Who should be blamed or held responsible for the prevention and or detection of financial statement fraud?

Introduction

The value of an organisation is driven by its financial performance. Public organisations are keen on share price maximisation because shareholders’ wealth maximisation is measured by dividends received and capital gains from share appreciation. The demand and supply of the company’s shares are influenced by the current and projected performance of the organisation. The financial statement published by the organisation provides shareholders and other stakeholders with information on the current and expected performance of the organisation that enables them to make decisions on whether to invest, withdraw or stick with the organisation.

Some of the corporate scandals that have occurred over the years including the fall of Enron in 2001 caused by application of mark-to-market accounting; WorldCom in 2002 manipulating losses and overstating profits; Qwest 2002 understating expenses and overstating revenue; Adelphia 2002, Parmalat in 2003 and more recently the UK supermarket giant Tesco overstating revenue by £250m causing its share price to tumble (Felsted and Oakley 2015). These and several other scandals caused by financial statement fraud have led to the question this paper hopes to address:

“Who should be blamed or held responsible for the prevention and or detection of financial statement fraud?”.

To answer the question of the essay “who should be blamed,” the next chapters will provide an analysis of the roles and regulatory negligence of the major participants at the two ends of the continuum: external auditors and the audit committee.

Understanding Financial Statement Fraud

Various types of fraud are perpetrated within the organisation. Albrecht (2006) categorised fraud into employee embezzlement, management fraud, investment scams, vendor fraud and customer fraud. Financial statement fraud is an intentional act by organisations, involves providing inaccurate information in the financial statement to mislead the users of the financial statement. The Association of Certified Fraud Examiners (ACFE) defines financial statement fraud as “the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosure in the financial statements to deceive financial statement users”.

Methods used to perpetrate financial statement fraud are:

Improper revenue recognition: recognising fictitious revenue, early recognition and overstatement, Enron adopted marked-to market accounting involving recognising projected revenue early, an accounting policy allowed at that time in the US on the basis that projected revenue was probable (Hopwood, Leiner and Young 2009), Qwest overstated revenue by $2b and wrote off $2.2b as bad debt (Jauhari, Sehgal and Chaudhary 2014).
Overstatement of Assets: usually by recognising fictitious assets, omitting receivables, and capitalising expenses. WorldCom was accused of capitalising operating costs to the tune of $3.85 billion, recognising those costs as investments (Rezaee and Riley 2010).

Understatement of expenses/liabilities: It involves deliberate omission of liabilities, intending to cover debt, reduce expenses and improve the overall outlook of the balance sheet. Aldephia manipulated expenses (Rezaee and Riley 2010).
Misappropriation of assets: this involves theft of the company’s assets or improper use, usually by those charged with governance. In the case of Parmalat, the CEO diverted cash from the company to his daughter (Uplaksh et al. 2014), ESM executives withdrew approximately $60m in salaries, and the chairman, Ronnie Ewton, spent over $1.5m on luxury goods (Jamieson 2014).

Non- disclosures: this includes non-disclosure of related party transactions, going concern issues, and other loopholes in the financial reporting. Adelphia was alleged to have non-disclosure of related party transactions (Rezaee and Riley 2010). ESM did not disclose the true state of the ESMFG-affiliated company, which had no assets but owed ESM $1.6b (Jamieson 2014).
Inappropriate disclosures: deliberately omitting transactions from the balance sheet, usually known as off-balance sheet accounting, Lehman Brothers and Enron were both accused of this practice (Albrecht, Albrecht and Albrecht 2006).

The survey conducted by the committee of sponsoring organisation (2010) on 347 public listed companies between 1998 and 2007 produced the data in figure 1, shows that 28% of financial statement fraud were based on revenue recognition scheme, followed by overstatement of assets 23% and lastly understating liabilities 14%, while other schemes were almost evenly adopted.

