ACC114A GOVERNANCE RISK MANAGEMENT AND INTERNAL CONTROL

Chapter -- Fraud and Error

Learning Objectives:

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.

Topics:

4.1 Introduction
4.2 Types of Misstatements
4.3 The Fraud Triangle
4.4 Rationalizing the Fraud
 Risk factors arising from Misappropriation of assets.
 Risk factors arising from Fraudulent Financial Reporting.
 Responsibility for the Prevention and Detection of Fraud.

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 description 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,
b. Misstatements arising from fraudulent financial reporting.
 Intent to deceive is what distinguish fraud from errors.
 Auditors routinely find financial errors in their client’s books, but those errors are not
intentional.

TYPES OF MISSTATEMNTS

A. 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 the embezzling cash
receipts, stealing assets, or causing the company to pay for goods or services that were not
received.
 Asset misappropriation commonly occurs when employees:
 o Gain access to cash and manipulate accounts to cover up cash thefts.
o Manipulate cash disbursements through fake companies.
o Steal inventory or other assets or manipulate the financial records to cover up the
fraud.
B. Misstatements arising from fraudulent financial reporting.
 The intentional manipulation of reported financial results to misstate the economic
conditions of the organization is called fraudulent financial reporting.
 The perpetrator of such fraud generally seeks gain through the rises 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:
o Manipulation, falsification, or alteration of accounting records or supporting
documents.
o Misrepresentation or omission of events, transactions, or other significant
information.
o Intentional misapplication of accounting principles.

THE FRAUD TRIANGLE

 The fraud triangle characterizes incentives, opportunities and rationalizations that enable fraud
to exist.
 The Three Elements of the fraud triangle are:
a. Incentive to commit fraud
b. Opportunity to commit and conceal the fraud
c. Rationalization – the mindset of the fraudster to justify committing the fraud.

a. Incentive or Pressures to commit fraud.

 Incentives relating to asset misappropriation include:
o Personal factors, such as severe financial considerations.
o Pressure from family, friends, or the culture to live a more lavish lifestyle than
one’s personal earnings allow for
o Addictions to gambling or drugs
 The Incentives include the following fraudulent financial reporting:
o Management compensation scheme.
o Other financial pressures for either improved earnings or an improved balance
sheet.
o Debt covenants
o Pending retirement or stock option expirations
o Personal wealth tied either to financial results or survival of the company.
o Greed – for example, the backdating of stock options was performed by
individuals who already had millions of pesos of wealth through stock.

b. Opportunity to commit and conceal the 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 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:
o Significant related- party transactions
o 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.
o Management inconsistency involving subjective judgments regarding assets or
accounting estimates.
o Simple transactions that are made complex through an unusual recording
process.
o Complex or difficult to understand transactions, such as financial derivatives or
special purpose entities.
o 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.
o Complex or unstable organizational structure
o Weak or non-existent internal control

c. Rationalizing the fraud

 For asset misappropriation, personal rationalization often evolve 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 rationalization for asset misappropriation:
o Fraud is justified to save a family member or loved one from financial crisis.
o We will lose everything (family, home, car and so on) if we don’t take the
money.
o No help is available from outside.
o This is “borrowing”, and we intend to pay the stolen money back at some point.
o Something is owed by the company because others are treated better.
o 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 they may include the following:
o This is one-time thing to get us through the current crisis and survive until things
get better.
o Everybody cheats on the financial statements a little, we are just playing the
same game.
 o We will be in violation of all of our debt covenants unless we find a way to get
this debt of the financial statements.
o We need a higher stock price to acquire company XYZ, or to keep our employee
through stock options and so forth.

Risk factors contributory to misappropriation of assets.

 Misappropriation of assets involves the theft of an entity’s assets and is often

perpetrated by employees in relatively small and immaterial amounts.
 However, it can also involve management who are usually more able to disguise or
conceal misappropriations in ways that are difficult to detect.
 Misappropriation of assets can be accompanied toa variety of ways including:
o Embezzling receipts (for example, misappropriating collections on account
receivable or diverting receipts in respect of written-off accounts to personal
bank accounts).
o Stealing physical assets or intellectual property (for example, stealing inventory
for personal use or for sale, stealing scrap for resale, colluding with a competitor
by disclosing technological data in return for payment).
o Causing an entity to pay for goods and services not received (for example,
payments to fictitious vendors, kickbacks paid by vendors to the entity’s
purchasing agents in return for inflating prices, payments to fictitious
employees).
o Using an entity’s assets for personal use (for example, using the entity’s assets
as collateral for a personal loan or a loan to a related party).
 Misappropriation of assets is often accompanied by false or misleading records or
documents in order to conceal the fact that the assets are missing or have been pledged
without proper authorization.

