In the report submitted to the Nation on Occupational Fraud and Abuse, by the Association of Certified Fraud Examiners (ACFE) it was stated that fraudulent reporting which is one of the three categories of fraud (the other two being asset misappropriation and corruption) had collectively estimated to cost almost $1trillion per year in the united states. And this type of fraud is not only limited to the United States (Zack, 2009). According to Jackson et.al, 2008, Fraud is generally defined as an intentionally false representation of a material fact made by the party with the pure intention to mislead and persuade another party to justifiably rely on the representation, to his or her detriment.
Fraudulent financial reporting is the intentional misstatement or omission of material i.e, very significant information from the company's financial statement. Such types of frauds are also called as 'Management Fraud' as it requires active involvement of the management. Many of these cases include misstated amounts and also inadequate or missing disclosures.
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The above figure shows the percentage of types of fraud that occurs in an organization. From the above it can be seen that the majority of financial scams are because of the fraud committed through revenue recognition which constitute 41% of the pie chart, followed by improper disclosure in the financial statement which is around 12%. The least is the investment fraud which is just 1% of the total fraud scheme.
According to Vona, 2008, the legal definition of the fraud explains fraud as:
An intentional misinterpretation of the truth or the suppression of a material fact that persuades another to act on their detriment.
A misrepresentation made recklessly without the belief in its truth to induce other person to act.
A tort occurring from a knowing misrepresentation, suppression of material fact, or reckless misrepresentation made to induce another to act to their detriment.
Unconscionable dealing especially in contract law. The unfair use of power arising out of the parties' relative position and resulting on an unconscionable bargain.
Accounting fraud can be explained as an intentional and unacceptable manipulation of accounting details like sales revenue and/or expenses in order to make company's profit appear better than what it actually is. The common techniques adopted by many companies in order to manipulate their accounting records are as follows:
Not recording prepaid expenses or other assets in connection to it.
No proper classification of certain current assets and/or current liabilities.
Reducing the short term and long term loans in one sum (http://www.articlesbase.com/accounting-articles/what-is-accounting-fraud-1717680.html)
According to the research made by Ball and Ray, 2009, the news of scandal spreads very widely and too quickly. It has a drastic effect which includes: a decline in the worldwide reputation of many U.S institutions that includes Generally Accepted Accounting Principles (GAAP), auditors, financial markets, regulators and security analyst.
Types of accounting fraud:
An accounting or financial crime is a non-violent misconduct which is committed by/or against an individual or corporation and often results in a big financial loss thus when a financial institute is involved in such type of crime it is called as financial sector crime. Most common type of financial crime is tax evasion, embezzlement of company funds and the sale of fictitious insurance plan where as other frauds such as money laundering, credit card fraud and check fraud all comes under financial sector crime. Most financial crimes are lawbreaking which carries harsh sentences and such types of crimes are increasing day by day. This can be judged from the data that in the year 1998 alone, more than 300,000 people were convicted for financial fraud case while in the very next year, around one third of the Americans were involved in some or the other type of financial or financial sector crime (http://www.lawyershop.com/practice-areas/criminal-law/white-collar-crimes/financial-crimes)
There are different types of financial fraud, but the most basic and important are three of them which are explained and shown as under:
Frequency of Types of Occupational Fraud and Abuse:
Always on Time
Marked to Standard
The above figure shows the frequency of the occurrence of the three major and general frauds. Asset misappropriation tops the chart with highest percent in all the four years both the given year 2003,2005,2007 and 2009 followed by accounting fraud or fraudulent statement and lastly corruption and bribery.
Misappropriation of assets involved stealing of company's asset. Mostly, third party or employees who work in the organization abuse their position to steal the assets from the company. This type of fraud is mainly committed by the director of the company or its employees or any person who is entrusted to manage and look after the assets and interest of the organization. They are probably the most often occurring fraud may be because they are the easiest schemes to understand. This kind of fraud generally includes things like check forgery, payroll fraud, theft of money, inventory theft or theft of services. Data's which are collected recently, shows that asset misappropriation occurs in more than 91% of the fraud schemes. The statistics shows that it is the most common type of fraud but is the least expensive fraud on a pre fraud basis. In an average, the asset misappropriation costs a company $150,000. The above figure shows us the data of four years which states that in asset appropriation is always high in every year. It was highest in the year 2007 that is 70% and lowest in the year 2003 which was 60% which increased to 92.7% in the year 2004.
