Fraudulent Financial Reporting - Book Report/Review Example

Fraudulent Financial Reporting Fraudulent financial reporting is the most costly type of the three types of occupational fraud. Recent surveys found that financial fraud is substantial and affecting the relevance and reliability of financial statements; potentially causing long-term damage to the usefulness of financial statements (Schipper & Vincent, 2006). According to the Association of Certified Fraud Examiners (ACFE) there are three types of occupational fraud (ACFE, 2006). The three categories are asset misappropriations, corruption, and fraudulent financial results, and this report focuses on the last item, financial reporting fraud. According to the ACFE 2006 survey, ten percent of reported occupational fraud cases are financial statement fraud. This is not the most common type of occupational fraud but according the certified fraud examiners (CFEs) it is the most costly; the median loss due to financial statement fraud was $2,000,000 while the median loss for asset misappropriation was $150,000 - thirteen times greater (ACFE, 2006). According to the ACFE 2006 survey the most common manipulations of fraudulent financial reporting are: (1) reporting fictitious or overstated revenues; (2) concealing or understating liabilities or expenses; (3) timing differences recording revenues or expenses in the incorrect period; (4) improperly valuing assets; or (5) failing to disclose significant information (ACFE, 2006; Buckhoff, 2001). PREVALENCE OF FINANCIAL FRAUD IN ORGANISATIONS Due to heightened awareness of and increased interest in fraudulent financial reporting, many in the field of accounting and financial fraud have conducted their own research. PricewaterhouseCoopers (2006) 2005 survey found a 140% increase in financial fraud from 2003 and that the average financial fraud was $1.7 million. This is consistent with KPMG’s 2003 survey, which stated that FFR had increased in rate of occurrence from three percent to seven percent at an estimated cost of $250 million (KPMG Forensic, 2003). KPMG compared the $250 million in total losses to medical insurance fraud, which cost $33.7 million (KPMG Forensic, 2003). The ACFE (2006) stated US organisations lost 5% of annual revenues due to fraud. When applied to the estimated 2006 Gross Domestic Product the 5% figure translates to approximately $652 billion in fraud losses (ACFE, 2006). In addition, the ACFE (2006) study found 30% of occupational fraud was committed by employees in the accounting department and 20% were committed by upper management or executives. These violations are material, increasing in frequency, and have a significant economic impact on stakeholders, as financial fraud has cost investors more than $100 billion over the past two years (Rezaee, 2002). As a result, financial statement reliability is being compromised and decision usefulness eroded. Financial fraud may range from simple financial schemes to more highly complex accounting techniques employed specifically to deceive investors that typically might contain intentional misstatements of the true financial condition of the firm (Lomax, 2003). There are several examples of the methods used in financial reporting scandals that misstate financial reports. The most common forms of fraudulent reporting techniques include (a) fictitious revenues, (b) recording revenues prematurely, (c) overstatements of revenue, (d) overstatements of accounts receivable, (e) recording fictitious assets, (f) capitalising expenses as noncurrent activities that understates expenses and falsely increases earnings, and (g) understatement of expenses or other liabilities (Beasley, Carcello, & Hermanson, 1999). A review of the literature regarding fraudulent financial reporting showed emerging themes, that fraud is sometimes difficult to detect, difficult to eliminate, and that no company is immune from financial fraud (Black, 2003; Wells, 2007). Studies have shown that anyone may commit fraud, and fraud is a growing problem worldwide (ACFE, 2006; Peterson & Zikmund, 2004; Wells, 2007). In the US 2003 national survey of 459 public companies with annual revenues of at least $250 million, state and federal governmental agencies, KPMG Forensic (2003) found 344 (75%) of the companies surveyed reported that fraud was on the increase. While employee fraud might be the most prevalent form of fraud, fraudulent financial reporting and medical/insurance fraud are more costly (KPMG Forensic, 2003). The greatest impact of financial fraud using relative scaling occurred with smaller businesses (Adams et al, 2006; ACFE, 2006; Peterson & Zikmund, 2004). COST OF FINANCIAL FRAUD In a KPMG study of 459 public companies with annual revenues of $250 million or more, state, and federal government agencies, the average cost of financial reporting fraud reported was $258 million (KPMG Forensic, 2003). A more recent expanded study by other researchers consisted of five sections of 77 questions was distributed