3200400-22860000MAKERERE UNIVERSITYCOLLEGE OF BUSINESS AND MANAGEMENT SCIENCESSCHOOL OF BUSINESSMASTER OF BUSINESS ADMINISTRATIONMBS 7101: FINANCIAL ACCOUNTINGASSIGNMENT “You have been appointed a board member of a publicly listed company and you have been asked to prepare a report to be presented in the next board meeting; discussing in detail the particular factors that motivate preparers of financial statements to engage in accounting fraud, and safeguards available in preventing accounting fraud”ByANAYO PAULA REG. NO. 2018/HD06/3460UTable of Contents TOC o “1-3” h z u 1.INTRODUCTION PAGEREF _Toc527215648 h 32.ACCOUNTING FRAUD PAGEREF _Toc527215649 h 42.1Definition of Accounting Fraud PAGEREF _Toc527215650 h 42.2Types of Accounting Fraud PAGEREF _Toc527215651 h 42.
3Motivators of Accounting Fraud PAGEREF _Toc527215652 h 82.4Safeguards that can be employed to combat Accounting Fraud PAGEREF _Toc527215653 h 112.5Notable Accounting Fraud Cases: PAGEREF _Toc527215654 h 133.CONCLUSION PAGEREF _Toc527215655 h 134.REFERENCES PAGEREF _Toc527215656 h 14ACCOUNTING FRAUD, MOTIVATORS AND SAFEGUARDS AVAILABLE IN PREVENTING ACCOUNTING FRAUD.Abstract: The Accounting standards require publicly traded companies to prepare and issue financial statements that are transparent to ensure that investment decisions are not based on materially misstated financial statements. This implies that corporate managers, auditors, board of directors, investors and regulatory agencies urgently need to be able to detect and prevent potential earnings frauds.This report examines accounting fraud and its different forms.
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The report also exposes the different techniques used by the different actors of accounting fraud and portrays the different motives that urge these actors to commit fraud. Keywords: accounting fraud, actors of fraud, and motivators of fraud. INTRODUCTION Publicly traded companies are required to prepare and issue financial statements that fairly reflect their performance and financial position. While the vast majority of public companies provide financial reports that are free from material misstatements; fraud continues to exist including the well-publicized frauds at Enron and WorldCom among others. As such, accounting fraud is an issue of great concern to the business community including: (a) auditors who are engaged to render an opinion as to whether the financial reports fairly present the company’s financial position and results of operations in conformity with established standards; (b) board of directors who bear the primary responsibility for the preparation and content of the financial reports; (c) investors and potential investors; (d) corporate managers; and (e) the general public, and as a result, regulators, legislators and other public policy makers.
These parties all have an interest in preventing and detecting fraud before investment decisions are made on materially misstated financial statements. This report critically analyses literature based on the factors, motivation and antecedents of fraudulent financial reporting. The overall objective for the review is to improve understanding of anatomy of fraud, thereby improving the ability to detect fraud. This report examines accounting fraud and its different forms, the different actors or players in accounting fraud and the particular factors that motivate preparers of financial statements to engage in accounting fraud and the safeguards available in preventing accounting fraud. ACCOUNTING FRAUD Definition of Accounting Fraud In current literature fraud has various definitions.
Rubin (2007) suggests a broad definition for fraud as “an intentional act to gain an unfair or unlawful advantage or gain”. Accounting fraud is an ever present threat to the effective utilization of resources and it will always be an important concern of management (Brink and Witt, 1982). Wells (2009) emphasizes that there is no accidental fraud and that the following four elements exist in any case of fraud: a material false statement, knowledge of the falsity of the statement, reliance on false statement by the victim and damages as a result.
Indeed the definitions of fraud vary from very narrow to very broad and it is useful to consider the case that MacDonald (1993) makes that distinction exists between fraud and error based on the psychological intent. He also specifies fraud as a legal term used only when intent can be proven in court.Accounting fraud is the intentional, material misstatement of financial statements or financial disclosures or the perpetration of an illegal act that has a material direct effect on the financial statements or financial disclosure (Beasley et al, 2010). Types of Accounting FraudWhen inaccuracy of accounting records occurs, there are two possible reasons for the discrepancy: error or fraud. An error is unintentional and often occurs due to computer malfunction or human error, such as carelessness or lack of knowledge. In contrast, fraud is intentionally committed in order to render some gain for the perpetrator. The two means through which fraud is committed include the misappropriation of assets and the misrepresentation of financial statements.
Misappropriation of Assets Misappropriation of assets occurs when an employee steals company assets, whether those assets are of monetary or physical nature. Physical assets of the company include everything from office supplies and office furniture to expensive items in inventory, such as cars or large machinery. With lack of supervision or security, employees could take inventory right out of a facility. However, misappropriation of physical assets includes not only taking items, but also the unauthorized use of company assets.