Bribery and corruption:
Fraud and corruption have a disturbing effect on the every section of the society. Public sector bribery, fraud and corruption have started becoming the matter of concern for legislators around the globe. Bribery and corruption is the next most frequently occurring fraud which consists of 30% of all fraud that is uncovered. Corruption and Bribery includes things like kickbacks, shell company schemes, bribes to influence decision-making, manipulation of contracts, or substitution of inferior goods. It is more costly then asset misappropriation fraud as it costs around $538,000 per scheme. The diagram shown above states that in the year 2003 corruption crime was around 14% which than increased to 30% in the year 2007.
Financial statement/Accounting fraud:
According to the American Institute of Certified Public Accountants (AICPA, 1997), the financial statement is an intentional misstatement or omission in financial statement. Whereas, Association of Certified Fraud Examiner (ACFE) defines and explains financial statement fraud as an intended, deliberate, misstatement and or omission of material fact of accounting figures which are deceptive and, when considered with all information made available would cause the reader to change or alter his or her judgment or decision (Rezaee & Riley, 2009:5)
This is the least common type of fraud, though it occurs less frequently that is just 10% of all fraud case it is the most expensive for the organization. The average financial fraud costs around $2 million to the company. Such fraud includes manipulation of financial statement in order to show better position of the company which actually is not. The diagram shown above states that in the year 2003 the fraudulent fraud were around 510% which has increased to 38% in the year 2004 (http://www.allbusiness.com/crime-law-enforcement-corrections/criminal-offenses/6635361-1.html).
Who all are responsible for such frauds?
According to Edwin Sutherland, 1949, White Collar Crimes are approximately those crimes which are committed by respectable and high social status people in the course of their occupation. Many of the white collar crime committed by high profile people in USA like Enron, WorldCom & Adelphia fits in this definition. Zhou and cong, 2001, defines occupational fraud as a part of white collar crime that "refers to an actÂ whereby the individual illegally uses his or her position for personal benefit". They also stated that bribery and corruption exists at both individual as well as organizational level. All big officials who are indulging in such crimes believe that the chances of getting caught are very extreme and this is true because of the following reasons:
The political power that they have allows them to make abuse of their power.
If they caught, they get free by paying penalty or by bribing the government authority because of the power they hold.
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It is even believed by many people that there is a social privilege attached to having official social standing.
Accountants in all the organizations are well trained to make the report and to analysis the financial position of the company. The head of the company or the organization influences these accountants to manipulate the accounting details by writing the false numbers to make the company's account look good and the accountant hides the truth for the sake of their employers. Even the when the company hires other outer firm to do their accounts and audit, the top executives becomes friendly with them and thus those accounting firm compromises their integrity to maintain good relationship with their major clients. Thus, majorly the top level executives of the companies including the CEO, CFO and Auditors are involved in the financial fraud which leads to the collapse of the company this conclusion can be drawn by looking at the case of Enron, Adelphia, World Com, Satyam etc (http://www.beginnersguide.com/accounting/accounting-fraud/what-are-the-causes-for-accounting-fraud.php)
Reasons behind increase in fraud in U.S
In today's world financial fraud are increasing both in frequency and in amount. The most important reason for the occurrence of financial fraud is financial pressure. Generally when management fraud occurs, they over states the assets of the company in the balance sheet of the company and increase net income in the income statement. According to Albrecht, 2009 management gets involved in such type of fraud because they generally have pressure to do so, there can be many reasons for doing this like poor cash position of the company, high n umbers of receivables which are not collectibles, losses of customers, obsolete inventory, decline in market etc.
According to the study made by Steve et.al, 2001, the top reasons for which such financial fraud occurs are as follows:
Generally it was believed that fraud affects mostly other organization and is more serious problem in other countries rather than U.S but, it was the other way round. Organizations which deny the threat of fraud are involved in major fraud cases. Those which believe that fraud is the problem with other organization had higher number of fraud cases filed against them. According to the research made, US have the 16th highest fraud rate in the world. In the year 2000, more than 50% of the large US organizations were indulged in fraud costing company around $500,000 on average. It was estimated by the Association of Certified fraud Examiner that the total fraud in US could exceed $400 billion per year in future.
A blind faith and trust on the honesty of the employee may be harmful for the business so, one need to make employee feel trusted but yet have control in place to prevent destroying the business of the company because of one dishonest employee. There is a need to eliminate one or more of these three elements which make up the fraud; perceived pressure, perceived opportunity, and rationalization. These are the three elements which forms the fraud triangle and this peruse an honest employee to do dishonest things.
