The term fraud or dishonesty shall be deemed to encompass all those risks of loss that might arise through dishonest or fraudulent acts in handling of funds. As such, the bond must provide recovery for loss occasioned by such acts even though no personal gain accrues to the person committing the act and the act is not subject to punishment as a crime or misdemeanor, provided that within the law of the State in which the act is committed, a court would afford recovery under a bond providing protection against fraud or dishonesty. As usually applied under State laws, the term ``fraud or dishonesty'' encompasses such matters as larceny, theft, embezzlement, forgery, misappropriation, wrongful abstraction, wrongful conversion, willful misapplication or any other fraudulent or dishonest acts resulting in financial loss.
Fraud in financial statements usually takes the form of:
Overstated assets or revenue
Understated liabilities and expenses
Overstating assets and revenues, say by the inclusion of fictitious assets or revenues, has the effect of suggesting greater financial strength and value to the organization than what it would otherwise have. The understatement of liabilities and expenses, say by the exclusion of costs or financial obligations, has a similar effect. Both result in increased earnings per share and increased equity value and net worth for the company.
To demonstrate these under/overstatements, the schemes have been divided into five classes. These are:
Fictitious revenues
Timing differences
Concealed liabilities and expenses
Incorrect or misleading disclosures
Incorrect or misleading asset valuations
Because the accounting system is based on double-entry book keeping, fraudulent entries should affect at least two accounts and, therefore, usually at least two areas in the financial statements. While the areas described below reflect general financial statement classifications, the reader should remember that that the other side of the fraudulent transaction exists somewhere, quite probably in another area of the accounts.
Frauds using falsified financial information have direct connection with accounting standards. False information is either made-up information with no support from actual projects or relates to accounting standards and codes. Since the beginning of reform, China has made progress in improving accounting codes. Apparently, the designing and implementation of accounting codes can influence information truthfulness and give rise to the opportunities to produce false information.
Accounting codes is a very technical issue. Many think the accounting codes as a "steel ruler" that allows no vagueness. However, the complexity of modern economy has put some areas of accounting subject to discretion and interpretation or even personal preference, which result in a ruler with flexibility. The issue of accounting codes did not attract much attention at the beginning of the reform. It was not until 1993 that reforms were witnessed in corporate accounting and regulations. During the Asian financial crisis more concrete progress was made in improving the account rules, which should be recognized and valued. At the same time, that more is required to be done to bring our accounting rules up to the international standards. Some people still think in China there are too complicated an accounting system including a corporate accounting system and also distinctive accounting systems for different industries. For instance, some corporate accounting rules require enterprises to build value-loss reserves based on the recoverability of assets. Although accounting rules of different industries have similar requirements, they are all inadequate in terms of soundness comparing to corporate rules. Another issue is that, since there was no luxury of a strong accounting industry and external auditing facilities, when banks assessed the reliability of enterprises financial information, they did not require borrowers to provide external auditing results. In the future, banks may consider acquiring financial information audited by accounting firms and assessment on enterprise's compliance and borrowing conditions made by law firms, and valuation of collaterals made by evaluation firms and bond classes given by rating firms. However, it may take years for the above intermediate services to develop, and the expertise, reputation, brand-name, service quality also take tens of years to build. Are the audited statements trustworthy? It really depends and relates to the expertise and internal control of the firms. The development of intermediate financial service providers is affected by market liberalization as well. If all of these issues cannot be dealt with effectively, probability of enterprises' providing false information and engaging in financial frauds will continue to be high.
This situation is not about stock valuation, product quality or whether or not Microsoft has monopoly power in its markets. Nor is it part of a pro or anti-Microsoft movement. This situation is instead a shining example of financial fraud and corruption enabled by bad government policy. Even the best are manipulating the financial statements. This is the reason why it is important to stop manipulation of financial statements.
There are many reasons why individuals dishonestly manipulate their organizations' financial statements. It may be to look company's earning better. It may be also to cover up the misappropriation of company money and other management frauds. Some of the most common reasons why employees commit financial statements frauds are:
To encourage investment in the company
To demonstrate increased earnings per share, thereby encouraging increased dividend payments
To cover negative cash flows
To obtain new finances or to obtain it in more favorable terms than would otherwise be provided
To obtain higher purchase price in takeover
To demonstrate compliance with financing covenants
To meet company goals and objectives
To receive performance related bonuses
It should be noted from this list that the motivation for financial fraud does not necessarily involve personal gain. Fraudulent financial statements often arise from the pressures either the organizations or its managers to 'perform' together with the belief that the fraud will not be detected. These pressures may act as "red flags" to the auditor and fraud examiner. [1]
Examples of such pressures are:
Sudden decreases in the company's sales or market share
Unrealistic budget pressures, particularly for short term results
Financial pressures arising from bonus plans that depend on short term economic performance.