to 11,112 Certified Fraud Examiners (ACFE, 2006). From this population, there were 1,134 responses used in the report, which represented a 10.21% response rate. These respondents reported on actual fraud cases from 2004 to 2006, whereby the median loss for financial statement fraud was reported at $2 million (ACFE, 2006). Researchers of this same organisation reported in its 2004 Report to the Nation on Occupational Fraud and Abuse that the estimate of the typical company in the U.S. loses about 6% of its earnings to fraud (ACFE, 2006). The percentage of losses translates to approximately $660 billion when applying the Gross Domestic Product for 2003 (ACFE, 2004). Another study on the detection and prevention of financial crime estimated the cost for this type of crime ranges from 1% to 6% of corporate earnings and that not much is known about the conditions within the companies that can be taken to reduce this cost (Schnatterly, 2003). Because not all fraud cases are reported to the SEC or to prosecutorial authorities, the absolute true cost of fraud is not known. For example, the top four reasons why organisations decided not to prosecute the perpetrators of fraud were (a) fear of the negative publicity, (b) discipline was handled internally, (c) a private settlement was reached, and (d) the cost was prohibitive to pursue further (ACFE, 2006). THEORETICAL FRAMEWORK FOR FINANCIAL FRAUD DETECTION Theorists in the twentieth century believed crime was the result of the environment or that crime was symptomatic of an emotional disorder (Samenow, 2004). Common in the literature were reasons why people committed financial crimes. Considered one of the most prominent theories used to explain the occurrence of fraud is known as the fraud triangle (Peterson & Zikmund, 2004; Wells, 2007). The American Institute of Certified Public Accountants (AICPA), in conjunction with the Association of Certified Fraud Examiners (ACFE), released a computer-based training program and video using the fraud triangle as its underlying theory to explain the elements of fraud (Highlights, 2003). Theorised by Dr. D. R. Cressey (1919 – 1987), all three elements of the fraud triangle had to be present before an individual or individuals could perpetrate the fraud (Highlights, 2003). These three elements are (a) pressure or motive, (b) perceived opportunity, and (c) rationalisation (Peterson & Zikmund, 2004). A new way of thinking that might enhance the detection and prevention of financial fraud is to consider adding an expanded element to the fraud triangle. Given the elements in the fraud triangle of pressure, opportunity, and rationalisation, a fourth element that was proposed is the capability to commit the fraudulent act. The capability encompassed the ability of the perpetrator and the personal traits to carry out the fraudulent act. This added element has been transformed into a new model known as the fraud diamond (Wolfe & Hermanson, 2004). While other studies have confirmed the validity and rationality of the fraud triangle, no substantive extant research was found in the review of the literature to corroborate the acceptance and effectiveness of the proposed fraud diamond. FINANCIAL FRAUD DETECTION TECNIQUES AND STRATEGIES The detection of financial fraud expands beyond a review of financial data and compliance with Generally Accepted Auditing Standards. While auditors have traditionally used analytical reviews as a key tool to detect the potential risk of financial statement fraud (Mahoney & Carpenter, 2005), other suggestions were to expand the methods to detect and mitigate the risk of financial fraud. Some of the suggested detection techniques involved fraud-based interviewing, minimising conflicts of interest, managing fraud risk through internal controls, internal audits, and whistleblowing (Hall, 2005; Kaplan, 2004; Snyder & Dietz, 2006). Another suggested detection tool was to incorporate software by using a risk based approach in testing accounting journal entries. This tool might enable auditors and fraud examiners to concentrate on the riskier journal entries involving revenue recognition and capitalisation of expense items. A limitation of this tool is that it is not designed to replace the unique skills of auditors and fraud examiners (Lanza & Gilbert, 2007). In its 2003 fraud survey, KPMG Forensic (2003) found in its survey of 459 public companies that over 75% of the organisations discovered fraud by auditing management’s internal controls. The second highest fraud detection method that emerged from this study was the use of internal audits, followed by tips provided by employees, then accidental discovery, anonymous tips, outside customers, regulatory or law enforcement agencies, vendors, and last was the work of external audits. The findings in this study varied from the findings of the ACFE studies conducted in 2002, 2004, and 2006. Researchers at Ernst & Young conducted a fraud survey of global companies and found that 20% of the companies