Financial Reporting Fraud - Essay Example

Financial Reporting Fraud Accountants are guided by strict of ethics and professional of conduct in their preparation of financial statements. Amongst the guiding principles are the Generally Accepted Accounting Principles (GAAP). These are a group of accounting principles, standards and procedures that are used by public companies in the compilation of their financial statements. The United States Securities and Exchange Commission (SEC) have adopted these principles. The guidelines are meant to harmonize the manner in which financial statements are prepared by all companies in the United States and help in the achievement of the objective of financial statements being prepared. GAAP have been categorized into three groups: Assumptions, Principles, and constraints. The following assumptions are made during financial reporting under the guidelines of GAAP. The business is a separate entity from its owners and therefore the revenue and expenses of the business should be separated from personal expenses. It is also assumed that the business will continue to operate for the unforeseeable future (Duska, Brenda & Julie, pp145-212). A stable currency such as the US dollar is assumed to be a unit of record. The final assumption is that the activities of the business can be divided into artificial time periods such as a fiscal year. The accounting principles are as follows. The matching principle requires firms to apply the accrual basis of accounting where expenses are matched with revenues. For example, the wages of an employee should be reported in the week that the employee worked and not when the employee was paid. The second principle is the revenue recognition principle that stipulates that revenue, for example from sales should be recognized as soon as the product is sold regardless of when the money is actually received. There are four constraints stipulated in the GAAP. The objective principle which states that the information provided by an account in the financial statements should be based on tangible evidence. There is the materiality principle which says that an item should be reported in the financial statements on if it is capable of affecting decision making of the user of the statements (Duska, Brenda & Julie, pp145-212). The consistency principle requires a company to use the same accounting principles, guidelines and methods in the preparation of the financial statements from each period to another. However, fraudulent company employees and executives with the intention to swindle the company some funds or for personal gain consciously circumvent the aforementioned assumptions, principles and constraints. The methods involved are very complex and usually involves overstatement of revenue, understatement of expenses, misuse or misdirection of funds, misreporting of the assets and liabilities of the company. This is what is referred to as financial reporting fraud. Financial reporting fraud is carried out with the intention of meeting one or more of the following objectives (Duska, Brenda & Julie, pp145-212). To obtain additional funds from a financing institution such as a bank, to report unrealistic profits and hide losses so as to evade accountability by the top executive of the company, attract customers and investors by making the company to appear more successful than it is, to achieve a performance related bonus or incentive by the employees and to conceal theft either by the employees or the company executive. An example of a major accounting scandal in the United States is the Enron Scandal. The Enron scandal was an financial reporting fraud that was discovered in 2001 and lead to the bankruptcy of Enron corporation, an American energy corporation formed in 1985 through merger of Houston Natural Gas and InterNorth and was based in Texas. It became the largest organization in America to be declared bankrupt. Its biggest failure was attributed to audit failure. J. Skilling after being hired as the chief accounting officer formed a staff executive who defrauded the company billions of dollars using poor financial reporting and accounting loopholes (Duska, Brenda & Julie, pp145-212). The chief financial officer misled the audit committee as well as the company’s board of director with his poor and high-risk accounting practices. A shareholder of the company filed a law suit against the company after the company stock’s poor performance in the securities exchange. The United States Securities Exchange carried out investigations. A deal for a takeover by its competitor, Dynegy failed to go through due to the low bid price. In December 2001, the company applied for bankruptcy under chapter 11 of the United States Bankruptcy Code. The company overstated its revenue in order to show a better stock price. This is in violation of the revenue recognition principle where the revenue is recognized after a product has been sold and not when the payments were received. This was a violation of the principle of objectivity and integrity by the chief financial officer as he was aware of the fraud. There are several legislation that have been enacted in the United States with the objective of curbing financial statement frauds. One of the most conspicuous legislation is the Sarbanes-Oxley Act of 2002. The Act called for the improvement of financial disclosures from companies and corporations to protect investors from fraudulent accounting activities. This was as a result of erosion of investor confidence in financial statements, and therefore urgent overhaul of the regulatory standards was necessary (Duska, Brenda & Julie, pp145-212). The two major sections of the Act are Section 302 that require the senior management of a company to certify the accuracy of the financial statements before they are presented to investors and other users and Section 404 that has mandated the management and internal auditors of a company to put in place internal controls and report on the effectiveness of those controls. Establishing and maintaining internal controls is very expensive and thus Section 404 of has had very costly implications on companies trading publicly in the securities exchange market. In conclusion, financial statement fraud is a monster vice which has led to the bankruptcy of numerous companies and loss of investment by investors, as well as revenue by the government. More legislation is encouraged to seal the existing miniature loop holes in financial reporting. But it will be the duty of every accounting professional to abide by the Professional Code of Conduct. Work Cited Duska, Ronald F, Brenda S. Duska, & Julie Ragatz. Accounting Ethics. Chichester, West Sussex, U.K: Wiley-Blackwell, 2011. Read More