing, intentional improper related
party transactions, and intentional failure to record or disclose significant information,
prohibited business activities and tax fraud. While corporate fraud is mostly committed
on behalf of the company, some perpetrators commit fraud for their personal benefit.

Fraud perpetrated against an organisation for some benefit to the perpetrator are, for
example, accepting kickbacks or bribes, diverting a transaction that would have been
profitable to the organisation to an outsider or employee, the theft of money or property,
the intentional concealment or misrepresentation of events or data, or false claims
submitted for services of goods not actually provided to the organisation.

Fraud has a wide-ranging impact on a company. Firstly, fraud can potentially have an
adverse effect on share prices. Schilit (1993:12) found that the share prices of
companies with fraud allegations against them tend to decline rapidly. In a study by
Dechow, Sloan and Sweeney (1996:27), it was found that the share prices of firms were
severely affected by reports of earnings manipulations. Fraud also has an adverse effect
on efficiency, productivity and innovation, because financial (and in some cases non-
financial) resources are diverted and allocated to non-constructive activities. Glover and
Aono (1995:4) have identified other losses associated with fraud; such as, lower sales,
lower employment, lower productivity and poor credibility.

Davia, Coggins, Wideman and Kastantin (2000:34) hypothesize that the full extent of
corporate fraud will never be known. They place fraud cases into three categories,
namely fraud that has been prosecuted (20% of cases), fraud that has been discovered
but not prosecuted (40% of cases) and fraud that has not been discovered (40% of
cases). This means that only 20% of fraud cases are exposed to public scrutiny, while

26
the rest are hidden and their details lost. As with an iceberg, where the largest part lies
hidden beneath the surface, most corporate fraud cases are hidden from view.

2.4 MISAPPROPRIATION OF ASSETS – EMPLOYEE FRAUD

In this study, the focus falls mainly on fraud by managers, or accounting fraud. However,
for the sake of completeness, employee fraud is also briefly discussed.

Misappropriation of assets is the act that occurs most often in this category of corporate
fraud. Misappropriation is simply the theft of an entity's assets with the goal of obtaining
a benefit without having to pay for it. The asset may be anything in an organisation,
ranging from a pencil to a computer or even something larger.

Robertson (2002:181) formally defines the misappropriation of assets as taking property

or money from an employer by fraudulent means. It involves falsification of some sort
and consists of three stages; namely, the fraudulent act, conversion of the money or
property to the fraudster's use and the cover-up to avoid detection.

According to Connelley (2003) there are a number of methods through which employee
fraud is committed. The most prevalent amongst those involve misuse or
misappropriation of company assets; for example, skimming a cash sale, stealing a daily
deposit, stealing inventory or scrap, scrapping and selling good inventory, stealing fixed
assets, personal use of assets, stealing cheques, stealing paycheques, diverting loan
proceeds and underpaying dividends while diverting the rest.

Robertson (2002:73) refers to the alteration of documents, the kiting of money between
two bank accounts, fictitious accounts receivable, the embezzlement of scrap proceeds,
false charges to inventory accounts, over-billing, conflict of interest, using assets as
collateral for a loan, borrowing money to earn interest, overtime abuse, withholding tax
and personal expense reimbursement. There are a multitude of other schemes being

27
used to defraud companies and even more schemes are most probably still being
thought out.

Even though employee fraud as a separate subject is not included in this study, it may
be worthwhile to note that, if such schemes are detected in a corporate environment,
other types of fraud such as accounting fraud may perhaps also be committed. It
sometimes happens that a company develops a “culture” that fosters fraudulent
conduct, especially if the management of a company do not properly address the issue.

Financial statement fraud as the end result of accounting irregularities have been
discussed extensively in the previous paragraphs. From this point onward, the focus of
the document moves away from financial statement fraud and rather falls on the
accounting irregularities that generally occur before financial statement fraud occurs.

2.5 CORPORATE MISCONDUCT BY MANAGERS – ACCOUNTING

IRREGULARITIES MANIFESTED IN THE FINANCIAL STATEMENTS

Accounting irregularities refers to the falsification of an organisation’s accounting

records to make the financial statements appear either more, or in some cases less
profitable.

2.5.1 Defining accounting irregularities

Quinn Mills (2003:82) is of the opinion that the main objective of accounting changed
during the 1990’s; from revealing organisational information to concealing organisational
information. He even goes as far as claiming that accountants have become allies in
management attempts to improve financial results. The extent of judgement that is
allowed in the interpretation of accounting rules can possibly make it easier to hide
information.

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This was also the observation by Cronje and Gouws (2011:55), who observed that the
preparers of financial information use an accounting language that needs to be
interpreted correctly by users to enable them to understand and use the information
appropriately. In order to convey the meaning of accounting successfully, the sender
and the receiver of a message need to use the same method to encode and decode the
message. However, it does not always happen that this communication process
happens smoothly and it can happen that the preparers of financial information abuse
the fact. This provides the opportunity to mislead the users of financial information by
means of the use of language.

Quinn Mills (2003:85) also quotes Turner, who was the chief accountant at the
Securities Exchange Commission (SEC) in the late 1990s, saying that fraudulently
misstating financial results is part of “day-to-day business operations in accounting firms
and on Wall Street”. If this is in fact the case, it becomes a cause for concern when
investors and other interested parties could not rely on their most readily available
source of information about the companies that they have an interest in. It is therefore
necessary that everyone becomes knowledgeable about accounting irregularities in
order to expand the base of individuals who are able to detect and identify its
occurrence.

Savage (2003:6) reported on a regular fraud survey done by the audit firm Ernst and
Young’s Forensic Services. They found that 50% of perpetrators of accounting
irregularities hold positions in management. The reasons he suggested are the growing
complexity of businesses and accounting practices, as well as a recessionary
environment. This can be seen in that younger businesses tend to fail more frequently
than older more established ones (Altman & Hotchkiss, 2006:13), giving managers in
younger businesses more incentive to improve performance, albeit through unethical
means. Modern managers also have more access to information and opportunities
through the Internet.