Financial Statement Fraud Triangle

For this article, I will focus on financial statement fraud (FSF) that led to the failure of the company. Individuals or groups of individuals perpetrate FSF within the organisation, but before fraud occur,s three factors must be present, represented by the fraud triangle, a model by fraud Dr Donald Cressey:

The Pressure: The pressure is the driving force or motivation to commit fraud; it can be a financial or non-financial need, such as work pressure, need to take advantage of a loophole in the system, maintaining a social status, or need to maintain a personal or family relationship (Albrecht et al. 2006). Bell and Carcello (2000) identified that the quest for rapid growth, earnings projection, aggressive attitude to financial reporting and incentives schemes are factors that give rise to pressures. Rezaee and Riley (2010) stipulate that pressures arise from poor earnings status, poor organisational performance, industry lifecycle at decline and economic recession. In a recent report, KPMG (2011) it is states that the major motivation for fraud is personal financial gain and greed being at the centre of it all. The major motivation for companies that commit fraud is the desire to reduce the cost of capital so as to attract cheap funds (Dechow et al. 1996). However, Makkawi and Schick (2003) postulate that increased pressure to commit fraud emanates from increased stock ownership, competition for investors’ money, increased publication of short-term financial returns and executive equity-based compensation, resulting in myopic performance focus and pressure to increase revenue and earnings.

The Opportunity: Opportunity denotes the incentive to commit fraud, which, in general terms, is a weakness in the internal control system (such as lack of segregation of duties, non-compliance with standards and regulations) of the firm, regulatory framework and presence of management circumventing control . These weaknesses will give perpetrators the avenue to commit fraud, conceal it and get away unpunished. Six factors that create opportunity to commit fraud: lack of access to information, overriding controls, inability to appraise good performance, existence of moral hazard, lack of access to relevant information, ignorance and lack of audit trail (Albrecht, Albrecht and Albrecht 2006). A report sponsored by COSO (2010) revealed that a significant number of firms that committed fraud changed auditors after the end of their clean published financial statement. Beasley (1996) and Beasley et al. (2000) believe that fraud companies have a weak governance structure, the board is composed of fewer independent non-executive directors and fewer audit meetings compared to those of non-fraud companies. The higher the lack of independence of the audit committee, the more opportunity there is for fraudsters to commit fraud. Similarly, Abbott, Parker and Peters (2004) argue that there is a negative relationship between independence and the activity level of an audit committee with the occurrence of fraud. Albrecht, Albrecht and Albrecht (2006) identifies misplaced executive incentive as major fraud cases revealed executives received stock-based compensation which exceeded their salary based compensation; example the CEO of Worldcom, received cash-based salary of $935,000, he was also able to exercise share options and made profits, he received loan to the tune of $409million for share purchase despite all these the company still reported loss and eventual bankruptcy.

The Rationalisation: Every fraudster has a reason or justification for a fraudulent attitude, according to Merriam-Webster dictionary (2014), rationalisation means “to think about or describe something (such as behaviour) in a way that explains it, makes it seem proper and more attractive”. Rationalisation that may be used includes: rules are made and broken, I am the boss, I deserve it, everyone else does it, I will never get caught, who cares, it is for a good purpose, I have worked so hard, it is for the good of the company, I am only borrowing the money, there is no other way to manage these problems, I had to provide for my family etc. Unlike other elements of the fraud triangle, rationalisation is difficult to substantiate because it is an unseen attitude usually in the mind of the fraudster but voiced when questioned or caught, and sometimes never spoken.

Analysis of Financial Statement Fraud Cases Using the Fraud Triangle

Case 1: Waste Management, located in the United States, failed in 1998. The fraud was perpetrated by the CEO, management team and auditors, but was discovered by the new CEO, who subsequently set up a company hotline to report suspicious activities.

Scheme: manipulated depreciation by increasing it, and understated liabilities by omitting losses.

Pressure

Maintaining earnings status as the industry leader;

Intense industry competition;
Internal budgets and earnings targets are set by the chairman.
Greed and the desire to maintain status.

Opportunities

Personal judgment is used to determine depreciation charges.
Exploiting loopholes in the accounting standards regarding IAS 8 Accounting policies, changes in accounting estimates and errors which were used to manipulate the useful lives of the assets, residual value and disposal values;
Adopting an accounting system not recognised in any standard, which involved adjusting actual results.
Auditors approved the accounting practices adopted.
Lack of auditor independence, Arthur Anderson provided internal audit and consultancy.

Rationalisation

The CEO and management team convinced themselves that writing off accumulated errors in future periods was good practice. We have to maintain our industry position and also meet our earnings target.

Case 2: Enron, the second-largest bankruptcy ($63.4bn) in 2001, perpetrated by the CEO and other executives. The fraud was discovered by an internal whistleblower.

