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How companies carry out fraudulent activities despite the presence of GAAP

“GAAP principles have been developed by the accounting profession over the years to
provide a consistent system of financial reporting in a constantly changing environment”
From the earliest days of accounting up through the first third of the 20th century, GAAP
were developed through common usage.

The primary purpose of GAAP is to help accountants provide relevant and comparable
information. In other words, financial accounting practices should produce information that is
relevant to the decision made by financial statement users. GAAP identify uniform practices
that make financial statements more understandable and useful.

“The ground rules used by business entities in presenting financial information are called
generally accepted accounting principles (GAAP).” Jack L. Smith.

The principles of GAAP:

The most important principles of GAAP are

1. Business entity concept


2. Periodicity concept
3. Going concern concept
4. Cost principles
5. Accrual concept
6. Cash concept
7. Conservatism concept
8. Consistency concept
9. Double entry concept
10. Objectivity principle
11. Stable dollar concept
12. Matching concept

GAAP PRINCIPLES

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Business Entity Concept: Data gathered in an accounting system relate to a specific
business unit of entity. The business entity concept assumes that each business has an
existence separate from it’s owners, creditors, employees, customers, other interested parties
and other business.

Periodicity Concept: Accounting to periodicity concept or assumption an entity’s life can be


meaningful subdivided into time periods (such month or years) for purposes of reporting the
results of its economic activities.

Going Concern Concept: Unless strong evidence exists to the contrary, accountants assume
that the business entity will continue operations into the indefinite future. Accountants call
this assumption the going concern or continuity assumption.

Cost Principle: Assets such as land, buildings, merchandise and equipment are typical of the
many economic resources that will be used in producing revenue for the business. The
prevailing account is that such assets should be used at their cost. When we say that an asset
is shown in the balance sheet at its historical cost, we mean the original cost of the asset to
the business entity; this amount may be very different from the asset’s current market value.

Accrual Concept: Accounting that recognizes revenues and expenses as they occur, even
though the cash receipt from the revenue or the cash disbursement related to the expense may
occur before or after the event that causes revenue or expense recognition.

Cash Concept: After accrual transaction when we receive or pay cash in form of revenue or
expenses then we record it in our accounting book. It’s not a fact when the transaction has
happened but main thing is receiving or paying cash in this concept.

Conservatism: Conservatism in accounting relates to making judgments and estimates that


result in lower profits and asset valuation estimates rather than higher profits and asset
valuation estimates. Accountants try to avoid wishful thinking estimate that could result in
overstating profits for a current period.

Double entry Concept: Double entry concept means each entry has two sides one is debtor
and the other is creditor. In this concept only those transactions are recorded which creat
effect on business directoty.

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Objectivity Concept: objectivity is the posy entry measurement. That means what is
actually happened; take place in the accounting book. We take the information from different
documents. For example:- sales document, purchase invoice, property deeds and transfers of
title and put that amount in the financial statement. There is no place of subjectivity in our
accounting book that means pre-entry measurement.

The stable dollar concept: Money is the unit of measure employed in recording financial
transactions. Knowing the money values assigned to financial transactions enables the user of
financial statements to estimate the profitability of a business enterprise. The dollar is not a
precise and unchanging unit of measure. A dollar of previous is not the same as dollar of
today because the effects of inflation. The value of dollar changes over time but accountants
cannot build useful statements with unstable units of measurement. Therefore a financial
statement is prepared on the basis of stable dollar concept.

Consistency Concept: Consistency means in the matter of depreciation if the company uses
straight-line method then the company must use this method in each period.

Matching concept: All expense of the accounting period must be matched against the
revenue earned in the period. If a benefit has been consumed, the effect must be recorded
weather or not documentation has been received. This argument is referred to as the
matching concept.

Background on fraudulent:

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) placed a


report that examined fraudulent financial reporting from 1987–97 by US public companies.

Some of the most critical insights of the study are as follows:

(a) The companies committing fraud mostly were small, and 78% of the samples were not
listed in the New York or American Stock Exchanges.

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(b) Incidences of fraud went to the very top of the organizations concerned; in 72% of the
cases, the CEO appeared to be associated with the fraud, and in 43% the CEO was associated
with the financial
statement fraud.

(c) The audit committees and boards of the respective companies appeared to be weak. Most
audit committees rarely met, and the companies’ boards of directors were dominated by
insiders with
significant equity ownership and apparently little experience of serving as directors of other
companies. Twenty-five per cent of the companies did not have an audit committee.