reported problems with fraud during a two-year period (Ernst & Young, n.d.). Another finding in this study was that in a review of SEC enforcement cases from 1999 to 2003 the number of reported cases had doubled, which suggested that the impact of the Sarbanes-Oxley Act of 2002 might be working. The premise of this study was to highlight to managers that all organisations are susceptible to fraud. The study cited studies conducted by the ACFE and recommended that managers be aware of the signs of potential fraudulent activity known as red flags (Ernst & Young, n.d.). Limitations in this study were that it lacked specific information about the population for the study, how the sample set was selected, and the research methodology used to complete the study. INTERNAL AUDITING The utulisation of internal auditing for detecting and prevention of financial fraud in companies has been widely considered in literature and business practice as the most effective strategy. For instance, Cynthia Cooper was an internal auditor and consultant who exposed the fraud at WorldCom in 2002 (Cooper 2008). She conducted a thorough investigation in secret and uncovered that the company had concealed $3.8 billion losses (the losses eventually added up to $9 billion). She then reported the information to the audit committee and the fraud was exposed. Cooper’s case highlights the importance of internal auditors in the organisation and also the importance of internal auditors’ willingness to investigate items outside of a pre-established audit plan if necessary. Internal auditors are in a unique position within companies to be able to identify fraud due to their extensive knowledge of company operations. The detection of fraud is beneficial to most stakeholders of an organisation, especially if it can be detected or deterred before it becomes substantial. The continued focus on fraud by the internal audit profession is evidenced by the recently proposed addition of a new International Standard for the Professional Practice of Internal Auditing, “The internal audit activity must evaluate the potential for the occurrence of fraud and how the organisation manages fraud risk” (Standard 2120.A2, IIA 2008). It is also noted in the new standards that, “Internal auditors must have sufficient knowledge to evaluate the risk of fraud and the manner in which it is managed by the organisation” (Standard 1210.A2, IIA 2008). Deterring fraud has always been a fundamental role of internal audit. Research has found that organisations with an internal audit function are more likely to detect fraud than those without (Coram, Ferguson, and Moroney 2008). Uniqueness of internal auditor institution lies in auditors’ exclusive ability to detect fraudulent financial reporting. From the historical perspective, the primary purpose of internal audit was to become “eyes and ears” of the organisation. However, in contemporary context with the advent of financial regulation such as Sarbanes-Oxley Act, the process of internal auditing became more structured (Martin and Sanders 2009). On one hand, structured character of audit significantly contributed to overall audit consistency and efficiency, while on other hand audit became less flexible (Asare and Wright 2004). FRAUDITOR A new approach toward the detection of fraud might expand the practices of the auditor that asks predetermined simple yes or no questions and tends to follow an interview script while proceeding to gather evidence of whether internal controls are being followed as prescribed by management. This new suggested approach may change the current audit paradigm and the attitude of auditors to use a more probative approach into a new audit role. Lekan (2003) used the term “frauditor” to depict this new audit role (p. 30). The frauditor is a professional skilled at detecting and exposing fraud by attempting to mitigate the negative affect of fraud. Compared to the current audit paradigm, Lekan (2003) characterised the frauditor as a practitioner containing the following traits: (1) Suspicious and presumes the existence of altered documents. (2) Attempts to create a new paradigm by looking for examples of deceit, misleading information, or lies. (3) Asks open-ended questions to seek inconsistencies and avoids asking simple yes or no questions. (4) Uses nonverbal clues to try to understand the true meaning of what the person being interviewed might be trying to say or hide. (5) The frauditor seeks clues that might lead to further investigations. WHISTLEBLOWING The ACFE (2006) conducted several studies and found that the most prominent form of detecting fraud was by a tip. Other detection methods ranked in a descending order involved accidental discovery, routine internal audits, internal control procedures, and external audits (ACFE, 2006). What might seem contrary to the perception that auditors are primarily responsible for detecting fraud, a majority of the fraud cases detected in the ACFE studies came from tips and accidental