Financial Statement Fraud: An analysis

What is Financial Statement Fraud

Financial statement fraud is an intentional modification of a company's financial statements to deceive users of financial information and convey a glowing picture of the company's net worth, financial position, and Cash flows. This usually includes understating assets, income and profits, and overstating liabilities, expenses and losses. Financial statement fraud is usually facilitated by management to achieve the desired goals. Company management can misrepresent financial statements in order to make the stock attractive to investors and, as a result, manipulate the stock price. In addition, management can misrepresent financial statements to justify bonuses and high salaries given to the employees of the company. This usually happens when management compensation is related to the company's performance.

Why Financial Statement Fraud is committed

The main reason for financial statement fraud is that the company's position looks better on paper. Financial statement fraud is not always motivated by one person, but it is committed by many. Many other reasons for financial statement fraud include:?

• To increase the market capitalization of listed stock.?
• To project inflated sales that lead to more profits so that the company can pay more dividends.?
• To avoid false market perceptions.?
• The main reason is to raise funds for the company and, if already funded, to get better funding terms.?

Hence, due to contextual pressure and the potential to commit fraud, company management is motivated to change the appearance of annual financial statements to give the users of financial statements a different perspective of the company.

Types of Financial Statement Fraud

Financial statement fraud can take several forms:?

1. Overstating revenues by recording expected future sales.?
2. Inflate net worth of assets due to deliberate failure to apply a proper depreciation schedule.?
3. Hide commitments and/or liabilities from the company's balance sheet.?
4. False disclosure of related party transactions and structured finance transactions.?

Global data on Financial Statement Fraud?

As per the study conducted by the Association of Certified fraud examiners, financial statement fraud, in which the perpetrator deliberately causes a material misstatement or omission in an organization's financial statements, is the least common (10%) amongst the other operational frauds, yet most expensive category of business-related fraud, with an average loss of $ 954,000.?

Most industry sectors develop fraud control mechanisms to protect themselves from the greatest threats. Despite different anti-fraud measures in developed in each industry sector, the percentage of financial statement frauds committed varies from industry to industry, with the highest percentage of financial statement frauds committed in the construction industry at 25%, followed by the manufacturing industry at 18% and the real estate industry at 15%, whereas the industry sectors with lowest fraud rates are government and public administration at 4%, and transportation and warehousing at only 3%.?

Among the high-risk departments in an organization that commit financial statement frauds, 30% of the executive/ upper management is involved, followed by 15% of the accounting department, 14% of the finance department, whereas in contrast, only 1% of the customer service department is involved financial statement fraud.

It is crucial to understand that internal control weakness is the primary reason due to which such frauds are committed in an organization. The factors that contribute to the internal control weaknesses are:?

• Lack of reporting mechanism: 1%;?
• lack of clear lines of authority: 2%;
• lack of employee fraud education: 3%;
• lack of competent supervisory personnel in the management: 6%;?
• lack of independent checks/audits: 5%; and
• others: 6%.?

However, the lack of internal control is more common in small and medium-sized companies than large companies; override of internal control is more common in large companies than in small and medium-sized enterprises.?

Preventive measures to prevent financial statement fraud

The role of internal audit in fraud prevention and detection Internal audit detects and prevents fraud:?

• Identify potential hazard signals.?
• Understand the characteristics of fraud and the specific techniques, schemes, and scenarios used to commit fraud.?
• Evaluate fraud indicators to determine if further action or investigation is needed?
• Check the effectiveness of controls to prevent or detect fraud?

How can Internal Auditors identify and prevent financial statement fraud?

Fraud is arguably one of the greatest corporate governance risks facing businesses, regardless of industry, size, or jurisdiction. Internal audit not only reduces the financial and reputational impact of fraud, but also plays an important role in preventing harm to business goals. Following are some measures that an Internal Auditors can take to detect and prevent financial statement fraud:?

Check the detection control

By reviewing the annual plans to make sure that detective controls are as strict as preventive measures. This makes it more likely that fraud will be identified by such control and preventive measures. Detection can extend to whistle blower arrangements where the reporting of fraud can prevent the fraud. Internal auditors should work with senior management of the company to ensure that whistle blower practices do not discourage employees from stepping forward at critical moments in the business.?

Providing training on the risk of fraud?

Regular training keeps audit professionals informed of more sophisticated fraud methods and systems in the modern world. Data monitoring and analytical skills should also be considered important as they are increasingly effective in reducing fraud losses and duration by identifying fraud schemes based on anomalous trends and patterns.?

Invest in audit management software?

Risk-based audit management solutions help streamline data mining while providing a real-time view of information that can reveal fraud. It is also useful for reviewers.?

? Evaluate the effectiveness and application of controls and the reliability of data?

? Determine the adequacy of controls to protect assets?

? Evaluate compliance with policies, procedures, and legal obligations?

? Establish partnerships and active communication with management?

? Promote financial and accountability at all levels?

? Investigate financial deficiencies?

? Identify and make recommendations to mitigate the risk of fraud

Conclusion

Though different laws have been enacted by relevant government agencies in each country to ensure that companies report true financial information in good faith while protecting the interests of investors and shareholders, however, while safeguards are in place, it also helps investors know what to look for when reviewing a company's financial statements.

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