(d) The founders and board members owned a significant portion of the companies. In nearly
40% of the companies, authorizations for votes by proxy provided evidence of family
relationships among the directors and officers. The founder and current CEO were the same
person or the original CEO, President was still in place in nearly half of the companies.

(e) Severe consequences resulted when companies committed fraud, including bankruptcy,
significant changes in ownership and suspension from trading in national exchanges detecting
falsified financial statements.

Why GAAP principles fail to prevent fraud:

Before, financial reporting was based on GAAP that were relatively easy to
apply. International and British accounting systems are still based on GAAP. They do so,
based on the fact that accounting rules are easy to evade and provide a false certainty
regarding the accuracy of a financial statement at a given point in time.
Accounting has evolved to highly complex practices and like alcohol prohibition laws, can be
evaded. Some companies manipulate such opportunities to improve accuracy or to
artificially inflate earnings. These alterations are not covered by the specific accounting
rules. Through such practices, the government has encouraged firms to abide technically to
the rules.
Polls demanded from corporations to provide financials reports in black and white without
any gray area regarding profits. But in practice, accounting is full of gray areas according to

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textbook definition of accrual accounting. This includes documentation of expected cash
business transactions and the expectations involve assumptions, estimates, and interpretation.
Matching principle of accounting says that expenses should be recognized in the period when
the revenue was generated. But exceptions to this rule such as difficulty in estimation of the
expenses spread over multiple periods occur.
Assets are becoming more difficult to value since they compromise of intangibles such as
goodwill, patents and brand names. It is difficult to assign values for such assets and in many
occasions these forecasts are not appropriately estimated. Such inaccuracy might not be
apparent over several years. Pointing faults at auditors is not a viable way as estimating
values of assets may vary from industry to industry and within the same industry. Auditors
can only conform to the fact that their methods are consistent with GAAP.

Fraud:

There are various reasons why people are provoked to adopt unethical means to reap out
benefits for self interest and auditors are no different. It does not mean that all auditors are
potentially capable of frauds. However, these are the people who have first hand access to
accounting data and any fraudulent financial reporting that occurs, the first finger is generally
directed towards them. Over the years, it has been a proven fact that auditors have a big part
in committing frauds in various major companies of the world.
The term ‘fraud’ includes all acts committed by a person/s with an intention to deceive. The
acts include false statement, active concealment, deception, omission etc. Fraudulent
financial reporting includes intentional misstatements, omissions, and lack of disclosures for
the purpose of deceiving interested parties. Another view of application of frauds in financial
reporting is: fraudulent practices include the deliberate misapplication of accounting
principles; for example recognizing premature revenue, overstating receivables or inventory,
disregarding liabilities, and shifting current expenses to future periods by capitalizing costs
that should have been expensed. These practices are also referred as management fraud
because of the active support and participation of management to persuade such practice.
Most techniques for manipulating profits can be grouped into three broad categories:

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changing accounting methods, fiddling with managerial estimates of costs, and shifting the
period when expenses and revenues are included in results.

The following are some common schemes used to capitalize on fraud:


• Using accounts receivable: The most common variety of fraud occurs by diverting
customer payments for personal use. The process is as simple as opening a bank
account using a similar name to the company's and depositing checks meant for the
company. The employee may conceal this fraud by using the payment from another
customer to credit the account of the customer whose payment the employee diverted
to the bogus company account.
• Inventory fraud: This occurs when an employee appropriates business inventory for
personal use. The inventory items that are small and easy to conceal are the most
vulnerable. In addition to stealing for personal use, stolen inventory is also used for
resale. An inventory record may show 50 items however there may be less items
stored in the warehouse. The rest items find their way to person in charge. Similarly,
the inventory supplier may be directed to deliver portions of the stock to several
locations, one of which will be controlled by the employee.
• Purchasing fraud: The purchase operation is particularly vulnerable to fraud. The most
common practice is paying invoices to a fictitious company. The employee creates a
fake entity into the company's books as a vendor and the invoices from the fake
vendor get processed.
• Cash fraud: Cash frauds occur in several ways. Employees may use company checks
to withdraw cash directly or pay personal expenses and post the transactions to
various expense accounts. Another way is to simply remove part of the cash before it
even enters into the books.
Professor Felix Pomeranz explains some of the causes behind fraud in his journal ‘Fraud: the
Root’:

Recessions:

Executives often have to make future business forecasts and commitments based on hope and
predictions. However, amidst uncertainty not all of their actions are successful. During
recessions these executives who have made extravagant forecasts and commitments may be

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trapped because of economic down turn. ‘Such individuals have limited options: they can
accept dismissal; seek mercy by citing mitigating circumstances; or cook the books’
(Pomeranz, Fruad: ‘The Root’).