An employee driving a company car for personal use would be an example of this. Monetary assets susceptible to fraud typically include cash or cash equivalents because these items are highly liquid and often easily accessible. With poor internal controls, a company employee could steal checks and cash them for themselves. Another example of fraud includes causing the company to pay for goods or services that were not actually received or utilized by the company (Kennedy, 2012). Misrepresentation of Financial Statements Misrepresentation of financial statements, often referred to as “cooking the books”, occurs when the financial statements are intentionally misstated in order to make the financial position of the company look better than it actually is. This often involves increasing reported revenues and/or decreasing reported expenses. It could also involve misrepresenting balance sheet accounts in order to make ratios, such as the current or debt to equity ratios, look more favourable.
Reporting amounts different from what would have been reported under GAAP is also considered a misrepresentation of financial statements (Kennedy, 2012). This is also known as Financial Statement fraud. Financial Statement FraudFinancial statement fraud is defined as a deliberate attempt by corporations to deceive or mislead users of published financial statements, especially investors and creditors, by preparing and disseminating materially misstated financial statements. Financial statement fraud involves intent and deception by a clever team of knowledgeable perpetrators (e.g., top executives, auditors) with a set of well-planned schemes and a considerable gamesmanship.Financial statement fraud may involve the following schemes (Kennedy, 2012):Falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions;Material intentional misstatements, omissions, or misrepresentations of events, transactions, accounts or other significant information from which financial statements are prepared;Deliberate misapplication, intentional misinterpretation, and wrongful execution of accounting standards, principles, policies and methods used to measure, recognize, and report economic events and business transactions;Intentional omissions and disclosures or presentation of inadequate disclosures regarding accounting standards, principles, practices, and related financial information;The use of aggressive accounting techniques through illegitimate earnings management; and,Manipulation of accounting practices under the existing rules-based accounting standards which have become too detailed and too easy to circumvent and contain loopholes that allow companies to hide the economic substance of their performance.Reasons for financial statement Fraud (Kennedy, 2012):The upper management of a company may choose to engage in fraudulent financial reporting if:The personal assets or capital of the management is closely associated with the performance of the company in terms of profit sharing.
Enough opportunities are present for the management to commit the financial statement fraud.The management is willing to maximize shareholder value for handling some internal or external pressure.Top level executives are ready to take personal risk for corporate benefits.The chances of detection of fraud are negligibleOnce, the management has decided to be engaged in fraudulent financial reporting then they may use any of the following recipes for “cooking the accounting books”.Overstatement of Revenue. Revenue may be overstated by inflated sales.
This can be achieved by entering fictitious sales or by entering a sale before the revenue is earned actually in the financial statements.Understatement of Expenses. Holding expenses incurred during the current period over to the next financial period is termed as understatement of expenses. This can happen by wrongly capitalizing an expense over a number of periods, rather than properly expensing it immediately.Overstatement of Assets. Assets could be overstated by not booking down the accounts receivables or by not writing down the assets with impaired values or obsolete inventory.Understatement of Liabilities.
Liabilities may be understated by improperly recording liabilities as equity or by moving them between short term and long term.Improper use of Reserves. Reserve accounts such as reserves for accounts receivables, warranties, inventory obsolescence and sales returns are intrinsically risky because a great deal of judgement is required to determine their balances at the end of the financial period.Mischaracterization as one/time expenses. The management of an organization may remove onetime expenses from the accounting books for giving a false impression about the organization’s operating results to the capital market participants.Misapplication of Accounting Rules.
Financial statement fraud may be perpetrated by exploiting loop holes present in the accounting rules.Misrepresentation of Information. Management deliberately misrepresent or omit certain information in the financial statement to mislead the users of financial statement about the operations of the organisation.Financial statement fraud has colossal conquences to an organization and the business environment in which it operates. In general, financial statement fraud is only a means to improve results. Financial statement fraud has larger implications than many managers realize. Financial statement fraud, no doubt is going to harm the company in which it is perpetrated, but it can also affect economic markets.
The following provide a summary of the potential harmful effects of financial statement fraud:It undermines the quality and integrity of the financial reporting process;It jeopardizes the integrity and objectivity of the accounting profession;It diminishes the confidence of capital markets and market participants in the reliability of financial information;It makes the capital market less efficient;It adversely affects a nation’s growth and prosperity;It may result in litigation losses;It destroys the careers of individuals involved in the fraud;It causes bankruptcy or economic losses by the company engaged in the fraud;It encourages a higher level of regulatory intervention; andIt causes destructions to the normal operations and performance of the alleged companies. Motivators of Accounting FraudThere are several theories that explain the different motivators of Accounting Fraud. This report will feature two major theories of Accounting Fraud. The Fraud Triangle The Fraud Triangle Theory of Fraud was first examined by, Donald Cressey, in 1950. He was a criminologist, who started the study of fraud by arguing that there must be a reason behind everything people do. The three elements of frauds summarized by Cressey (1953) are commonly presented in a diagram shown in Figure 1.
