Fraud And Capital Market - Research Paper Example

?   FRAUD AND CAPITAL MARKET College: Introduction Law requires that all public companies present financial statement at the end of every financial period. Financial statements presented by corporations are as results of proper book keeping and independent auditing. According to Scharff, company’s strength and survival is demonstrated by the financial position and the level of profits in competitive market structures. Scharff, states that, the qualities of financial statements or reports have been eroded by individual interests that have resulted in fraud, this can be inform of individual, corporate, online or advanced fee fraud (Scharff 2005). These eroded financial statements are referred to as fraudulent financial reporting which can be defined in broad sense as deliberate misstatements or oversight of monetary values or disclosures in financial statements prepared to mislead financial statement users. Previous cases of fraud have left investors and regulators looking for answers like how can creative accounting be stopped, how it start and who is to blame when its revealed in their companies. Generally, these entire questions seem to be answered by putting liabilities to management for failure to comply with Generally Accepted Accounting Principles (GAAP). Again, failure to detect fraud can be a backlog of independent auditors for failure to apply Generally Accepted Auditing principles (GAAP) accordingly. To counteract these frauds, regulators, corporations and government have instituted various professional ethics and liability laws to reduce such cases. Fraud detection and procedure Fraud detection is not necessarily the duty and obligation of the obvious and recognized agents such as investors, SEC and the independent auditors; rather it is the obligation of community which includes the media, industry regulatory actors, and the company employees. According to the research conducted by the (Kuhn & Sutton, 2006) whistleblowers defer in their capacity to detect frauds. Essentially, the researches indicate that, under legal duties and obligations, the independent auditors and the security regulators are the primary detector agents, auditors can either be internal or external. A fraud can either be detected by an internal auditor or external auditor since both have mutual interests in regard to internal financial controls. The internal auditor is usually part of the company or organization; their roles are stipulated by their respective boards, management and the professional standards while external auditors are not part of the organization but in the line of duty they are engaged by the organization (Harrison 2002). Their roles are set by their client and primary statute for a purpose of providing an independent opinion toward the organization financial statement and this is done annually. Both external and internal auditors ought to meet and share common interest which are directly related to auditing Procedures that auditor needs to go through to discover fraud There are three main steps auditors go through in detecting fraud, these steps are planning, execution and reporting, these steps involve follow up actions that reflect the performance of the audit. In a normal audit, fraud detecting can be done during the planning and execution stage. The table below show procedures an auditor ought to go through in order to detect fraud. Overview of fraud and detection process during normal audit During planning, the auditors assess the risk of fraud; this involves discussions between auditors to consider how and where the financial entity is likely to be susceptible to fraud (Harrion 2002). This assessment involves known external and internal factors that affect the financial entity and also consider risk of management overrule of control, and how the auditor is likely to react to the susceptibility of the entity in regard to fraud. During planning, it is important to obtain information required to identify fraud. The auditors are supposed to get sufficient knowledge of any entity and the sector in which it operates in, they should also be attentive to any data that might be useful indentifying fraud (Chatterjee 2003). At this stage the auditors should also determine the level of technology as it defines the complexity of the business, in that a business that uses more of technology is more likely to be complicated and hence appropriate mechanism to deal with fraud should be put in place. This is crucial in carrying out a fraud risk assessment of an entity, in most cases checklist is the most common tool employed by auditors. Nevertheless, auditors ought to discern that application of check list is not supposed to substitute their professional judgment and professional skepticism. At this point depending on the type of information collected auditors ought to identify fraud based on incentives, opportunities and attitudes (Chatterjee 2003). The auditor should put in consideration the nature of the entity i.e. size and complexity and attribute of fraud. This is important in assessing the indentified risks after taking into consideration an evaluation of the entity and controls to prevent fraud. Excution is the second stage in in auditing, it is performed after the auditors have identified high risk areas (red flags) from the financial files assessed. Red flags are abnomalities the reflect signs of fraud. During excution, red flags does not necessary mean there has been fraud thus auditors ought to demonstrate high level of profesional judgement in coming up the conclusion on existanance of fraud (Kuhn & Sutton, 2006). The auditors respond to fraud assessment and to the redflags influenced by the nature and importance of fraud as being present, the entity program and control measures that deal with the particular faud are also assessed. The auditors must determine the effect of risk assessment on the kind of audit conducted and reaction to his might be in the following ways; The response might have an overall impact in manner the audit was carried out, this is a general response and it may involve additional