Detection and Deterrence of Financial Statement Fraud

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Introduction

There has been increased demand for improved detection and deterrence of financial statement fraud. This need has been highlighted in the aftermath of scandals that rocked the corporate world. The best examples are the accounting fraud that was discovered in well-respected companies like WorldCom, Fannie Mae and, Enron. Consequently, the reputation of financial reporting has greatly been tarnished, and many are questioning why detection of fraud came too late. There had been policy changes initiated implemented by the Securities and Exchange Commission (SEC) such as the restructuring of regulations to address corporate governance and as well as establish internal controls. It is imperative to continuously study and improve on these policy changes to increase detection and act as an effective deterrent against financial statement fraud.

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Fraud Detection

In the current context, fraud is the intentional act of misrepresentation of financial statements which basically amounts to deliberate dishonesty, cheating and stealing. The result of fraud is more than a monetary loss but also the loss of confidence in private companies that needed the support of investors. If there is no one willing to invest then the stock market will be crippled and companies will have to declare bankruptcy. This will also result in job losses and economic failure.

Stakeholders are very much concerned as to why there seems to be no effective way to detect financial fraud before it becomes so pervasive and extensive and brings down a company (Alleyne & Howard 284). In an ideal setting, third-party auditors are expected to detect fraud. External auditors provide crucial service in assuring the stakeholders that the financial statements provided by the company are true and correct. For this reason, potential investors, shareholders, employees, creditors and other people can use the audit report to make their decisions regarding the company (Alleyne & Howard 284). By studying the report stakeholders can decide to invest or not.

There is only one problem with this system of checks and balances because in the very beginning the role of auditors to detect fraud has never been clearly defined (Chowdhury, Innes, & Kouhy 895). According to Boynton auditors are required to be more proactive in their search for fraud as they do their auditing job as suggested under Revised ISA 240 (Boynton, Johnson, & Kell 75). Auditors are supposed to adhere to strict standards and if they find any irregularities they have to pursue it. They have to ask hard questions especially if they discover errors in accounting, unusual transactions and reluctance of corporate leaders to correct mistakes in financial reports (Alleyne & Howard 287). This kind of mindset has to be the norm among auditors.

Since the fall of Enron, changes in auditing standards were made. Part of the change is the emphasis given on the role of auditors to detect fraud and not just to append their signature on financial reports (Boynton, Johnson, & Kell 75). This assertion is based on ISA 315 that is concerned with risk management and ISA 240 addressed the responsibilities of auditors (Boynton, Johnson, & Kell 76).

Fraud Prevention

Three strategies can be used in the prevention of fraud. First is the dependence on the internal controls of the company to detect and prevent fraud (Chowdhury, Innes, & Kouhy 895). This is a passive means of deterrence. The second strategy is more reactive and auditors are used after fraud has been committed. The third strategy is more proactive and it utilizes the help of auditors to detect fraud (James 315). However, a good plan to prevent fraud is to use all three strategies and incorporate everything into one grand strategy.

Auditors are also as important in prevention as they are with detection of fraud (Romas 28). Even though their primary role would be to detect fraud, their secondary responsibility is to prevent fraud (Chowdhury, Innes, & Kouhy 899). Prevention of fraud is made possible the authority vested on financial managers in accordance with NSA 5 and ISA 240 regulations (Rezaee 67a). Under these provisions, the managers and those doing the governing job should emphasize fraud prevention tactics to discourage people from committing fraud (Boynton, Johnson, & Kell 77). This can be accomplished by increasing the effectiveness of auditors to detect fraud and at the same time increasing the degree of punitive actions against those responsible for financial statement fraud.

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Another approach to the prevention of fraud is not to consider it as an accounting problem but as a social issue (Rezaee 67a). This is not just an ordinary type of white-collar crime because it is similar to someone stealing money from a bank but in this case, deception is used. But the same impact is felt because people lost their hard-earned money.

A dishonest individual under the US legal system can be regarded as a fraudster and fraud has certain features that identify it (Rezaee 278b).It is both a state and federal offense to engage in any type fraudulent activity although there are different types of criminal behavior under this family of crimes Rezaee 69a). In order to prove accounting fraud, the prosecutors have to show the existence of the following elements: 1) a false financial statement of fact; 2) the perpetrator knew the statement to be false; 3) the perpetrator intentionally deceived the alleged victim; 4) the victim depended on the statement for information; and 5) the victims suffered economic loss as a result of the deception (James 317).

Fraud is a criminal offense and because it entails a lot of premeditation and planning, its punishment is severe. Federal and state statutes prescribe harsh punishment for individuals who are convicted of fraud (Rezaee 69a). The sentencing guidelines have recommendation as how this type of criminals should be punished in accordance to the law. The severity of the sentence also depends on the vulnerability of the target victims and the damage done to them.