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The report of the National Commission on Fraudulent Financial Reporting (1987) – also
called the Treadway Commission – defines fraudulent financial reporting as "intentional
or reckless conduct, whether by act or omission, that results in materially misleading
financial statements". This is also the definition that Robertson (2002:105) refers to. A
document currently being used by auditors, ISA 240 (IAASB, 2012), defines fraudulent
financial reporting as intentional misstatements in the accounting records, including
omissions of amounts or disclosures in financial statements to deceive financial
statement users.

For the purposes of the law, to have a case of accounting fraud, a company must have
issued financial statements that contain false or misleading information about the
company's financial condition or results (Davia et al., 2000:15). The perpetrators must
also have had the intention to defraud a third party, like a creditor or investor.

Accounting irregularities have to be clearly distinguished from non-fraudulent earnings

management and accounting errors. Non-fraudulent earnings management implies that
a legitimate GAAP method is chosen because it has a favourable impact on the financial
statements (Rezaee, 2002). This may, for example, involve deciding on certain inventory
valuation or depreciation methods. Errors, on the other hand, are unintentional mistakes
that appear in financial statements.

As errors happen without intent, they are normally easier to detect. However, those who
perpetrate accounting irregularities go to great lengths to conceal intentional
misstatements in order to make it more difficult to trace. Sherman, Young and
Collingwood (2003:6) compare irregular accounting entries to “landmines” in the books
of a company. They are hidden in the books and records of companies and may never
“detonate”. However, in a case where such an “accounting landmine” is discovered or
“detonated”, its effects can potentially have a devastating impact on investors, creditors,
and the public’s confidence.

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2.5.2 Reasons for accounting irregularities

Elliot and Willingham (1980:47) claim that accounting irregularities occur because
managers are mostly seen to be outside the system of internal control. Since they are
the guardians of internal control measures, it becomes easier for them to bypass such
controls. Tipgos (2002:34) also observes that no controls can ever completely control
management’s actions, because "(m)anagement controls internal control". The board of
directors has the power to govern the activities of managers, as they are the
representatives of the shareholders. However, it is difficult for them to oversee all the
day-to-day activities of managers. It was found that boards rarely ask probing questions
about management's activities. Therefore managers are basically free to do as they
please. Rezaee (2002:35) claims that a lack of non-financial information, a lack of
information about intangible assets and a lack of forward-looking information also
provide opportunities for irregularities, as managers are not obliged to discuss such
aspects of the business.

Companies are all different and, for this reason, GAAP allows for different interpretations
of standards and different interpretations of financial statement line items based on the
subjective judgement of management. In their research efforts Shi, Dharwadkar and
Harris (2011:40) provide preliminary evidence about the importance of the social context
for accounting choices and recommend that future researchers consider both the
monitoring and social context factors simultaneously in order to better understand an
organisation’s accounting choices. Cieslewicz (2012: 246) also claims that a fraud
model can only be appropriate for use internationally if it takes into account societal-
level influences.

The subjectivity inherent in the accounting rules makes it easier for managers to
perpetrate irregularities, since it provides opportunities to manipulate the statements to
present better or poorer results, depending on the needs of management. GAAP is also
full of exceptions (Sherman et al, 2003:149) which help managers to be more “creative”
in their practices. Exceptions to financial statement standards have been introduced to

31
ensure that a company is able to present true and fair results, even if a particular
accounting standard is not applicable or useful in the particular circumstances. In some
cases it happens that managers even seek out exceptions that they can use to
manipulate results (McBarnet & Whelan, 1999:103). Even though managers are obliged
by law to fully disclose any departures from GAAP (McBarnet & Whelan, 1999:41), it is
not to say that they will in fact do so. Therefore, such exceptions can perhaps be
manipulated by a company if a specific GAAP requirement will cause the company’s
results to appear different from what the company’s management desires.

Fridson and Alvarez (2002:4) indicate that the goal of financial statements is to provide
information that accurately measures the profitability and financial position of a
company. However, the managers who are responsible for those figures want to present
a favourable picture to interested parties, because volatility is often seen as a negative
sign. Since the financial statements are the responsibility of management, accounting
irregularities occurs mostly with the knowledge and consent of management. According
to Quinn Mills (2003:104), accounting irregularities also occur in some cases with the
knowledge eand consent of parties other than managers. He found, for example, that
banks may be convinced to structure loans to companies in such a way as to conceal
the debt from investors.

2.5.3 Means to prevent accounting irregularities

The various interested parties that are likely to be affected by accounting irregularities
need to take positive action in detecting and identifying such cases. Robertson
(2002:63) has found that the victims of accounting irregularities could be persons inside
and outside the organisation. The potential victims of accounting irregularities are
therefore ideal gatekeepers to prevent or otherwise detect cases of accounting
irregularities. The National Commission on Fraudulent Financial Reporting (1987:26)
lists the following victims of irregular financial reporting:
• banks and financial institutions (lenders);
• shareholders (investors);

32
• suppliers;
• customers;
• merger partner’s defrauded statements reflecting more than the company's actual
worth;
• underwriters who distribute securities;
• financial analysts who give investment advice based on faulty information;
• the company's accountants who become subject to investigation;
• insurance companies which receive large claims;
• management and directors of the company who suffer a loss of reputation and
standing;
• employee shareholders;
• honest employees and managers who suffer from guilt through association; and
• public confidence lost through media attention.
According to Morley (1984: ix), the government and tax gatherers also belong on the list.
All these individuals and institutions have to be aware of accounting irregularities and
the likelihood of their occurrence. Being familiar with the characteristics and
relationships that are normally observed in the financial statements in cases of
accounting irregularities can possibly help these parties to take a proactive approach in
safeguarding their interests.

2.6 THE MOTIVATION BEHIND ACCOUNTING IRREGULARITIES

In order to better understand what accounting irregularities entails; it is helpful to

understand the reasons why they are committed and the motivations of the people who
are involved.

