CHAPTER 14.

FRAUD
AND ERROR
Governance, Business Ethics, Risk Management
& Internal Control
 REPORTERS:
•APRIL JOY DARADAR
•JEAN MARGARETTE
DELLAVA
•RHESIANE LEONES
GROUP 11
OBJECTIVES:
• After studying the chapter, you should be
able to:
• Explain what fraud means.
• Explain the major types of misstatements,
namely:
• Misstatements arising from misappropriation of
assets.
• Misstatements arising from fraudulent financial
reporting.
OBJECTIVES:
• Give and explain the elements of a fraud
triangle
• Give and explain the risk factors contribute to
misappropriation of assets
• Explain who is primarily responsible for the
prevention and detection of fraud in a business
enterprise
• Give and explain the risk factors that
contribute to fraudulent financial reporting.
 FRAUD
Fraud – an intentional act involving the use of
deception that results in a material misstatement
of the financial statements.

Types of Misstatements:
a. Misstatements arising from misappropriation
of assets.
b. Misstatements arising from fraudulent
financial reporting.
 ASSET
MISAPPROPRIATION:
• Occurs when a perpetrator steals or misuses
an organization’s assets.
• The dominant scheme perpetrated against
small business and the perpetrators are
usually employees.
• Can be accomplished through embezzling
cash receipts, stealing assets, or causing the
company to pay for goods or services that
were not received.
ASSET MISAPPROPRIATION COMMONLY
OCCURS WHEN EMPLOYEE:
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
Fraudulent Financial Reporting – it 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.
THREE COMMON WAYS IN WHICH FRAUDULENT
FINANCIAL REPORTING CAN TAKE PLACE:

1.Manipulation, falsification, o 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:
1.Incentive to commit fraud.
2.Opportunity to commit and conceal the fraud.
3.Rationalization – the mindset of the fraudster
to justify committing the fraud.
A.Incentive / Pressure
This may exist when management is under pressure,
from sources outside or inside the entity, to achieve an
expected earnings target or financial outcome.
B.Opportunities
• May exit when an individual believes internal control
can be overridden.
C.Rationalization
• 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.
INCENTIVES OR PRESSURES TO
COMMIT FRAUD
Incentives relating to asset misappropriation
includes:
• 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.
THE INCENTIVES INCLUDE THE FOLLOWING
FOR FRAUDULENT FINANCIAL REPORTING:
• Management compensation schemes
(Other financial pressures for either
improved earnings or an improved balance
sheet)
• Debt covenants
(Pending retirement or stock option
expirations)
THE INCENTIVES INCLUDE THE FOLLOWING
FOR FRAUDULENT FINANCIAL REPORTING:

• Personal wealth tied to either financial

results or survival of the company.
• Greed – for example, the backdating
of stock option 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.

Opportunities that the top managements should

consider:
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.
Opportunities that the top
managements should consider:
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.
 Opportunities that the top
managements should consider:
Ineffective monitoring of management by
the board, either because the board of
directors is not independent or effective,
or because there is domineering manager.
Complex or unstable organizational
structure.
Weak or nonexistent internal controls.
 RATIONALIZING THE
FRAUD
Rationalizing the Fraud
• For asset misappropriation,
personal rationalization often revolves
around mistreatment by the company,
or a sense of entitlement by the
individual perpetrating the fraud.
 COMMON RATIONALIZATION FOR
ASSET MISAPPROPRIATION
• Fraud is justified to save a family member or a loved one from
financial crisis
• We will lose everything 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 four
 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 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
 RISK FACTORS CONTRIBUTORY TO
MISAPPROPRIATION OF ASSETS
This involves the theft of an entity’s assets and is
often perpetrated by employees in relatively small and
immaterial amounts.
Misappropriation of assets can be accompanied in
a variety of ways:
• Embezzling receipts
• Stealing physical assets or intellectual property
• Causing an entity to pay for goods and services not received
• Using an entity’s asses for personal use
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
created by the following:
a. Known or anticipated future employee benefit.
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. This increases when:
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.
 B. OPPORTUNITIES
2. Inadequate internal control over assets may
increase the susceptibility of misappropriation of
those assets. It could occur because of:
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.
 B. OPPORTUNITIES
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.
g.Inadequate physical safeguards over cash,
investments, inventory, or fixed assets.
h.Lack of complete and timely reconciliations of
assets.
 B. OPPORTUNITIES
i. Lack of timely and appropriate documentation of
transactions.
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 risk related to
misappropriation of assets.
2.Disregard for internal control over
misappropriation of assets by
overriding existing controls of by failing
to correct known internal control
deficiencies.
 C. ATTITUDES /
RATIONALIZATIONS
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
May be accomplished by:
• Manipulation, falsification, or alteration of
accounting records or supporting documents 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.
 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.
THANK YOU
FOR
LISTENING!