The top element of the diagram represents the pressure or motive to commit the fraudulent act while the two elements at the bottom are perceived opportunity and rationalization (Wells, 2011). Perceived Pressure/Incentive/Motive Perceived pressure refers to the factors that lead to unethical behaviours. Every fraud perpetrator faces some pressure to commit unethical behaviour (Abdullahi and Mansor, 2015).
These pressures can either be financial or non-financial pressures. Albrecht et al. (2006) pointed out that, since the pressure to commit fraud may not be real it is important to use the word perceived. If the perpetrators believed that they were pressurized, this belief could lead to fraud.
Lister (2007) defined the pressure to commit fraud as “the source of heat for the fire”. But having this pressure does not become a reason for someone to commit fraud. Murdock (2008) also argued that the pressure could be financial, non-financial, political and social. Perceived Opportunity The second necessary element of fraud to occur is perceived opportunity. Opportunity is created by ineffective control or governance system that allows an individual to commit organizational fraud. In the field of accounting, this is termed as internal control weaknesses. The concept of perceived opportunity suggests that people will take advantage of circumstances available to them (Kelly ; Hartley, 2010).
The nature of perceived opportunity is like perceived pressure in the sense that the opportunity does not have to be real too. However, the opportunity exists in the perception and belief of the perpetrator. In most cases, the lower the risk of being caught, the more likely it is that fraud will take place (Cressey,1953). Wilson (2004) explains “opportunity” as the ability to override fraud controls.
Rae and Subramanian (2008) alarm that opportunity refers to the ability and power of an employee to realize the weaknesses of the organizational system and taking advantage of it by making fraud possible. Rationalization The rationalization is the third element of the Fraud Triangle Theory. This concept indicates that the perpetrator must formulate some morally acceptable idea to him before engaging in unethical behaviour. Rationalization refers to the justification and excuses that the immoral conduct different from criminal activity. If an individual cannot justify dishonest actions, it is unlikely that he or she will engage in fraud. Some examples of rationalizations of fraudulent behaviour include “I was only borrowing the money”, “I was entitled to the money because my employer is cheating me.” Additionally, some fraudster excuses their action as “I had to steal to provide for my family”, “some people did it why not me too” (Cressey, 1953).
Rationalization is difficult to notice, as it is impossible to read the mind of the fraud perpetrator. Individuals who commit fraud possess a particular mind-set that allows them to justify or excuse their fraudulent actions (Hooper ; Pornelli, 2010). The Fraud Diamond Theory The Fraud Diamond Theory is viewed as an expansion of the Fraud Triangle Theory. It was first presented by Wolfe and Hermanson in December 2004. In this theory, an element named capability has been added to the three initial fraud components of the Fraud Triangle Theory. Wolfe and Hermanson (2004) argued that although perceived pressure might coexist with an opportunity and a rationalization, it is unlikely for fraud to take place unless the fourth element (i.
e., capability) is also present. In other words, the potential perpetrator must have the skills and ability to commit fraud. Wolfe and Hermanson (2004) maintained that opportunity opens the doorway to fraud, and incentive (i.e. pressure) and rationalization lead a person toward the door. However, capability enables the person to recognize the open doorway as an opportunity and to take advantage of it by walking through repeatedly.
Capability This is the situation of having the necessary traits or skills and abilities for the person to commit fraud. It is where the fraudster recognized the particular fraud opportunity and ability to turn it into reality. Position, intelligence, ego, coercion, deceit, and stress, are the supporting elements of capability (Wolfe and Hermanson 2004). Mackevicius and Giriunas (2013), emphasize that not every person who possessed motivation, opportunities, and realization may commit fraud due to the lack of the capability to carry it out or to conceal it. Albrecht et al. (1995) orate that this element is of particular importance when it concerns a large-scale or long-term fraud. Furthermore, Albrecht et al.
