Financial Statement Fraud: Motives, Methods, and Detection - Essay Example

Financial ment Fraud: Motives, Methods, Cases and Detection Introduction Fraud is a highly controversial topic and none more so than financial statement fraud. Despite the tightening of regulations, the continuous improvements in accounting and auditing standards and the increasing watchfulness of the public and regulators alike, financial statement fraud continue to be a very serious concern in the business community, the regulators and the financial market, as well. Fraud as it deals with financial statements or reporting had been officially defined as “an intentional act”, committed by a certain individual or certain individuals (i.e., employees, management, board of directors or third parties), by using deception “to obtain an unjust or illegal advantage” (p. 19, IFAC, 2010). This paper focuses on the motives behind and the methods used by the fraud perpetrators (i.e., the ones who are responsible for the fraud) to commit financial statement fraud. It also discusses financial statement fraud cases, how these were committed and how these affected the company and the public. Lastly, it also discusses how to prevent and to detect financial statement fraud. Financial Statement Fraud: Motives There are many motives behind financial statement fraud. Motives represent the cause that eventually directed the behaviour to commit financial statement fraud and gives us the ‘why’ behind the fraudulent actions (Hasnan, Rahman and Mahenthiran, 2008). There are several motives behind financial statement fraud. These are discussed in the following paragraphs. Motive Number One: Show Better Company Performance One motive is the desire to make the company’s performance look good or look better. The pressure to do this may have come from a desire for the company to obtain more credit; financing or additional capital or the perpetrators want the company to retain or even to increase the value of its stocks (p. 58, Rezaee and Riley, 2010). Another underlying purpose behind this is that the perpetrators want to conceal “deficiencies” in the performance of the company (p. 58, Rezaee and Riley, 2010). Such a pressure may have been created and felt by the perpetrators themselves or were created by other parties (i.e., the stockholders) who are expecting much more than what the perpetrators can actually deliver, hence the need to ‘window – dress’ the company’s financial statements. Motive Number Two: Maintain Personal Status or Control Another motive is “to preserve personal status or control” (p. 328, Wells, 2007). This is more on the personal egos of the fraud perpetrators. In financial statement fraud, the perpetrators may be motivated to commit fraud because they are not willing “to admit that their strategy has failed” and that the company’s performance is bad because by doing so, they might find themselves out of their jobs (p. 328, Wells, 2007). Alternatively, there may be a personal motivation to commit financial statements fraud because they are trying to maintain a certain image or prestige for the company (which will redound to their benefit in the end). Motive Number Three: Obtain Personal benefits Lastly, another motive is to “obtain personal benefits” through better compensation (i.e., as the company’s earnings increase, compensation also increases), obtaining stock bonuses or stock options (a two-fold motive as this combines the first and this third motive), or even getting a promotion or maintaining ones current (high) position in the company (p. 58, Rezaee and Riley, 2010). Financial Statement Fraud: Methods Methods are like the twins of motives because without the former the latter cannot be put into action and there will be no financial statement fraud in the first place. There are many ways one can commit financial statement fraud and these are discussed in the following sections. Method Number One: Fictitious Revenues One common method for committing financial statement fraud is through “fictitious revenues” or reporting sales that did not actually happen (Colby, n.d.). This method may entail either “creating fake…customers or sales” or “creating phony invoices or increasing quantities or prices” (Colby, n.d.). Method Number Two: Timing Differences Another method is to record revenues or expenses or both in “improper periods” or what is called “timing differences” (p. 364, Wells, 2007). Through this method, the perpetrators can “shift revenues or expenses” (p. 364, Wells, 2007) from one period to another to either cover a negative performance by the company, to shift earnings from a better-than-average calendar year to a not-so-good year or to cover up previous shifting of revenues or expenses. Method Number Three: Concealing Liabilities or Expenses Another method is to conceal the company’s liabilities or expenses by not recording accounts payable, accrued expenses, contingent liabilities or unearned revenues (Colby, n.d.). This is to improve the financial ratios of the company as nonrecording of liabilities or expenses will increase current ratio, working capital ratio, debt to equity ratio and the ratios involving income and return on assets. This will also make the balance sheet of the company look better as the amount of its assets are much more than the amount of its liabilities. Method Number Four: Making Improper