Financial Statement Fraud in an

Organization

INSTRUCTOR: MR. PIERRE KMEID

STUDENT NAME: REBECCA HAJJ

Course Name: Special Topics

 Summer 2020

Table of contents
Introduction......................................................................................................................... 3

Fraud....................................................................................................................................3

A. Definition...................................................................................................................... 3

B. Indicators......................................................................................................................4

C. Classification................................................................................................................4

Financial statement fraud....................................................................................................7

A. Causes of financial statement fraud.............................................................................8

B. Fraud triangle...............................................................................................................8

C. Reasons behind fraudulent financial reporting..........................................................10

D. Methods of producing fraudulent financial statements.............................................10

E. Consequences of financial statement fraud...............................................................11

F. Flowchart of financial statement fraud.......................................................................12

Summary............................................................................................................................ 12
Introduction
In the present age of scams, financial statement fraud represents enormous cost to the
economy globally. Collapses of high-profile companies have left a dirty smear on the
effectiveness of corporate governance, quality of financial reports, and credibility of audit
functions. An exponential increase in the use of technology has further aggravated the
problem and provides opportunities for crimes to be committed across borders. It has
become a critical issue in the businesses around the world and in the confidence of the
investors.

The intentional misstatement of numbers in the accounting books with the help of well -
planned scheme by an intelligent people of knowledgeable perpetrators in order to
deceive the capital market participants is termed as financial statement fraud.

My project will explain the causes, methods and consequences of financial statement
fraud.

Fraud

A. Definition

Fraud is a broad legal term referring to dishonest acts that intentionally use deception to
illegally deprive another person or entity of money, property, or legal rights.

Unlike the crime of theft, which involves the taking of something of value through force
or stealth, fraud relies on the use of intentional misrepresentation of fact to accomplish
the taking.

Therefore, Fraud may be defined as an intentional act meant to induce another person to
part with something of value, or to surrender a legal right. It is a deliberate
misrepresentation or concealment of information in order to deceive or mislead.

There are numerous of items that must be identified when discussing a case of Fraud
such as:

1. a victim

2. details of the deceptive act thought to be fraudulent

 3. the victim's loss

4. a perpetrator (i.e., a suspect)

5. evidence that the perpetrator acted with intent

6. evidence that the perpetrator profited by the act(s).

"Fraud always involves one or more persons, out of which one for his own enrichment act
secretly to deprive another of something of value".

B. Indicators

The symptoms of fraud can be differentiated from errors or mistakes with the help of the
bellow three categories of fraud indicators:

a) Personal Shortcomings

1. Person living beyond their means (spending more money than they
can afford)

2. High turnover of personnel

3. Uncharacteristic behavior by employees.

b)Financial Shortcomings

1. Unexplained entries in records

2. Unusually large amount or numbers of cash transactions

3. Missing records or documents

4. Non-serial number transactions

c) Operational Shortcomings

1. Lack of internal controls

2. One person in control with no separation of duties

3. Inventories and financial records not reconciled

 4. Unauthorized transactions

C. Classification

The word fraud is a generic term used to describe any deliberate act to deceive or
mislead another person, carry harm or injury. This intentional, wrongful act can be
differentiated and defined in many ways, depending on the type of perpetrators. For
example, frauds committed by individuals such as embezzlement or theft, are
distinguished from frauds perpetrated by corporations or top-level management such as
financial statement fraud.

The first one is known as employee fraud and second one as management fraud
illustrated in the bellow image.

Fraud is classified on the basis of perpetrator relationship to the company as internal

versus external fraud. There are several types of corporate fraud. The most prominent
distinction one can make in fraud classification is internal versus external fraud. Fraud is
external if victim is external to the organization, internal otherwise. for example, fraud
committed by employees, internal auditors, executives, the board of directors, and
managers, who may suffer a financial loss and or reputation loss, is termed as internal
fraud. Fraud in which external such as investors, creditors, suppliers, customers, and
external auditors are involved is known as external fraud.

In addition to other classifications, another way of classifying fraud is transaction versus

statement fraud. Statement fraud may be defined as the intentional misstatement of
certain financial values to enhance the appearance of profitability and deceive
shareholders or creditors whereas transaction fraud is intended to embezzle or steal
organizational assets. We distinguish two related types of fraud: financial statement
balance fraud and asset theft fraud. The difference between those two is that there is no
theft of assets involved in financial statement balance fraud. Well-known examples of this
type of fraud are “Enron and WorldCom”.

