Prevention of Financial Frauds - Research Paper Example

?Running Heading: Prevention of Financial Frauds Prevention of Financial Frauds This paper focuses on one of the important issues of the world; financial frauds which could impact the overall financial stability of the economy. Financial analysts and auditors have stressed a lot in the last few years to eliminate financial frauds and thus several techniques and methods have been recommended by auditors and financial analysts from different parts of the world to prevent financial frauds. The paper also discusses about the types of financial frauds according to their nature; inclusive frauds and exclusive frauds. There are two types of frauds according to the people involved in the fraud and these two types are internal frauds and external frauds. Besides defining these frauds, the paper explains how such frauds can be prevented. The paper also focuses on one of the biggest financial scandals; Enron and it explains how the management of Enron was successful in their fraudulent activities. It also highlights the impact of Enron’s case on the overall economy. INTRODUCTION Financial frauds are widely perceived to be deliberately made criminal acts that seriously violate civil law while based on financial transactions and meant to attain myriad personal benefits. For the last so many years, auditors and financial analysts have been emphasizing to eliminate the financial frauds and for this purpose there have been many research conducted on this given topic. With the passage of time and as more and more financial frauds have emerged, the need to fight against these financial frauds have increased enormously and people of all ages have to face consequences of such financial frauds. In criminal law, the word fraud is defined as a planned and calculated deception which is made for some kind of personal gain or to damage another individual. On the other hand, financial frauds mean frauds that occur particularly in the financial statements or financial documents of the company like balance sheet, income statement etc in order to manipulate the financial strength of the company. Financial Frauds can be planned on a large scale which might have an impact on the overall industry or economy of the country and there might be financial frauds which might not be as large but these frauds would weaken the financial stability of an organization. Both these types of frauds have become a serious issue for everyone who is involved with the organization either directly or indirectly. Since financial frauds could affect the economy and organizations and everyone who is involved with the organization therefore it is critical to stop such financial crimes and to prevent such financial frauds there have been several techniques, tools, applications and methods developed by auditors and financial analysts from all over the world and still more research is being done on the topic (Singleton, & Singleton, 2010). LITERATURE REVIEW It is important for the organization and employees of the organization who are responsible for handling and managing of important and sensitive documents to keep these documents in safe and do not let anyone to have access to such documents as one of the ways through which financial frauds can occur is to have access to such sensitive information. A layered security approach and effective tools are required to handle this dramatic emergency of felonious financial frauds and by controlling who first receives sensitive documents like bank statements, small organizations can prevent financial fraud occurrence (CBIA News, 2007). Financial information of a corporation is used by investors in order to evaluate the company’s progress and growth and its profitability as well as in order to predict the future profitability of the organization. Thus, these financial statements are used by investors to make decision whether they should invest in the company or not. Therefore, one of the greatest risks faced by investors is that the financial statements on the basis of which they make investment decisions have been materially misrepresented. Financial statements can be misrepresented intentionally or mistakenly and with such errors, the financial statements do not reflect the true picture of the organization and they tend to mislead the users of the financial statements. This is one of the kinds of financial frauds as described by Fich & Shivdasani (2007). According to Fich & Shivdasani (2007) the most common types of financial frauds are in the heads of revenues, expenses, assets and liabilities. Revenues are generally overstated and expenses are understated to show better profitability of the company and similarly assets are overstated and liabilities are understated to show better financial stability of the company. Overstatement of earnings of the company or misrepresentation of expenses or costs are generally made to show better profitability of the company and such frauds are called as inclusive frauds whereas if intentional omission of liabilities have been made then it would be categorized as exclusive frauds. Researchers and expert policy makers at Research Centre on the Prevention of Financial Fraud have suggested a three-fold strategy in order to prevent the rise in financial frauds around the world. According to them, there can be huge losses saved every year that occur because of financial frauds (Research Centre on the Prevention of Financial Fraud, 2009). There have been many financial frauds cases where people who have become victim are not aware that they have been victimized by financial frauds and one of the main reasons for this is that such frauds are made by professional businessman or professional people involved in the business (Button, Lewis, & Tapley, 2009). Many analysts have emphasized on eliminating criminal and fraudulent activities out of businesses in order to make the financial system more effective as these frauds not only impact the employees of the organizations but stakeholders of the organization who are somehow connected to the organization also have to face consequences. For instance, a fraudulent activity might