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Procedia Economics and Finance 28 (2015) 46 – 52

7th INTERNATIONAL CONFERENCE ON FINANCIAL CRIMINOLOGY 2015

13-14 April 2015,Wadham College, Oxford, United Kingdom

Roots of Responsibilities to Financial Statement Fraud Control

Norazida Mohameda*, Morrison Handley-Schachlerb
a
Faculty of Accountancy, Universiti Teknologi MARA, Kelantan Campus, Malaysia
b
Teesside University, United Kingdom

Abstract

Financial statement fraud cases also occur when weak internal controls exist. Besides these reasons, the research differentiates
between the two major types of financial statement fraud. This research discusses the responsibilities of financial statement fraud
control by looking at agency theory, stakeholder theory, public interest theory; capital needs theory and communication theory.
This discussion is in tandem with the principal investigation of internal control strategies in relation to financial statement fraud
control. The output of this paper provides a comprehensive understanding of responsibilities for financial statement fraud control
in the context of the above theories and finally contributes recommendations for improvement in financial statement fraud control
in public interest entities.

©
© 2015
2015 The
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PublishedbybyElsevier
ElsevierB.V.
B.V.This is an open access article under the CC BY-NC-ND license
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Peer-review under responsibility of ACCOUNTING RESEARCH INSTITUTE, UNIVERSITI TEKNOLOGI MARA.
Peer-review under responsibility of ACCOUNTING RESEARCH INSTITUTE, UNIVERSITI TEKNOLOGI MARA
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1. Introduction

The collapse of a number of large companies such as Enron Corporation (Moncarz et al., 2006), WorldCom
(Thornburgh, 2006), Global Crossing (Gomez, 2008) and Adelphia (Barlaup et al., 2009) at the turn of the 21 st
Century, after the publication of financial accounts which were found to be misleading, affected the confidence of
investors and led to legislative responses typified by the Sarbanes-Oxley Act 2002 in the United States.. These
accounting scandals raised general questions concerning the reliability of financial information in the US capital

* Corresponding author. Tel.: +6097417701

E-mail address: azida767@kelantan.uitm.edu.my

2212-5671 © 2015 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Peer-review under responsibility of ACCOUNTING RESEARCH INSTITUTE, UNIVERSITI TEKNOLOGI MARA
doi:10.1016/S2212-5671(15)01080-1
 Norazida Mohamed and Morrison Handley-Schachler / Procedia Economics and Finance 28 (2015) 46 – 52 47

market, the extent of market misconduct in the US and the responsibility of auditors in relation to financial
statement fraud detection (Razaee, 2002). More recent, further doubt was thrown on the reliability of accounting
practice in the relatively simple grocery business of retailing, when the major UK retailer Tesco revealed that
interim profits had been overstated by £250 million – over a quarter of the true figure (Felsted, Oakley and Agnew,
2013).
The subsequent attention to financial statement reflected an increasing number of global financial statement
fraud cases (PricewaterhouseCoopers, 2005). Research done by Skousen et al. (2008) explored examined the effects
of pressure and opportunity on the incidence of financial statement fraud. Financial statement fraud cases occur
where there are weak internal controls. Besides these reasons, the research differentiates between the two major
types of financial statement fraud. The first type of financial statement fraud committed by top management
involves misleading the company investors, which results in large losses to investors and diminishes the company’s
reputation and that of accounting professionals associated with it. Generally, the second type of financial statement
fraud might be committed by top or middle management concerned with fulfilling the company’s expectations,
particularly to earn bonuses and compensation.
This paper discusses the responsibilities for financial statement fraud control by looking at agency theory,
stakeholder theory, public interest theory; capital needs theory and communication theory. This discussion is in
tandem with the principal investigation of internal control strategies in relation to financial statement fraud control.
The output of this paper provides a comprehensive understanding of responsibilities for financial statement fraud
control in the context of the above theories. Finally, this paper also contributes recommendations for improvement
in financial statement fraud control in public interest entities.

