CHAPTER 14
FRAUD AND ERROR
Expected Learning Outcomes
After studying the chapter, you should be able to...
1. Explain what fraud means.
2. Explain the major types of misstatements, namely
a. Misstatements arising from misappropriation of assets
b. Misstatements arising from misappropriation of assets and explain
3. Give and explain the elements of a fraud triangle.
4. Give and explain the risk factors contribute to misappropriation of assets.
5. Explain who is primarily responsible for the prevention and detection of
fraud in a business enterprise.
6. Give and explain the risk factors that contribute to fraudulent financial
reporting.
INTRODUCTION
In the previous chapters, corporate governance has been described as the
process by which the owners and various of stakeholders of an organization
exert control through requiring accountability for the resources entrusted to the
organization.
This chapter introduces fraud risk and errors and how they can be reduced if
not totally avoided by having effective internal control - a tool of good corporate
governance.
Fraud is an intentional act involving the use of deception that results in a
material misstatement of the financial statements. Two types of misstatements
are relevant to auditors' consideration of fraud: (a) misstatements arising from
misappropriation of assets, and (b) misstatements arising from fraudulent
financial reporting.
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Intent to deceive is what distinguishes fraud from errors. Auditors routinely find
financial errors in their client's books, but those errors are not intentional.
2 TYPES OF MISSTATEMENTS
1. Misstatements arising front misappropriation of assets
2. Misstatements arising from fraudulent financial reporting
Misstatements arising from misappropriation of assets
Asset misappropriation occurs when a perpetrator steals or misuses an
organization's assets. Asset misappropriations are the dominant fraud scheme
perpetrated against small business and the perpetrators are usually
employees. Asset misappropriations can be accomplished in various ways,
including embezzling cash receipts, stealing assets, or causing the company
to pay for goods or services that were not received.
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Asset misappropriation commonly occurs when employees:
Gain access to cash and manipulate accounts to cover up cash thefts.
Manipulate cash disbursements through fake companies.
Steal inventory or other assets and manipulate the financial records to
cover up the Fraud.
Misstatements arising from Fraudulent Financial Reporting
The intentional manipulation of reported financial results to misstate the
economic condition of the organization is called fraudulent financial reporting.
The perpetrator of such a fraud generally seeks gain through the rise in stock
price and the commensurate increase in personal wealth. Sometimes the
perpetrator does not seek direct personal gain, but instead uses the fraudulent
financial reporting to "help" the organization avoid bankruptcy or to avoid some
other negative financial outcome.
Three common ways in which fraudulent financial reporting can take
place include:
1. Manipulation, falsification, or alteration of accounting records or supporting
documents.
2. Misrepresentation or omission of events, transactions, or other significant
information.
3. Intentional misapplication of accounting principles.
THE FRAUD TRIANGLE
The Fraud Triangle characterizes incentives, opportunities and rationalizations
that enable fraud to exist.
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Donald R. Cressey
- he is a criminologist who found out that three factors exist
when fraud occurs and those three factors are incentive,
opportunity, and rationalization.
The three elements of the fraud triangle are:
Incentive to commit fraud
Opportunity to commit and conceal the fraud
Rationalization - the mindset of the fraudster to justify committing the
fraud.
Incentives or Pressures to Commit Fraud
Incentives relating to asset misappropriation include:
Personal factors, such as severe financial considerations
Pressure from family, friends, or the culture to live a more lavish lifestyle
than one's personal earnings allow for
Addictions to gambling or drugs
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The incentives include the following for fraudulent financial reporting:
Management compensation schemes
Other financial pressures for either improved earnings or an improved
balance sheet
Debt covenants Pending retirement or stock option expirations
Personal wealth tied to either financial results or survival of the company
Greed - for example, the backdating of stock options was performed by
individuals who already had millions of pesos of wealth through stock
Opportunities to Commit Fraud
One of the most fundamental and consistent findings in fraud research is that
there must be an opportunity for fraud to be committed. Although this may
sound obvious - that is, "everyone has an opportunity to commit fraud" it really
conveys much more. It means not only that an opportunity exists, but either
there is a lack of controls or the complexities associated with a transaction are
such that the perpetrator assesses the risk of being caught as low.
Some of the opportunities to commit fraud that the top management
should consider include the following:
Significant related-party transactions
A company's industry position, such as the ability to dictate terms or
conditions to suppliers or customers that might allow individuals to
structure fraudulent transactions
Management's inconsistency involving subjective judgments regarding
assets or accounting estimates
Simple transactions that are made complex through an unusual recording
process
Complex or difficult to understand transactions, such as financial
derivatives or special-purpose entities
Ineffective monitoring of management by the board, either because the
board of directors is not independent or effective, or because there is a
domineering manager
Complex or unstable organizational structure
Weak or nonexistent internal controls
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Rationalizing the Fraud
For asset misappropriation, personal rationalizations often revolve around
mistreatment by the company or a sense of entitlement (such as, "the
company owes me!") by the individual perpetrating the fraud.
Following are some common rationalizations for asset misappropriation:
Fraud is justified to save a family member or loved one from financial
crisis.
We will lose everything (family, home, car and so on) if we don't take the
money.
No help is available from outside.
This is "borrowing", and we intend to pay the stolen money back at some
point.
Something is owed by the company because others are treated better.
We simply do not care about the consequences of our actions or of
accepted notions of decency and trust; we are for ourselves.
For fraudulent financial reporting, the rationalization can range from
"saving the company" to personal greed, and may include the following:
This is one-time thing to get us through the current crisis and survive until
things get better.
Everybody cheats on the financial statements a little; we are just playing
the same game.
We will be in violation of all of our debt covenants unless we find a way to
get this debt off the financial statements.
We need a higher stock price to acquire company XYZ, or to keep our
employees through stock options, and so forth.
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