According to Hussain, Kennedy and Kierstead (2010:72) the root of the problem lies with
managers that continuously experience pressure to increase profits as well as the
competitive tendency to grow in business. Schilit (1993:3) claims that accounting fraud
happens for three basic reasons: it pays, it is easy to do and it is unlikely that one will
get caught. Firstly, managers would rarely engage in accounting irregularities if they did

33
not expect to benefit from it. Secondly, there is the ease with which the accounting
irregularities are accomplished, because there are a number of options to choose from
in the case of some accounting principles. Finally, poor controls and good hiding
techniques make accounting irregularities difficult to detect.

Rezaee (2002:30) claims that managers of a company have three options when
financial results are not as favourable as they would like the public to believe. The first is
to publish the adverse results, receive an unqualified audit opinion and face the
consequences. The second is to violate GAAP in order to present results that are more
favourable. However, in that case the auditors are likely to detect such manipulation and
issue a qualified audit opinion. The third option is to engage in the manipulation of
accounting records to report better results. If it goes undetected by the auditors, the
company ends up with the best outcome of the first two options, namely an unqualified
audit opinion and favourable financial results. It therefore appears to be more beneficial
for managers to adjust the financial statements by fraudulent means.

Robertson (2002:105) has found that accounting irregularities are mostly committed
because management tries to make earnings look better. This method is usually
covered up through valuation judgements and by manipulating the timing of entries and
valuations. There are other reasons for accounting irregularities: encouraging
investment, demonstrating higher earnings per share (EPS), dispelling negative market
perceptions, obtaining financing, receiving higher acquisition purchase prices,
demonstrating compliance with financing covenants and receiving performance-related
bonuses.

Kravet, Myers, Sanchez, and Scholz (2012:29) state that the manipulation of financial
statements is used to create false improvements in reported financial performance
before negotiations for acquisition start to increase share prices. These inflated share
prices facilitate share-based acquisitions because they lower the purchase price. They
found a positive association between misstatements and acquisitions. They observed
that misstatements associated with acquisitions were more serious than are other

34
misstatements. This is an important observation because previous research speculates
that acquisition-related misstatements arise as a result of the complex accounting that is
involved in merger and acquisition transactions.

Although accounting irregularities are usually associated with cases where misconduct
is performed on behalf of a company, there are cases where managers use their own
influence to manipulate company records for their own benefit (Elliot & Willingham,
1980:8). In such cases, the financial statements have the potential to harm investors
and creditors because assets that they believe to exist do not really exist.

Sherman et al. (2003:158) state that, apart from managers, investors and all other
interested parties are partly to blame for accounting irregularities. They are the ones
who tend to keep score of company performance and encourage better performance.
When circumstances either within or outside of the control of the company cause poor
performance, those who are responsible for the accounting reports may be tempted to
try and enhance performance by means of “creative” accounting.

Ethicality is a subjective concept, meaning that it is not the same for all cultures and also
not the same for all individuals. What one person may find acceptable is totally
unacceptable for another. Each person has to decide for him or herself what is ethical
and what not (Els, 2007:13). The line between what is ethical and what is not is
therefore thin and managers are motivated and pressured to operate as closely as
possible to that line and sometimes even to cross it. Rezaee (2002:183) identifies
additional reasons for management to dance close to or over the line, that being that
they might have the perception that the benefits outweigh the costs, that of having
internal and external pressures to show more favourable results, as well as having an
attitude of “living dangerously” and desiring the personal satisfaction involved in taking
risks.

In some cases, however, inappropriate misstatements are not necessarily connected to

the morals of the perpetrator. Adu-Boateng (2011:94) finds that accountants do not put

35
away their moral reasoning when they face an ethical decision about, for example, the
methods of earnings management. The accountant’s interest is intertwined with a
company’s interest, since the accountant’s well-being is tied to the company’s well-
being. Therefore, an accountant’s moral reasoning may be explained by collectivism (a
search to promote the common good), and it is reduced due to situational factors (like
earnings management) which sets out to promote the company’s interest. Individualism
features when a situational pressure gets the upper hand over moral reasoning. It thus
happens that accountants may decide to select unethical earnings management over
other interests in order to enhance the financial performance and position of a company.

Adu-Boateng (2011:95) therefore claims that an accountant’s choice of unethical

practice may be the result of situational factors combined with moral reasoning.
Opposing factors, namely moral sensitivity and situational pressures in decision-making
result in the choice dilemmas. Research findings show that individuals make different
ethical choices given differing situations. As an example, the results of the research by
Adu-Boateng indicate that accountants tend to engage in unethical earnings
management when their firms face financial hardships. It then stands to reason that
managers have the ability to create situations that influence ethical choices.

Du Plessis (1999a:2), identified that a number of pressures or motivations lead to

accounting irregularities. Examples include market expectations (especially those of
analysts and investors), earnings deterioration affecting the bonuses and share options
of senior management, inability to meet profit expectations and poor performance that
cause delays to projects and expansion plans. From a South African viewpoint
specifically, Els (2007:144) identified four factors that may have an impact on the
ethicality of managers and the occurrence of accounting irregularities:
• globalisation – misunderstandings about what is ethical in terms of business
transactions may occur;
• democracy – in a democracy power is given to the people and as a relatively
young country the culture of respect for human rights is still being developed; and

36
 • cultural diversity – different cultures have different views on what is ethical and
South Africa has many different cultures living together.

2.6.1 Categories of accounting irregularities related to motivations for its

occurrence

Turner, in Elliot and Willingham (1980:101), suggests the following categories of

accounting irregularities, which also relate to the reasons why they occur:
• financial statements as the vehicle to commit irregularities, with the company as the
receiver of the benefit (for example, where performance is manipulated to display
better results in order to obtain credit, financing or capital investment, results inflated
to conceal poor performance by management and to evade taxes);
• financial statements as the vehicle to commit irregularities with the perpetrator as the
receiver of the benefit (for example, where accounting records are manipulated to
create a desired change in the company's share price - this may involve increased
share values so that management have the option to sell at higher prices, or
decreased values so that management have the option to purchase at lower prices;
manipulation also benefits them by hiding poor performance);
• financial statements as the vehicle to disguise irregularities with the company as the
receiver of the benefit (for example, by concealing the sale of fictitious or
misrepresented assets, by concealing business activities that are not allowed by law,
or hiding improper payment such as bribes); and
• financial statements as a vehicle to disguise irregularities with the perpetrator as the
receiver of the benefit (for example to disguise irregularities where the perpetrator
receives benefits through acts of embezzlement).