2. Financial Statement Fraud

Financial statement fraud constitutes a variety of offenses in different jurisdictions. For example, in the UK it
constitutes false accounting under the Theft Act 1968, s.17, fraud by false representation under the Fraud Act 2006,
s.2 and potentially market abuse under the Financial Services and Markets Act 2000, s.118.The National
Commission on Fraudulent Financial Reporting (1987) defines financial statement fraud as reckless conduct by act
or omission that results in materially misleading financial statements. Grazioli et al. (2006) define financial
statement fraud as an intentional process of deception by the company management and KPMG (2005) explains that
financial statement fraud occurs when financial records have been falsified or manipulated or altered. However, this
goes beyond the requirements for intent in common law, where recklessness is sufficient to constitute the necessary
mens rea for most criminal acts. The Fraud Act 2006, s.2(3) requires only that the person making the false
representation “knows that it is, or might be, false or misleading,” while the Financial Services and Markets Act
2000, s.188(7) establishes an even lower threshold, only requiring that a person disseminating misleading
information to the market “knew or could reasonably be expected to have known that the information was false or
misleading.
Financial statement fraud may occur through the fabrication of numbers in the accounts or by the misapplication
and wilful misinterpretation of accounting standards (Rezaee, 2002; Spathis, 2002). A number of financial statement
fraud issues have been discussed in the literature. The Federal Bureau of Investigation (FBI) (FBI, 2010) and
Telberg (2004) identify improper revenue recognition and profit inflation as the most common forms of financial
statement fraud, with Fifth (2005) identifying the use of fictitious customers balanced by fictitious suppliers as a
common method of recording fictitious revenue. There have been proven cases where managers of listed companies
have committed financial statement fraud to increase share prices and attract company investors by inflating the
company’s profit (Kellogg & Kellogg, 1991). Other common types of financial statement fraud are delaying
financial disclosure and including false information in the company’s prospectus (Rezaee 2002; Cheng et al., 2006).
Such fraud not only breaches the Listing Requirements but also misleads the existing and potential investors in the
company. In relation to this, the motives for financial statement fraud are mainly (1) to increase the share price (2)
to attract the investors and (3) to “window dress” the company’s financial performance to meet the Listing
Requirements (Beasley et al., 1999).
48 Norazida Mohamed and Morrison Handley-Schachler / Procedia Economics and Finance 28 (2015) 46 – 52

3. Fraud Triangle Theories

3.1. Agency Theory

Ross (1973, p.134) describes agency as the prescribed relationship between the principal and agent in
‘essentially all contractual arrangements’. This is exemplified but the relationship created by the separation of
ownership in the form of the shareholders of a company from control in the form of management, which Berle and
Means (1932) identified as being the key problem at the root of undesirable corporate behaviour in the USA. In the
context of agency theory as proposed by Ross (1973), the agent, who is the manager, is supposed to act as directed
by the principal, who may be assumed to be giving directions in his own interest. If the company’s objects include
making a profit, the achievement of this object indirectly increases shareholders’ wealth. In the context of the
company, the manager is directed by the shareholder to achieve the firm’s objectives. While so doing, the
management is required to provide reliable financial statements to the shareholders to reduce agency risk – the risk
that the agent fails to carry out his duties as instructed or that he exercises less diligence in furthering the principal’s
stated interests than he would in pursuing his own (Ross, 1973; Eisenhart, 1989) or adopt a different attitude to risk
from the attitude which the principal would have personally adopted (Jensen and Meckling, 1976; Eisenhart, 1989).
Shareholders, as the company’s owners, provide capital and either (depending on whether it is a limited or unlimited
company) bear the risk of losing their paid in capital or bear all the financial risks of the business. These risks are
beyond their control if they are not involved with business operations. The responsibility to ensure all risks are
mitigated lies with the management of the company.
From the perspective of agency theory, directors and managers have a responsibility to ensure that true and fair
view financial statements are issued to the existing shareholders, to provide information on the quality of their
stewardship of the company. The directors’ role in overseeing financial accounting processes and the risk of
unethical behavior in this function creates an agency cost for the shareholders. In the context of the agency
relationship between shareholders and directors, financial statement fraud may be used to conceal the failure of
company directors in their duties towards the company’s shareholders. In this case, the financial figures are altered
and the company’s true activities are not reported to shareholders. They are consequently also concealed from
principals in other agency relationships, such as grant-awarding bodies, from some other stakeholders, including
bondholders, and from regulators.
Financial statement fraud may be a retrospective step in frauds committed by agents, where deliberate
misstatements are used to conceal poor, negligent or dishonest performance which has already occurred. However, it
can also constitute a preparatory step towards an intended fraud, where it used deliberately to conceal assets which
the perpetrator has earmarked for future theft. The nature of the misstatement in financial accounts will depend on
the pressure or motive behind it. If the motive is misappropriation of assets, the misstatement required will involve
the understatement of income and assets and the overstatement of expenses and liabilities, in order to conceal the
extent of equity which ought to be available to owners or the amount of unused grants repayable to funding bodies.
If the motive is to conceal poor or negligent performance, the misstatement required will involve the overstatement
of income and assets and the understatement of expenses and liabilities, in order to create a false and optimistic view
of performance.
An essential control to prevent financial statement fraud lies in the oversight of accounting systems by
independent non-executive directors who are not directly responsible for the operations of the firm but are charged
with the control of its systems and governance. The risk that non-executive directors will be highly influenced by
the executive directors is, however, high, especially as non-executives are also responsible for key strategy decisions
and for general oversight of company management and not only for the accounting system.

