Financial Statement Fraud Regulation


With increased white-collar theft, there has been an increased demand for authentic auditing services beyond the mere substantiation of responsibility in companies. Fraud is a serious financial crime, hence understanding its detection, prevention and legal implication is very paramount to business ethical behavior. Several major accounting scandals instill fear, among them WorldCom, Famie Mac, and Enron. Consequently, the reputation of financial reporting has greatly been tarnished, effectively inspiring a renewed concern on the cases and exposure of corporate scandals in finance. Consequently, the Securities and Exchange Commission (SEC) regulation was restructured to effectively address corporate governance issues and help establish internal controls. Fraud is the intentional act of misrepresentation of financial statements which basically amounts to deliberate dishonesty, cheating, and stealing. The public company accounting oversight board’s definition of fraud is that it is the deliberate misstatement of financial reports subject to auditing to give a false impression of the company position. The result of this is financial or monetary loss.

Fraud Detection

Stakeholders are concerned about the reason why auditors are not able to detect fraud intent before it happens (Alleyne & Howard 284). It is traditionally known that the role of auditors is to financial inconsistencies leading to fraud. External auditors offer crucial services to assure stakeholders that the financial statements provided by a company are accurate and acceptable (Alleyne & Howard 284).

The problem with addressing the auditor’s role has been that since, during its inception, auditors’ duty was never clearly defined, however, the responsibility of detecting fraud developed over years of practice (Chowdhury 895). According to Boynton, auditors are required to be more proactive in their search for fraud as they do their auditing job as the Revised ISA 240 Act requires. Their job is to identify incentives and opportunities that can attract fraudsters or cause rationalizing whether to justify fraud or not. Auditors are also required to interrogate errors of accounting, unusual transactions, and unwillingness to correct mistakes in financial reports (Alleyne & Howard 287).

Since the fall of Enron, serious changes in auditing standards have been instituted with more emphasis placed on the role of auditors as fraud detectors and not just to verify financial accounts (Boynton 75). These changes are based on the ISA 315 (ISA – International Standard on Auditing) dealing with risk management and ISA 240 addressing responsibilities of auditors (Boynton 76). Consequently, there are two types of fraud issues that are the most appropriate to auditors. They are the ISA 240 (revised), the misstatements emerging from counterfeit financial reports, and also the misstatements coming from the embezzlement of assets. Fraud is differentiated from an error based on intent like in the omission of some amounts of cash or disclosure. The underlying action has to be intentional for the mistake to be termed a fraud case. The ISA 315 requires auditors to understand the entity and the environment for instance the entities’ internal controls in their job is identifying and analyzing risk.

Fraud Prevention

Generally, three strategies can be used in preventing fraudulent deals. First is the dependence on the internal controls of the company to detect and prevent fraud (Chowdhury 895). This is a passive means of deterrence. The second and reactive method is to employ investigators after a fraud has taken place. The third method is proactive and it utilizes the instruments and processes routinely used for detecting fraud (James 315). In this 21st century, the parties interested in company financial statements are more informed than ever (Chowdhury 898). However, the accountants preparing these statements are even more knowledgeable and can commit intentional errors that would take time to detect.

Auditors are also as important in prevention as they are with the detection of fraud (Romas 28). Even though their primary role would be to detect by verification of the financial statements whether they depict the true and correct financial situation of the company, their secondary responsibility is to prevent fraud from happening (Chowdhury 899). The primary responsibility of prevention is the duty of the agencies responsible for governance and management even though the financial reports represent management efficiency (Romas 30). Failing to detect financial fraud by auditors is basically the responsibility of professional legislators, regulators, and accountants’ efforts to necessitate that the accounting unit takes on more responsibilities of assessing and reporting on internal controls (Romas 32).

Prevention of fraud is vested in individuals responsible for governing an entity and managing the entity according to National Security Agency and ISA 240 regulations (Rezaee 67a). Under these provisions, the managers and those doing the governing job should emphasize fraud prevention tactics to alleviate chances of fraud and also apply fraud deterrence by dissuading people from committing fraud (Boynton 77). This can be done by instituting severe punitive measures for culprits.

Another approach to the prevention of fraud is not to consider it as an accounting problem but as a social issue (Rezaee 67a). When financial crimes are defined disregarding the numerous differences, then money can be obtained from a victim via three unlawful ways; by force, stealth or deception. The first two are diminishing in society but the third one has been persistent (Rezaee 67a).