When there exist trusts that if the fraud will occur in the organization the employees will raise an alarm if not then the auditors will find it out. But, it is not always possible for the employee to inform about the fraud the possible reasons are:
Not sure who to inform about the fraud if top level management are themself involved in the fraud.
Some time they themselves are not sure whether it is actually a fraud or not.
They think it may be wrong to accuse someone without proof.
Sometime organizations itself don't allow to disclose.
Relying only on the auditor for detecting fraud is not so much reliable source for the organization. Because according to the studies, auditors only detect about 19% of all fraud. So, even employees should be trained to recognize the fraud and to report it. Generally majority of fraud are uncovered by accidents, chance or tips from people.
The next reason for the occurrence of fraud is the belief that such fraud won't cost much to the organization. But that is not the case, considering the case of General Motors (GM), the company which created fraud of $436 million in the year 1990s'. The company had a profit margin of 10% so, in order to recover the loss, the company had to increase its revenue by $4.36 billion. Thus, if any company had a profit margin of 10% it has to increase its revenue by 10 times of its losses in order to cover the effect of the fraud.
Many times there is a blind belief that the organization had a good control system so there is no possibility of occurrence of fraud. It is not possible because even if there is high level of control, the fraud can occur in the company that is because the people who build such a strong control system gets involved in the fraudulent activities. The people who make the rule, themselves break the rule.
Thus, these are some of the common reasons of why the frauds are increasing day by day. So, managers had to be active enough to stop such kinds of fraud as preventing fraud costs much less as compare to detecting or investigating them.
Defining auditor and their responsibilities to detect fraud.
According to Fernando (2009), auditor is the person who is appointed by the organization in order to perform audit. Auditor is required to officially state that the accounts produced by his client companies have been prepared according to the normal accounting standards and present a true and fair view of the organisation. An auditor is appointed to act on behalf of the shareholders so he is a representative of the shareholder who forms a link between government agencies, investors, stockholders and creditors. Usually a company appoint a chartered accountant as an auditor of the company. People who invest in big companies are affected greatly by frauds and scams. They suffered great losses when big giants such as ZZZZ Best, World Com, Enron, Adelphia were in the news because they were involved in the financial scam. Many investors lost their money as well as faith in the management and Auditors of the company. Once again such investing public were shocked in the year 2009, when the news of Satyam scam hit the press. In the Satyam scam, near about $ 1 billion in cash, supposedly the easiest asset to audit was admitted by the CEO to be nonexistent.
Efficiency, liquidity, safety, and robustness of financial market are crucial to the nation's economic prosperity and growth as more than millions of people directly or in directly invest in the capital market. Investors participate in capital market only when they have in built confidence in the quality, reliability, and transparency of public finance information dispersed to the markets. All financial information presented in the financial statement prepared by public companies and audited by independent auditors greatly persuades investor's confidence. Auditor's accountability and responsibilities for searching, detecting and reporting financial statements fraud are receiving considerable interest and attention in rebuilding investor's confidence and public interest (Rezaee & Riley, 2009)
Responsibilities of auditor:
It is important to understand the basic responsibilities of the auditors which they need to fulfil while performing audit of the company. When the fraud occurs auditors are blamed for it, we have the wrong perception that it is auditor's responsibility to detect fraud in the company but, in reality auditing standards states that auditor's responsibility is just to state whether the financial statement gives true and fair view of the company or not. He has to perform detailed investigation to make sure that information in the financial statement is true and reliable.
According to Fernando (2009), The Institute of Chartered Accountant of India (ICAI) has issued Standard Accounting Practices (SAP) and Auditing and Accounting Standards (AAS) which focuses on effective auditing practices. It describes integrity, objectivity, independence, confidentiality and responsibility of an auditor. According to Standard Auditing Practices (2), following are the responsibilities of the auditor.
If proper disclosure regarding the material misstatement disturbing the prior period financial statement is not made then it is the responsibility of the auditor to issue the modified report on the current period financials modified with respect to the corresponding figures included.
Secondly, auditor has to state in the report that corresponding figures are not audited if he finds that prior period financial statements are not audited.
He has to make sure that he had proper and sufficient audit evidence that shows that the closing balances of the previous year have been correctly brought forward to the current period and the opening balances does not contain any material misstatement which can affect the financial statement of the current year.
If he finds any material misstatement and feels that this can be the result of fraud then he has to evaluate the implications of those dealing with the organizational position of the person or the person involved.
It is the responsibility of the auditor to inform the management, those charged with governance and, in some circumstances, when so required by the laws and regulations, to regulate and enforce authorities also.
