CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

CHAPTER 3
FINANCIAL STATEMENT FRAUD: CAUSES AND CONSEQUENCES

3.1 Introduction

3.2 Definition of Fraud

3.3 Classification of Fraud

3.4 Financial Statement Fraud

3.5 Causes of Financial Statement Fraud

3.5.1 The Fraud Triangle

3.5.2 Reasons behind Fraudulent Financial Reporting

3.5.3 Methods of producing Fraudulent Financial Statements

3.6 Consequences of Financial Statement Fraud

3.7 Flowchart of Financial Statement Fraud

3.8 Summary

3.1 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 in 21st century and provides opportunities for crimes to be committed across
borders. It has become a critical issue in the businesses around the world, which has
significantly; dampen the confidence of the investors.

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

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

causes, methods and consequences of financial statement fraud. In order to understand the
concept, Section 3.2 defines fraud. Section 3.3 explains different classification of fraud.
Section 3.4 introduces the concept of financial statement fraud. Section 3.5 elaborates the
causes offinancialstatement fraud by explaining fraud triangle. This section also explains the
reasons behind financial statement fraud, followed by the tricks used by the management for
achieving their aim of fraudulent financial reporting. Section 3.6 explores the consequences
of fraudulent financial reporting. Section 3.7 elucidates the flowchart for producing
fraudulent financial statements followed by summary of the chapter under Section 3.8.

3.2 DEFINITION OF FRAUD

Fraud encompasses an array of irregularities and illegal acts characterized by intentional

deception. Webster's New World Dictionary defined fraud as "The intentional deception to
cause a person to give up property or some lawful right". The legal definition of fraud states
as "A generic term, embracing all multifarious means which human ingenuity can devise, and
which are resorted to by one individual to get advantage over another by false suggestions by
suppression of truth and includes all surprise, trick, cunning, dissembling and any unfair way
by which another is cheated".

Fraud is defined in many scholars and dictionaries. [Singleton06] defines fraud as:
"intentional deception, lying, and cheating are the opposites of truth, fairness, and equity.
Fraud consists of coercing people to act against their own best interests". [Hopwood09]
opines: "Fraud (false pretence) involves intentional and material misrepresentation of one or
more material facts with the intent of taking of property from a victim. American heritage
dictionary (second college edition) defined fraud as "a deception deliberately practiced in
order to secure unfair or unlawful gain. Black's law dictionary describes fraud as "the
intentional use of deceit, a trick or some dishonest means to deprive another of his/her/its
money, property or a legal right".

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.

[DaviaOO] identified a number of items that must be identified, when articulating a case of
fraud:

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

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".

The symptoms of fraud can be differentiated from errors or mistakes with the help of fraud
indicators. Fraud indicators are clues that may warrant further review of a specific area or
activity. Fraud indicators can be broadly classified into three categories mentioned below:

a)- Personal Shortcomings:

1. Person living beyond their means
2. Hightumover of personnel
3. Uncharacteristic behaviour by employees or co-workers.
b) Financial Shortcomings:
1. Unexplained entries in records
2. Unusually large amount or numbers of cash transactions
3. Altered inadequate or 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

3.3 CLASSIFICATION OF FRAUD

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 classes 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 former is known

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CHAPTER-3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

as employee fraud and later as management fraud (Figure 3.1). [Bologna95] classifies fraud
on the basis of relationship of the perpetrator 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.
Financial Statement Fraud

iVIisrepresentation of material assets

Misrepresentation of assets

Management

Concealment of Material Facts

Illegal Acts

Bribery

Conflict of Interest

Embezzlement of money of property

Employee Fraud Breach of fiduciary duty

Theft of trade secrets of intellectual property

Illegal Acts

Figure 3.1: Classification of Fraud

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CHAPTER-3 FINANCIAL STATEMENT FRAUD: CAUSES i& CONSEQUENCES

In addition to other classifications, anotlier 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.
[DaviaOO] distinguish two related types of fraud:financialstatement balance fraud and asset-
theft fraud. The authors state that the main difference between the former and the latter 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. [Bologna95] give two more
classifications of fraud - all classifying corporate fraud.
A first classification is fraud fiyr versus against the company. The former contains frauds
intended to benefit the organizational entity, while the latter encompasses 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. The authors draw attention to the fact that not all frauds fit
conveniently into this schema, for example arson for profit, planned bankruptcy and
fraudulent insurance claims [Jans09].