(1995) believe that only the person who has an extremely high capacity will be able to understand the existing internal control, to identify its weaknesses and to use them in planning the implementation of fraud. Similarly, Wilson (2004) discloses that rationalization and capability are all inter-related, and the strength of each element influences the others. Safeguards that can be employed to combat Accounting FraudIt is with no doubt that Accounting Fraud exists and could potentially be at any organizations door step. However not all hope is lost as there are a number of safe guards that can be adopted to combat Accounting Fraud as explained below:Ethics training Ethic training is in demand nowadays as a consequence of various kinds of frauds that is infecting organizations. The ethics training program serves as a preventive control against fraud in many of its forms. Moreover, ethics training may provide an ideal avenue to lessen the influence of cultural factors on ethical decision making (Bierstaker, Brody and Pacini, 2006). Cultural factors may influence the action by the perpetrator since the perception of right or wrong, justice, morality and loyalty may differ across countries. Inventory observations According to Wells (2000), this technique should be carefully implemented since inventory is usually represented as the largest single asset for an organization and becomes as one of the most targeted choices for the fraudster.
The inadvertent conduct by the auditor during inventory observation may cost harm to the entire company. This happens when the auditor depends solely on the employees for the counting process in the warehouse. The workers might increase the inventory count without the auditor’s knowledge.
Thus, to ensure that this technique is done effectively, the auditors in charge should carefully observe the stock in order to verify the inventory. Fraud hotline Fraud hotline is one of the fraud’s reporting mechanisms that should be implemented in order to receive tips from both internal and external sources (CAQ, 2010). Such reporting mechanism should allow anonymity and confidentiality of the informer by setting up through a vendor. The employees should be encouraged to report any suspicious activity without fear of reprisal that accompanies being a whistleblower (Bierstaker et al., 2006). This technique does not only serve as an effective detection tool but can function as a deterrence tool as well, whereby the potential fraudster will likely have to consider the risks of being caught (Bierstaker et al., 2006).
Password protection By ensuring that managers are capable of accessing into the user computer’s security and auditing features, the use of password can assist them in preventing and detecting employees’ fraud. This can be done by requiring a password before gaining access to functions that diverge from the standard procedure. In addition, to be more effective, the user password ought to be changed regularly. According to (Bierstaker et al., 2006) although passwords are the oldest line of computer defences, they still represent as the most effective and efficient mean in controlling access. The advanced technology in certain developed countries has built up new forms of password protection.
The password employs biological features of the users or known as biometrics such as thumbprint, voiceprint, retina pattern and digital signature (Bierstaker et al., 2006). Continuous auditing According to Albrecht (2002), continuous auditing can be done once computer queries and scripts are written. In fact, tests can be programmed into live corporate systems in order to provide continuous monitoring of transactions rather than audit on historical data during normal audit process. A number of companies have successfully used continuous monitoring. Increased role of audit committee The presence of an audit committee has not significantly affected the likelihood of fraud but rather it depends on the way audit committee operates (Alleyne ; Howard, 2005). It was proven for companies with audit committees that consist of independent directors and meet up at least twice a year are less likely to be sanctioned for fraudulent or misleading reporting.
Reference check on employees Normally, the Human Resource department will ask for consent of a prospective employee to do a thorough background check. This involved activities of checking references, past employments and any criminal convictions. (Bierstaker et al., 2006) revealed that this process helped screen out repeat offenders who surprisingly has committed a large number of the fraudulent actions. Normally, only a few candidates with a troubled past will provide references to an employer with a reputation for such investigation. Data mining Data mining technique is a computer-aided fraud detection that is primarily used by fraud investigators and forensic accountants. Albrecht (2002) concluded that this method is a user-friendly, low-cost technique to evaluate the entire database. Moreover, this technique can help to avoid from making inaccurate generalizations based on limited information.
However, this method is only suitable for a small company because data mining software does not efficiently process large volumes of information and does not allow programmers to focus suspicion on a specific type of fraud. Notable Accounting Fraud Cases:In the past decade, there have been many large cases of accounting fraud, most notably the Enron and Bernie Madoff scandals. Along with these scandals are those of WorldCom, Tyco International Ltd., and Adelphia Communications Corporation.
Each of these cases led to vast losses for many individuals involved in the companies. In order to help prevent future accounting fraud scandals, it is important to understand how past fraud was perpetrated and how it went undetected for so long. In serious cases, fraud can result in the bankruptcy of the company, loss of pensions for employees, staggering lawsuits, and legal prosecution of the highest perpetrators.
Many of these consequences occurred in the case of WorldCom, which involved fraudulent financial reporting (Kennedy, 2012). CONCLUSION Accounting fraud is a global phenomenon and no organization will be immune from fraud. Despite the best attempts by the top management to eliminate fraud, there is no substantial solution for fraud other than creating awareness among their employees on the activities that can and may be considered as fraud and the solutions engaged to avoid and detect them. Hence, all the components of deterrence, prevention, detection, mitigation, analysis, policy, investigation and prosecution must be simultaneously implemented. REFERENCES Albrecht, W. S., and Albrecht, C .C.
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