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
• 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
• 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

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 may increase the susceptibility of
assets to misappropriation.

For example, 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
naisappropriated.
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 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.