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FRAUDULENT FINANCIAL REPORTINGINTRODUCTION:
Firstly what exactly is financial reporting? It is a set of documents (statements) or reports of an organization collected and disclosed to the public, investors, and the government in other to know the financial status of an organization. On the other hand fraudulent financial reporting is false representation, or deliberate omission of data from financial statements, with the sole aim of misleading investors and government of organizational assets (strengths).
Fraudulent financial reporting varies from other causes of substantially deceptive financial statements, such as accidental errors. The distinguishing factor of fraudulent financial reporting from other corporate indecencies, such as employee thefts, desecration of environmental or product safety protocols, and tax fraud, is that it causes the financial statements to be materially incorrect.
All organizations are to abide by the rules and regulations of IFRS (International Financial Reporting Standards), or it may be considered as a civil or criminal offence and is punishable by law. In recent years financial reporting frauds (FRF’s) have become a grave hazard to the business community, accounting line of work, academicians, and regulators. FRFs mostly arise when organizations involve in definite fraudulent practices intended to hide the real financial position, performance and predictions to remain attractive to the public. There are different reasons to why organizations resort to fraudulent financial reporting, and the different categories of the fraud include: overstating assets, false disclosures on financial statements, manipulation of liabilities and expense manipulation.
The financial statements, and the auditor's knowledge, provide the stock markets with information on which to foundation their investment and other big business decisions. Even though auditors have significant incentives for predicting fraudulent effects that “coat” false financial information, uncovering is not always achieved.
According to research conducted by the ACFE (Association of Certified Fraud Examiners), fraudulent financial reporting accounts for roughly 10% of incidents relating to white collar crime. Asset embezzlement and fraud have a tendency to occur at a greater frequency, even though the financial force of these grave crimes is substantially less brutal. Gluttony and work demands are the most frequent factors promoting employees and management to mislead creditors and investors.
FRAUDULENT FINANCIAL REPORTING
There are three most common types of fraudulent financial reporting and according to recent surveys, financial fraud is significant and is bearing on the usefulness and reliability of financial statements. (Schipper & Vincent, 2006). The three types of fraudulent financial reporting are assets misappropriations, corruption, and the last, but not the least, fraudulent financial reporting and this report is focused on the last item, fraudulent financial reporting. Fraudulent financial reporting is one of the foremost challenges in the business world. To continue to enlist the trust of investors and general public, a company or corporation might decide to hide or maneuver its accounts. This is known as fraudulent financial reporting. Financial statements are prepared and presented at least once a year and aim to meet the information needs common to a number of potential users. Many visitors take the financial statements presented as the main source of financial information and therefore a misrepresentation may affect decisions.
Fraudulent financial reporting is quite common in private companies. According to the Association of Certified Fraud Examiners, the average loss due to financial statement fraud is over $1 million. (Chris Bradford, 2014) To pull off a financial statement fraud, someone(s) in the top management is probably involved. Simply put, the five basic types of fraud include:
- Unsuitable disclosures,
- Hidden liabilities,
- Improper expense recognition,
- Fictitious sales and,
- Incorrect asset valuation.
The general categories and their definitions are as follow:
- Manipulating expenses,
Capitalizing normal operating expenses is an example of manipulating expenses. This causes a delay in the recognition of an expense and falsely raises the income. An example of this type of scheme is the WorldCom scandal. WorldCom listed many operating expenses as capital on balance sheet. Failure to record accounts payables or report everyday expenses on financial statements are some of the ways to conceal liabilities and cause a liabilities fraud.
- Improper revenue recognition,
This is one of the most common schemes used in financial fraud. Deliberate manipulation of revenue figures are done to mislead the investors and potential investors. Manipulation of revenue figures usually involves posting sales before they are made or before payment is received. An example of this would be recording product shipments to company-owned facilities as sales or pre-billing for future sales
- Improper disclosures,
Misrepresenting a company or making false representations in press releases is known as disclosure fraud. False statements written in the commentary sections of annual reports are another source for improper disclosures. Some disclosures might be intentionally confusing or obscure and incomprehensible the reader so as to mislead the reader.
- Overstating assets,
Another method of fraud is to overstate the value of current assets or to overlook the actual value of depreciation expenses on the financial statements. In the same way, inflation of a company’s assets can be achieved by over stating the inventory or accounts receivables.
It is important to note that fraudulent financial reporting takes place when there is a conscious act to beguile others regarding the financial ball game of a business or other entity. Rather than some data being overlooked by accident, the wilful cancellations are carefully chosen so as to change the overall appearance created by the financial reports that are issued to shareholders and basically to the general public. Typically, supporting documents are adjusted as part of the fraudulent financial reporting, in an effort to support the beguiling impression. This affixed deceit only serves to increase the level of fraud involved.
Even though various regulations are present and there are strict laws against the use of fraudulent reporting, there is still a probability that people resort to this method of fraud. By using vertical and horizontal financial statement analysis, it is possible to easily detect fraud. Vertical analysis is a process in which all the items on the income statement are takes as a percentage of revenue and then the trends from the entire year are compared. Horizontal analysis is a process in which all the financial information is represented as a percentage of the base year’s figures. So, unexplainable variations cause an alarm if they are not quickly sorted out.