The same reviews were given by Apostolou et.al, (2008), but he added some points to the responsibilities of the auditors. According to him the standards adopted by the Public Company Accounting Oversight Board (PCAOB), Au section 110.02, and states that it is the responsibility of the auditor to plan and perform the audit in order to obtain satisfying assurance that the financial statements are free of material misstatements whether caused by error or fraud.
On 22nd of January 2007, the PCAOB issued a report stating implementation of PCAOB standards that states the Auditors Responsibilities with respect to frauds. AU section 316.52 converse the change in the nature, timing, and extent of the audit procedure. According to it following are the responsibilities of the auditors:
It is the responsibility of the auditor to check the nature of auditing procedure and reliability of the financial documents but, the auditors may now use computer-assisted audit techniques that may provide him with corroborative evidence about significant accounts. The adjustment was made in the timing of substantive tests for example substantive testing should be done for assessing the risk of material misstatement due to fraud on or near the reporting date. The extent of the procedures employed reflects the assessment of the risk of material misstatement due to fraud some changes were made in them likeÂ for example, increasing the sample size, which might be suitable for proper evaluation.
When the auditor comes across the material misstatement while performing his audit procedure, auditor should document the nature and effect of the misstatement and should examine whether the misstatement might be inductive of fraud.
AU section 316.08 states that management is in a position to perpetuate fraud as they are in a state to directly or indirectly manipulate accounting statements and records and present fraudulent financial information. In order to address this risk of overriding of control by management, AU section 316 requires that auditors should perform certain procedures like checking journal entries and other adjustments review accounting estimates for possible biases which may result in material misstatement due to fraud. The example of it can be the Rite Aid's management who directed its accountant to make a false entry in order to reduce cost of goods sold and account payable in every quarter form the year 1997 to 2000 in order to manipulate their reporting earnings. This resulted in overstatement of pre-tax income by $100 million.
The slight different explanation about the auditor's responsibilities was given by Bostick, (2007) according to him the prime responsibility of an auditor is to understand the entity and its environment in which he is working.
Understanding the Entity and Its Environment: Statement on Accounting Standard (SAS) 109, states that it is important for an auditor to understand its entity and its environment before assessing the risk of material misstatement so that while performing audit ne can formalize the linkage between the risk of material misstatement in an entity's financial statement and the overall operating environment of an entity. So the two prime responsibility of an auditor will be:
Performing certain risk assessment procedure so that he can properly understand its entity and environment including its internal control system.
Assess, with audit team members, the susceptibility of the entity's financial statements to material misstatement.
Illegal acts of clients: In the year 1988, the AICPA issued SAS 54, in which it provides guidelines on the auditor's responsibilities for detecting illegal acts in the audit of financial statement. SAS 54 classifies illegal acts in two, one with the direct effect on the financial statement and other with indirect effect on the financial statement. Direct effect is related to the financial and accounting aspect of the company whereas, indirect is generally related to the operating aspect of the company. It is auditor's responsibility under SAS 54 to make investigation of certain issues regarding compliance with laws and regulation, and then he should obtain management representation concerning violation of laws and regulation and should disclose it in the financial statement.
Laws and Regulations: SAS 99 as well as SAS 109 both of them requires an auditor to be fully informed about the entity's business and the industry in which it operates. For this, Auditors should:
Initially make an inquiry about the management and others within the entity, like different employees and the level of authority they hold, operating personnel not directly involved in the financial reporting process, those who are involved in initiating, recording, or processing complex or unusual transaction, and in-house legal counsel.
He should consider all the unusual or unexpected relationship which he comes across while performing analytical procedure.
To consider whether or not one or more fraud risk factors exists.
To consider all other information that may be helpful.
SAS 99 and SAS 109 provide specific inquiries that an auditor is suppose to make to identify risk of material statement. For example, auditors should ask management and other employees within the company if they have knowledge of any violation of laws and regulation. The auditor should also make an inquiry of the internal audit with the internal auditor about their procedure to identify or detect fraud during the year. Whether or not management cooperates with them to provide all the information needed while conducting audit procedure.
SAS no 99 also explains that when an auditor finds evidence that fraud may exist in the company, he should bring that matter to the attention of the proper level of management. No matter how small the issue is like minor defalcation by the employee at a low level in the company.
