Misstatements arising from misappropriation of assets
Misstatements arising from fraudulent financial reporting
Give and explain the elements of the fraud triangle.
Give and explain the risk factors that contribute to misappropriation of assets.
Explain who is primarily responsible for the prevention and detection of fraud in a business enterprise.
Give and explain the risk factors that contribute to fraudulent financial reporting.
Definition of Fraud
Fraud is an intentional act involving the use of deception that results in a material misstatement of the financial statements.
Two types of misstatements relevant to an auditor’s consideration of fraud:
Misstatements arising from misappropriation of assets.
Misstatements arising from fraudulent financial reporting.
Intent to deceive distinguishes fraud from errors.
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 businesses and the perpetrators are usually employees.
Asset misappropriations can be accomplished in various ways, including:
Embezzling cash receipts
Stealing assets
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
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 some other negative financial outcome.
Three common ways in which fraudulent financial reporting can take place include:
Manipulation, falsification, or alteration of accounting records or supporting documents.
Misrepresentation or omission of events, transactions, or other significant information.
Intentional misapplication of accounting principles.
The Fraud Triangle
The three elements of the fraud triangle are:
Incentives 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.
Addictions to gambling or drugs.
Incentives for fraudulent financial reporting include:
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.
Opportunities to Commit Fraud
Some of the opportunities to commit fraud that top management should consider include:
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 by the individual perpetrating the fraud.
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 a 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 Misappropriations 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.
It can be accompanied by a variety of ways including:
Embezzling receipts
Stealing physical assets or intellectual property
Causing an entity to pay for goods and services not received
Using an entity’s assets for personal use.
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
Personal financial obligations may create pressure on management or employees with access to cash or other assets susceptible to theft to misappropriate those assets.
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
Certain characteristics or circumstances may increase the susceptibility of assets to misappropriations. Opportunities to misappropriate assets increase when following situations exist:
(a) Large amounts of cash on hand are 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.
Inadequate internal control over assets may increase the susceptibility of misappropriation of those assets. Examples:
(a) Inadequate segregation of duties or independent checks.
(b) Inadequate oversight of senior management expenditures, such as travel and other reimbursement.
(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.
(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/Rationalization
Disregard for the need for monitoring or reducing risks related to misappropriation of assets.
Disregard for internal control over misappropriation of assets by overriding existing controls or by failing to correct known internal control deficiencies.
Behavior indicating displeasure or dissatisfaction with the entity or its treatment of the employee.
Changes in behavior or lifestyle that may indicate assets have been misappropriated.
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.
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 earnings target or financial outcome - particularly since the consequences to management for failing to meet financial goals can be significant.
B. Opportunities
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. Rationalization
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.