INTRODUCTION CHAPTER 14
FRAUD AND ERROR
- In the previous chapters, corporate governance has been described as the process by
which the owners and various stakeholders of an organization exert control through
requiring accountability for the resources entrusted to the organization.
- This chapter introduces fraud risk and errors and how they can be reduced if not totally
avoided by having effective internal control - a tool of good corporate.
- Fraud is an intentional act involving the use of deception that results in a material
misstatement of the financial statements.Two types of misstatements are relevant to
auditors' consideration of fraud: (a) misstatements arising from misappropriation of
assets, and (b) misstatements arising from fraudulent financial reporting. Intent to
deceive is what distinguishes fraud from errors. Auditors routinely find financial errors in
their client's books, but those errors are not intentional.
TYPES OF MISSTATEMENTS
a. Misstatements arising front misappropriation of assets
- Asset misappropriation occurs when a perpetrator steals or misuses an
organization's assets. Asset misappropriations are the dominant fraud scheme
perpetrated against small business and the perpetrators are usually employees.
Asset misappropriations can be accomplished in various ways, including
embezzling cash receipts, stealing assets, or causing the company to pay for
goods or services that were not received.
- Asset misappropriation commonly occurs when employees:
● Gain access to cash and manipulate accounts to cover up cash theft.
● Manipulate cash disbursements through fake companies.
● Steal inventory or other assets and manipulate the financial records to
cover up the Fraud.
b. Misstatements arising from Fraudulent Financial Reporting
- The intentional manipulation of reported financial results to misstate the
economic condition of the organization is called fraudulent financial reporting.
The perpetrator of such a fraud generally seeks gain through the rise in stock
price and the commensurate increase in personal wealth. Sometimes the
perpetrator does not seek direct personal gain, but instead uses the fraudulent
financial reporting to "help" the organization avoid bankruptcy or to ávoid some
other negative financial outcome. Three common ways in which fraudulent
financial reporting can take place include:
1. Manipulation, falsification, or alteration of accounting records or
supporting documents.
2. Misrepresentation or omission of events, transactions, or other significant
information.
3. Intentional misapplication of accounting principles.
THE FRAUD TRIANGLE
- The Fraud Triangle characterizes incentives, opportunities and rationalizations that
enable fraud to exist.
- The three elements of the fraud triangle are:
● Incentive to commit fraud
● Opportunity to commit and conceal the fraud
● Rationalization –the mindset of the fraudster to justify committing the fraud.
a. Incentives or Pressures to Commit Fraud
- Incentives relating to asset misappropriation include:
● Personal factors, such as severe financial considerations
● Pressure from family, friends, or the culture to live a more lavish lifestyle
than one's personal earnings allow for.
● Addictions to gambling or drugs
- The incentives include the following for fraudulent financial reporting:
● Management compensation schemes
● Other financial pressures for either improved earnings or an improved
balance sheet
● Debt covenants
● Pending retirement or stock option expirations
● Personal wealth tied to either financial results or survival of the company
● Greed – for example, the backdating of stock options was performed by
individuals who already had millions of pesos of wealth through stock
b. Opportunities to Commit Fraud
- One of the most fundamental and consistent findings in fraud research is that
there must be an opportunity for fraud to be committed. Although this may sound
obvious that is, "everyone has an opportunity to commit fraud" it really cónveys
much more. It means not only that an opportunity exists, but either there is a lack
of controls or the complexities associated with a transaction are such that the
perpetrator assesses the risk of being caught as low. Some of the opportunities
to commit fraud that the top management should consider include the following:
● Significant related-party transactions
● A company's industry position, such as the ability to dictate terms or
conditions to suppliers or customers that might allow individuals to
structure fraudulent transactions.
● Management's inconsistency involving subjective judgement regarding
assets or accounting estimates
● Simple transactions that are made complex through an unusual recording
process.
