Financial Statement Fraud: Motives, Methods, Cases and Detection - Assignment Example

Project Financial Statement Fraud: Motives, Methods, Cases and Detection Name Institution Course Tutor Date Table of Contents Table of Contents 2 1.0 Introduction 3 2.0 Financial statement fraud overview 3 3.0 Motivations of financial statement fraud 5 4.0 Methods of financial statement fraud 7 5.0 Prevention and detection of financial statement fraud 8 Conclusion 11 Reference List: 12 Appendices 14 Appendix A: A List of Harmful Ways of Financial Statement Fraud 14 Appendix B: The motives for Financial Statement Fraud 16 Appendix C: Common Types of Financial Statement Schemes 17 Appendix D: Financial Statement Frauds Methods 18 Appendix E: Fraud Detection Methods 19 Table 1: Fraud detection methods 19 1.0 Introduction The highly competitive business environment in the global market has contributed to some corporate executives involving in financial statement fraud in order to redeem the face of the organization before potential investors, and attract new clients. The rate of financial statement fraud within organizations has gone high and is still increasing. This can be seen from highly publicized fraud cases in major world companies such as Enron, Xerox, Global Crossing, WorldCom, and SunBeam. Financial Statement Fraud is one of the commonest kinds of fraud in the corporate and has led to most organizations losing their annual revenue. Financial statement frauds are most likely to happen because they are important documents that must be seen by investors and creditors when making decisions about investing in a company. Financial statement frauds are involved with low costs and take only a short time to take effect. The purpose of this project report is to give an overview of the financial statement fraud, and highlights the motivation behind, and methods for conducting this fraud, as well as provides recommendations for preventing and detecting future incidences. 2.0 Financial statement fraud overview A financial statement is usually a written report that contains substantial data of a company’s performance in a given period, usually, quartile, or, annual basis. The statement is a combination of income statement and balance sheet, and can report the cash flow statement. A financial statement is a vital report issued by a company as it reflects its financial health to the market (Hubpages 2011). As such, the financial statement is the most referred to document by investors and leaders in decision-making about investments and lending. The information in financial statements can sometimes be given in a way that it intentionally misstates the financial position and performance of an organization. This misstatement of financial statements can result from falsifying, manipulating, or changing accounting records. Such intentionally manipulated statements are misleading and can cause devastating problems in the market and the economy. There are several cases of Executives who have served jail terms while others charged with fines for participating in financial statement frauds (Ernst & Young, 2009, p.1). Financial statement fraud differs in definitions in scholarly and practitioner literatures although the Australian Securities & Investments Commission (ASIC) (2005) emphasize that for it to be fraud, the act must be deliberate and intentional. The Association of Certified Fraud Examiners (ACFE) (2010) entails that a financial statement fraud involves a misinterpretation or deception made by an entity or individual who knows that it can lead to some unauthorized benefit to the entity or the individual, or a third party. It can also be defined as an act of omission which leads to misleading results portrayed in the financial statement (Rezaee, 2002, p.2). Cooper (2005, p. 3) asserts that the deliberate omission or disclosure in a fraudulent act concerning the financial statement is to woe financial statement users, especially investors and creditors. According to the ACFE (2010) report, about 10 percent of financial statement frauds constitute white collar crimes. Financial statement fraud is very costly yet the most common type of fraud committed in companies which has led to concerns and shaken confidence in the financial reporting system and capital markets (Albrecht et al., 2009, p. 358). This and many other harmful consequences (see Appendix A) occur from financial statement frauds (Rezaee 2002, p.7). Real life examples of financial statements frauds have been reported to occur in some of the world’s largest companies such as Enron, Qwest, Global Crossing, WorldCom, and Xerox (ASIC, 2005; Rezaee, 2002). The high-profile cases indicated how financial statement fraud can harm the interests of shareholders and investors, as well as cause the economic downfall of companies. Although accurate figures of losses to the market concerning the frauds are hard to pin, it was estimated that Enron’s case alone cost about $80 billion loss and ended up being declared bankrupt after 3 years of conducting financial statement frauds (Cooper, 2005, p.4). Investors’ confidence and trust is shaken when such acts are uncovered and due to increasing cases, regulations guarding financial reports of organizations have become stringent. 