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FRAUD AND ERROR

FRAUD

is an intentional act involving the use of

deception that results in a material
misstatement of the financial statements
MISSTATEMENT

- a DIFFERENCE between the amount,

classification, presentation or disclosure of a
reported financial statement item and the
amount, classification, presentation, or
disclosure that is required for the item to
be in accordance with the applicable
financial reporting framework
FRAUD
Is an intentional act by one or more individuals among
management, those charged with governance, employees, or
third parties involving the use of deception to obtain an unjust or
illegal advantage.

• management fraud – fraud involving one or more members

of management or those charged with governance
• employee fraud – fraud involving only employees of the
entity

• In either case, there may be collusion within the entity or with

third parties outside of the entity
TWO TYPES OF
MISSTATEMENTS

a. Misstatements arising from

misappropriation of assets, and
b. Misstatements arising from fraudulent
financial reporting
ERROR

is an unintentional misstatement in the

financial statements, including the omission of
an amount or disclosure
ERROR

- May arise from:

• Mathematical or clerical mistakes in the
underlying records and accounting data;
• An incorrect accounting estimate arising
from oversight or misinterpretation of
facts;
• Mistake in the application of accounting
 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.
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TYPES OF
MISSTATEMENTS
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. It can be accomplished in various
ways, including embezzling cash receipts, stealing
assets, causing the company to pay for goods or
services that were not received, or using an
entity’s assets for personal use.
MISSTATEMENTS ARISING FROM
MISAPPROPRIATION OF ASSETS

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 the fraud
MISSTATEMENTS ARISING FROM
FRAUDULENT FINANCIAL REPORTING

• Is the intentional manipulation of reported financial

results to misstate the economic condition of the
organization
• 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
to avoid bankruptcy or to avoid some other negative
MISSTATEMENTS ARISING FROM
FRAUDULENT FINANCIAL REPORTING

• Three common ways in which fraudulent financial

reporting can take place include:
• 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
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THE FRAUD TRIANGLE

THE FRAUD TRIANGLE

• Is a model for explaining the factors that cause someone

to commit occupational fraud. It consists of three
components which, together, lead to fraudulent behavior.

(Association of Certified Fraud Examiners)

THE FRAUD TRIANGLE

• The fraud triangle originated from Donald Cressey’s

hypothesis:

“Trusted persons become trust violators when they

conceive of themselves as having financial problem which
is non-shareable, are aware this problem can be secretly
resolved by violation of the position of financial trust, and
are able to apply to their own conduct in that situation
verbalizations which enable them to adjust their
conceptions of themselves as trusted persons with their
conceptions of themselves as users of the entrusted funds
THE FRAUD TRIANGLE
INCENTIVES OR PRESSURES TO
COMMIT FRAUD

• Incentives relating to asset misappropriation

include:
• Personal factors, such as severe financial
considerations
• Pressure from family, friends, or the culture to
live a more lavish lifestyle than one’s personal
earnings allow for
• Addictions to gambling or drugs
INCENTIVES OR PRESSURES TO
COMMIT FRAUD
• Incentives relating to fraudulent financial reporting
include:
• Management compensation schemes
• Other financial pressures for either improved earnings
or an improved balance 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
 Risk Factors Relating to Misstatement Arising
from the Fraudulent Financial Reporting

1. Threatened financial stability or profitability brought

about by economic, industry, or entity operating
conditions such as:
a. High degree of competition or market saturation, accompanied by declining
margins
b. High vulnerability to rapid changes.
c. Significant declines in customer demand and increasing business failures in
either the industry or overall economy.
d. Operating losses making the threat of bankruptcy, foreclosure or hostile
takeover imminent.
e. Recurring negative cash flows from operation or an inability to generate
cash flows from operations while reporting earnings and earning s growth.
f. Rapid growth or unusual profitability especially compared to that of other
companies in the same industry.
Risk Factors Relating to Misstatement Arising
from the Fraudulent Financial Reporting

2. Excessive pressure from management to meet the

requirements or expectations of third parties due to
the following:
• Profitability or trend level expectations, including
expectations created by management.
• Need to obtain additional debt or equity financing to
stay competitive.
• Marginal ability to meet exchange listing requirements
or debt repayment or other debt covenant
requirements.
• Perceived or real adverse effects of reporting poor
financial results on significant pending transactions,
Risk Factors Relating to Misstatement Arising
from the Fraudulent Financial Reporting

3. Threatened personal financial situation of

management or those charged with governance
relative to the entity’s financial performance due to:
• Significant financial interests in the entity
• Significant portions of their compensation being
contingent upon achieving aggressive targets
• Personal guarantees of debts of the entity.
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. Although this may sound obvious –
that is, “everyone has an opportunity to commit fraud” – it
really conveys much more.

It means not only 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:

• Significant related-party transactions

• 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
• Management’s inconsistency involving subjective
judgments regarding assets or accounting
estimates
• Simple transactions that are made complex
• 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

• Is the belief that a fraud has not really been

committed. For example, the perpetrator
rationalizes that “This is not a big deal!” or “I am
only taking what I deserve.” (IFAC Guide, Volume
2, Third edition, page 90)

• For asset misappropriation, personal

rationalizations often revolve around
mistreatment by the company or a sense of
RATIONALIZING THE FRAUD

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
RATIONALIZING THE FRAUD

For fraudulent financial reporting, the rationalization

can range from “saving the company” to personal greed,
and may include the following:
• This is a 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
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 misappropriation 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 a loan
RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS

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.
RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS
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
RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS
B. Opportunities

1. Certain characteristics or circumstances may increase the

susceptibility of assets to misappropriation. For example,
opportunities to misappropriate assets increase when the
following situations exist:
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
RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS
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 records keeping with respect to assets
RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS

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
RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS
C. Attitudes/Rationalizations

1. Disregard for the need for monitoring or reducing risks related to

misappropriation of assets
2. Disregard for internal controls 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
• 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 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
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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.
INCENTIVE/PRESSURE

• 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.
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 weaknesses in internal control.
Fraudulent financial reporting often involve 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.
• 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.
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
not to take place, and fraud deterrence, which could
persuade individuals not to commit fraud because of the
RESPONSIBILITY FOR THE
PREVENTION AND DETECTION OF
FRAUD

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 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.
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Synthesis:

The fraud triangle identifies incentives,

opportunities, and rationalizations as the
three elements associated with most frauds.
Describe how each of these elements is
necessary for fraud to occur.