The National Commission on Fraudulent Financial Reporting was jointly sponsored by

five major professional associations in the United States, namely the American
Accounting Association, the American Institute of Certified Public Accountants (AICPA),
the Financial Executives International, the Institute of Internal Auditors, and the National

37
Association of Accountants (now the Institute of Management Accountants). The
Commission conducted a number of studies into the causes of accounting irregularities
and published the causes identified, together with some guidelines in the Report of the
National Commission on Fraudulent Financial Reporting in October 1987. The
Commission’s findings suggest that accounting irregularities occur most often as the
result of environmental, institutional or individual forces and opportunities (National
Commission on Fraudulent Financial Reporting, 1987:23). These forces and
opportunities add pressures and incentives for individuals and companies to perpetrate
accounting irregularities. A well-known incentive is an improvement in the financial
appearance of the company, in line with the goal of obtaining a higher price for a share
or a debt offering, or to meet the expectations of investors. Other incentives are related
to personal gain in the form of gaining bonuses or promotions and escaping penalties.

A fraud report by Ernst and Young South Africa’s Forensic Services (2003) states that
the main aim of false accounting is to present the affairs (therefore more than just
earnings) of a company as being in a better position than they actually are. A common
feature of such irregularities are the necessity to falsify records, alter numbers, and, in
extreme cases, to keep two separate sets of accounting books. This was also the finding
by Sloan and Sweeney (1996:1), who show that, to attract external financing at the
lowest possible cost, managers may attempt to influence investors’ perceptions of the
firm's value.

2.6.2 The issue of creative accounting

Apart from accounting irregularities, the issue of creative accounting arises. Shah, Butt
and Tariq (2011: 536) define creative accounting as the use of accounting knowledge to
influence the reported figures while remaining within the jurisdiction of accounting rules
and laws. Therefore, instead of showing the actual performance or position of the
company, they reflect what management wants to tell interested parties. Honest
managers may therefore use creative accounting in a legal way to make results appear
better, but they have the potential to become accounting irregularities if the conditions

38
that lead to creative accounting are not alleviated and managers have to perpetrate
even more egregious acts to maintain the front they created with creative accounting
practices.

Creative accounting is therefore often seen as negative if it is used with the intention to
mislead or deceive interested parties (Du Plessis & Koornhof, 2000:73). Unfortunately
deception is the reason why it is used most of the time, as many of the benefits of
accounting irregularities can possibly be obtained from creative accounting practices
that still fall within the ambit of the law (McBarnet & Whelan, 1999:5). Consequently,
creative accounting does not constitute accounting irregularities. However, creative
accounting may be thought of as unethical and unacceptable to society, depending on
the moral standards of the observer.

Shah, Butt and Tariq (2011: 536) find that the abuse of creative accounting practices will
never be completely stopped. The improper use of creative accounting practices has
been able to fool interested parties in the past (e.g. Enron) and it is likely to continue to
do the same. Business transactions can be complex and diverse while the latitude
available in the accounting standards and policies may make it difficult to handle the
issue of creative accounting. Creative accounting solutions are not necessarily wrong. It
is the intent and the magnitude of the disclosure which determines its true nature and
justification.

Creative accounting is therefore considered to be a "Type 2" accounting irregularity

(Tipgos, 2002:37), because it is not an accounting irregularity per se, although it does
intend to deceive the users of financial statement information. Both "Type 1" (as
previously discussed) and "Type 2" accounting irregularities fall within management's
discretionary powers and are also referred to as "pure" accounting irregularities. These
types of accounting irregularities appear to be almost impossible to stop, because they
occur within the management domain and there are no controls to prevent them from
happening. One needs to be aware that different individuals’ ideas of what is ethical and

39
what is unethical differ. There is always the possibility that accounting irregularities may
be occurring.

2.7 HOW ACCOUNTING IRREGULARITIES ARE PERPETRATED

When one wants to detect and identify accounting irregularities, a good starting point is
to have some knowledge about how accounting irregularities are generally perpetrated.
This will give one an understanding of how the irregularities may be manifested in the
financial statements. The paragraphs that follow give a broad overview of the types of
methods that are used to perpetrate accounting irregularities.

Nieschwietz, Schultz Jr and Zimbelman (2000:204) categorise the types of most

prevalent accounting irregularity acts (in order of severity) as follows:
• Type 1: Asset overstatement;
• Type 2: Events not recorded;
• Type 3: Revenue overstated;
• Type 4: Specious accounting judgements;
• Type 5: Expenses recorded incorrectly; and
• Type 6: Omitted or misleading disclosures.

Other irregular activities, according to ISA 240 (IAASB, 2012) are: deception through
falsification, manipulation or alteration of accounting records, misrepresentation of
events, transactions or other significant information in the financial statements and
intentional misapplication of accounting practices related to measurement, recognition,
classification, presentation or disclosure.

Overstated revenue is the method most often used in accounting irregularities,

especially in the high-profile accounting irregularity cases in the USA. Out of the 20
cases that were observed by Rezaee (2002:47), all had at least one account of
earnings manipulation or revenue overstatement. Several other researchers, for
example, Beasley, Carcello, Hermanson and Lapides (2000), Beneish (1997), Fridson

40
and Alvarez (2002), Gerety and Lehn (1997), Mulford and Comiskey (2002) and
Robertson (2002) all found that improper revenue recognition, improper expense
recognition, overstatement of assets and inadequate disclosure are the most prevalent
methods of enacting accounting irregularities.