● Complex or difficult to understand transactions, such as financial
derivatives or special-purpose entities
● Ineffective monitoring of management by the board, either because the
board of directors is not independent or effective, or because there is a
domineering manager
● Complex or unstable organizational structure
● Weak or nonexistent internal controls
c. Rationalizing the Fraud
- For asset misappropriation, personal rationalizations often revolve around
mistreatment by the company or a sense of entitlement (such as, "the company
owes me!") by the individual perpetrating the fraud. Following are some common
rationalizations for asset misappropriation:
● Fraud is justified to save a family member or loved one from financial
crisis.
● We will lose everything (family, home, car and so on) if we don't take the
money.
● No help is available from outside.
● This is "borrowing", and we intend to pay the stolen money back at some
point.
● Something is owed by the company because others are treated better.
● We simply do not care about the consequences of our actions or of
accepted notions of decency and trust; we are for ourselves.
- For fraudulent financial reporting, the rationalization can range from "saving the
company" to personal greed, and may include the following:
● This is one-time thing to get us through the current crisis and survive until
things get better.
● Everybody cheats on the financial statements a little; we are just playing
the same game.
● We will be in violation of all of our debt covenants unless we find a way to
get this debt off the financial statements.
● We need a higher stock price to acquire company XYZ, or to keep our
employees through stock options, and so forth.
Risk Factors Contributory to Misappropriation ofAssets
- Misappropriation of assets involves the theft of an entity's assets and is often
perpetrated by employees in relatively small and immaterial amounts. However, it can
also involve management who are usually more able to disguise or conceal
misappropriations in ways that are difficult to detect. Misappropriation of assets can be
accompanied in a variety of ways including:
● Embezzling receipts (for example, misappropriating collections on accounts
receivable or diverting receipts in respect of written-off accounts to personal bank
accounts).
● Stealing physical assets or intellectual property (for example, stealing inventory
for personal use or for sale, stealing scrap for resale, colluding with a competitor
by disclosing technological data in return for payment).
● Causing an entty to pay for goods and services not received (for example,
payments to fictitious vendors, kickbacks paid by vendors to the entity's
purchasing agents in return for inflating prices, payments to fictitious employees).
● Using an entity's assets for personal use (for example, using the entity's assets
as collateral for personal loan or a loan to a related party).
- Misappropriation of assets is often accompanied by false or misleading records or
documents in order to conceal the fact that the assets are missing or have been pledged
without proper authorization.
A. Incentives / Pressures
1. Personal financial obligations may create pressure on management or
employees with access to cash or other assets susceptible to theft to
misappropriate those assets.
2. Adverse relationships between the entity and employees with access to cash or
other assets susceptible to theft may motivate those employees to
misappropriate those assets. For example, adverse relationships may be created
by the following:
(a). Known or anticipated future employee layoffs.
(b). Recent or anticipated changes to employee compensation or benefit
plans.
(c) Promotions, compensation. or other rewards inconsistent with
expectations.
B. Opportunities
1. Certain characteristics or circumstances may increase the susceptibility of assets
to misappropriation. For example, opportunities to misappropriate assets
increase when following situations exist:
(a) large amounts of cash on hand or processed.
(b) inventory items that are small in size, of high value, or in high demand.
(c) fixed assets which are small in size, marketable, or lacking observable
identification of ownership.
2. Inadequate internal control 'Over assets may increase the susceptibility of
misappropriation of those assets. For example, misappropriation of assets may
occur because of the following:
(a) Inadequate segregation of duties or independent checks.
(b) Inadequate oversight of senior management expenditures, such as
travel and other reimbursements.
(c) Inadequate management oversight of employees responsible for
assets, for example, inadequate supervision or monitoring of remote
locations.
(d) Inadequate job applicant screening of employecs with access to
assets.
(e) Inadequate record keeping with respect to assets.
(f) Inadequate system of authorization and approval of transactions (for
example, in purchasing).
(g) Inadequate physical safeguards over cash. investment, inventory, or
fixed assets.
(h) Lack of complete and timely reconciliations of assets.
(i) Lack of timely and appropriate documentation of transactions, for
example, credits for merchandise returns.
(j) Lack of mandatory vacations for employees performing key control
functions.
(k) Inadequate management understanding of information technology,
which enables information technology employees to perpetrate
misappropriation.