persons with special skills and knowledge in a specific field e.g. information technology who has to give more light on the audit conducted The response may entail the fraud identified involving the nature, time and the level of auditing procedures to be carried out. The response varies with the type of risk identified. It involves both test controls and substantive test. However, the management is likely to oversee controls that would appear to be working effectively, it is doubtful that risk is capable of being reduced considerately by carrying only control test and thus this response should include aspects of changing nature and timing of substantive tests The execution stage goes beyond the red flags; it includes further examination of results of the fraud by application of professional skepticism in analyzing the earlier evidence obtained from audit (Zingales, & Dyck, 2008). This forms the foundation of further investigation aimed at identifying and obtaining more evidence that will be used to support auditor’s conclusion in relation to fraud. Finally, the auditors should document all documents in a critical manner depending on the audit activity as this will be required for future reference. Finally, auditors have to communicate their finding to the relevant authority , this is based on strong evidence and indications that actual fraud occurred, and this has to be done in compliance to a particular legal framework since the information is sensitive to the given organization. Examples of historical financial statements scandals due to committing fraud This section tries to bring forth answers and the application of fraud accounting in a real company. WorldCom and Enron law firm are among recent reputed and large companies to be implicated with such accounting frauds. Up until the year 2000, WorldCom the then largest internet provider and Telephone Company in the United States recorded the largest and unique accounting fraud through which Enron stated as the creative accounting. For over 15 years the company had grown significantly and became the largest corporation in the telecommunication industry through its acquisition strategies. The nature of the fraud was similar to that of Enron though of different magnitude In the case of WorldCom Corporation, European and United States industrial regulators blocked merger of Sprint Corporation and the WorldCom Corporation in 2000. Kuhn & Sutton, argues that analyst and observers in the telecommunication industry detected the stagnation of the earnings ratio of WorldCom for a specific period. According to the analysts, WorldCom management manipulated all accounting information to maintain the consistency and this was a clear indicator of malpractices. Some of the approaches the company utilized included classifying expenses as capital expenditures thus would not appear in the income statement and writing down future expenses as acquired assets (Kuhn & Sutton, 2006). Also, management reclassified value acquired MCI assets as goodwill which is intangible and amortizable (Kuhn & Sutton, 2006). These techniques impacted to increasing profits and reducing key earnings ratios suggesting viability of the company and strong financial base. Basically, internal auditors and employees were not involved in WorldCom fraud detection rather independent auditors and financial analysts via the security regulators in Europe and United States were involved in unraveling the company’s accounting malpractice. On the other hand, the collapse of the Enron Corporation can be largely attributed to audit failures, which resulted to one of the largest corporation collapses in business history involving USD 8.5 billion hidden debt. This is significantly attributed to the company’s auditor malfunction to conduct in depth investigations and report any signs of suspicious accounting procedures and methods that had been long practiced by the company. One of the reasons why the audit failures resulted to the Enron fraud and ultimately collapse is that the auditor’s acceptance of non-audit engagement together with audit engagement; this served to put at risk the autonomy and reputation of the auditing process (Bovaird & Loffler 2000). The second reason why the auditing failures occurred is the intimate relationship that exists between the external auditor and the client, which lead to the viewpoint that the collapse of Enron Corporation can be significantly attributed to the lack of auditor independence. A friendly relationship between the external auditor and the client places the auditor in a complex situation and makes it difficult to establish probes and query any possibility of suspicious accounting policies adopted by the Enron Corporation (Chatterjee 2003). This resulted to what Andersen, the company’s external auditor referred to as high risk accounting practices. The third reason why the auditing failures at Enron Corporation happened is because of the fact the external auditors were fee dependent on the client, which was Enron Corporation. This immense reliance on fees from clients implies that the auditor’s ability to deploy impartial judgment and objectivity is significantly reduced when giving their audit opinions (Dyck et al,2008). This is because in most auditing cases involving audit engagement, company auditors are usually unwilling to risk their share of the money acquired from audit services and the revenue generated from services that are not audit-oriented. I addition, long audit tenure with Enron Corporation resulted a situation characterized with over-familiarity of company’s control system and the business context of the corporation. As a result, the audit failures of the Enron Corporation were because Andersen underestimated any instances suspicious activities and shortages found in the internal control system of the company. These reasons are a significant threat to auditor independence (Curall & marc 2003). Methods used to discover fraud There are mainly two main methods used to discover fraud and they include; professional judgment and professional skepticism. Professional judgment requires auditors to practice