Robertson (2002:107) identified that schemes of overstated earnings, overstated assets

and improper disclosure are usually accomplished through any one of nine general
methods, namely: improper revenue recognition, revenue recognition in the wrong
period, improper sales accounting, improper percentage-of-completion, inadequate
disclosure of related-party transactions, improper asset valuation, improper deferral of
costs and expenses, inadequacies/omissions in disclosures and omissions of
expenses, losses or liabilities. Each of these schemes, in turn, is accomplished in a
number of different ways. When looking at the multitude of different ways by means of
which a company’s performance can be overstated, it becomes all the more important
that more people are aware of these schemes and are on the lookout for their
occurrence.

Beneish (1997:277) adds to the schemes the use of false invoices, keeping the books
open, recognising revenues too early, the inappropriate use of the matching principle by
recording fictitious inventory, failure to write off impaired assets and capitalising
expenses. Gerety and Lehn (1997:589) found schemes such as violations related to the
deferral of expense recognition, revenue recognition in the wrong periods and false
statements about the financial future of the company. Beasley et al. (2000:447) indicate
that improper revenue recognition also includes false confirmations, conditional sales
and modified terms through side letters, unauthorised shipments and consignment
sales. Fridson and Alvarez (2002:149) include the loading of distribution channels as a
means to overstate revenue, where companies convince retailers to accept larger
shipments of goods than usual, while arranging with the retailers to take the goods back
after the companies’ financial statements have been prepared and published.

41
As indicated in a categorisation of schemes by Robertson (2002:114), expenses are
sometimes understated to make earnings look better than they actually are. DeFond and
Jiambalvo (1991:645) note that depreciation methods that lead to increased earnings
are often used. This is not necessarily an accounting irregularity, but is unethical; as
such methods are not in the interest of all parties.

To add to the already-long list of accounting irregularity schemes, Connelley (2003)

identified the misuse of uncertainties about collectability of debt, substantial continuing
involvement by the seller, sham transactions, inter-company accounts with
unconsolidated affiliates, concealment of accounting irregularities through inventory
accounts, inventory overstatement, manipulation of fixed assets to conceal other
accounting irregularities and contract and bidding irregularities.

To facilitate clarity and understanding, the most common methods of accounting

irregularities can be schematised, as displayed in Figure 2.3.

42
Figure 2.3: Common methods of accounting irregularities

Improper revenue
recognition
Overstatement of assets
and revenues
Improper asset
valuation

Inadequate
disclosure of related
party transactions
Accounting False, inadequate or
irregularities omitted disclosures
Inadequate, omission
of, or inappropriate
disclosures

Improper deferral of
expenses and
liabilities
Understatement of
liabilities or expenses
Improper
depreciation,
amortisation, deletion
and write-offs

Source: Adapted from Rezaee (2002:89)

Sherman et al. (2003:106) recognised the use of related-party transactions in

accounting irregularities. According to them it is a problem also recognised by the
American Institute of Certified Public Accountants (AICPA). The problem is that the
definition of a related-party transaction is not in all cases clear enough and places
placing the decision of whether or not to disclose (and to what extent to disclose related-
party transactions) in the hands of a company’s management. This situation should,
however, become less of a problem with the adoption of stricter accounting standards
worldwide.

However, if related-party transactions are misused successfully, it can possibly have the
effect of inflated earnings and a false impression of growth (Sherman et al., 2003:109).

43
Activities that are hidden when related-party transactions are not properly disclosed
include
• borrowing or lending interest-free or well below market rates;
• the sale of real estate at prices that differ from the appraised values;
• non-monetary exchanges of property;
• loans with no due date or repayment terms;
• sales with a commitment to repurchase;
• accruing interest at above market rates;
• loans to parties that are not able to repay;
• advancing company funds to a debtor unable to repay the debt in order for the debtor
to repay and thus helping the company to avoid the cost of an uncollectible debt;
• services or goods received at very little or no cost;
• payments for services never rendered or at inflated prices;
• sales at below market rates to unnecessary “middle men” who make a profit when
reselling the goods; and
• purchases of assets in excess of market value.

Mulford and Comiskey (2002:172) point out that there does not need to be anything
wrong with any of the above-mentioned actions, unless they are misused. For example,
a side letter is sometimes used to clarify or modify agreements, but it also has the
potential to be misused through liberal rights of return, excusing the debtor from
payment or giving the debtor the right to cancel an order at any time. An innocent
practice is therefore sometimes manipulated for a purpose it was not intended for.

As one learns more about the schemes that individuals and companies employ to
change accounting records to make financial statements appear more favourable for
their purposes, it becomes clear that a lot will have to be done to eliminate their
occurrence completely. However, knowing more about the accounting irregularity
schemes that are used is a first step in empowering one to detect and identify such
occurrences.

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2.8 THE RESPONSIBILITIES FOR CONTROL, DETECTION AND
IDENTIFICATION OF IRREGULARITIES

According to the Prevention and Combating of Corrupt Activities Act, Act 12 of 2004
(South Africa, 2004), the duty to detect and identify irregular activities rests on a person
with authority, which is defined as the managers, the secretaries, the company directors
and the members of close corporations. In terms of the Prevention and Combating of
Corrupt Activities Act, auditors do not have any duty to report irregularities. Auditors may
be in a good position to detect irregularities by virtue of the fact that they have the
opportunity to include in their investigations discussions with the client’s personnel,
expectations from previous years, analytical reviews, and general auditing procedures,
tests of detail (analysis and review, obtaining evidence and scanning) and estimates of
value (Hylas & Ashton, 1982:757). Rezaee (2002:204) claims that internal auditors are
in an especially good position to detect problems because of their responsibility to
continuously monitor the internal control system. This gives them opportunities to
identify and investigate any red flags that signal the likelihood of accounting
irregularities. Many of these information sources and procedures are not available to
investors, creditors or other parties with an interest in the company, which makes any
such investigation more difficult for them to accomplish.