FRAUD DETECTION USING FINANCIAL STATEMENTS
As a forensic accountant, you may not always have to reconstruct financial statements, but you should not take the ones given on face value. It's more a mindset than a method. The analysis of accounting records without such a mindset is called auditing. Looking for signs of deception is forensic accounting. An auditor, however, may help provide an investigative lead by discovering the absence of a business purpose for a transaction. Or, an auditor might find an insufficient amount of documentation for a transaction. All these inconsistencies and out-of-ordinary transactions will be part of any standard audit report. Forensic accountants will be looking further into these matters for "suspect" transactions, and may very well start with the journals or ledger to scrutinize the "Explanation" section of books. For example, a capital investment account might mention the name of someone external to the organization (e.g., "Loan from Malik Bashir"), and securitization of the books might establish that Malik Bashir is also heavily involved in cash disbursements for supplies or subcontracted services. The investigation then proceeds from securitization to comparison, looking for comparable vendors or subcontractors to see from such benchmarking if something is out of the ordinary with him. The original source documents (cancelled checks) written to him might be analyzed to see which bank they were cashed at. Those source documents might reveal that the bank transferred the deposit to another account or name that was on the State Department's Entities list.
Fraud is usually discovered when several small events, taken together, point to a possible pattern of deception, and the following indicators are the classic "red flags", according to the IRS (1999), which relate to fraud through financial statements and accounting systems:
Maintaining two sets of books and records (and/or destruction of books and records)
Concealment of assets (altered entries in asset categories)
Large or frequent cash transactions (or frequent use of cashier's checks)
Payments to fictitious companies or persons
false invoices or billings (excessive billing discounts or double billing)
purchase of over-valued assets (excessive spoilage or defects)
Large company loans to employees or other persons
Using photocopies of source documents instead of originals
Personal expenses paid with corporate funds
Payee names left blank on checks and filled out later
Second or third-party endorsements on corporate checks
Unnecessary use of collection accounts
Excessive use of exchange banks or clearing accounts
msbargraph699
The fundamental problem is that Microsoft is incurring massive losses and only by accounting illusions are they able to show a profit. Specifically, Microsoft is granting excessive amounts of stock options that are allowing the company to understate its costs. What would happen to Microsoft's stock price if the public suddenly realized that they lost $10 billion in 1999 rather than earning the reported $7.8 billion? If 80 percent of its stock value or roughly $400 billion is the result of a pyramid scheme, one might also ask what kind of effect this could have on the retirement system. It is also important to note that this is a relatively new situation that did not occur before 1995. Microsoft has always been a highly valued stock and that might have been justified prior to 1995.
There are many underlying reasons for financial risks. First, the rapid global economic, technological and financial development has made it difficult to address new problems with existing theories and experiences. Among these are the uncertainties in financial stability. Second, in the transition from planned to market economy, some aspects of institution building is still in a vague, non-planned and non-market, or conflicting stage. Third, reality has proved that all kinds of problems in the economy are reflected in the workings of the financial system, which was particularly evident during the Asian financial crisis. Financial risks, if not addressed in a timely manner, could continue to grow and develop into economic and financial crisis. We must put more emphasis on understanding the financial risks and the uncertainties involved. Only by taking timely measures, could potential risks be removed. It is a worldwide experience that the longer the risks are left unattended, the harder it is to solve them.
METHODS OF COMMITING FRAUD THROUGH FINANCIAL STATEMENTS
Fraud includes the improper usage of resources and the misrepresentation of facts to receive gain. It is related to the misallocation of resources, or the distorted reporting of the existence and availability of resources. Fraud is a parasite that maims and eventually kills an organization. After a while, its contagious effect would find its way to another host organization.
It erodes the bottom lines and in the end or ultimately the very existence of any organization is negatively impacted. Whatever an organization is, be it non-profit or profit/business in nature, it cannot remain healthy to survive and be competitive if fraud continues to go undetected and unchecked because obviously any organizational resource that is misallocated or "misused" threatens the continued existence of an organization. Some of the methods through which financial frauds are committed are mentioned below:
Fictitious revenues
Fictitious or fabricated revenue involves the recording of the sale of goods or services that did not occur. Fictitious sales usually involve fake or fictitious customers, but they may involve legitimate customers. For example, a fictitious invoice may be prepared for a legitimate customer where the goods are not delivered or the services are not rendered. At the start of the next accounting period, the sale is then reversed. Another method of using legitimate customers' accounts is to alter invoices to include higher amounts or quantities than are actually sold.