An example of fraudulent financial reporting is the case of WorldCom in 2002. WorldCom, one of the largest global telecommunication companies in America, was facing a case because they had portrayed failed business projections into capitalized costs. In their case, the accounting entries were falsified and the SEC, which is the Securities and Exchange Commission, disclosed around nine billion dollars’ worth of business transactions misstated as capitalized investment costs in comparison of expenses. This was done because they did not want to lose the case. The SEC is an agency of the United States government responsible for securities laws, rules and industry.
Another big scandal in accounting that is worth noticing is that of Enron, a major oil and gas enterprise. They were involved in gas trading, stock market trading and accounting manipulation. By stocking the prices through trade manipulations; they were intentionally cutting off gas in some regions in the United States in order to limit supply and thus create an artificial high demand. They were both guilty for their actions.
There are a plethora of victims due to financial statement frauds. The Investors are, of course, the first victims of fraudulent financial reporting. If company earnings are overstated, investors who buy stocks are deceived, and if earnings are understated, the buyers will lose money. However, they are not the only ones that bear the immediate and harmful effects of statement fraud. The victim list includes others who rely on information from the company's financial reports: banks and other financial institutions which lend funds to the company, suppliers, customers seeking to make performance on the company’s contracts, partners, financial analysts providing investment advice about the issuer and its securities, lawyers for the issuer and probably for the issued insurance companies issuing insurance for directors and officers trust and then large claims.
So as to counteract financial statement frauds, more so in the aftermath of the Enron case, many new rules and acts were enacted. The US congress introduced the Sarbanes Oxley Act (Public Company Accounting Reform and Investor Protection Act), which is intended to protect the rights of the stakeholders and the public from accounting errors and frauds. Financial statement frauds are also questionable under the False Claims Act and the Dodd Frank Act.
To explain the entire process in one example, the following:
Mercedes Benz is a company founded in Germany in 2004, which specializes in making cars. Let’s assume that the company, in the past ten years, has a consistent growth rate of 20% or higher in its profit margin and in the third quarter of 2014, it was only able to achieve 14% of its sales growth
0.5 Million shares of the company are owned by the CEO. At the end of financial year 2014, a draft income statement was made and the company had only managed a 16% growth. This would’ve resulted in a 30% decrease in market capitalization. The CEO, along with the CFO, showed increased unearned revenue of 400 million dollars as earned. The result was a net profit margin growth of 21%. The board of directors approved the financial statements as they do not have in depth knowledge about financial statements.
This is an example of a situation of fraudulent financial reporting because the management has misstated the revenue and profit and thus, the assets and retained earnings. A number of factors played a role in the misstatement of financial position, be it the personal gains of the head of the corporation or the ease with which he was able to do it with.
Fraudulent financial reporting is one of key challenges faced by today’s business world. Financial crime and frauds cause annual loss of $3.5 billion to businesses. Errors or mistakes while making reports are common and generally fixed through internal auditing. These instances of overlooked data should not be confused with fraudulent financial reporting. An organization is engaged in Fraudulent reporting when someone consciously alters a financial statement to bring on a positive spin on the company’s financial standing. This can be done in many ways but most common methods include hiding information, misreporting figures, wrong asset valuations, adding bogus sales (or un earned revenue), and improper expense recognitions.
Usually high level management is involved in such frauds as the financial reports are approved at the high level. The term “cooking the books” is used when a company is found augmenting financial data to show a more encouraging result. The main aim of cooking the books is to attract investors. Other reasons include, but are not limited to, to gain loans from banks, avoid acquisitions, and as a means to justify salary increments and yearly bonuses for top management.
The primary affected party of such a fraud is investors of the company. However they are not the only victims. Banks that provide loans, suppliers and partners, consumers and customers who use the company’s products are all negatively affected when an organization engages in fraudulent financial reporting. When such frauds are brought to light, the employees of the company go out of jobs and those involved in the fraud run the risk of going to jail.
There are many checks and balances present to avoid such frauds. The Securities and Exchange Commission (SEC) with Sarbanes-Oxley Act of 2002 ensures accounting firms uphold standards and fraudulent activities are minimized.
Investors and financial institutes can avoid getting involved with companies who indulge in such practices by exercising vigilance and look for clues which signify some shady activity. Cash flows vs. earning report disparity, high profits in tough market conditions, steady sales vs. rising debt, and very high management compensations are all some of the items that should be carefully investigated.
American Institute Of Certified Public Accountats(AICP),American Acconting Association(AAA), 1989. Report Of The National Commission On Fraudulent Financial Reporting, s.l.: National Commission On fRaudulent Financial Reporting.
Ashim, P., 2014. Financial Reporting Fraudes:Causes,Consequences and Remedies. Accounting and Tax, 49(6), p. 51.
Chris Bradford, D. M., n.d. Chron. [Online] Available at: http://smallbusiness.chron.com/financial-statement-fraud-57182.html [Accessed 17 November 2014].
Pinkasovitch, A. (2011). Detecting Financial Statement Fraud. [online] Investopedia. Available at: http://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp [Accessed 18 Nov. 2014].