CHAPTER 14 FRAUD AND ERROR

INTRODUCTION

In the previous chapters, corporate governance has been described as the process by which
the owners and various of 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 can 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 front 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 more lavish
• Pressure from family, friends, or the culture to live 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
• Pending retirement or stock option expirations
• Personal wealth tied to either financial results or survival of the company
• Debt covenants
• 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. Although this may sound obvious that is, "everyone
has an opportunity to commit fraud" - it really conveys much more. It means not only that 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 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 (such as, "the company owes me!") 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 a 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 susceptibility of assets to misappropriation.
For example, may increase the opportunities to misappropriate assets increase when
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.

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 reconciliations 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. Attitudes / Rationalizations
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), accounting records or supporting

documentation or alteration of 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

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 misstating the financial statements. In
some entities, management may be motivated to reduce earnings by a material amount to
minimize tax or inflate earnings to secure bank financing.

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.
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 weaknesses 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
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 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 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.