(l) Inadequate access controls over automated records. including controls
over and review of computer systems event logs.
C. Attitudes / Rationalizations
1. Disregard for the need for monitoring or reducing risks related to
misappropriation of assets.
2. Disregard for internal control over misappropriation of assets by overriding
existing controls or by failing to correct known internal control deficiencies.
3. Behavior indicating displeasure or dissatisfaction with the entity or its treatment of
the employee.
4. Changes in behavior or lifestyle that may indicate assets have been
misappropriated.
5. Tolerance of petty theft.
Risk Factors Contributory to Fraudulent Financial Reporting
- Fraudulent financial reporting may be accomplished by the following:
● Manipulation, falsification (including forgery), or alteration of accounting records
or supporting documentation from which the financial statements are prepared.
● Misrepresentation in, or intentional omission from, the financial statements of
events, transactions or other significant information.
● Intentional misapplication of accounting principles relating to amounts,
classification, manner of presentation, or disclosure.
- Fraudulent financial reporting involves intentional misstatements including omissions of
amounts or disclosures in financial statements to deceive financial statement users. It
can be caused by the efforts of management to manage earnings in order to deceive
financial statement users by influencing their perceptions as to the entity's performance
and profitability. Such earnings management may start out with small actions or
inappropriate adjustment of assumptions and changes in judgments by management.
Pressures and incentives may lead these actions to increase to the extent that they
result in fraudulent financial reporting. Such a situation could occur when, due to
pressures to meet market expectations or a desire to maximize compensation based on
performance, management intentionally takes positions that lead to fraudulent financial
reporting by materially misstated the financial statements. In some entities, management
may be motivated to reduce earnings by a material amount to minimize tax or inflate
earnings to secure bank financing.
- Fraud, whether fraudulent financial reporting or misappřopriation of assets, involves
incentive or pressure to commit fraud, a perceived opportunity to do so and some
rationalization of the act.
A. Incentive/ Pressure
- Incentive or pressure to commit fraudulent financial reporting may exist when
management is under pressure, from sources outside or inside the entity, to
achieve an expected (and perhaps unrealistic) earnings target or financial
outcome -particularly since the consequences to management for failing to meet
financial goals can be significant.
B. Opportunities
- A perceived opportunity to commit fraud may exist when an individual believes
internal control can be overridden, for, example, because the individual is in a
position of trust or has knowledge of specific weaknesses in internal control.
- Fraudulent financial reporting often involves management override of controls
that otherwise may appear to be operating effectively. Fraud can be committed
by management overriding controls using such techniques as:
● Recording fictitious journal entries, particularly close to the end of an
accounting period, to manipulate operating results or achieve other
objectives.
● Inappropriately adjusting assumptions and changing judgments used to
estimate account balances.
● Omitting, advancing or delaying recognition in the financial statements of
events and transactions that have occurred during the reporting period.
● Concealing, or not disclosing, facts that could affect the amounts
recorded in the financial statements.
● Engaging in complex transactions that are structured to misrepresent the
financial position or financial performance of the entity.
● Altering records and terms related to significant and unusual transactions.
C. Rationalizations
- Individuals may be able to rationalize committing a fraudulent act. Some
individuals possess an attitude, character or set of ethical values that allow them
knowingly and intentionally to commit a dishonest act. However, even otherwise
honest individuals can commit fraud in an environment that imposes sufficient
pressure on them.
Responsibility for the Prevention and Detection of Fraud
- The primary responsibility for the prevention' and detection of fraud rests with both those
charged with governance of the entity and management. It is important that
management, with the oversight of those charged with governance, place a strong
emphasis on fraud prevention, which may reduce opportunities for fraud to take place,
and fraud deterrence, which could persuade individuals not to commit fraud because of
the likelihood of detection and punishment. This involves a commitment to creating a
culture of honesty and ethical behavior which can be reinforced by an active oversight by
those charged with governance. In exercising oversight responsibility, those charged
with governance consider the potential for override of controls or other inappropriate
influence over the financial reporting process, such as efforts by management to
manage earnings in order to influence the perceptions of analysts as to the entity's
performance and profitability.
