Financial Statement Fraud

Prevention and Detection

Zabihollah Rezaee, Richard Riley

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470543238
• Edition: 2
• Topic: Business
• Subtopic: Auditing
• Index: Business

Practical examples, sample reports, best practices and recommendations to help you deter, detect, and prevent financial statement fraud

Financial statement fraud (FSF) continues to be a major challenge for organizations worldwide. Financial Statement Fraud: Prevention and Detection, Second Edition is a superior reference providing you with an up-to-date understanding of financial statement fraud, including its deterrence, prevention, and early detection.

You will find

• A clear description of roles and responsibilities of all those involved in corporate governance and the financial reporting process to improve the quality, reliability and transparency of financial information.
• Sample reports, examples, and documents that promote a real-world understanding of incentives, opportunities, and rationalizations
• Emerging corporate governance reforms in the post-SOX era, including provisions of the SOX Act, global regulations and best practices, ethical considerations, and corporate governance principles
• Practical examples and real-world "how did this happen" discussions that provide valuable insight for corporate directors and executives, auditors, managers, supervisory personnel and other professionals saddled with anti-fraud responsibilities
• Expert advice from the author of Corporate Governance and Ethics and coauthor of the forthcoming Wiley textbook, White Collar Crime, Fraud Examination and Financial Forensics

Financial Statement Fraud, Second Edition c ontains recommendations from the SEC Advisory Committee to reduce the complexity of the financial reporting process and improving the quality of financial reports.

Part One
Financial Reporting and Financial Statement Fraud

Chapter 1
Financial Statement Fraud Defined

WILL HISTORY REPEAT ITSELF?

The existence and persistence of financial fraud continues to be of great concern for regulators and the business as well as the investment community. Since July 2002, the Department of Justice (DoJ) has obtained nearly 1,300 fraud convictions. These figures include convictions of more than 200 chief executive officers (CEOs) and corporate presidents, more than 120 corporate vice presidents, and more than 50 chief financial officers¹ (CFOs). To combat this problem, the 2002 Sarbanes-Oxley Act (SOX), also known as the Public Company Accounting Reform and Investor Protection Act of 2002, was signed into law. Despite changes in regulation and oversight, a question remains: Are we destined to suffer through more of these types of nefarious acts? Or more simply, will history repeat itself? Ironically, the answer is yes, according to the 2008-2009 KPMG Integrity Survey, which suggests the prevalence of corporate fraud and malfeasance.²

Consider the following.³

Basis of the Fraud	Older Example	Year	Recent Example	Year
Fictitious revenue, documentation forgery,	ZZZZ Best	1987	Enron	2001
and theft of corporate assets
Personal use of assets, false documentation, and financial statement fraud	Phar-Mor	1992	Adelphia	2002
Capitalizing expenses, among other issues	Waste Management	1997	WorldCom	2002
Abuse of accounting standards	Savings and loan crisis	1982	Stock options backdating	2006

While the more recent examples presented here began pre-SOX, readers may be skeptical about whether SOX will have its intended effect, especially given the 2008 subprime mortgage and financial institution meltdowns. Further concerns were raised when allegations of misconduct were leveled against Bernard Madoff and Stanford Financial for their Ponzi schemes, costing billions of dollars. While Ponzi schemes are not new, the sheer magnitude is almost unprecedented, especially in a post-Sarbanes-Oxley world. The investing public was further shocked in January 2009 when news of the Satyam fraud hit the press. In the Satyam case, approximately $1 billion in cash, supposedly the easiest asset to audit, was admitted by the CEO to be nonexistent.

A CLOSER LOOK

Efficiency, liquidity, safety, and robustness of financial markets are vital to the nation’s economic prosperity and growth, as more than 110 million Americans directly or indirectly invest in the capital markets. Investors participate in capital markets as long as they have confidence in the quality, reliability, and transparency of public financial information disseminated to the markets. High-quality financial information contained in financial statements prepared by public companies and audited by independent auditors greatly influences investor confidence. Auditor accountability and responsibility for searching, detecting, and reporting financial statement fraud are receiving considerable interest and attention in rebuilding investor confidence and public trust. Until recently, corporate America dismissed financial statement fraud as “irrational irregularities.” Now virtually any organization may be affected by financial statement fraud. Not a day passes without fraud-related news, especially in regard to financial reporting. This undermines the quality, reliability, and integrity of the entire financial reporting process and, thus, the efficiency and global competitiveness of our capital markets.

Emerging corporate governance reform, corporate and securities laws, corporate guidance, best practices regulations, and accounting standards are intended to identify and minimize potential conflicts of interest, incentives, and opportunities to engage in financial statement fraud. This chapter (1) addresses financial statement fraud, its definition, nature, and significance; (2) discusses the financial reporting process of corporations; and (3) examines the role of corporate governance, particularly gatekeepers, in preventing and detecting financial statement fraud.

DEFINITION OF FINANCIAL STATEMENT FRAUD

A complete understanding of the nature, significance, and consequences of fraudulent financial reporting activities requires a proper definition of financial statement fraud. Fraud is defined in Webster’s New World Dictionary as “the intentional deception to cause a person to give up property or some lawful right.” The legal definition of fraud can also be found in court cases. One example of such a definition is “A generic term, embracing all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get advantage over another by false suggestions by suppression of truth and includes all surprise, trick, cunning, dissembling, and any unfair way by which another is cheated.”⁴ Fraud is commonly referred to as an intentional act committed to harm or injure others securing an unfair or unlawful gain.⁵ This intentional, wrongful act can be differentiated and defined in many ways, depending on the classes of perpetrators. For example, frauds committed by individuals (e.g., embezzlement) are distinguished from frauds perpetrated by corporations (financial statement fraud) in terms of the classes of perpetrators.

Clear definitions of financial statement fraud are difficult to discern from pronouncements and/or authoritative statements, primarily because it has been only during the past decade that the accounting profession has used the word fraud in its professional pronouncements. Previously, the terms intentional mistakes or irregularities were used. The American Institute of Certified Public Accountants (AICPA, 1997), in its Statement of Auditing Standards (SAS) No. 82, refers to financial statement fraud as intentional misstatements or omissions in financial statements. Financial statement fraud is defined by the Association of Certified Fraud Examiners (ACFE) as:

The intentional, deliberate, misstatement or omission of material facts, or accounting data which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision.⁶

The broadly accepted definition of financial statement fraud, which is also adopted in this book, is articulated by the National Commission on Fraudulent Reporting (Treadway, 1987, p. 2) as “intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements.”⁷

The common theme among these definitions is that fraud, particularly financial statement fraud, is deliberate deception with the intent to cause harm, injury, or damage. The terms financial statement fraud and management fraud have been used interchangeably, primarily because (1) management is responsible for producing reliable financial reports, and (2) the fair presentation, integrity, and quality of the financial reporting process is the responsibility of management. Exhibit 1.1 classifies fraud into management fraud and employee fraud and provides further classification of these two types of fraud.

Fraud can be classified into several types, with the most common category being asset misappropriations and financial misstatements. The former is often referred to as employee fraud involving embezzlement, theft of cash or inventory, payroll fraud, or skimming revenues; the latter is viewed as financial statement fraud, usually perpetuated by management. The DoJ defines corporate fraud in three broad areas: accounting fraud or financial fraud, self-dealing by corporate insiders, and obstructive conduct.⁸ Accounting fraud consists of falsifying financial information by cooking the books or misleading ...