Disclosures Financial statements are not complete if there are no notes or disclosures accompanying them. Thus, financial statements fraud may be committed not only on the financial statement figures but also in the narrative disclosures as well. According to J. Wells (p. 373, 2007), this method can take on different forms. It may include failure to disclose important facts about the company’s liabilities (i.e., loan covenants or contingent liabilities). It may include deliberate omission of disclosures related to subsequent events which may affect the value of the company’s assets or show the understatement of the liabilities. Improper disclosures may also include failure of management to disclose fraudulent activities done by company officers and employees. Failure to properly and completely disclose related party transactions and to properly restate the financial statements for accounting changes also fall under this category. Method Number Five: Improper Asset Valuation This pertains to the deliberate misstatement of the value of various assets. This can be done either by deliberately failing to write down assets to their recoverable values, overallocation of the purchase price (in case of business combinations), improperly stating property and equipment, improperly capitalising expenses and, generally, “misrepresenting asset value” (pp. 375 – 380, Wells, 2007). Financial Statement Fraud: Cases Enron Perhaps no fraud case is more talked about or has the most impact in the accounting industry than the Enron case. Its main business was in energy and power. Enron was a publicly listed company in the U. S. The total value of its stocks reached a high of $100 billion (p. 286, Fox, 2003) while individual shares reached a high of $90 (The Associated Press, 2006). When it filed for bankruptcy in 2001, it was then touted as “the largest bankruptcy in U. S. history at that time” (p. 286, Fox, 2003). Investigations that followed showed that the company’s top management engaged in massive financial statement fraud by deliberately keeping off its balance sheet certain investments and transactions that can undermine the value of its assets. WorldCom At the time of its bankruptcy filing, Enron was thought to be the largest bankruptcy at all times. However, this was not quite true. WorldCom, which filed for bankruptcy in July 2002, became the biggest bankruptcy case in the U. S. with its over $100 billion in assets (p. 286, Fox, 2003). WorldCom was a former key player in the telecommunications industry in the U. S. It was also a publicly listed company, with its share price peaking at more than $64 in 1999 (Reuters, 2005). An audit after its bankruptcy showed its bookkeeping practices were fraudulent, several acquisitions were “overvalued…by a total of $5.8 billion” (McCafferty as quoted by Romar and Calkins, 2006) and that it overstated its 2000 profit (among others) by more than $55 billion. The total fraud committed by the company was estimated to be around $79.5 billion (Romar and Calkins, 2006). Parmalat Parmalat is an “Italian food group active in milk & dairy products and fruit – based beverages” (Parmalat website, 2007). This case was said to have highlighted the fact that financial statement and corporate fraud are not limited in the U. S. only. The financial statement fraud in this case involved the reporting of a $ 4 million fictitious bank account in Bank of America (O’Rourke, 2004), fictitious assets of around $10 billion and diversion of funds from listed companies to private firms (Parmalat Fraud, 2004). Unlike Enron and WorldCom which were only limited in one country, the Parmalat fraud spanned continents (Europe and America), involved a lot of companies within the group and also involved various financial institutions. Satyam Computer Services One of the most recent financial statement fraud cases, Satyam Computer Services is “a leading Indian outsourcing company that serves more than a third of the Fortune 500 companies” (Timmons and Wassener, 2009). In this case, and as admitted by its CEO, about $1 billion in cash was virtually nonexistent (p. 4, Rezaee and Riley, 2010). Financial Statement Fraud: Detection There are various ways to detect financial statement fraud. The first way to detect fraud is to become aware of red flags or those indications that there may be fraud committed on the financial statements. Red flags may include balances that don’t make sense, relationships between accounts that also don’t make sense, sudden fluctuations in balances without credible explanations, etc. Once the person who is trying to detect fraud becomes aware of these red flags, the corresponding detection methods may follow. Another way to detect fraud is by putting into place an empowered and experienced internal audit team that can detect and even prevent fraud. Internal auditors assess the “accounts and transactions together with the underlying infrastructure of accounting systems and built – in risk controls” (p. 163, Golden, Skalak and Clayton, 2006). However, there must be an assurance that the internal auditors are independent of management and report only to the board of directors, otherwise, their capacity to detect fraud will be diminished. In support of this, the company should also have an independent audit committee who will oversee the “antifraud programs” of the company (p. 