affect the profitability of the organizations or it might affect the working capital of the organizations and the organization might be forced to dismiss some of the employees therefore people who are linked with the organization would also have to face the consequences of this fraudulent activity. Therefore a fraud not only disturbs the flow and profitability of the organization but it also affects the stakeholders of the organization. One of the methods to analyze the frauds that might occur and prevent it is to take interviews and gather data by collecting information from the stakeholders of the organization as it will be helpful in knowing areas where the company is at highest risk (Adams, et al., 2006). Singleton & Singleton (2010) said that the every employer and auditor aims to eradicate all types of criminal activities from the organizations so that the organizations do not show short term profitability and the financial statements are not inflated only for a short period of time as this would affect the long term existence of the organization and long term profitability. Both Singleton & Singleton (2010) have emphasized that people who are already employed in the organization can be involved in fraudulent activities and if such is the case then this kind of fraud is called as internal fraud. Also fraud can be made by people with whom the organization is conducting businesses such as suppliers, external auditors, distributors, outsourcing firms etc and if these people are involved in fraud then this kind of fraud is called external fraud. There have been several measures and techniques that could decrease the probability of frauds occurring in the organization and these are: If an organization hires employees who are reliable and they are referred by some reliable person then this reduces the chances of internal frauds. Also it is important to have a background check of employees during the pre-employment phase as this evaluates and analyzes the past history of the person before he or she is hired by the organization. However, most organizations do perform these background checks when hiring employees but only for sensitive positions. By having a proper system implemented in the organization that can be monitored by the top management and the auditors of the organization frequently reduces the chances of fraudulent activities as anyone in the organization would know before making any kind of fraud that the top managers are evaluating their activities and they are being monitored. The other technique that can be effective in reducing the fraudulent activities from the organization is to have a policy to dismiss employees from the organization as well as prosecution for fraudulent activities. This would help the organization as employees would have a fear in their minds before they are involved in such activities. Frauds are not only made by people from the middle management or lower management but senior or top management employees are also involved in fraudulent activities therefore organization should not allow the top management or senior managers to have too much control or dominate the organization. Bank Negara Malaysia (2010) published a research report in which the bank claimed that most of the financial frauds mimic legitimate courses so that the victims stay satisfied and do not think about pointing out at the fraudsters who are white collar criminals. According to Zhao & Meersman (2006), laws, regulations and cases about illegal solicitation of financial products on the web develop a fraud forensic ontology. Rezaee and Riley (2011) in their book have focused on the issue of prevention of fraudulent activities as well and they have claimed that there has been a change in the way auditors evaluate the fraudulent activities in an organization. Today, with the advancement of technology, there has been a shift in how auditors detect and identify frauds in the financial statements of the organization. According to Rezaee and Riley (2011)auditors today do not make use of manual methods to detect financial frauds instead they utilize technology to identify and prevent financial frauds. With the use of different types of auditing software and applications, auditors can get significant amount of help in identifying areas where fraud can take place in the organization. With the feature of internal checks available in auditing software, auditors and managers can better detect irregular relationships in the financial statements and thus they can better identify and predict financial frauds. Some software like Computerized Audit tools and Techniques (CATTs) have given the opportunity to auditors that they can review almost all the transactions thus auditors are in a better position to identify frauds more effectively (Lin, & Wang, 2011). These fraudulent cases not only ruin that particularly organization but the overall industry is damaged which impacts the economic condition of the country because there are certain industries which are important for the survival and growth of the country’s economy and if these industries experience something as bad as frauds then it would make situation worse. Also such fraud cases hurt the trust of investors and people become reluctant to invest their money in such companies and industry. CASE STUDY: ENRON SCANDAL One of the largest financial fraud or scandal was identified in 2001, in which one of the biggest organizations, Enron, was involved. This financial and accounting fraud led to default of the Enron Corporation. Enron, known to be one of the famous energy companies of America, became the biggest case and example of not only bankruptcy but also of audit failure (Dembinski, Lager, Cornford, & Bonvin, 2006). Enron was considered to be involved in the securities fraud as the organization used inappropriate accounting practices in order to manipulate the financial results being communicated to the public. At the same time the company was found guilty of lying to Securities and Exchange Commission (SEC) (Dembinski, Lager, Cornford, & Bonvin, 2006). This scandal appeared on screen after the announcement of huge loss by the organization on 16th