Schemes

Pressure:

• Energy company Enron was faced with price instability and foreign exchange risk. Expectation of profits from the market:
• An aggressive management culture, which adopted the Rank or Yank appraisal system,”meet target or you are fired”, created pressure on all staff; Unrealistic targets were set for the staff
• Off-balance sheet accounting, to hide debt and losses from underperforming subsidiaries and special purpose vehicles;
• Improper revenue recognition with the use of mark-to-market accounting practice that allowed a company to recognise probable projected revenue over the short-term, but was used by Enron for 20 years;
• Understating liabilities, debts, and costs
• Overstating assets by capitalising costs that should be expensed
• Changing accounting policies on existing business contracts.

Opportunity:

• Flaw in the incentive system (Rank or Yank) and management culture;
• Lack of auditor independence, Arthur Anderson provided audit and consultancy service of about $25m and had one of their offices located in one of Enron’s building;
• Lax accounting practice;
• Deregulation of the energy sector in the 1980’s;
• Audit committee were ineffective;
• Lack of regulation for speculative trading which Enron was involved in;
• Poor ethical values of politician who received payments;
• Lack of independence of financial analyst paid to provide positive investment status of Enron;
• Inappropriate business model;
• Wall street was bribed and bullied.

Rationalisation:

• We need to maintain earning;
• It is for the good of the company;
• The company cannot fail.
• Management doesnt care

Case 3: WorldCom largest bankruptcy ($101.9bn) in 2002 , the fraudsters were the CFO and financial controller. The fraud was exposed by the internal auditor also questions were raised when the bid to acquire a competitor Sprint failed.

Scheme

• Overstatement of revenue via recognizing fictitious revenue;
• Overstatement of pre-tax income and reserves;
• Overstating assets by capitalising operating expenses;
• Understating liabilities by omitting operating expense.

Pressure

• Competition was high in the sector;
• Economy was under performing and business was weakening;
• Profit expectations were high;
• Wall street expectations for WorldCom were high;
• Financial controller was under pressure to obey CEO’s orders;
• Pressure from bank to cover margins.

Opportunities

• Lax accounting practice;
• Aggressive accounting practice;
• Lack of auditors independence which emanated from self interest threat;
• No checks and balances by auditors;
• Ineffective audit committee.

Rationalisation

The financial controller in an interview, said he was convinced by the CEO that they were doing what was best for the company. He also mentioned that he was following order so could not do otherwise. The financial controller said he respected the CEO’s intelligence.

Case 4: Satyam 2009 the Enron of India, fraud to the tune of $1bn was carried out by mainly founder/chairman, the fraud was exposed by central bureau of investigation in India as the proposed acquisition of a family business Maytas (Satyam spelt backwards).

Schemes

• Inflated cash (non-existent) and bank balances;
• Accrued interest (non-existent);
• Understated liabilities;
• Overstated debtors positions;
• Overstated revenues;
• Forged 10,000 salary accounts;
• Funds were diverted to personal and family accounts.

Pressure

• Huge revenue projections;
• High performance expectations from shareholders and the market as they pursued vision to be Number one Information technology company;
• Fierce competition of the market;

Opportunity

• PWC lack of independence due to self interest threat (receiving huge fees);
• Ineffective audit committee;
• Ineffective auditors.

Rationalisation

• We need to be Number 1 in the market;
• We cannot go back;
• We can fix it.

Conclusion and discussion

The recurring variables in the four cases analysed above reveal all to be public listed company, even though at the time of Enron there was no corporate governance code such as Sabanese-Oxley’s Act and the UK combined code, which made it mandatory for all listed companies to have audit committee and spelled out the roles of the audit committee. In all the cases the audit committees were ineffective and lacked the necessary experience and independence to detect fraud.

In all cases, earnings maintenance was the major pressure, boosting revenue and understating expenses. Another interesting factor was the lack of auditors independence and the fact that these frauds did not go unnoticed by the auditors. In addition, executive management involvement was revealed in all cases, spanning from the chairman to the CEO, CFO, COO and other members of management even in some cases loyal staffs.

The only way to prevent and detect financial statement fraud is to design strategies using the fraud triangle to eliminate pressure and reduce opportunities by adopting healthy corporate culture including establishing policies on budgetary process (especially sales or profit forecast). It is said that prevention is better than cure but companies spend money hiring forensic accountants to investigate fraud and trace assets which sometimes are never retrieved by stakeholders while fraudsters smile home. Hopwood, Leiner and Young (2009) reiterates (shown in figure 3) that corporate culture is a major source of pressure and opportunity to commit fraud so should be used as a preventive tool.

Written by- Amaka Akinteye