Fraud is commonly identified as deception aimed at benefiting an individual or group of people and causing the victim to lose money. A dishonest individual under the US legal system can be regarded as a fraudster (Rezaee 278b). Fraud is both a state and federal offense to engage in any type of fraudulent activity though they are criminality at different levels (Rezaee 69a). In order to prove fraud, the prosecutor has to prove that the alleged fraudster act included the following five elements; 1. There was 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 a loss as a result of the trickery (James 317).

Fraud is a criminal offense and because it entails a lot of premeditation and planning, its punishment is always severe. Federal and state statutes prescribe harsh punishment for individuals who are convicted of fraud (Rezaee 69a). The sentencing guidelines have a recommendation for the way fraud criminals should be charged and sentenced. The guidelines have increased reprimand from standard sentences particularly in cases where the target victims were assessed and found to be very vulnerable or gullible because of a lack of understanding of the processes involved in these transactions (Rezaee 278b).

The largely publicized fraudulent act is the corporate fraud which is controlled by the securities exchange act that was established in 1934 as well as other provisions that have been instituted by the Securities and Exchange Commission (Rezaee 279b). These rules were set in reaction to serious corporate crimes in the 1930s. These laws oversee the trading of securities on stock markets and govern all the related business activities ranging from manipulation of stock prices to insider business deals. The provisions also state the civil and criminal penalties that the perpetrators would face upon conviction.

Despite these laws and the SEC, fraud has been endemic in the wake of the 21st century with WorldCom and Enron being the main culprits (Rezaee 69a). It’s in light of these incidences that the US Congress thought it wise to employ stringent rules to govern fraud cases bypassing 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 alleviate possibilities of fraud (Ribstein 57). The Sarbanes regulation created the Public Company Oversight Board and gave it the mandate of controlling accounting firms. These companies are required to register with this board so as to enhance the powers of monitoring by SEC and even to do investigations into scandals (Ribstein 57). This measure has enhanced compliance with the regulations of the SEC because of the harsh penalties that were introduced. A firm should have proper financial reports with apt internal controls for detecting fraud in the financial reports (Ribstein 58).


A good program to deter, prevent and detect fraud is that which will include fraud risk assessment tools, strategy to implement anti-fraud control activities, allow open communication and information flow, and proper monitoring instruments. Lack of reporting should be faced with dire consequences. Strict adherence to the corporate ethics code, having an efficient and valid internal control system, and complying with this internal control process can adequately mitigate the eventual punishment of a company even when found guilty of fraud.

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’s a case the common people can easily recall. Due to its repute in 2001, Enron used its stock and assets to acquire loans but somehow they were mismanagement and it started suffering losses (Healy & Palepu 5). Since is its CEO, Kenneth Lay was a respected man for his achievement, he was able to keep securing loans through his connections. The company excluded debts from its financial reports and profits were consequently inflated. Arthur Anderson, Enron’s accounts manager hid and shredded financial documents. CEO Jeffery Skilling and Lay Kenneth were convicted were charged with fraud and insider trading and securities (Healy & Palepu 5).

Enron was closed down because of breaching federal laws (the federal rules). The underpinning principle of the laws is that public companies must report all their information to the potential investor (or investing public) to ensure that any citizen can access the correct company position which can lead to their decision to invest (Healy & Palepu 7). Regarding this principle, there are two basic security laws that were violated: the 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). The company’s financial statements must be certified by an independent auditor before being allowed to sell bonds or stocks to the public. Enron’s case violated this and SEC revised its rules to prevent auditing firms from offering any other services to companies they have audited before (Healy & Palepu 9).

The impact of the scandal was that, Enron had to file for bankruptcy and close down its operations, sold its assets, workers lost their pension benefits in stock, investors (public and some workers) lost over $ 60 billion (Healy & Palepu 4).

Works Cited

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

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

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

Healy P.M & Palepu K.G. The Fall of Enron. Journal of economic Perspectives, 17, 2, (2003): pp 3-26.

James, Kevin. The Effects of Internal Audit Structure on Perceived Financial Statement Fraud Prevention. Accounting Horizons,17.4(2003): 315-328.

Rezaee, Zabillah. Causes, Consequences And Deterrence Of Financial Statement Fraud. Critical Perspective On Accounting, 16.3(2005): 277-298.

Rezaee, Zabillah. 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(2002):56 – 60.

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

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