October, 2001. As a result, Securities and Exchange Commission (SEC) started an investigation about the accounting practices of Enron, on 22nd October, 2001 (Tesfatsion, 2011). It was found with the help of investigation that the company was using complicated and doubtful accounting practices or schemes for the process of reducing the payments associated with tax, inflating the overall profit and income of the organization, inflating the share price and credit rating, hiding the losses associated with off balance sheet units, formulating off balance sheet methods in order to obtain money for personal uses, misrepresenting the financial situation of the company to the public (Tesfatsion, 2011). The management of Enron used different accounting loopholes along with entities developed for special purpose and inappropriate reporting of financial condition, in order to hide large amount of liabilities and debts which were generated because of unsuccessful projects and deals. Andrew Fastow, the Chief Financial Officer of Enron at that time, not only deceived and gave wrong impression about the different high risk and complex accounting practices, to the audit committee and board of directors, but also forced Andersen, the external audit firm, to overlook the matter (Tesfatsion, 2011). As a result of this financial fraud, investors lost huge amount of money, as the share prices of Enron fell considerably (Dembinski, Lager, Cornford, & Bonvin, 2006). In reaction to this huge and most controversial financial scandal, authorities came up with different new and more effective rules and regulations related to accounting practices of the organizations. The concerned authorities formulated and implemented different legislations in order to ensure more accuracy in the process of financial reporting by the public organizations. One example of these laws and regulations is Sarbanes – Oxley Act (Tesfatsion, 2011). The impact of this financial fraud or accounting misrepresentation was not only tolerated by the organization and other associated parties, but was also experienced by investors and general public. This case of Enron is a prime example of the fact that implications and effects of fraud are huge and results in influencing the overall economy. For this reason it is essential to come up with appropriate methods and strategies for the prevention of any kind of financial fraud. It is important to devise strategies for preventing any kind of misrepresentation in the financial reporting, as it is associated with the general public who invest in a particular organization and have right to get accurate data and information. CONCLUSION Financial frauds and cases like Enron have disturbed the overall economic situation and this also lead to decrease in investment as investors had a fear that whether the financial statements of organizations are misrepresented or not. Therefore one fraud does not only hurt the financial performance of an organization but other companies also have to face consequences. Financial frauds have become a major concern in today’s world as almost every day billions of dollars are being loss both at national and public level therefore financial frauds cannot be said to affect only the big corporations but it has an impact on the overall economy. Even though there have been many software and applications developed to evaluate and analyze the financial statements and financial transactions of an organization in a better way and auditors today are better placed to evaluate the financial performance of an organization however financial frauds cannot be completely eliminated from both national level and public level. Though there are certain measures, techniques and steps that an organization needs to take in order to reduce the chances of such fraudulent activities. It is important to take different actions in order to prevent such fraudulent activities from the organization so that the organization is able to achieve profitability in the long run rather than achieving profits in the short run. Organizations also need to make people aware regarding different kinds of financial frauds that could occur and also the nature of these frauds. If everyone in the organization would have better understanding of these kinds of frauds then it would help in prevention of financial frauds. References Adams, G.W., Campbell, D.R., Campbell, M., & Rose, M.P. (2006). Fraud Prevention: An Investment No One Can Afford to Forego. The CPA Journal. Retrieved from http://www.nysscpa.org/cpajournal/2006/106/essentials/p56.htm Bank Negara Malaysia. (2010). What is Financial Fraud? Retrieved from http://www.bnm.gov.my/microsites/fraudalert/01_what.htm Button, M., Lewis, C., & Tapley, J. (2009). Fraud typologies and victims of fraud: literature review. Retrieved from http://fraudresearchcenter.org/2011/10/fraud-typologies-and-victims-of-fraud-literature-review/ CBIA News. (2007). Nine ways to Prevent fraud in your workplace. The Journal of the Connecticut Business & Industry Association, 85. Retrieved from http://www.cbia.com/cbianews/2007/05/200705SB_PreventFraud.htm Dembinski, P., Lager, C., Cornford, A., & Bonvin, J. (2006). Enron and World Finance: A Case Study in Ethics. New York: Palgrave MacMillan. Retrieved November 10, 2011, from Fich, E. & Shivdasani, A. (2007). Financial fraud, director reputation, and shareholder wealth. Journal of Financial Economics. 86 (2), 306-336. Lin, C. & Wang, C. (2011). A selection model for auditing software. Industrial Management & Data Systems, 111 (5), 776 - 790 Research Centre on the Prevention of Financial Fraud. (2009). Combating Financial Fraud. Retrieved from http://longevity.stanford.edu/financial-security-2/combatting-financial-fraud/ Rezaee, Z. And Riley, R. (2011). Financial Statement Fraud Defined. New York: John Wiley and Sons. Singleton, T. & Singleton, A. (2010). Fraud Auditing and Forensic Accounting. New York: John Wiley and Sons. Tesfatsion, L. (2011). The Enron Scandal and Moral Hazard. Ames, IA: Iowa State University, Department of Economics. Retrieved November 10, 2011, from Zhao, G. & Meersman, R. (2006). Towards a Topical Ontology of Fraud. Read More