3.2. Stakeholder Theory

In addition to the relationship between agent and principal in the Agency theory and the responsibility of
company management in the theory of firm, the research discusses the stakeholders’ theories in the context of
business ethics, financial statement fraud issues and control. Freeman (2010) views the stakeholder theory as
organizational management’s theory that emphasizes the morals and values in business organization and emphasizes
responsibilities of company management to balance the shareholders financial interest against the interest of
 Norazida Mohamed and Morrison Handley-Schachler / Procedia Economics and Finance 28 (2015) 46 – 52 49

stakeholders. In relation to this, the present research is concerned on the stakeholders’ theories in the view of what
companies are supposed to deliver on the best interest of duties to the companies’ stakeholders. The stakeholders are
defined as any individual agency (Gray et al., 1996), shareholders, employees, creditors, bank, government and
communities (Gamble & Kelly, 2001). Smith (2003) asserts that company management has duties to ensure the
ethical rights in business conduct and ‘balance the legitimate interests of the stakeholders when making decisions’.
According to Friedman and Miles (2006), the normatively correct behaviour of company management practice can
be achieved by changing management attitudes to fiduciary relationships between management and other
stakeholders, which may be achieved by developing an awareness of the moral underpinning of the role of the firm
(Freeman et al., 2010).
In consequence, financial statement in a stakeholder theory context may be viewed as being the result of a wider
range of pressures than in a straightforward agency relationship. In a stakeholder theory context, there will be
pressure to commit financial statement fraud wherever the accountant responsible for producing accounts has been
captured by one stakeholder group which has a motive to present false information to another stakeholder group.
The stakeholder group best positioned to capture the accounting function is the one to which the accountants usually
belong, namely the employee group, with senior managers who have power over the accountants’ employments and
rewards being best placed within the employee group to capture the accounting function. While shareholders and
other funding stakeholders may still be viewed as potential victims in a stakeholder context, the stakeholder theory
of the firm presents other potential victims, especially customers and suppliers. This alters the balance of probability
between the deliberate overstatement of profits and deliberate understatement. As it is in the interests of customers
to demand more and better goods and services at a lower price and as it is in the interests of employees to demand
higher wages in return for less work, it is also in the interests of employees to falsify accounts in order to give the
impression that value added is already minimized and that reductions in price, increases in volume and
improvements in quality are impossible. Suppliers will, like employees, be seeking higher rewards for less work and
again, this presents employees with pressure to understate the value added in order to conceal any excess net income
which is available for redistribution backwards along the supply chain.

3.3. Public Interest Theory

In relation to the theory of the firm, Dodd (1932) considers the responsibility of the company management
towards society as a whole and not merely towards the company’s shareholders, on the basis that the firm is an
“economic institution which has a social service” and is concerned with public and not purely private matters. From
this perspective financial statement fraud in companies could affect the public interest, not merely affecting the level
of taxes paid to the public treasury, but also in concealing the misuse of company resources which were available for
general public use. In particular, financial statement fraud in regulated industries could be used to conceal excess
profits – rents obtained by company owners by the exploitation of the company’s position in the supply chain to
obtain inputs and an undervalue or to sell outputs at an overvalue. The under-reporting of profits could be used to
avoid regulatory action which would reduce profits and to reduce the attractiveness of industry-specific taxes. This
motive for financial statement fraud is different from the motive which can arise from the directors’ position as
agents of the shareholders, but both types of financial statement fraud constitute a breach of reporting duties in a
relationship of trust. In both cases, the manager seeks to conceal the misuse of assets which are not his own or to
conceal the assets with a view to future misappropriation. While Dodd (1932) evidently takes an unashamedly
socialist view of the firm as being public property, with the concept of private property essentially delegitimized, it
is worth noting that this does not introduce entirely new concepts of financial crime which would be absent in
capitalist systems. The public interest view of the firm still places reliance on the manager as agent or trustee
providing true and fair information to those to whom he is accountable. The defining difference between capitalist
and socialist systems is not a difference in the inherent nature of economic activity, but a difference in the
possession of power over and ownership of the means of production and trade. It is therefore to be expected that
those who are responsible for the conduct of these functions will have very much the same motive to lie about the
quality and honesty of their stewardship.
50 Norazida Mohamed and Morrison Handley-Schachler / Procedia Economics and Finance 28 (2015) 46 – 52