Internal Fraud
Statement Fraud Trarisaction fraud
4 , .—^
i 1 .J. .
j ri • •" • 1 ;
; i ^ a n a g 3ment Fraud ' ^' Non-JVlanagement Fraud j
' Fraud for j ; Fraud i 1
• the j" .-p. .

: company r*" — • against |

company ;

External Fraud

Figure 3.2: Fraud Classification Overview

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CHAPTER-3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

A last distinction [Bologna95] refers to is management versus non - management fraud, also
a classification based on the perpetrator's characteristics. These different classifications all
present another dimension and can display some overlap. Figure 3.2 represents an overview
of the different classifications and their relations to each other, hereby making some
assumptions.
Different types of frauds along with different perpetrators and victims have been given below
as Table 3.1 [Shuklal2].

Table 3.1 : Types of Fraud

Type of Fraud Perpetrator Victim Explanation
Employee Employees directly or

Embezzlement or Employee Employers indirectly steels from

Occupational Fraud Employers

Stockholders, lenders Top management provides

Management Fraud Top Management and other who rely on misrepresentation, usually in

financial statements financial information

Individuals tricks investors into

Investment Scams Individuals Investors putting money into fraudulent

investments

Organisations or Organisations overcharge for

individuals that Organisations that goods or services or no

Vendor Fraud
sells goods or buy goods or services shipment of goods, even though

services payment is made

Customers deceive sellers into

Organisations that giving customers something

Customer Fraud Customers sells goods or they should not having or

services charging them less than they

should

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

3.4 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'sfinancialreports 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, through the use of 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 also known as management fraud with the goal
to artificially improve thefinancialperformance 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 (e.g., top
execufives, auditors) with a set of well-planned schemes and a considerable gamesmanship.
Financial statement fraud may involve the following schemes [RazaeelO]:
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

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

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.

3.5 CAUSES OF FINANCIAL STATEMENT FRAUD

The management of an organisation 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.

3.5.1 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 rationalisation, and motive or pressure. These three factors constituted the Fraud
Triangle (Figure 3.3) and are present in various forms in the characteristics of a firm that is
engaged in fraudulent financial reporting [Cressey86].The elements are as follows (in no
particular order):
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) Rationalisation 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

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CHAPTER-3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

in competition witii other organisations 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.

Figure 3.3: Fraud Triangle.

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 organisation usually feel pressured to do fraudulent activity
because of a poor cash position, a loss of customers, declining market etc.

3.5.2 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.

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

3.5.3 METHODS OF PRODUCING FRA UDULENT FINANCIAL STA TEMENTS

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 loop holes 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 organisation.
3.6 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.

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

Financial statement fraud, no doubt is going to harm the company in which it is perpetrated,
but it can also affect economic markets. [Rezaee02] gives the following summary of the
potential harmful effects of financial statement fraud:

• It undermines the quality and integrity of thefinancialreporting 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.

3.7 FLOWCHART OF FINANCIAL STATEMENT FRAUD

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

their revenue and income, so as to disguise losses and avoid punishment from the regulatory
bodies. Such firms boost their revenue by creatingfictitioustransactions. 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 3.4 represent the flowchart of
financial statement fraud [BelinnaOS].

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CHAPTER-3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

•n
Balance Sheet Income Statement
Overstate accounts receivable
Overstate Revenue
Overstate Cash

Overstate Inventory Create Fake Transactions

* Overstate Current Assets

Overstate Fixed Assets Overstate Expenses

Overstate Total Assets

Understate Liabilities

Overstate Equity Overstate Income

Figure 3.4: Flowchart of Financial Statement Fraud

3.8 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 reflects its actual financial health by analysing which, stockholders can form a wise
decision about investing in the company.
This chapter provides a theoretical concepts and framework of financial statement fraud.
Section 3.2 presents the concept of fraud. In order to have better understanding regarding the
nature and category of financial statement fraud, Section 3.3 presents a brief overview of
classification of fraud. Section 3.4 defines one of the management frauds - financial
statement fraud.

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CHAPTER - 3 FINANCIAL STATEMENT FRAUD: CAUSES & CONSEQUENCES

Reasons behind fraudulent financial statements are explained along with fraud triangle, which
helps in understanding different causes of financial statement fraud, is presented in Section
3.5. This section further explains different recipes of cooking the accounting books generally
used by management. Section 3.6 elaborates the consequences of financial statement fraud.
The framework of financial statement fraud is presented in section 3.7 as a flow chart for
producing fraudulent financial statements. Overall this chapter provides a theoretical platform
for understanding financial statement fraud.

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