Chapter 14: FRAUD AND ERROR

Expected Learning Outcomes

After studying the chapter, you should be able to …

1. Explain what fraud means.

2. Explain the major types of misstatements, namely
a. Misstatements arising from misappropriation of assets
b. Misstatements arising from misappropriations 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.

INTRODUCTION

In the previous chapters, corporate governance has been described as the process by which the owners
and various 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 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 deception 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, and (b) misstatements arising from fraudulent
financial reporting.

Intent to deceive is what distinguishes fraud from errors. Auditors routinely find financial errors in their
client’s books; but those errors are not intentional.

TYPES OF MISSTATEMENTS

a. Misstatements arising from misappropriation of assets

b. Misstatements arising from fraudulent financial reporting

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 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:

 Gain access to cash and manipulate accounts to cover up cash thefts.

 Manipulate cash disbursements through fake companies.
 Steal inventory or other assets and manipulate the financial records to cover up the Fraud.

Misstatements arising from Fraudulent Financial Reporting

The intentional manipulation of reported financial results to misstate the economic condition of the
organization is called fraudulent financial reporting. The perpetrator of such a fraud generally seeks
gain through the rise 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:

1. Manipulation, falsification, or alteration of accounting records or supporting documents.

2. Misrepresentation or omission of events, transactions, or other significant information.
3. 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:

 Incentive to commit fraud

 Opportunity to commit and conceal the fraud
 Rationalization – the mindset of the fraudster to justify committing the fraud.

INCENTIVES OR PRESSURES TO COMMIT FRAUD

Incentives relating to asset misappropriation include:

 Personal factors, such as severe financial considerations

 Pressures from family, friends, or the culture to live a more lavish lifestyle than one’s personal
earnings allow for
 Addictions to gambling or drugs
The incentives include the following for fraudulent financial reporting:

 Management compensation schemes

 Other financial pressures for either improved earnings or an improved balanced sheet
 Debt covenants
 Pending retirement or stock option expirations
 Personal wealth tied to either financial results or survival of the company
 Greed – for example, the backdating of stock options was performed by individuals who already
had millions of pesos of wealth through stock.

OPPORTUNITIES TO COMMIT FRAUD

One of the most fundamental and consistent findings in fraud research is that there must be an
opportunity for fraud to be committed. Some of the opportunities to commit fraud that the top
management should consider include the following:

 Significant related-party transactions

 A company’s industry position, such as the ability to dictate the terms or conditions to suppliers
or customers that might allow individuals to structure fraudulent transactions
 Management’s inconsistency involving subjective judgments regarding assets or accounting
estimates
 Simple transactions that are made complex through an unusual recording process
 Complex or difficult to understand transactions, such as financial derivatives or special-purpose
entities.
 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
 Complex or unstable organizational structure
 Weak or nonexistent internal controls

RATIONALIZING THE FRAUD

For asset misappropriation, personal rationalizations often revolve around mistreatment by the
company or a sense of entitlement by the individual perpetrating the fraud. Following are some
common rationalizations for asset misappropriation:

 Fraud is justified to save a family member or loved one from financial crisis.
 We will lose everything (family, home, car and so on) if we don’t take the money
 No help is available from outside
 This is “borrowing”, and we intend to pay the stolen money back at some point
 Something is owed by the company because others are treated better
 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 may include the following:

 This is one-time thing to get us through the current crisis and survive until things get better
 Everybody cheats on the financial statements a little; we are just playing the same game.
 We will be in violation of all of our debt covenants unless we find a way to get this debt off the
financial statements
 We need a higher stock price to acquire company XYZ, or to keep our employees 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 in a variety of ways including:

 Embezzling receipts (for example, misappropriating collections on accounts receivable or

diverting receipts in respect of written-off accounts to personal bank accounts).
 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).
 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).
 Using an entity’s assets for personal use (for example, using the entity’s assets as collateral for a
personal loan or 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 or 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 may be created by the following:
(a) Known or anticipated future employee layoffs.
(b) Recent or anticipated changes to 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 exist:
(a) Large amounts of cash on hand 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 reconciliation 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. Attitude / Rationalization

1. Disregard for the need for monitoring or reducing risks related to misappropriation of
assets.
2. Disregard for internal control over misappropriation of assets by overriding existing controls
or by failing to correct known internal control deficiencies.
3. Behavior indicating displeasure or dissatisfaction with the entity or its treatment of the
employee
4. Changes in behavior or lifestyle that may indicate assets have been misappropriated.
5. Tolerance of petty theft.
RISK FACTORS CONTRIBUTORY TO FRAUDULENT FINANCIAL REPORTING

Fraudulent financial reporting may be accomplished by the following:

 Manipulation, falsification (including forgery), or alteration of accounting records or supporting

documentation from which the financial statements are prepared.
 Misrepresentation in, or intentional omission from, the financial statements of events,
transactions or other significant information.
 Intentional misapplication of accounting principles relating to amounts, classification, manner of
presentation, or disclosure.

Fraudulent financial reporting involves intentional misstatements including omissions of amount 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 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 management. Pressures and incentives may lead these actions to increase to
the extent that they result in fraudulent financial reporting. In some entities, management may be
motivated to reduce earnings by a material amount to minimize tax or inflate earnings to secure
bank financing.

A. Incentive / Pressure

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

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 weakness 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:
 Recording fictitious journal entries, particularly close to the end of an accounting period,
to manipulate operating results or achieve other objectives.
 Inappropriately adjusting assumptions and changing judgments used to estimate
account balances.
 Omitting, advancing or delaying recognition in the financial statements of events and
transactions that have occurred during the reporting period.
  Concealing, or not disclosing, facts that could affect the amounts recorded in the
financial statements.
 Engaging in complex transactions that are structured to misrepresent the financial
position or financial performance of the entity.
 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
and 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 behavior which can be reinforced by an active oversight by
those charged with governance. In exercising oversight responsibility, those charged with governance
consider the potential 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.