Two more classifications of fraud are fraud “for “versus fraud “against” the company. The
fraud for, contains frauds intended to benefit the organizational entity, while fraud
against is frauds that intend to harm the entity. Examples of fraud for the company are
price fixing, corporate tax evasion and violations of environmental laws. While these
frauds are in the benefit of the company at first, in the end the personal enrichment
stemming from these frauds are the real incentives. Frauds against the company are only
intended to benefit the perpetrator, like embezzlement or theft of corporate assets.

Different types of frauds along with different perpetrators and victims have been given
below as Table.

Type of Fraud Perpetrator Victim Explanation

Employee Employees directly or

Embezzlement or Employee Employers indirectly steels from
Occupational Fraud employers

Stockholders, lenders Top management

and other who rely on provides
Management Fraud Top Management
misrepresentation, usually
financial statements in financial information
Individuals tricks investors
Investment Scams Individuals Investors
into putting money into
 fraudulent investments
Organizations or
individuals that Organizations overcharge
sells goods or Organizations that buy for goods or services or no
Vendor Fraud
services goods or services shipment of goods, even
though payment is made

Customers deceive sellers

into giving customers
Organizations that sells something they should
Customer Fraud Customers
goods or services not having or charging
them less than they
should

Financial statement fraud

A complete understanding of the nature, significance, and consequences of fraudulent
financial reporting activities requires a proper definition of financial statement fraud.
ACFE (Association of Certified Fraud Examiners) 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."

When the managers of a company provide false financial information, it's called financial
statement fraud. Financial statement fraud is usually committed with the aim that a
financial statement audit ensures that a company's financial reports are free from
material misstatement and fraud. In today's challenging economy, organizations need to
be prepared to fight fraudulent activities. Business professionals may prefer to believe
that fraud will never occur. Financial reporting fraud involves the alteration of financial
statement data, usually by a firm's management, to achieve a fraudulent result.

Financial statement fraud may be defined as a deliberate, wrongful act committed by

publicly traded companies, with materially misleading financial statement, that causes
harm and injury to the investors and creditors. Falsifying financial statement is usually
committed by top-level management and thus known as management fraud with the goal
to artificially improve the financial performance and results of the company.

Financial statement fraud may further be defined as a deliberate attempt by corporations

to deceive or mislead users of published financial statements, especially investors and
creditors, by preparing and disseminating materially misstated financial statements.
Financial statement fraud involves intent and deception by a clever team of
knowledgeable perpetrators such as top executives, auditors, with a set of well-planned
schemes and a considerable competitiveness.

Financial statement fraud may involve the following schemes:

1. Falsification, alteration, or manipulation of material financial records,

supporting documents, or business transactions

2. Material intentional misstatements, omissions, or misrepresentations of

events, transactions, accounts or other significant information from which
financial statements are prepared

3. Deliberate misapplication, intentional misinterpretation, and wrongful

execution of accounting standards, principles, policies and methods used to
measure, recognize, and report economic events and business transactions

4. Intentional omissions and disclosures or presentation of inadequate

disclosures regarding accounting standards, principles, practices, and related
financial information

5. The use of aggressive accounting techniques through illegitimate earnings

management

6. Manipulation of accounting practices under the existing rules-based

accounting standards, which have become too detailed and too easy to
circumvent and contain loopholes that allow companies to hide the economic
substance of their performance.

A. Causes of financial statement fraud

The management of an organization may use financial statement fraud as a strategic tool
in spite of the corporate governance or environmental pressure because of its own
characteristics in terms of loyalty, aggressiveness, control ineffectiveness and lack of
moral principles. These characteristics are explained below in terms of fraud triangle.

B. Fraud triangle
Financial statement fraud is a deliberate, wrongful act committed by the top
management of publicly traded companies. Fraud usually includes three characteristics
namely, opportunity, attitude or rationalization, and motive or pressure. These three
factors constituted the Fraud Triangle (Figure A.1) and are present in various forms in the
characteristics of a firm that is engaged in fraudulent financial reporting.