Employee Disaffection:

All industries in America today go through restructuring processes due to changes in


strategies, globalization, economic growth, technological innovation, etc. As a result layoffs
are common. Thus employees are at constant threat of being replaced by radical technology
or other competitive specialized employees. As a result they may become potentially
hazardous for committing frauds. In the past fraud driven by individual weaknesses and
needs, this is still so but new forms of fraud have emerged in the US.
Surveys show most employees would engage in dishonest activities if they believe that their
acts are rational to themselves. This is termed as the equal opportunity employer. Moreover, a
new type of 'macho' thief has emerged; he or she has always felt misunderstood and
unappreciated; accordingly, he or she may set out to 'show the boss who is smarter'
(Pomeranz, Fruad: ‘The Root’).

Indifference to Internal Control:

Internal control is a strong mechanism for prevention of fraud. The late Criminologist,
Donald Crissey provides three basics before fraud can take place. These are: an object worth
stealing, a potential employee willing to steal and an opportunity to commit the crime.
According to Cressey, successful internal control involves keeping potential fraud committers
away from the asset and away from the opportunity and knowledge of the asset by policies,
procedures, devices etc. A survey by Audit Commission in 1987 concludes that there is an
alarming lack of internal control mechanisms which are emphasized in text books. In most
cases one individual had absolute control on a particular process and there was no steps taken
to insure such lack of internal control.
In many cases lack of internal control mechanisms results from negligence on the basis of
employee integrity; mangers simply take it granted that they do not have such employees.

Erosion of Business Ethics and Difficulty of Teaching Ethics:

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Former commissioner to SEC, Roberta S. Karmel wrote on declining ethics and comments
1985 as the era of greed. She concedes that greed and market based solutions had become
synonymous in 1985. About 350 companies in between 1985 and 1995 reported of
questionable payments. However, the amounts were small relative to the size of the
corporations and only 3% was contributed by public companies. This widely reported low
ethics and morale has spurred companies to offer courses on ethics. But teaching ethics is not
an easy task. Ethicists like the late Fulton J. Sheen ascribed that ethics cannot be taught but
have to be practiced. Followers of the economists Milton Friedman believed that mangers are
constrained by laws and business strategies with minimal ethics. However, most people now
recognize the impact of dealings not related to stakeholders but carried by unethical means.
Then again, the outside world has a perspective of morality and ethics as relative and not
world standards and there is a difference of what is considered morally right.

Technological Enhancements:

Technological enhancement has facilitated some fraud. Technology has led to the
development of sophisticated fraudsters. Obsolete systems resulting from increase in volume
of activities and unforeseen transactions that were not accounted by the system have
facilitated fraud. However, founder of Association of Certified Fraud Examiners, Joseph
Wells, argues that it is not the sophistication of fraudsters but the fact that fraud is not well
concealed and most frauds are discovered by accidents.

Safeguards Lag Irregularities:

Historic pattern shows that inclination to entrepreneurialism has outraced the pace at which
reforms regarding appropriate controls are carried out into system.

Skepticism of Auditors:

In the US most external and internal auditors have detected few frauds leading to business
upheavals. A senior official in the US General Accounting Office (GAO) states that much of
the savings and loan failures caused my management fraud were not detected by auditors.
The American Institute of Certified Accountants has been slow to be up to date with its own
rules on audit skepticism and has not devised proper methods to supplement auditor’s
responsibility to detect fraud. SEC provides ground rules on audit skepticism which states

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carry out procedures with a healthy attitude where questions may arise and seek explanations
especially to those issues which individuals divert to stop further inquiry. However, fraud
detection continues to be a secondary objective by auditors.

