Fraud in Financial reporting

 The Association of Certified Fraud Examiners (ACFE) defines accounting

fraud as:

“Deception or Misrepresentation that an individual or entity makes knowing

that the misrepresentation could result in some unauthorized benefit to the
individual or to the entity or some other party."

Put simply, financial statement fraud occurs when a company alters the
figures on its financial statements to make it appear more profitable than it
actually is, which is what happened in the case of Enron.
Frauds in financial reporting
 Frauds in financial reporting  is the intentional misrepresentation of a firm’s
financial statements with the aim to give investors a mistaken impression about the
firm’s operating performance and profitability.

 Fraudulent financial reporting occurs due to:

1. personal incentives

2. pressures from the market

3. lack of ethics

4. deliberate compliance with the projections of financial analysts

5. attempts to affect the price of stock

Methods

 Fictitious or Overstated Revenues and Assets.

Fraudsters use any of multiple methods to create fictitious revenues or assets in order to
inflate income on financial statements. A slightly different approach is simply to overstate
income—either by omitting elements that would lower actual revenues (such as returns of
purchases) or by using mark-to-market accounting to make records of (future) income more
"flexible."
 Fictitious Reductions of Expenses and Liabilities.
Perpetrators improve the bottom line on financial statements using unscrupulous approaches
—fictitious reductions of expenses and liabilities—to mask a corporation's true losses or debt.
 Premature Revenue Recognition. Premature revenue recognition is a means of recording
income as actual in order to inflate earnings totals when sales have not been completed,
the products delivered, or invoices paid. Misclassified Revenues and Assets. Securities
investments have been widely misclassified by fraudulent corporate chiefs.
 Financial statement Red Flags
 can signal potentially fraudulent practices. The most common warning signs include:

 Accounting anomalies, such as growing revenues without a corresponding growth in 

cash flows.

 Consistent sales growth while competitors are struggling.

 A significant surge in a company's performance within the final reporting period of a fiscal year
.

 Depreciation methods and estimates of assets' useful life that don't correspond to those of the
overall industry.

 Outsized frequency of complex third-party transactions, many of which do not add 

tangible value, and can be used to conceal balance sheet debt.

 The sudden replacement of an auditor resulting in missing paperwork.

 A disproportionate amount of management compensation derived from bonuses based on 

short-term targets, which incentivizes fraud.
 Financial Statement Fraud Detection Methods

Vertical and horizontal financial statement analysis introduces a straightforward approach to

fraud detection. 
 Vertical analysis involves taking every item in the income statement as a percentage of
revenue and comparing the year-over-year trends that could be a potential flag cause of
concern.
 A similar approach can also be applied to the balance sheet, using total assets as the
comparison benchmark, to monitor significant deviations from normal activity.
 Horizontal analysis implements a similar approach, whereby rather than having an
account serve as the point of reference, financial information is represented as a
percentage of the base years' figures.
 Comparative ratio analysis likewise helps analysts and auditors spot accounting
irregularities. By analyzing ratios, information regarding day's sales in receivables,
leverage multiples, and other vital metrics can be determined and analyzed for
inconsistencies.
Financial reporting Fraud- Types
 These types of fraud can be thought of as the three M's of financial reporting fraud:

 (1) Manipulation, (2) Misrepresentation, (3) Misapplication.

Ways of Financial reporting Frauds

 1. Recording revenue before it is earned

 2. Creating fictitious revenue
 3. Boosting profits with nonrecurring transactions
 4. Shifting current expenses to a later period
 5. Failing to record or disclose liabilities
 6. Shifting current income to a later period
 7. Shifting future expenses to an earlier period
 Fraud Prevention - Internal Controls:

Internal controls are the most essential element in managing risk.

The absence or lapse of internal controls in an organization is a tempting

open door or opportunity for fraud.

Internal controls were defined in the COSO Report as

"a process, effected by an entity's board of directors, management and

other personnel, designed to provide reasonable assurance regarding the
achievement of objectives in the following categories:

• Effectiveness and efficiency of operations,

• Reliability of financial reporting, and

• Compliance with applicable laws and regulations."

Controlling Fraudulent financial reporting

 Fraudulent reporting can be controlled with external auditing, regulations and an

independent board of directors. However, an ethical corporate culture is the main
prerequisite for fair financial reporting

 A mathematical approach known as the Beneish Model evaluates eight ratios to

determine the likelihood of earnings manipulation, including asset quality,
depreciation, gross margin, and leverage. After combining the variables into the
model, an M-score is calculated.
 Satyam – Enron of India
 Fourth largest Indian IT company listed in India and US
 55000 employees and USD 2-00 Bn annual revenue
 600 plus customers including 200 Fortune 500 Cos
 Operations in 66 countries
 Financial Advisor : Merril Lynch
 Bankers: CITI , HSBC,HDFC, BNP Paribas
 Auditors : PWC
 Satyam – Fraud ( 2006-08)
 Fudging of accounts
 Overstated assets of Rs. 500 Crores
 Fake cash Balance of Rs.5000-00 crores in bank accounts
 Understated liabilities of Rs.1230-00 score
 Rs.7000-00 Crores fake invoices

Impact:
Investors lost Rs.10,000-00 crores in market capitalization
Chairman, MD,CFO, Auditor, key associates were behind the bar
Huge damage to brand india
 Fraud Identification
 J-Score, a statistical equation based forensic rating model to identify creative accounting practices
 Compares ratios of published financials to arrive at red flags, which are assigned numeric values to arrive at
score to identify frauds
 Considers more than 100 red flags associated with different elements of financial statements
Legal landscape