130, Singleton, et. al., 2006). Another way to detect fraud is through putting into place internal controls that are effective and are designed to detect fraud. These internal controls may include surprise cash counts, surprise audits, good whistleblower policy, independent confirmations, mandatory vacations for key employees and frequent reconciliation of critical accounts (pp. 130 to 131, Singleton, et. al., 2006). A thorough analysis of the financial statements may also detect fraud. This will include “horizontal and vertical analysis” as well as “ratio analysis, especially trends over several years” (p. 130, Singleton, et. al., 2006). Doing this may bring to light questionable fluctuations in balances or relationships between balances. Hand in hand with this detection method is the question and answer that follow which actually seek explanations for the results of the financial analysis. Conclusion Financial statement fraud is a serious concern in the corporate world and the financial market. Various fraud cases in the past have brought about the closure of big companies and even big accounting firms (i.e., Arthur Andersen). There are a lot of motives behind financial statement fraud. These motives range from the desire to make the company look good, to the desire to make one look good and finally to obtain personal benefits from making the company look good. These motives, however, will not culminate to actual fraudulent activities if there are no methods to commit fraud. Methods as far as financial statement fraud is concerned may include recording or reporting of fictitious revenues, making improper disclosures, taking advantage of timing differences, concealing liabilities or expenses or both and misstating the value of assets. High – profiled financial statement fraud cases include Enron and WorldCom, two of the biggest bankruptcy cases in the U. S. They also include Parmalat, an Italian – based food group, with a financial statement fraud case that spanned companies, continents and financial institutions. The latest high – profiled fraud case to hit the news was Satyam Computer Services, an Indian – based company. There is hope; however, as these financial statements fraud can actually be detected. Methods of detecting them range from knowledge of the indications of fraud, to setting up and empowering a good internal audit team (and an audit committee), to effective internal controls and to financial analysis. Not all of these methods may apply to a single financial statement fraud. In the same way, not all fraud cases may be detected through these methods. Ultimately, detection of financial statement fraud will depend on the alertness and degree of knowledge of the one who is trying to detect the fraud and the willingness to delve further to uncover the magnitude of such financial statement fraud. References Colby, E. (no date). Financial Statement Fraud: Part 3. [Online] Available at: https://www.cga-pdnet.org/Non_VerifiableProducts/ArticlePublication/FinStatFraud/FinStatFraud_p3.pdf (Accessed: May 8, 2010). Fox, L. (2003). Enron: The Rise and Fall. New Jersey: John Wiley & Sons, Inc. Available at: http://books.google.com.ph/books?id=3-qvLpoYXUIC&printsec=frontcover#v=onepage &q&f=false (Accessed: May 6, 2010). Golden, T., Skalak, S. and Clayton, M. (2006). A Guide to Forensic Accounting Investigation. New Jersey: John Wiley & Sons, Inc. Available at: http://books.google.com/books?id=NBH1UHgivWkC&printsec=frontcover#v=onepage&q&f=false (Accessed: May 9, 2010). Hasnan, S., Rahman, R. and Mahenthiran, S. (2008). Management Predisposition, Motive, Opportunity, and Earnings Management for Fraudulent Financial Reporting in Malaysia. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1321455 (Accessed: May 7, 2010). International Federation of Accountants (2010). 2010 Handbook of International Quality Control, Auditing, Review, Other Assurance and Related Service Pronouncements – Part I. Available at: http://web.ifac.org/publications/international-auditing-and-assurance-standards-board/ handbooks#2010-handbook-of-internatio. (Accessed: May 5, 2010). O’Rourke, M. (2004). Parmalat Scandal Highlights Fraud Concerns. Risk Management. 1 March 2004. Available at: http://www.allbusiness.com/accounting-reporting/fraud/1081567-1.html (Accessed: May 9, 2010). Parmalat Website (2007). Available at: http://www.parmalat.com/en/ (Accessed: May 9, 2010). Parmalat Fraud Scandal Spreads to International Proportions. Gourmet Retailer. 7 January 2004. Available at: http://www.allbusiness.com/retail-trade/food-stores/4206502-1.html (Accessed: May 9, 2010). Rezaee, Z. and Riley, R. (2010). Financial Statement Fraud: Prevention and Detection. New Jersey: John Wiley & Sons, Inc. Available at: http://books.google.com.ph/books?id=ZgovwP9x9dAC&printsec=frontcover#v=onepage&q&f=false (Accessed: May 5, 2010). Romar, E. and Calkins, M. (2006). WorldCom Case Study Update 2006. Available at: http://www.scu.edu/ethics/dialogue/candc/cases/worldcom-update.html (Accessed: May 9, 2010). Singleton, T., et. al. (2006). Fraud Auditing and Forensic Accounting. 3rd edition. New Jersey: John Wiley & Sons, Inc. Available at: http://books.google.com/books?id=HN4KzlG8q7wC&printsec= frontcover#v=onepage&q&f=false (Accessed: May 9, 2010). The Enron Trials: An Enron Chronology. 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