3.4. Capital Needs Theory

The foregoing theories, agency theory, stakeholder theory and public interest theory, all create pressure to
commit financial statement fraud as a result of managers’ obligations to report to broader or narrower groups of
people on whose behalf the firm is carrying on business. In other cases, however, the manipulation of financial
figures is used to manipulate participants in capital markets by smoothing reported profits and losses, temporarily
inflate profits, exhibit earnings growth (Lev, 1989),alter profit margins or the ratio between profit and assets,
circumvent borrowing restrictions or enhance apparent management performance (Whelan &McBarnet, 1999). In
mergers and acquisitions, the inflation of assets might also give rise to a misrepresentation of a company’s value if
placed under new management. Temporary overstatement of profits or smoothing of profits and losses may be used
to attract new investors and retain existing investors. If one group of buyers or sellers, such as senior managers who
own or wish to own shares in the company, has captured the accounting function, they may also use false reports to
increase the share price when they are selling and to lower it when they are buying. A further motive for
manipulation of share prices by means of false statements may arise where the acquiring firm is making an all-share
offer for the acquisition target and managers seek to reduce the number of new shares required to be issued and the
consequent dilution of existing shareholders’ rights in return for ownership of the target company.
Financial statement fraud cases have had a great financial impact upon the shareholders as they will have been
led to value their shares incorrectly as a result of the fraud and may have paid too much for them or failed to sell at
the best possible price at the best possible time. Thus, stringent control in regard to financial statement processes is
required to avoid the distortion of information relevant to the economic value of the company due to financial
statement fraud. Smith (2003) views accounting scandals and financial statement fraud cases as a result of failings
relating to the shareholder theory. The shareholder theory also relates directly to finance and hence capital needs and
emphasizes a responsibility of company management to maximize the shareholder returns (Friedman, 1970). Smith
(2003) states another responsibility of company management is to ensure the balance of financial interests of
shareholders and other stakeholders. In the meantime, Friedman (1970) emphasizes that one of the objectives of
commercial companies is to achieve the optimum profit. He states, “There is one and only one social responsibility
of business - to use its resources and engage in activities designed to increase profits so long as it.... engages in open
and free competition, without deception or fraud”. The deceptions of fraud in financial statements have had a huge
impact to the company shareholders and stakeholders (Smith, 2003). The alteration of figures in financial statement
has also led to misrepresentation of financial position; therefore, misleading the companies’ stakeholders to make
decisions, in particular investment decisions. This is a result of managers seeking to meet capital funding needs by
unfair means at the expense of shareholders and bondholders.
Financial statement frauds arising from capital needs differ radically from frauds arising from agency theory,
stakeholder theory and public interest theory. Purely capital-needs-driven frauds have as their sole purpose the
raising of new funds from investors. They therefore always require that profits are either overstated or presented as
being of higher quality, in other words more consistent, than they really are. While some cases of capital market
fraud, including some cases of insider trading, may require sellers of securities to be misled into believing that their
securities are worth less than they are, in all cases where managers are seeking more funds for the firm itself, the
nature of the fraud will be an overstatement of profit. This is not necessarily true of frauds in an agency theory
context and is in marked contrast to frauds explained by stakeholder theory and public interest theory.

3.5. Communication Theory

Communication Theory aims to provide an understanding of communication processes and improvements in

information provision (Gabor, 1952). The theory of communication is relevant to the efficiency of the public
dissemination of financial information to users of accounts, with the control of the financial statement production
process being one means of improving the efficiency and effectiveness of information dissemination. It is the
responsibility of management to issue reliable financial information reflecting the actual results of operations (Kuhn
2008). The effective dissemination of information does not occur where indicators of bad financial performance or
the risk of insolvency are suppressed and the public does not receive warning signals prior to the financial collapse
of the enterprise.
Xu and Liu’s (2009) study recognizes computer systems as a source of opportunity for fraud in financial
statements. According to their study, the fraud in the financial system could be perpetrated by those with access to
 Norazida Mohamed and Morrison Handley-Schachler / Procedia Economics and Finance 28 (2015) 46 – 52 51

computer systems at the network and the system access level and could involve use of the internet. System access
and the maintenance of independence of systems programming and maintenance staff from operational staff with an
interest in either concealing poor performance or concealing income and assets is therefore an essential control to
prevent financial statement fraud.

4. Conclusion

As a conclusion, the reliability of financial statements is desirable from the perspective of agency relationships,
fair treatment of stakeholders, the public interest, capital markets and the effectiveness of communication. Motives
for financial statement fraud may vary and different theories may be used to highlight different motives. Any
company could become a vehicle for financial statement fraud for a variety of reasons, with the directors being best
placed to perpetrate it. Segregation of duties between executive and non-executive directors and more generally
between employees responsible for performance and employees responsible for accounting and information systems
is therefore an essential part of an effective internal control system to mitigate the risk of fraud.

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