It should be recognised however that apart from the benefits of their position, accounting
irregularities in particular can be difficult to detect, as the management of a company
and those charged with the governance thereof, are often in a position to override
established controls. There are natural limits to what anyone without inside information
into an organisation can reasonably accomplish.

Rezaee (2002:141) recognises the importance of the role of the board of directors in
identifying and preventing the occurrence of irregularities. The board is chosen by
shareholders and has a responsibility to protect the interests of those shareholders, as
well the interests of other interested parties. The board of directors therefore has to
control and monitor the actions of management and has to oversee the adequacy and

45
effectiveness of internal controls, audit functions and the financial reporting process.
Quinn Mills (2003:97) mentions that executives and directors have a fiduciary
responsibility to shareholders. This responsibility includes three duties: firstly, to read
documents and literally “do their homework”; secondly, not to prefer their own interests
above those of the company or its shareholders; and thirdly, a duty to disclose all
material facts. However, due to the extent of decisions and actions that have to be
delegated to managers by the board of directors, there is often some risk that
management may abuse that power and act inappropriately.

As early as 1987, the National Commission on Fraudulent Financial Reporting indicated

that the main responsibility for reliable financial statements lies with the company's
management, as management is responsible for setting the tone and establishing the
control environment. The Commission’s definition of internal control clearly states that
one of the responsibilities of management is ensuring the reliability of financial reports.
This is also the view of AICPA (2002), especially where issues of legality and ethics are
concerned. DeFond and Jiambalvo (1991:646) and Robertson (2002:232) recognise the
importance of a good control environment too. Managers ought to work closely with
lawyers, investment bankers, financial analysts, business advisors and others to ensure
the most reliable financial reports. Apart from managers, the National Commission on
Fraudulent Financial Reporting (1987) also recognises the importance of what the public
understands about inappropriate financial reporting.

The USA legislative structure imposes a duty on a company and its management to be
aware of what employees are doing, putting more of the onus of detecting irregularities
on the individual managers and employees. Some USA court decisions have already
found that companies had an obligation to know that the chief financial officer was
stealing (Colapinto, 1998:29). The introduction of the Sarbanes Oxley Act in the USA
was supposed to make managers more careful and diligent in their efforts to establish
strict internal controls (Vaksman, 2004:19). The Act was set in place to regulate the
accounting and financial reporting process and made it possible for managers who
knowingly misreport results to be punished. De Souza (2006:23) reports that the Act has

46
already had an impact on South African companies with ties in the USA, and many
companies are now in the process of becoming compliant with the Act. However, it has
been proven through research by De Vay (2006:112) that the Sarbanes Oxley Act is not
completely successful in preventing accounting irregularities and that it may be a waste
of time and resources.

Under South African law, according to section 77 (Liability of directors and prescribed
officers) of the Companies' Act 71 of 2008 (South Africa, 2008), an individual manager
may be held responsible for accounting misconduct. A manager no longer has the
opportunity to hide behind the company and let it pay for his or her mistakes. The
management and/or owners may also be held liable for losses if the court believes they
could have prevented the accounting irregularities from happening. This approach is
bound to result in better internal control procedures.

There has therefore been a realisation that other parties are also responsible for helping
authorities in the detection and identification of accounting irregularities. Many
accounting irregularity cases have been uncovered through whistle blowing where
employees and other interested parties complain or disclose their concerns (McBarnet &
Whelan, 1999:34). The ACFE has found that, of the larger accounting irregularities (over
$1 million) investigated in the US, 43% were detected by tips (ACFE, 2012:14). This
implies that it is important for all parties with an interest in a company to be aware that
financial statements are not to be trusted completely (Glover & Aono, 1995:8).
Everybody therefore needs to be on the lookout for questionable practices and activities.

It is important that investors know what they can potentially gain from financial
statements and other public company reports. Based on this information, they are then
able to formulate their own opinions on how secure their investments or other interests
in a company are.

47
2.9 DETECTION AND IDENTIFICATION OF ACCOUNTING IRREGULARITIES

Davia et al. (2000:37) claim that auditors discover only 20% of detected accounting
irregularity cases. The remaining 80% of detected accounting irregularities are
discovered by accident. The percentage of accounting irregularities discovered by
accident might be even higher, as the study did not take into account how many of the
discoveries by auditors are also accidental. Fortunately, accounting operates on a
double-entry basis (Beneish, 1997:284), which means that perpetrators cannot adjust
income or expense accounts without also affecting an asset account. It follows that
sudden changes to receivable or inventory turnover ratios indicate that sales, for
example, may have been tampered with.

2.9.1 Red flags that act as indicators of accounting irregularities

In order to detect and identify accounting irregularities, red flags have the potential to act
as useful indicators to detect irregularities. Red flags are all the conditions that are more
likely to be present in the case of irregularities (Du Plessis & Koornhof, 2000:75). Such
red flags are useful to all interested parties who observe financial statements and who
are concerned about irregularities (Krambia-Kapardis, 2002:267). Mulford and Comiskey
(2002:186) mention that the informational content of notes to the financial statements
should not be underestimated. Any number of red flags may very well be seen if one
knows what to look out for.

A first item to analyse is the quantitative, or financial, section of an annual report.

Auditors usually use analytical procedures to trace irregularities in financial statements.
In an analytical review, the auditor predicts or arrives at some expectation of what the
book values ought to be and compares these with the actual values (Kinney, 1979:149).
Lendez and Korevec (1999:49) suggest that analytical procedures should also be used
by management. This gives them an opportunity to detect unusual transactions and
disclosures, which enhances the probability that accounting irregularities will be
detected.