3.0 Motivations of financial statement fraud Understanding the motivation behind fraud can enable better investigation and analysis of fraud. For every act of financial statement fraud, there is motivation behind it although this can vary from one case to another (Rezaee & Riley, 2010). Nevertheless, every case’s motivation seems to have the inclusion of three common factors which are perceived opportunity, perceived pressure, and rationalization as described by the fraud triangle (Albrecht et al., 2009, p.33) (See Appendix B). Perceived opportunity comes about from a lack of organizational controls and security. A company not well equipped in these areas creates a sufficient opportunity for fraud to occur. Perceived pressure comes about when there is an urge to meet the market expectations. This is mostly pressure created by demands to meet earning targets, often tied to compensation under management incentive plans (Earnest & Young, 2009, p. 1). For example, the case of WorldCom saw the Chief Financial Officer (CFO) adjusting financial statement figures improperly to show that the company is meeting its earnings projections. Sullivan, WorldCom’s CFO case also showed that he was trying to respond to pressure after realizing the competition was getting stronger, and he resort to improper records in the financial statement that would help the company obtain more debt and equity financing from creditors and investors (Cooper, 2005, p.4). Rationalization comes about when there is a way to lay low the act only for a short term (Colby, p.2-3). With the volatile market environments consisting of trends of technology, competitors, and stakeholders’ expectations, the executive and employee face many pressures and some fall for corrupted means to survive in the market (Albrecht et al., 2009, p. 359). People must see an opportunity to try an act of fraud, and this can be enabled by the weak or oversight from the board of directors or audit committee, and complex accounting systems or weak internal control (Colby, p.2-3). A way to rationalize the act of fraud can also be identified such as having the shareholder’s interest at heart, acting for the good of the company, or expecting the problem to subside on its own in the future (Albrecht et al. 2009, p. 360). For example, Enron’s case reflected the organization’s motive to meeting the expectation of its investors and other stakeholders. Enron had become worried that its leverage ratios were below the mark as on the Standard & Poor’s credit rating agencies. Therefore, many limited liabilities were placed as special purpose entities that allowed Enron to increase leverage and reimburse assets without confirming debt on its balance sheet. This would retain the generally growing stock price and maintain critical investment ratings on credit hence increasing the company’s attractiveness to potential investors (McConnel, 2010). The cases of Enron and WorldCom are examples that show that show how short-lived financial statements frauds are as the companies have suffered long-term negative public image and damage. 4.0 Methods of financial statement fraud Many different methods for financial stamen frauds exists but Quizlet (2011) identifies five schemes common in the market and these are fictitious revenue, concealed liabilities or expenses, timing differences, improper asset valuations, and improper or fraudulent disclosure (See Appendix C). According to Razaee (2002, p, 80) asset and revenues overstate are leading as they involve recording improper asset valuation or revenue recognition. On the other hand, understatement of expenses and liabilities is also often used in improper deferral of expenses and liabilities and improper depreciation (Rezaee, 2002, p, 80). Other methods include omitted, false, or inadequate disclosures, of related party transactions or insufficient, omission of, or inappropriate disclosures (Rezaee 2002, p, 80) (See Appendix D). Sunbeam’s case offers a good example for a financial statement fraud method. Sunbeam’s CEO Albert J. Dunlap established a huge financial statement fraud whereby he involved other Sunbeam executives using a range of fraudulent techniques to produce the statements and this included recording the revenue on contingent sales, heightening sales from previous periods to present ones, and using inappropriate bill and hold transactions (Cooper, 2005, p.4). This resulted to an inflated profit of about $60 million and a consequent filed bankruptcy (Brandt, 2008). WorldCom is also another example for analysis of financial statement fraud. WorldCom’s fraud act was accomplished through two major ways. One, the CFO intentionally underreported interconnection expenses with other telecommunication companies through capitalizing the costs as investments on the balance sheet rather than expensing them in a proper manner (Tran, 2002). Cooper (2005, p, 4) asserts that the WorldCom’s inflated profits were caused by improperly spreading the operating expenses. The second way was through inflating revenues by creating fictitious accounting entries from unallocated revenue accounts with the objective of meeting profit projections (Cooper, 2004, p.4). WorldCom was finally found to improperly report $3.8 billion of capital investments rather than expenses and $3.3 billion in profits from 1990 to the first quarter of 2002, and this became a highly profile case of false bookkeeping in the corporate (Tran, 2002). 5.0 Prevention and detection of financial statement fraud Prevention and detection of financial statement fraud is now being given a very keen interest as companies seek more effective and efficient ways to deal with the problem in order to restore the confidence that investors and creditors have in the company. No chance should be left for fraud after witnessing the major scandals at seemingly high profitable companies like WorldCom and Enron. Although it is very difficult to totally eliminate the financial statement fraud risks, they can be managed to discourage fraud and minimize damages through establishing fraud risk and control policies and procedures (Vitez, 2011). Early detection of financial statement fraud can assist the company to prevent it and this can be achieved through various methods and ways depending on factors such as size, industry, and, management style (See Appendix E). Hotlines and anonymous tips by employees can be a