Some of the more important laws and policy changes regarding the prevention of fraud were ratified in the 1930s (Rezaee 279b). These rules came as a result of corporate crimes during this time period. These laws govern the sale of securities in stock, activities that range from manipulating stock prices to insider trade. The provisions also state the civil and criminal penalties that the guilty party would face if convicted.

Despite these laws and the creation of the SEC, accounting fraud resurfaced once again in the 21st century as in the case of WorldCom and Enron Rezaee 69a). The scandal prompted Congress to employ more stringent rules to detect and deter fraud by passing the Sarbanes Oxley Act in 2002 (Rezaee 281b). Besides other requirements, the Sarbanes-Oxley demanded that public companies should make frequent disclosure of their financial positions to make it more difficult to commit fraud (Ribstein 57). A public company oversight board was established to control accounting companies. These companies are required to register with this board so as to enhance the powers of monitoring by SEC and even to conduct investigations when fraud is detected (Ribstein 57). This measure has enhanced compliance because of fear of repercussion.

This is the step in the right direction. However, any man-made system has loopholes and it must be the duty of the SEC and other regulating bodies to study the rules and systems in place to make it less susceptible to the manipulation of accountants and corporate executives who are familiar with the strengths and weaknesses of the system.

Case Example: Enron

The Enron case is one famous example and a landmark case because of the impact it had on all of its stakeholders and the US economy. It is a case that even ordinary individuals can easily recall. Because of its reputation in 2001, Enron used its stock and assets to acquire loans but somehow it was mismanaged and suffered losses (Healy & Palepu 5). Since is its CEO, Kenneth Lay was a respected man in the industry he was able to secure loans in spite of the problems faced by Enron.

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In order improve its image debts were not included in the financial reports and profits were exaggerated and inflated. Arthur Andersen, an accounting firm was complicit in the commission of the crime. CEO’s Jeffery Skilling and Kennet Lay were charged with fraud and insider trading (Healy & Palepu 5). Enron had to be closed down because of violation of federal laws.

There were two basic security laws that were violated; Securities Exchange Act of 1934 and the Securities Act of 1933. The Securities Act of 1933 declared it unlawful for a firm to sell securities to the public if the securities are not registered by the securities Exchange Commission (SEC). An independent auditor must certify the company’s financial statements before being allowed to sell bonds or stocks to the public. Enron’s case violated this and SEC revised its rules. Enron filed for bankruptcy but the most important thing to understand is that employees lost their pension, stock options, and investors lost an estimated $ 60 billion in potential earnings (Healy & Palepu 4). A crime has been committed and this should not happen again.

Conclusion

A good program to deter, prevent and detect fraud is that which will include fraud risk assessment tools, strategy to implement antifraud control activities, and the existence of a mechanism that allows open communication, information flow and the use of proper monitoring instruments. Auditors must realize the consequences of inaction and deliberate participation in any fraudulent activity. According to the US federal organization sentence guide, adherence to ethical code and compliance to internal programs and efficient internal control can reduce the degree of penalties imposed on a company even if fraud has been committed. Non-compliance on the other hand will bring the full force of the law on erring companies. This is to encourage auditors to detect and help deter fraud.

Works Cited

Alleyne, Philmore and Michael Howard. “An Exploratory Study of Auditors’ Responsibility for Fraud Detection in Barbados.” Managerial Auditing Journal 20.3(2005): 284-303. Print.

Boynton, William, Raymond Johnson, and Walter Kell. Assurance and the Integrity of Financial Reporting. 8th ed. New York: John Wiley & Son, Inc., 2005. Print

Chowdhury, Riazur, John Innes, and Reza Kouhy. “The Public Sector Audit Expectation Gap in Bangladesh.” Managerial Auditing Journal. 20: 893-905. Print.

Healy P.M and K.G. Palepu. “The Fall of Enron.” Journal of Economic Perspectives 17.22003): 3-26. Print.

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James, Kevin. “The Effects of Internal Audit Structure on Perceived Financial Statement Fraud Prevention.” Accounting Horizons17.4(2003): 315-328. Print.

Rezaee, Zabilla. “Causes, Consequences And Deterence Of Financial Statement Fraud.” Critical Perspective On Accounting 16.3(2005): 277-298. Print.

Rezaee, Zabilla. Financial Statement Fraud: Prevention And Detection. New York: John Wiley and Sons, Inc., 2002. Print.

Ribstein, Larry. “Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002.” Journal of Corporation Law 28: 56 – 60. Print.

Romas, Mareseak. “Auditor Responsibility for Fraud Detection.” Journal of Accountancy (2003): 28-36. Print.

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