A. Incentives / Pressures
1. Personal financial obligations may create pressure on management employees
with access to cash or other assets susceptible to theft to misappropriate those
assets.
2. Adverse relationships between the entity and employees with access to cash or
other assets susceptible to theft may motivate those employees to
misappropriate those assets. For example, adverse relationships nay be created
by the following:
a. Known or anticipated future employee layoffs.
b. Recent or anticipated changes tom employee compensation or benefit
plans.
c. Promotions, compensation, or other rewards inconsistent with
expectations.
B. Opportunities
1. Certain characteristics or circumstances may increase the susceptibility of assets
to misappropriation. For example, opportunities to misappropriate assets
increase when following situation exists:
a. Large amounts of cash on hand or processed.
b. Inventory items that are small in size, of high value, or in high demand.
c. Fixed assets which are small in size, marketable, or lacking observable
identification of ownership.
2. Inadequate internal control over assets may increase the susceptibility of
misappropriation of those assets. For example, misappropriation of assets may
occur because of the following:
a) Inadequate segregation of duties or independent checks.
b) Inadequate oversight of senior management expenditures, such as travel
and other reimbursements.
c) Inadequate management oversight of employees responsible for assets,
for example, inadequate supervision or monitoring of remote locations.
d) Inadequate job applicant screening of employees with access to assets.
e) Inadequate record keeping with respect to assets.
f) Inadequate system of authorization and approval of transactions (for
example, in purchasing)
g) Inadequate physical safeguards over cash, investments, inventory, or
fixed assets.
h) Lack of complete and timely reconciliations of assets.
i) Lack of timely and appropriate documentation of transactions, for
example, credits for merchandise returns.
j) Lack of mandatory vacations for employees performing key control
functions.
k) Inadequate management understanding of information technology,
which enables information technology employees to perpetrate a
misappropriation.
l) Inadequate access controls over automated records, including controls
over and review of computer systems event logs.

C. Attitudes/Rationalizations
1. Disregard for the need for monitoring or reducing risks related to misappropriation of
assets.
2. Disregard for internal control over misappropriation of assets to overriding existing
controls or by failing to correct known internal control deficiencies.
3. Behaviour indicating displeasure or dissatisfaction with the entity or its treatment of the
employee.
4. Changes in behaviour or lifestyle that may indicate assets have been misappropriated.
 3. Tolerance of petty theft.

Risk Factors Contributory to Fraudulent Financial Reporting

 Fraudulent financial reporting may be accompanied by the following

o Manipulations, falsification (including forgery), or alteration of accounting records or
supporting documentation from which the financial statements are prepared.
o Misrepresentation in, or intentional omission from, the financial statements of
events, transactions or other significant information.
o Intentional misapplication of accounting principles relating to amount, classification,
manner of presentation, or disclosure.
 Fraudulent financial reporting involves intentional misstatements including omissions of
amounts or disclosures in financial statements to deceive financial statement users.
 It can be caused by the efforts of management to manage earnings in order to deceive the
financial statement users by influencing their perceptions as to the entity’s performance and
profitability.
 Such earnings management may start out with small actions or inappropriate adjustment of
assumptions and changes in judgments by management.
 Pressures and incentives may lead these actions to increase to the extent that they result in
fraudulent financial reporting.
 Such a situation could occur when, due to pressures to meet market expectations or a desire
to maximize compensation based on performance, management intentionally takes
positions that lead to fraudulent financial reporting by materially misstating the financial
statements.
 In some entities, management may be motivated to reduce earnings by a material amount
to minimize tax or inflate earnings to secure bank financing.
 Fraud, whether fraudulent financial reporting or misappropriation of assets, involves incentive or
pressure to commit fraud, a perceived opportunity to do so and some rationalization of the act.

A. Incentives / Pressures

 Incentive or pressure to commit fraudulent financial reporting may exist when

management is under pressure, from sources outside or inside the entity, to achieve
an expected (and perhaps unrealistic) earnings target or financial outcome---
particularly since the consequences to management for failing to meet financial
goals can be significant.

B. Opportunities
C
  A perceived opportunity to commit fraud may exist when an individual believes
internal control can be overridden, for example, because the individual is in a
position of trust or has knowledge of specific weaknesses in internal control.
 Fraudulent financial reporting often involves management override of controls that
otherwise may appear to be operating effectively.
 Fraud can be committed by management overriding controls using such techniques
as:
o Recording fictitious journal entries, particularly close to the end of an
accounting period, to manipulate operating results or achieve other
objectives
o Inappropriately adjusting assumptions and changing judgments used to
estimate account balances.
o Omitting, advancing or delaying recognition in the financial statements of
events and transactions that have occurred during the reporting period.
o Concealing, or not disclosing, facts that could affect the amounts recorded in
the financial statements.
o Engaging in complex transactions that are structured to misrepresent the
financial position or financial performance of the entity.
o Altering records and terms related to significant and unusual transactions.

C. Rationalizations

 Individuals may be able to rationalize committing a fraudulent act.

 Some individuals possess an attitude character or set of ethical values that allow
them knowingly and intentionally to commit a dishonest act.
 However, even otherwise honest individuals can commit fraud in an
environment that imposes sufficient pressure on them.

Responsibility for the Prevention and Detection of Fraud

 The primary responsibility for the prevention and detection of fraud rests with both
those charged with governance of the entity and management.
 It is important that management, with the oversight of those charged with
governance, place a strong emphasis on fraud prevention, which may reduce
opportunities for fraud to take place, and fraud deterrence, which could persuade
individuals not to commit fraud because of the likelihood of detection and
punishment.
 This involves a commitment to creating a culture of honesty and ethical behaviour
which can be reinforced by an active oversight by those charged with governance.
 In exercising oversight responsibility, those charged with governance consider the
potential for override of controls or other inappropriate influence over the financial
reporting process, such as efforts by management to manage earnings in order to
influence the perceptions of analysts as to the entity’s performance and profitability.