very effective way of detecting fraud, as it comes from the internal environment (Coene, 2009, p.199). The ACFE (2011) report revealed that majority of fraud, about 66 percent, was by anonymous tips from employees rather than through internal audit and internal audit controls. A company should build a successful hotline based on a well-trained personnel and maintenance of anonymity (Griggs, 2011). Corporate governance is also another important tool that can help prevent the occurrence of financial statement fraud (Coene, 2009, p, 200; Rezaee, 2002, p, 77). This is because it is the top management that can approve and ensure that financial reports match the representation of the company as many cases of fraud occur with the knowledge of the management (Rezaee, 2002, p. 76). Successful corporate governance offers many legal choices for management decisions and makes it unbearable for them to undertake illegalities (Coene, 2009, p.201). The company must firmly stand by its morals and values and make sure that everyone is aware of the consequences of committing fraud. Poor corporate governance was witnessed at Enron where the company’s board allowed creating private partnerships to conduct business with it resulting to extensive amounts of debts concealed by these partnerships. This affected the company’s profit and share value (Jones, 2009). Internal control is also another important way by which fraud can be detected and controlled, and includes both internal control and operation internal control (James, 2011). Although internal control takes long to establish and is costly, it is very helpful in the long run especially when it is a strong one (Coene 2009, p.199). James (2011) and Coene (2009, p.199) agree that the major part of the operational control is to divide employee duties so that all have equal influence and no one has power to propel a fraud and cover it. For example, the same person should not be allowed to authorize the purchase order as well as communicate with suppliers and organise purchase payments. In another example, an employee who records cash receipts and expenses to journal ledger should be barred from posting them to the accounting system, or reconciling the bank statement. This will make it difficult for the employee who will now require more other people to collude for the illegal act to be created. Enron is a case in which a weak internal control system led to the highly publicized fraud scandal. Hays (2003) asserts that Enron’s board of directors failed to fulfil their responsibilities and did not have the knowledge or skills to implement an effective internal control system, and neither did they manage the risks facing the operating areas as well as failed to develop control practices for employees to adhere to (Locatelli, 2002, p.2). Enron also failed at segregation of duties as the external auditor Arthur Anderson did some internal audit-bookkeeping for Enron. Thus, the independence of external auditing was threatened by vulnerable internal control systems (Stevens & Schwartz, 2006, p.1). Internal controls alone may not be as effective as such in controlling fraud in the company. Vitez (2011) suggests that a management review of financial statements must be provided to reflect the accuracy of financial statements, although this method may be inadequate and will require involvement of an independent audit committee. A company keen in controlling the occurrence of fraud should invest in a team of independent Auditors Committee to assist in future fraud prevention. The committee can provide an oversight over the financial reporting of the company and prevent the management from applying aggressive accounting approaches (Rezaee, 2002, p.78). In the modern times filled with technology advancements, special software can be used to identify any red flags and suspicious situations where a fraud might occur. This includes use of techniques such as Data mining (Apparao et al., 2009, p.161). Expanding technology has made it easier for fraud to occur but it can also be tapped to ensure that prevention of the same takes place. Software can be rum over all the accounts and entries in order to detect anomalies and alert the system owner to proceed with further investigations (Albrecht et al., 2009, p.82). In my opinion, I recommend that the companies initiate an effective way of preventing fraud through screening employees during the recruitment and selection processes. The company should do a thorough background check to ensure that their staffs hold on to high moral values and a transparent history. The employees should also be explained to how fraud occurs and the legal implications that one might face when they involve in fraud. Monthly, annual, or special meetings can also be used as a platform to remind the employees of the importance of their moral values to the company and how prevention of fraud will help them maintain their jobs and improve job conditions. Employees can also be trained how to spot if someone is engaging in fraud. My opinion is that methods of preventing financial statement fraud should be focused on employees because fraud mostly occurs from the inside and within themselves they are likely to know who is on the wrong. The company should foster strict rules, updated software, and anti-frauds systems to ensure that fraud is kept at bay. Also new methods of detecting fraud should be researched and applied to ensure that preventive tactics are ahead of the perpetrator’s psyche. Conclusion In summary, the project report has discussed financial statement fraud in terms of overview, fraud motivations as discussed in the fraud triangle, real cases of fraud in major companies including Enron and WorldCom, and methods of detecting and preventing fraud. There is increasing temptation at the corporate to present attractive