The elements are as follows:

a) Opportunity is the circumstances that provide a chance for the

management to perform material misstatement in the financial statement.
The opportunity that may lead to financial statement fraud may include weak
or non - existent internal control, Absence of proper audit committee,
improper oversights by board of directors and complex organizational
structure.

b)Rationalization is the ability to act according to self-perceived moral and

ethical values. Fraudsters find a way to rationalize their actions and make it
acceptable for themselves. Management can think of financial statement
fraud just for being in competition with other organizations or to meet the
company goals. Top-level managers may rationalize their act of fraud by
saying that they are trying to protect shareholder by manipulating financial
reports to increase the share price.

c) Motive (incentive) is pressures that management experiences to materially

misstate the financial statement. These pressures can be classified as
"psychotic" (related to habit), egocentric (related to personal prestige),
ideological (believing that the cause is morally superior) or economic (related
to a need for money). Management of an organization usually feel pressured
to do fraudulent activity because of a poor cash position, a loss of customers,
declining market etc.
Figure A.1: Fraud Triangle.

C. Reasons behind fraudulent financial reporting

The upper management of a company may choose to engage in fraudulent financial

reporting if:

a)The personal assets or capital of the management is closely associated with

the performance of the company in terms of profit sharing.

b) Enough opportunities are present for the management to commit the

financial statement fraud.

c)The management is willing to maximize shareholder value for handling

some internal or external pressure.

d) Top-level executives are ready to take personal risk for corporate benefits.

e) The chances of detection of fraud are negligible.

D. Methods of producing fraudulent financial statements

Once, the management has decided to be engaged in fraudulent financial reporting then
they may use any of the following recipes for cooking the accounting books.

1. Overstatement of Revenue - Revenue may be overstated by inflated sales.

This can be achieved by entering fictitious sales or by entering a sale before
the revenue is earned actually in the financial statements.

2. Understatement of Expenses - Holding expenses incurred during the

current period over to the next financial period is termed as understatement
of expenses. This can happen by wrongly capitalizing an expense over a
number of periods, rather than properly expensing it immediately.

3. Overstatement of Assets - Assets could be overstated by not booking down

the accounts receivables or by not writing down the assets with impaired
values or obsolete inventory.

4. Understatement of Liabilities - Liabilities may be understated by

improperly recording liabilities as equity or by moving them between short
 term and long term.

5. Improper Use of Reserves - Reserve accounts such as reserves for accounts

receivables, warranties, inventory obsolescence and sales returns are
intrinsically risky because a great deal of judgement is required to determine
their balances at the end of the financial period.

6. Mischaracterization as one-time expenses - The management of an

organization may remove one - time expenses from the accounting books for
giving a false impression about the organization's operating results to the
capital market participants.

7. Misapplication of Accounting Rules - Financial statement fraud may be

perpetrated by exploiting loopholes present in the accounting rules.

8. Misrepresentation of Information - Management deliberately

misrepresent or omit certain information in the financial statement to
mislead the users of financial statement about the operations of the
organization.

E. Consequences of financial statement fraud

In general, financial statement fraud is only a means to improve results. Financial

statement fraud has larger implications than many managers realize.

Financial statement fraud, no doubt is going to harm the company in which it is prepared,
but it can also affect economic markets.

Giving the following summary of the potential harmful effects of financial statement
fraud:

 It undermines the quality and integrity of the financial reporting process;

 It jeopardizes the integrity and objectivity of the accounting profession;

 It diminishes the confidence of capital markets and market participants in

the reliability of financial information;

 It makes the capital market less efficient;

 It adversely affects a nation's growth and prosperity;

 It may result in litigation losses;

 It destroys the careers of individuals involved in the fraud;

 It causes bankruptcy or economic losses by the company engaged in the

fraud;

 It encourages a higher level of regulatory intervention; and

 It causes destructions to the normal operations and performance of the

alleged companies.
 F. Flowchart of financial statement fraud

The primary aim of organizations indulged in fraudulent financial reporting is to overstate

their revenue and income, to disguise losses and avoid punishment from the regulatory
bodies. Such firms boost their revenue by creating fictitious transactions. Overstating
revenue would jointly raise account receivables and/or cash (or the other way round), as
income is the primary source of shareholders' equity, both income and shareholders'
equity can be exaggerated. Sometimes firms choose to understate expenses instead of
overstate revenues, as understating expenses would jointly raise cash and/or inventory
(or the other way round), the effect is just equivalent. In the view of the above, Figure
below represent the flowchart of financial statement fraud.
Summary
Financial statement fraud is a serious social and economic problem worldwide and more
severe in growing countries. A company listed with any stock exchange is required to
publish its financial statements such as balance sheet, income statement, statements of
retained earnings and cash flow statements yearly and quarterly. Financial statements of
a company reflect its actual financial health by analyzing which, stockholders can form a
wise decision about investing in the company.

This project provides a theoretical concepts and framework of financial statement fraud.