According to Barson (1977), increasing fraud is not the problem of recent times but they do prevail in earlier period also. So, in order to reduce the increasing number of fraud, AICPA issued two new auditing standards dealing with corporate irregularities and illegal acts. SAS 16 and SAS 17 were the two new standards issued in January 1977. They were designed to provide guidance on the responsibility of independent auditor for detecting irregularities and illegal acts. This was evidence that AICPA was struggling hard in order to fix the auditors role in difficult areas. SAS 16 focused on the responsibility of auditor for detection of errors and irregularities. Specifically this statement says that, auditor must plan his examination in order to search for error or irregularities that would create a problem for recording entries in financial statement. SAS no.16 requires that auditor should assume a high level of responsibility in order to detect material falsification and other material misstatement which were committed deliberately in order to manipulate the financial statement.
SAS no.17 is related to the auditor's role in the detection of illegal acts. This new auditing standard was interpreted by many auditors as; it gives a moderate responsibility to the auditor for the discovery of illegal transaction. SAS 17 includes an examination conducted in accordance with generally accepted auditing standards will not assure the detection of illegal acts. Thus, it can be said that implementing new SAS was a major step taken towards narrowing the expected gap between the auditor and the financial community.
Triggers for financial investigation:
According to Hochberg (2006), financial investigation is mostly done by a company's board of directors, litigation committee or the audit committee. When the company declared itself to be bankrupt, this investigation is done by the creditor's committee or the bankruptcy trustee in order to find the reasons for bankruptcy. There are many triggers that leads to forensic financial investigations but, all of them falls in one of the below mentioned four categories.
Regular inquiries: When SEC challenges a company's practices of financial disclosure and accounting, it calls for an internal auditing investigation and it is often for a public limited companies. So, when SEC senses that there is some problem with the companies accounting procedure, it stars the investigation right away so that the problem won't create any harm in the future. This helps to protect the investors as board of directors and audit committee are legally required to determine whether indications of wrong doing have essence or not.
Actions of shareholders: As per the state laws, shareholders have full right to request or demand the company to take action against its offices or board members who have been found guilty for fraudulent financial reporting and 'self-dealing' transactions. They even have right to ask the company to redress the amount of loss suffered by them because of that officer. In legal terms this type of fraud is known as 'breach of fiduciary duty' which is caused by some corporate officials. In short, the shareholders tries to sue the corporation or ask them to take action against the individual who failed to carry out his duty or who tried to put his own interest above the company's interest. In response to this the company forms a special litigation committee (SCL) which includes the members from the board who are generally not an employee of the company and also who are not involved in any fraudulent activities.
Internal audits: Sometime audit department also raises some issue that may lead to financial investigation. In large companies the internal audit department itself have some resources to conduct forensic accounting investigation but in small companies they don't have it. However some serious issues may be investigated by the outside lawyers and accountants that because this will not have any involvement of the management and thus the result can be trustworthy. If the company appoints new management team or just a few CFO takes over, and if they find any situation which would create a problem for the company in future they may ask for financial investigation.
Independent audits: After the scam of Enron, the external auditing firm have become more cautious to any indication of financial reporting fraud. It is the responsibility of the auditor to react spontaneously to the fraud indicator. In this the auditor refuse to sign the audit report unless and until the company has conducted an independent financial investigation. Such an investigation is performed under the guidance of audit committee.
Indicators of fraud:
While performing the audit procedure the auditors may find some signs of fraud, which indicates the possibility of fraud in the company. the auditors must be smart enough to understand these indicators in order to rectify them so that those frauds are rectified before they create any problem. Some of the indicators of frauds are explained below:
Some employees in the company handles the activities of the other department for whic they are not responsible this may includes collecting daily mails, a person responsible to handle the financial contacts of the company deals with the accounting procedures etc.
Some employees, who work after hours in the company or just work in the weekends or insist on taking the work of the company home, are the people who commit fraud. The chances of fraudulent activities rise when the work of the employees in unobserved and unsupervised.
If an employee of the company refuses to accept and follow new accounting guidelines, then the owner of the company order all of the employees to strictly follow the new guidelines and must check all the old records of finance and pay roll.
If someone deals with all the financial operation of the company without direct supervision then the auditor should make a special investigation in that area. As there is high possibility that the person who alone is the responsible for records, payroll, receivables, deposits, payments and so on can manipulate the accounting record of the company.
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Ball & Ray, 2009, Market and Political /Regulatory Perspective on the recent Accounting Scandal, journal of accounting research, Vol.47, issue 2. P277-323.
Apostolou, Nicholas, Crumbley, D. Larry, 2008, Auditior's Responsibilities with Respect to fraud, CPA Journal, vol78, issue2, Feb 2008.
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