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2.9.2 Making use of auditing or financial management procedures to detect and
identify accounting irregularities

Because accounting irregularities are often detected by accident, the use of analytical
procedures by all interested parties may assist in increasing the chances of accidental
discovery. Any additional analyses that are performed over and above the norm would
increase the chance of detection and identification. However, Daroca and Holder
(1985:1) comment that, in order to detect the presence of irregularities, analysts need
some knowledge of accounting principles and practices. Their research focuses on
analytical procedures used by auditors and accountants, but which can also be used by
managers, investors and creditors. In an analysis of financial statements, Daroca and
Holder (1985) find that it is useful when financial statements are compared with previous
periods and with anticipated results if they are available. A further method he recognises
is to study the relationships between the elements of the financial statements to identify
patterns and changes to patterns. There are thus multiple ways to analyse the financial
statements for possible cases of accounting irregularities.

Kinney (1979:153) quotes Professor Lev, who recommends a method to analyse

whether accounting irregularities are present, namely by restating the financial
statements. He restates financial statements in percentages of a significant amount, for
example, sales. The details of this method (also called vertical analysis) are described in
Chapter Four of this study. The method is believed to be useful in predicting bankruptcy
and is associated with unexpected income changes; therefore it may be effective in
detecting irregularities.

Financial ratios are also considered to be useful, as they help to indicate areas where
the level of an account can be explained by another account (Kinney, 1979:164).
Because accounting operates on a double-entry basis, manipulation of one account
means that another account also needs to be manipulated. Ratios can possibly be
helpful in identifying such cases.

49
It is best for interested parties to focus on objective information, because subjective
information is sometimes difficult to obtain. Rosplock (2001:24) claims that a thorough
investigation should preferably include at least the following areas of concern:
• an historical analysis of the income statement and balance sheet;
• a ratio trend analysis;
• an examination of common-sized financial statements;
• comparisons with the industry;
• a cash flow trend analysis;
• assessments of the consistency of the income statement items;
• a check on increases or decreases in sales and the reasons for such changes;
• an analysis of aspects that affect levels of performance;
• an analysis of the trend of earnings before interest and tax (EBIT);
• a look at net worth, which is a method to observe assets and liabilities;
• an analysis of accounts payable;
• an awareness of long-term debt, especially where sales are low and unprofitable
conditions prevail;
• a look at fixed assets;
• knowledge of the current ratio; and
• knowledge of the total debt/equity ratio.
Observation and knowledge of at least these areas will increase the chances that
discrepancies are detected and identified. Any dramatic changes to trends can possibly
be indicators of an increased risk for accounting irregularities and ought to be monitored
closely.

2.9.3 Other means to detect and identify accounting irregularities

Mulford and Comiskey (2002:185) mention a number of steps that may be useful to
possibly detect premature or fictitious revenue, which is one of the most common
methods of producing accounting irregularities:

50
• understand the organisation’s policy regarding revenue recognition (in this regard,
the revenue recognition note gives a good indication of the methods the company
employs when recognising revenue; when a company's policies for revenue
recognition are better understood, questionable practices are detected more easily);
• examine the accounts receivable (prematurely reported revenue takes a long time to
be collected, while fictitious revenue may never be collected; so, if there are strange
increases in the accounts receivable, it may be an indication of wrongful practices -
as soon as the accounts receivable are noticeably different from the credit terms
offered, this is a warning signal; managers who recognise revenue prematurely or
recognise fictitious revenue would attempt to cover up the act through increased
assets or decreased liabilities); and
• check physical capacity (if the company does not have the capacity to generate the
reported revenue, there may be a problem; note that different measures are to be
applied for different companies, such as revenue per square metre, revenue per
employee, revenue per property, plant and equipment).
These methods can potentially be applied by most interested parties; even those that
are not directly part of the company, since the information that is required is mostly
available in the annual report.

Apart from the quantitative section of an annual report, the qualitative section also
contains some useful information. Rosplock (2001:24) recognised that, apart from
financial information and ratios, using industry and economic data to determine trends,
bankruptcy and cash flow risk, the information disclosed in notes together with the rate
of financing and substantial suits, liens or judgements that could affect the company are
also useful. Most of this information is found in the notes that accompany the
statements, making it readily available to all interested parties. A similar observation was
made by Ames, Brazel, Jones, Rich and Zimbelman (2012:C28) who found that non-
financial measures such as the number of employees, square metres of operations,
customer satisfaction and the number of customers can be useful to assess the risk of
accounting irregularities. They claim companies that commit accounting irregularities
may have a hard time falsifying non-financial measures.

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Sherman, Young and Collingwood (2003:64) identified various areas of qualitative
disclosure that need to be observed for possible red flags. These areas include large
inventory write-offs, provisions for expected losses, changes in measurement methods,
changes in the customer base, geography and technology, as well as mergers and
acquisitions. The notes also indicate whether or not the company is hiding its debt by
not reflecting it as a liability on the balance sheet and whether or not assets are
classified correctly.

Schilit (1993:19) makes it clear that the quantitative sections of an annual report should
not be considered the most important instruments to detect and identify accounting
irregularities. He recommends the auditor’s report as a useful tool, especially when
referring to whether a qualified report was given and/or if an opinion was withheld.
Additional useful information comes from the proxy statement for pending litigation and
executive compensation, the footnotes for accounting policy changes, related party
transactions and other contingencies or commitments, the chairman’s letter to determine
the forthrightness of management and any other quantitative documentation that may
give more information on management practices, disputes/disagreements and past
performance. All these documents need to be observed for discrepancies or significant
occurrences. It is especially useful if statements made in such narrative reports are
compared to statements made by competitor companies in the same industry in order to
verify their truthfulness.

Glover and Aono (1995:7) also point out that a lot can possibly be learnt from observing
other subjective aspects such as the corporate culture, the employee turnover, the
average employee tenure, the nature of customer complaints, product quality, employee
morale and employee benefits, the corporate board meeting minutes and various
policies and procedures. Information which can perhaps be helpful and that is usually
included in the financial reports is information on legal battles, credit ratings, investment
in employee development, warranty expenses, and comparisons of wages with industry
averages. Industry trait information is also publicly available – it is found in industry trade

52
journals, business periodicals and newspapers from which new trends can be observed.
However, it requires a lot of time and effort to research these, something a private
investor or other interested party may not have.