results in the current market environment through financial statement frauds. This has detrimental consequences to the economy and market as creditors and investors are tricked into investing in a company with false results of performance. New measures are being put in place to minimize fraud and prevent it from taking root and help protect the interest of stakeholders, creditors, and investors. Prevention or minimization of fraud relies on a combination of effective and efficient methods and ways such as strong internal control systems, good corporate governance, independent audit committee, employee tips via hotlines, and adopting software technologies. Reference List: ACFE’s 2010 Report to the Nation. (2010). Retrieved October 07, 2012 from http://www.acfe.com/rttn/2010-highlights.asp Albrecht, W. S., Albrecht, C. C., Albrecht, C. O., &Zimbelman, M. F. (2009).Fraud Examination (3rd ed.). Mason, OH: South-Western Cengage Learning. Apparao, G., Rao, G. S., Bhavani, B. Eswar, K., &Rajani, D. (2009). Financial statement fraud detection by Data-Mining.Journal of Advanced Networking and Applications, 1(3), 159-163. Brandt, T. (2008). Fraud committed by Sunbeam. Retrieved from http://www.mightystudents.com/essay/Fraud.committed.Sunbeam.60936 Cooper, J. (2005). Financial statement fraud: corporate crime of the 21st century. Australia Securities & Investments Commission.AICD NSW Division. Ernest and Young (2009). Detecting financial statement fraud: What every manager needs to know. Hays, K. (2003). Enron CEO: Sarbanes-Oxley won't work as intended. Retrieved October 07, 2012 from http://global.factiva.com Hubpages. (2011). The importance of financial statements. Retrieved October 7, 2012 from http://csanad.hubpages.com/hub/The-Importance-of-financial-statements James, K. (2011). How to prevent financial statement fraud. Retrieved October 07, 2012 from http://smallbusiness.chron.com/prevent-financial-statement-fraud-3789.html Jones, S. (2009). The Enron company collapse. Retrieved October 07, 2012 from http://ezinearticles.com/?The-Enron-Company-Collapse&id=2462105 Locatelli, M. (2002). Good internal controls and auditor independence. Retrieved October 07, 2012 from http://global.factiva.com/ McConnel, S. (2010).The Enron Debacle: a cautionary tale for the wise investor. Retrieved October 07, 2012 from http://www.open-spaces.com/article-v4n4-mcconnel.php Quizlet. (2011). Financial statement fraud. Retrieved October 07, 2012 from http://quizlet.com/5379221/chapter-12-flash-cards/ Rezaee, Z. (2002). Financial statement fraud: prevention and detection. Danvers, MA: John Wiley and Sons, Inc. Rezaee, Z., & Riley, R. (2010). Financial statement fraud: prevention and detection (2nd ed). Hoboken, New Jersey: John Wiley & Sons, Inc. Stephens, L..& Schwartz, R. G. (2006). The chilling effect of Sarbanes-Oxley: Myth or reality. Retrieved October 07, 2012, from http://global.factiva.com/ Tran, M. (2002). WorldCom accounting scandal. Retrieved from http://www.guardian.co.uk/business/2002/aug/09/corporatefraud.worldcom2 Vitez, O. (2011). Financial statement fraud prevention. Retrieved October 07, 2012 from http://www.ehow.com/way_5262579_financial-statement-fraud-prevention.html Appendices Appendix A: A List of Harmful Ways of Financial Statement Fraud Undermines the reliability, quality, transparency, and integrity of the financial reporting process Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms, e.g. Andersen Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information Makes the capital markets less efficient Adversely affects the nation’s economic growth and prosperity Results in huge litigation costs Destroy careers of individuals involved in financial statement fraud Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud Encourages regulatory intervention Causes devastation in the normal operations and performance of alleged companies Raises serious doubt the efficacy of financial statement audits Erodes public confidence and trust in the accounting and auditing profession (Rezaee, 2002, p. 7) Appendix B: The motives for Financial Statement Fraud (Albrecht et al., 2009, p. 33) Appendix C: Common Types of Financial Statement Schemes To meet the expectations of owners, banks, creditors and financial analysts To obtain and keep favorable credit terms, to meet criteria set by financial institutions for obtaining/renewing a loan To meet performance criteria set by the parent company To meet the personal performance criteria necessary to receive financial bonuses To inflate the company value when expecting its sale, merger or acquisition To create “redundant” profit and transfer it to another accounting period To maintain the impression of constant economic growth of the company (Rezaee& Riley, 2010, p. 66). Appendix D: Financial Statement Frauds Methods Fictitious Revenues Recording of goods or services that did not occur Fake or phantom customers Legitimate Customers Sales with conditions Pressures to boost revenues Timing Differences Recording revenue and/or expenses in improper periods Shifts revenues or expenses between one period and the next, increasing or decreasing earnings as desired Matching revenues with expenses Premature Revenue recognition Long-term contracts Channel stuffing Recording expenses in the wrong period Concealed Liabilities and Expenses Liability/expense omissions (i.e., shifting liabilities to off-balance sheet, unconsolidated affiliates) Capitalized expenses Failure to disclose warranty costs and liabilities Improper Disclosures Liability omissions Subsequent events Management fraud and related party transactions Improper Asset Valuations Inventory valuation Accounts receivable Business combinations (Quizlet, 2011) Appendix E: Fraud Detection Methods Table 1: Fraud detection methods (ACFE’s 2010 Report to the Nation, 2010) Read More