discovery. While federal and state statues have provisions to shield tipping employees (known as a whistleblowers) from retaliation by employers for turning in corporate fraudsters to outside authorities, the Sarbanes-Oxley Act encouraged corporate whistleblowers to come forth with this information (Moberly, 2006; Schreiber et al, 2006). Criticism of the whistleblower provision in the Act is that the protection is ineffective (Drowkin, 2007). Other research showed the opposite affect of the Act. In a study of 230 U.S. corporate fraud incidents from 1996 to 2004 conducted by the National Bureau of Economic Research showed a decline from 20% to 15% in whistleblower reports since the Act took affect (Alvarado, 2007). Other critics suggested a revision to Section 806, which provides protection to whistleblowers, because of three inherent problems with this section: (1) There is a lack of a monetary reward for the whistleblower. (2) The protections provided to the whistleblower are uncertain. (3) Lengthy delays to process whistleblower claims (Stroup & Iacono, 2007; Alvarado, 2007). Stroup and Iacono (2007) argued that a financial incentive might reduce some of the fears employees have from coming forward with claims of malfeasance and might also explain why there is a decline in the percentage of whistleblower reports. REFERENCES Adams, G. W., Campbell, D. R., Campbell, M. & Rose, M. P. (2006). Fraud prevention. CPA Journal, 76(1), 56-59. Alvarado, K. (2007). Sarbanes-Oxley changes sources of whistleblowing. Internal Auditor, 64(2), 18. Asare, S. K, and A. M. Wright. 2004. The Effectiveness of Alternative Risk Assessment and Program Planning Tools in a Fraud Setting. Contemporary Accounting Research 21 (2): 325-352. Association of Certified Fraud Examiners. (2006). 2006 Report to the nation on occupational fraud and abuse. Retrieved Oct 5, 2010, from Beasley, M. S., Carcello, J. V., & Hermanson, D. R. (1999). COSO’s new fraud study: What it means for CPAs. Journal of Accountancy, 187(5), 12-13. Black, W. (2003). Reexamining the law-and-economic theory of corporate governance. Challenge, 46(2), 22-41. Buckhoff, T. (2001). Employee Fraud: Perpetrators and their Motivations. The CPA Manager,Retrieved Oct 5, 2010 from < http://findarticles.com/p/articles/mi_qa5346/is_200111/ai_n21481182/> Cooper, C. 2008. Extraordinary Circumstances: The Journey of a Corporate Whistleblower. Hoboken, NJ: John Wiley & Sons. Coram, P., Ferguson, C., and Moroney, R. 2008. Internal audit, alternative internal audit structures and the level of misappropriation of assets fraud. Accounting and Finance. 48:543-559. Drowkin, T. (2007). SOX and whistleblowing. Michigan Law Review, 105(8), 1757- 1780. Ernst & Young. (n.d.). Detecting financial statement fraud: What every manager needs to know. Retrieved Oct 5, 2010, from Hall, J. J. (2005). Answer please: Fraud-based interviewing. Journal of Accountancy, 200(2), 61-65. Highlights. (2003). Journal of Accountancy, 195(2), 8. Institute of Internal Auditors (IIA). 2008. Standards for the Professional Practice of Internal Auditing. Altamonte Springs, FL: Institute of Internal Auditors Kaplan, R. L. (2004). The mother of all conflicts: Auditors and their clients. Journal of Corporation Law, 29(2), 363-383. KPMG Forensic. (2003). Fraud survey 2003. Retrieved Oct 5, 2010, from < http://www.surveys.kpmg.com/aci/docs/surveys/Fraud%20Survey_040855_R5.pdf> Lanza, R. B., & Gilbert, S. (2007). A risk-based approach to journal entry testing. Journal of Accountancy, 204(1), 32-35. Lekan, T. J. (2003). Making an auditor a “Frauditor.” Bank Accounting & Finance, 16(5), 30-32. Lomax, S. 2003. Cooking the books. Business & Economic Review, 49(3), 3-8. Moberly, R. E. (2006). Sarbanes-Oxley’s structural model to encourage corporate whistleblowers. Brigham Young University Law Review, 2006(5), 1107-1176. Peterson, B. K., & Zikmund, P. E. (2004). 10 Truths you need to know about fraud. Strategic Finance, 85(11), 29-34. Pricewaterhousecoopers. (2006). 2005 Fraud Survey. New York, NY: PWC, LLP. Samenow, S. E. (2004). Inside the criminal mind (revised and updated edition). New York: Crown Publishers. Schnatterly, K. (2003). Increasing firm value through detection and prevention of whitecollar crime. Strategic Management Journal, 24(7), 587-614. Schipper, K., & Vincent, L. (2003). Earnings Quality. Accounting Horizons, 97-110 The Association of Certified Fraud Examiners (ACFE). (2002). Report to the nation on occupational fraud and abuse. Austin, TX: Author. Schreiber, M. E., Marshall, D. R., & Young, R. (2006). Reducing the risk of whistleblower complaints. Risk Management, 53(11), 42-46. Stroup, G., & Iacono, C. A. (2007). Revamp Section 806 of Sarbanes-Oxley. Pennsylvania CPA Journal, 28(2), 31-32. Wells, J. T. (2007). Corporate fraud handbook: Prevention and detection (2nd ed.). Hoboken, NJ: John Wiley & Sons. Wolfe, D. T., & Hermanson, D. R. (2004). The fraud diamond: Considering the four elements of fraud. CPA Journal, 74(12), 38-42. Read More