Measures to detect irregularities, such as discussed in the preceding paragraphs, are

only applicable in certain circumstances (Elliot & Willingham, 1980:95), because there
are multitudes of ways through which irregularities are perpetrated. This is on the
increase, because perpetrators are constantly devising new methods to commit their
crimes. If more varied methods are used in analyses to detect and identify irregularities,
the chances of coming across it are higher. It can be detrimental to a study of financial
statements if the study is too limited. However, even with limited data, it remains
possible that the correct mind-set will help to detect an increased risk of accounting
irregularities.

2.10 REDUCING THE RISK OF BEING DEFRAUDED

It has been recognised that a greater awareness of accounting irregularities may help
people to detect irregularities earlier and to prevent its occurrence. Regular monitoring is
essential to raise awareness (Cameron-Ellis, 2000:66). As the old adage states:
“Prevention is better than cure.” All parties that have an interest in a company,
especially personnel, ought to learn what risks for irregularities there are and what such
irregularities look like so that the chances of early identification increase.

There are many steps that the managers of a company can take to reduce the risk of
accounting irregularities and their subsequent effect on the company. These include
factors such as the following, mentioned by Ernst and Young (2003): pre-employment
screening, physical security and access controls, employee monitoring and appraisal, a
fraud policy, an anti-fraud corporate culture, encouraging whistle-blowing, a contingency
plan and insurance.

53
One method to reduce the likelihood of accounting irregularities is to put in place fraud
and ethics policies. These policies are generally available to external parties, but
otherwise they can be requested from the company. It is important, however, that a
company adheres to its own policies. A fraud policy normally includes a definition of
disciplinary offences and states what action will be taken against perpetrators. It also
indicates which actions constitute irregularities, what constitutes a conflict of interest, the
duty of employees regarding confidentiality and inside information, gifts and
entertainment and anything else that might be important. The more detail is included,
the better. A fraud policy does not mean that a company will not be affected by irregular
action, but it does give some indication of the moral and ethical culture that the board of
directors and management attempt to instil. When evaluating a company’s accounting
irregularity risk, its fraud policies and procedures is a logical first place to observe.

Internal control is one of the best means to protect a company from accounting
irregularities. However, even though the scope of internal control has broadened over
the years, it cannot be completely relied upon (Davia et al., 2000:119). Internal controls
need to be adapted continuously to changing circumstances, because it is likely that
there will always be someone who is searching for ways to evade controls and who will
find a way to do so. However, investors have no control over the management and
internal controls of a company. If control measures are not in place, investors and other
parties face the risk of being done in. Over-confidence may have negative results. For
that reason, all parties with an interest in a company have to proactively search for
possible accounting irregularities, without relying only on internal controls and chance.

For an outsider, like an investor, a first step may be to get to know the industry in which
the company operates. Some industries can be more prone to accounting irregularities
as a result of the type of activities companies in a particular industry perform. Trade
journals may play a positive role in this regard. A second step is for interested parties to
get to know the company that they have an interest in. Training is also helpful if it will
lead to a better understanding of the financial statements. As mentioned previously, it is
believed that much can be learnt from financial statements, especially from the notes
that accompany the annual report. Quinn Mills (2003:247) sums up this argument by

54
stating that investors should “learn how the game is played” and set reasonable
expectations.

Some aspects of a company, like its culture and internal controls, are not available for
observation by outside parties and therefore also cannot be judged by them. That
makes it all the more important for any interested party to be aware of the risks and to
take reasonable steps to find out as much about the company as possible. Sherman,
Young and Collingwood (2003:159) also emphasise the importance of investors
recognising that there are no shortcuts to successful investing. They ought to make an
effort to inform themselves by going out and getting data before it comes to them. A vast
amount of information is available, especially on the Internet. That is not to say that an
individual investor will be able to detect accounting irregularities, but being observant
helps to some extent.

Unfortunately, the only information available to individual investors, if they want to gain
some insight into the operations of the companies they invest in, is often the financial
statements of a company (Kirby, 2005:21). The Promotion of Access to Information
Act 2 of 2000 can help investors to get access to more information, but then they should
have adequate reason and a substantial foundation for their request.

The Ernst and Young South Africa Forensic Service’s (2003) Fraud Guide, that forms
part of Ernst and Young’s documentation on fraud risk and prevention, aims to help
senior management understand more about accounting irregularities, its risks and
warning signs. Documents such as these, which facilitate better understanding, can also
be useful to individual investors and creditors. Furthermore, many of the aspects of
detecting and identifying accounting irregularities that are mentioned in the auditing
standard ISA 240 (IAASB, 2012) can be applied to individual investors or creditors.
These include professional scepticism, discussing the company with others and making
general inquiries.

55
2.11 SUMMARY

Companies have a degree of accounting irregularity risk that is inherent to their

management and accounting functions. This has been proven by the number of large
companies that became victims of accounting irregularities. If the risk of accounting
irregularities in a company is severe, the company has the potential to spiral down into
accounting irregularities.

There are a number of ways that managers and other employees can use to manipulate
accounting records and financial statements of a company for their own and the
company’s benefit. The most frequently observed schemes are summarised in
Figure 2.2 as depicted earlier in the chapter.

Legislation has placed a responsibility on managers to detect accounting irregularities.

Apart from those intimately involved in the operations of a company, such as managers,
employees and internal auditors, some responsibility can also be placed on investors. It
is their responsibility to gather facts about companies they want to invest in and to make
sure that the investment is safe. However, no method of accounting irregularity detection
and prevention is fool proof; and managers with unethical objectives in mind tend to
attempt to find new ways to trick the public.

For that reason it is imperative that as many individuals possible be aware of the risk of
accounting irregularities and the indicators that may accompany such occurrences.
Hence the motivation for this study – to give all interested parties a means to detect and
identify accounting irregularities.

In Chapter Three the use of financial analysis as a method to detect and identify
irregularities is discussed. Similar to Chapter Two, the chapter is also in the form of a
literature review, making reference to previous research.

56