Examples:

A) Audit Fraud has been a familiar subject to everyone and the most common example is of
Enron and Arthur Anderson.
A few years back Enron was accused of fraudulence and eventually it had to shut
down the whole organization as it went bankrupt. According to some people the main
problem occurred in the management level and it is not exactly an auditor’s job to track such
fraudulence. Auditors rely on the information sent by the employees as such was the case in
Enron, said by Robert McAdams, managing partner for Carneiro, Chumney & Co.
Regarding Enron’s case the auditors were not at a fault because they were working on the
information given to them by the management. Therefore auditors should not really be
blamed because ‘Accounting rules are not designed to detect fraud’ as said by Goode. The
accounting rules are more like yardsticks for comparing one company with another. Usually
when the auditors submit their reports they do not give a hundred percent assurance
because wrong information might be provided to them by the most trusted employees of the
organization.
On the other hand there was an investigation carried on against the fraudulency that
occurred at Enron. According to them Enron and the CFO Andrew Fastow had a
collaboration and they had concealed debts and inflated their profit amount as a result Mr.
Fastow earned more than $30 million. The auditors knew about this but instead of taking
actions against this they went along with the whole thing so in a way the auditors were
responsible. The board audit committee blamed the six-member panel because the report
that they prepared showed significant defects in results and controls. The audit committee
did not report to the higher order and they also had a good relationship with the company
which aroused suspicions although audit committee members refused such allegations.
They said that Enron hid information and misled them. Whereas Enron’s Vice President
Sherron Watkins expressed in a letter the lack of involvement in deciding which law firm to
chose in order to conduct the investigation on the partnerships and Enron’s finance and
public image. The audit committee gets to choose the law firm who will be conducting
investigation, "That's the only way you maintain the integrity of the company," says

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Roderick M. Hills, a former Securities and Exchange Commission chairman. Rather in
Enron the management decided to choose Vinson & Elkins, a Houston law firm, although
they were involved in some legal issues and that they commented the whole situation to be
not wrong even when Enron did not show the debt in the records and failed to mention the
accounting problems.

[Thomas, M.W. (March 1, 2002). Enron Auditors Were Not Trained To Detect Fraud. San
Antonio Business Journal.]

[Lublin, J. S. (February 1, 2002). Enron Audit Panel Is Scrutinized For Its Cozy Ties With the
Firm. The Wall Street Journal.]

B) Waste management received two suits for its accounting scandal, one was filed by U.S
Securities and Exchange Commission (SEC) in U.S. District Court and another one was a
class-action suit which was filed by its shareholders.

1) The first lawsuit was to claim that the former top executives of Waste Management Inc.
took part in a massive financial fraud that inflated the company's earnings and allowed
them to reap millions in personal profits and other benefits. The SEC suit seeks to have the
defendants return their allegedly ill-gotten gains and pay civil fines and it also seeks to bar
them from serving as corporate officers or directors and would prohibit future securities-law
violations.
Dean Buntrock, Waste Management founder and former Chief Executive, was a driving
force behind the alleged fraud. And it included the concerned top officers of the company as
well. These defendants tended to cook the books under the help of Arthur Andersen LLP,
which was one of its auditors, to meet company’s desired profit which could protect their
jobs and cheat unsuspecting shareholders. They repeated rosy earnings projections to
mislead the investors. Andersen and three of its audit partners also were fined $7 million by
the SEC in connection with the Waste Management audits, this was the largest fine ever paid
by a Big Five accounting firm in an enforcement action brought by the watchdog agency.
2) The second suit was a class-action suit which was filed in July 1999 and relates to conduct
around the company's 1998 merger with USA Waste Services Inc. and a 1999 accounting
scandal that triggered a stock plunge. Waste Management and its executives came under fire
from shareholders after the company twice revised reported earnings in 1999 and took a $1.8

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billion write-off. The company now agreed to pay $457 million to settle a class-action lawsuit
alleging securities-law violations and said it expects to receive $20 million in a related
settlement with its auditor. The company also said its auditor, Arthur Andersen LLP, settled
a suit that alleged "professional malpractice" by the accounting firm in relation to the alleged
securities violations. That suit was brought in a Texas state court in Harris County by
shareholders on behalf of Waste Management.

Maurice Myers, the new chairman and CEO of Waste Management, said that it had
maintained Andersen to help clean up the books after the accounting problems, but no
longer needs it. The new Waste Management with a new executive team has enforced a new
strategy and the company has chosen Ernst & Young as a partner right now to handle its
account. And the company also said it would recommend a binding resolution to require
annual elections of all directors to ensure better oversight.

Conclusion:

It is true GAAP provides guide lines for a better interpretation of the company’s stand, but
companies identify loop holes and use them to perform fraudulent activities. Better
enforcement of GAAP implementation is needed in order to confiscate the fraudulent
activities and monitoring by the authority is needed comprehensively in order to pinpoint
the further loop holes.

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