pragmatic care and attentiveness and to view the principles of serving the public interest by ensuring the optimum degree of honesty, impartiality and independence in applying professional judgment in aspects in their line of duty. Professional judgment also compels an accountability upon every auditor carrying out work under GAGAS adhere to GAGAS. In this case, auditors ought to stick to their principles, if they state they are auditing in accordance to GAGAS then they are supposed to justify departures from GAGAS (Thorne & Michelson, 2002). Generally professional judgment should be used by the auditors in determining the kind of duty to be carried out and the level of standard required to be applied, this will trickle down to define the scope of work, select the methodology, determine the sort and quantity of evidence to be collected, and select the tests and procedures and finally evaluate and report the results of the work Professional judgments go hand in hand with professional skepticism. Professional skepticism can be defined as an attitude that involves questioning of the mind and critical assessment of the evidence. In this field auditors apply knowledge, skills, and experience required as par their profession to carefully carry out, through integrity and good faith, the collecting of evidence and the purpose analysis of the sufficiency, competence and relevance of evidence. Since evidence is collected and analyzed right through the task, professional skepticism ought to be practiced throughout the assignment. During auditing, auditors should neither presume that the management is dishonest nor presuppose unquestionable honesty. In practicing professional skepticism, auditors are not supposed to be contented with less than persuasive evidence for the reason that the management is honest. The practice of professional judgment permits auditors to acquire reasonable reassurance that material misstatements or major inaccuracies in data will probably be detected if they are present (Moberg & Romar, 2010). It is not easy to attain Absolute assurance due to the nature of evidence and fraud characteristic. Therefore, audit carried in accordance to GAGAS is likely not to notice material misstatement whether it as a result of fraud, error, illegal acts or is it from infringement of contracts or agreements. Consequently, whilst this measure place responsibilities on every auditor and Audit Company to practice professional judgment in planning and carrying out the assignment, it doesn’t mean unlimited accountability nor infallibility to the auditor or the auditing company Impacts of detecting fraudulent financial reporting Financial statement’s users As indicated in the above paragraphs, financial statements users are the major beneficially of true and fair financial statements. Conversely, they become losers if malpractices or manipulation is done or when reporting disregards the Generally Accepted Accounting or Auditing Principles. Users of financial reports range from employees, government, suppliers, customers, shareholder and potential investors Capital market Once fraud is detected, there are various acts that proceed and comprise of initial discovery, interviewing, public record search, legal prosecution, and a forensic auditing to discover more in the documents and the individuals involved. All this triggers a number of internal and external responses (Bovaird & Loffler 2000). Most important is the manner the corporation reacts to frauds and the government response to minimize such cases in future. The first response of the government and corporation is to block the anticipated corporation merger. The intention of the fraud was basically to make rival Corporations exit competitive market environment or give up for acquisition or merger Conclusion Organization staffs have a duty to maximize shareholders wealth and attract potential investors. Ultimately, investors are impacted largely by improper accounting and the erosion of code of ethics in financial reporting. In fact, hardly a year goes without complaints of organization fraud through erroneous, understating or overstating financial records to strengthen their financial position and attract investors (Harrison, 2002). In most instances, false accounting takes place with certain hidden agenda which include; defrauding organization or strengthening organization falsely. Among them include; to hide losses, to attract lenders, to inflate share prices, attracting customers, cover fraud, to realize false bonuses, or/and to report false profits. References Bovaird, T & Loffler, E 2000, Public management and governance, Routledge, Oxon. Chatterjee, S 2003, 'Enron's Incremenetal Discent to Bankruptcy: A strategic and organizational analysis', Long Range Planning, vol 23, pp. 122-125. Curall, S & marc, E 2003, 'The fragility of organizational trust: Lessons from the rise and fall of Enron', Organizational Dynamics, vol 32, no. 2, pp. 193-206. Ethics institute of South Africa. (nd) WorldCom Case Study. Brooklyn Square, 0075, South Africa. Retrieved from http://www.irmsa.org.za/library/WorldCom.pdf Harrison, B. (2002). Does the WorldCom Bankruptcy Put My Telecom Service at Risk? Implications for WorldCom Customers and Non-Customers. Epicom Corporation. Retrieved from http://www.telecomdirections.com/PageFiles/Worldcom%20Bankruptcy%20and%20Implications.pdf Kuhn, R. & Sutton, S. G. (2006). Learning from WorldCom: Implications for Fraud Detection through Continuous Assurance JOURNAL OF EMERGING TECHNOLOGIES IN ACCOUNTING. Vol. 3. pp. 61–80 Moberg D. & Romar, E. (2010). WorldCom. Retrieved from http://www.scu.edu/ethics/dialogue/candc/cases/worldcom.html Scharff, M.M.  (2005) Understanding WorldCom's accounting fraud: did groupthink play a role?  Journal of Leadership & Organizational Studies.  Spring Thorne, B., Stryker, J. & Michelson, S. (nd). The Sarbanes-Oxley Act Of 2002: What impact has it had on small business firms?. Stetson University. Deland, Florida. Zingales, L., Morse, A. & Dyck, A. (2008) Who Blows the Whistle On Corporate Fraud? University of Toronto & University of Chicago, NBER, & CEPR. Read More