The Particular Factors that Motivate Preparers of Financial Statements to Engage in Accounting Fraud, and Safeguards Available in Preventing Accounting Fraud

Introduction

Recent corporate financial accounting scandals like WorldCom, Global Crossing, Tyco, Enron and many others have increased concerns about fraud globally, cost shareholders billions of dollars in value, and led to the corrosion of investor confidence in financial markets Peterson and Buckhoff (2004); Hogan, Rezaee, Riley and Veluri (2004). Fraud costs economy, businesses, investors and society more than $3 trillion every year. Beyond the financial cost, fraud may also generate damage to employees, customers, suppliers and society, as well as litigation costs and regulatory penalties Fleming et al, (2016).

Although larger businesses are more likely to experience economic crime, fraud may be more costly for small businesses. On a per employee basis, losses from fraud can be as much as 100 times greater at small firms than large firms. Despite the increased incidence of fraud and enactment of new anti-fraud laws, many organizations still use outdated anti-fraud efforts which are somewhat shallow. Hence the need to try new and different steps to combat fraud.

The Institute of Certified Public Accountants defines accounting as the art of recording, classifying, summarising in a significant manner and in terms of money, transactions and events which are, in part at least of financial character, and interpreting the results thereof. In simple terms, accounting involves setting up, maintaining, and reviewing the accounting records of a company in order to properly understand its financial position. There are many users of this accounting information, both internal and external. Internal users typically refer to management, while external users refer to investors and lenders. Financial reporting is meant to protect the investing public and provide confidence in the securities markets. Investors and lenders have the right to receive reliable financial information when making investing decisions about an entity.

Fraud as part of white-collar crimes is defined as “any illegal act characterized by deceit, concealment or violation of trust”. When inaccuracy of accounting records occurs, there are two possible reasons for the discrepancy: error or fraud. An error is unintentional and often occurs due to computer malfunction or human error, such as carelessness or lack of knowledge. In contrast, fraud is intentionally committed in order to render some gain for the perpetrator. According to the Association of Certified Fraud Examiners (2016), “the two means through which fraud is committed include the misappropriation of assets and the misrepresentation of financial statements. ”

Misappropriation of assets occurs when an employee steals company assets, whether those assets are of monetary or physical nature. Physical assets of the company include everything from office supplies and office furniture to expensive items in inventory, such as cars or large machinery. With lack of supervision, employees could take inventory right out of a facility. However, misappropriation of physical assets includes not only taking items, but also the unauthorized use of company assets. An employee driving a company car for personal use would be an example of this.

Misrepresentation of financial statements, often occurs when the financial statements are intentionally misstated in order to make the financial position of the company look better than it actually is. This often involves increasing reported revenues and/or decreasing reported expenses. It could also involve misrepresenting balance sheet accounts in order to make ratios, such as the current or debt to equity ratios, look more favourable.

Association of Certified Fraud Examiners (ACFE) defines financial statement fraud as "The intentional, deliberate, misstatement or omission of material facts, or accounting data which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision. "

The Motivators for Accounting Fraud in Organizations

The causes of accounting fraud are best explained using the fraud triangle phenomenon which states that for fraud to occur, three conditions must exist: rationalization by the person committing the fraud, incentives or pressures to commit fraud, and also the opportunity to do so. These factors are commonly known as the Fraud Triangle, which was first created by Dr. Donald Cressey in 1953 when he was studying criminology, specifically the behaviour of fraudsters.

Pressure is typically what causes a person to commit fraud. It is most often financial, such as the inability to pay medical or other bills; an addiction to drugs, alcohol, or gambling, a strong sense of self-esteem; or the desire for expensive luxury items (University of Michigan). However, some fraud is committed simply out of greed and with no pressure except the desire to gain wealth.

Weak corporate governance structure, lack of effective internal controls and improper control environment provide perceived opportunities for individuals to commit fraud and conceal it. If you eliminate opportunities for fraud to be committed, then it can be greatly reduced. Preventing fraud is much cheaper for companies than detecting it later because there is little chance that losses will be recovered once the fraud has already occurred. Opportunity is therefore where internal controls come into play. The more internal controls a company has designed and implemented, the less opportunity there should be for employees to commit fraud. It is important that their internal controls be effective and efficient in order to gain the most benefits for the company. Internal controls include: segregation of duties, supervision, and information technology controls (passwords, biometric scanners, etc. ).

Finally, rationalization involves making excuses for why it is acceptable to commit fraud in certain circumstances. A rationalization may be strong, for example a ransom case where someone might die without the money or a medical emergency where money is needed for surgery. However, it can also be weak, with simple reasoning such as “I want the money” or “I will not get caught” or “I deserve it for my hard work. ” Once these three fraud factors have been established, fraud will most likely be committed. As previously stated, it is most important to prevent opportunity from arising.

Other Reasons for fraudulent Financial Reporting

1. The personal assets or capital of the management is closely associated with the performance of the company in terms of profit sharing.
2. Enough opportunities are present for the management to commit the financial statement fraud.
3. The management is willing to maximize shareholder value for handling some internal or external pressure.
4. Top level executives are ready to take personal risk for corporate benefits.
5. The chances of detection of fraud are negligible in some firms therefore the fraudsters believe they can easily get away with anything.
6. Greed; human nature intervenes when an individual, or group of individuals, sees a chance to make quick money.
7. Excessively generous performance bonus payments – the more generous the bonus, when coupled to a demanding target; the more temptation there is to manipulate results to hit these targets.
8. Lack of clear moral direction from senior management at the top. These sometimes indulge in fraudulent behaviours which causes a trickledown effect to all the other employees.
9. Poor accounting controls; In cases where the accounting controls, such as a monthly reconciliation of the bank account, are lapse the signals that a fraud has occurred will be missed.

Ways of Preventing Accounting Fraud

Every organization should create and maintain a fraud policy for guiding employees. A corporate fraud policy should be separate and distinct from a corporate code of conduct or ethics policy. Such a fraud policy should be clearly communicated to employees. Various avenues of communication include use in orientation of new hires, employee training seminars, and annual performance evaluations. Written acknowledgment by each employee that the policy has been read and understood should be required.

2. Establish a telephone hotline

A rather innovative fraud approach that is becoming more common is the use of anonymous telephone hotlines. It is a very cost effective means for detecting occupational fraud and abuse. A hotline allows employees to provide confidential, inside information without the fear of punishment that accompanies being a whistle blower. Hotlines may be supported in-house or provided by a third party.

The results of all calls are provided to the client within two or three days. A hotline is not only an effective detection tool but it also enhances deterrence. Potential perpetrators will likely have second thoughts when considering the risks of being caught.

3. Educate management on the three indicators of fraud

According to the Association of Certified Fraud Examiners, financial statement fraud involves the intentional publishing of false information in any portion of a financial statement. To help prevent fraudulent activities, management must implement internal controls, or structure, and know what situations to look for. Individuals commit fraud when under situational or financial pressure, when the opportunity to commit fraud is present and when the perpetrator easily rationalizes the fraudulent activity.

4. Segregate accounting functions

One of the main factors of an effective internal control system is segregation of duties. Management helps to prevent fraud by reducing the enticements of fraud. One enticement, the opportunity to commit fraud, is reduced when accounting functions are separated. The act of segregating duties separates the recordkeeping, authorization and review functions in the accounting process. To segregate duties, involve more than one person in the financial statement preparation process. Therefore for fraud to occur, two employees must collude to perpetrate the crime.

5. Establish a strong control environment

A strong control environment involves enlisting management to demonstrate ethical behaviour. The ACFE notes that whatever tone management sets will have a trickle-down effect on employees of the company. A strong tone is developed by establishing and complying with a written set of policies. The policies must be concise and include consequences when procedures are disobeyed. In addition, according to the ACFE’s Fraud Examiners Manual, one of the easiest ways to establish a strong moral tone for an organization is to hire morally sound employees.

6. Initiate annual examinations of financial statements by an outside party

In many cases, management is the party committing fraud. Management may feel pressure to meet financial goals for the company or may receive incentives if certain goals are met. To help prevent management from engaging in overly aggressive adjustments to the financial statements, have an independent party examine financial statements on an annual basis. Engaging an auditor to perform a financial statement review or audit deters employees from knowingly presenting incorrect financial statements.

7. Employee reference checks

Organizations should conduct employee reference checks prior to employment. An employee with a history of perpetration of fraudulent schemes may move from one organization to another. When employee references are not checked, a dishonest person may be hired. A dishonest employee can defraud an unsuspecting organization and move on to a new job before the fraud is discovered. Resumes should be scrutinized and information verified to determine that the information provided is legitimate. An organization should not rely on the telephone numbers listed on the resume for prior employers, as they may be false. Employer phone numbers should be obtained by the organization independently.

8. Fraud vulnerability reviews

A fraud vulnerability review that investigates the organization’s exposure to fraud should be performed. This includes an assessment of what assets are held and how they could be misappropriated. A vulnerability review can help to direct an internal audit plan and, in particular, to highlight the most vulnerable assets. The review is considered a proactive step in fraud prevention and detection. Consideration of each class of asset and the evaluation of the exposure to loss helps the auditor or accountant to see what the thief sees. Steps then should be taken to eliminate, minimize, or at least control the exposures.

9. Password protection

The growth of the internet and e-commerce has led to a rise in the number of dial-in ports to computer networks thus increasing the exposure to fraud. Accountants and investigators should assure that only legitimate users have access to the computer network and associated data. Although passwords are the oldest line of computer defence, they still constitute the most effective and efficient method of controlling access. The difficulty with passwords is that there is an inverse relationship between making the password effective and usable. If password requirements are too complex, users will write the password down, placing it at risk. Therefore, every organization needs to evaluate the trade-offs. Passwords should be six to eight characters long with a mix of letters, numbers and special symbols. Users should be required to change their password often, for example, every 30-60 days. Additionally, users should have to cycle through 6-12 different passwords before being allowed to reuse a password. Also, employees should not be allowed to display their passwords in any location where unauthorized individuals may see them. Lockout procedures should be implemented if a user fails to input a correct password after three attempts.

10. Discovery sampling

Discovery sampling is a form of attribute sampling. The latter is a statistical means of estimating the percentage of a population that possesses a particular characteristic or attribute. Discovery sampling is based on an expected error rate of zero. It is employed when the accountant needs to know whether a population contains any error indicative of fraud. If a single case of significant error or fraud is found in a sample, the sampling process is stopped and the error or fraud is investigated.

11. Review All Reports Monthly

Even when bookkeeping and accounts payable/receivable are done by two different people, a manager should review their work monthly. This reduces the risk of collusion in fraud and will also allow false entries to be detected faster. When proper controls are in place, this takes little time beyond the work managers should already be doing to monitor the financial health of the company. The manager simply needs to compare the total of the month's receipts and invoices against the amounts entered in the books, and cross-check both figures against the cash in the bank.