Profit and revenue recognition is based upon the following criteria:
Definition
Measurability
Relevance
Reliability
The term 'revenue' is not defined either in the Companies Acts or in any current accounting standard. The nearest reference to it is in SSAP2 concerning the prudence concept:
'... revenue and profits are not anticipated, but are recognized by inclusion in the profit and loss account only when realized in the form either of cash or of other assets the ultimate cash realization of which can be assessed with reasonable certainty; provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate in the light of the information available'.
More than one scheme may be used simultaneously in order to overstate sales. In the following example, the company used fictitious sales, premature or early recognition of revenue.
EXAMPLE
A person wanted to raise its financial standing and engineered fictitious transactions over a period of more than seven years. Its management used shell companies to make a number of fictitious sales. The sham transactions also involved the payment of money for assets to the shell companies that would be returned to the parent company as payment for fictitious sales. The scheme went undetected for so long that profits were inflated by more than £50 million. However, the fraud aroused the suspicions of the internal auditors. The scheme was uncovered and the perpetrators prosecuted in both the civil and criminal courts.
A book keeping entry is made to record the purchase of fictitious fixed assets. This debits fixed assets for the amount of the purchase and credits cash for the payment in the usual way. A fictitious sales entry is then made for the same amount as the false purchase, debiting debtors and crediting sales.
The effect of this completely fabricated sequence of events is to increase both the company's assets and revenue.
Pressures are placed on owners and top management to perform by bankers, shareholders, and even families and the community. The following examples are instances in which they succumbed to the temptation to manipulate the numbers.
EXAMPLE
In a similar case, a publicly traded textile company engaged in a series of false transactions designed to improve its financial profile. Receipts from the sale of shares were paid to the company purporting to be sales. The management even went so far as to record a bank loan as profit. By the time the scheme was uncovered, the company books had been overstated by £30,000, in this case a material amount3.
The pressures to commit fraud sometimes come from within the organization. Departmental budget requirements including profit and profit goals also encourage financial statement fraud.
EXAMPLE
The accountant of a small company misstated financial records to disguise its financial problems. He designed a series of book keeping entries to meet budget projections and to cover up losses on the pension fund. Also, because of poor financial performance, he consistently overstated profit. To hide this, he debited liability accounts and credited the shareholders' equity account. The accountant finally resigned, leaving a letter of confession but was later prosecuted in criminal court.3
Uncompleted sales
These involve sales that are made on certain conditions that have not been met, or not completed, by the end of the accounting period and ownership has not yet passed to the purchaser. They should not be recognized as revenue until completed. The most common examples of this are conditional and consignment sales.
EXAMPLE
ABC person sells products that require further engineering before they are acceptable to customers. However, it records these as revenue before this has been done. In some cases, it may take weeks or even months. In other cases, the sale is specifically contingent upon the customer's trial and acceptance of the goods.
The revenue account would require correcting to comply with the revenue recognition criterion.
Additionally, a provision needs to be made for the unearned sales on Project C. An entry needs to be made on the debit side of the Sales account to reduce the sales for the period by £17,000 and carried down as a credit balance to represent unearned sales. This balance should then cancel the £17,000 debtor on the balance sheet.
In January, the project is started and completed. The entries below show the correct recording of the £15,500 of costs associated with the project:
The effect of these book keeping entries is to recognize revenue and expenses for the period to which they actually relate, i.e. January, thereby matching them. This example illustrates how easily the non-adherence to the matching principle may cause a material misstatement in yearly Profit and Loss Accounts.
Premature revenue recognition and the problem of long term contracts
Generally, revenue should be recognized in the accounting records when a sale is complete; that is, when title is passed from the seller to the buyer. The transfer of ownership completes the sale and is usually not final until all obligations surrounding the sale are complete.
This raises the problem of long-term contracts, especially construction contracts. A contract which extends for more than one year will usually require to be accounted for as a long term contract under SSAP 9 (para. 22). Here, turnover should be ascertained in a way both appropriate to the stage of the contract and to the industry in which the business operates (para. 28). For instance, if the outcome of a long-term contract can be assessed with reasonable certainty before its conclusion, the reported profit should be the difference between the reported turnover and the related costs for the contract (para. 29).
No definition of turnover is given in SSAP9. It merely states that turnover is ascertained in a manner appropriate to the stage of completion of the contract, the business and the industry in which it operates. It is left to individual firms to decide according to their own circumstances. However, the amount of profit taken in an accounting period would normally relate to separate or measurable parts of the contract completed within that period.
Hence, although accounting for long-term contracts represents an exception to the usual definition of sales (their occurrence being determined by the passing of ownership), it is based on conservatism and sound judgment leading to true and fair financial reports. Misrepresentation occurs when these principles are not applied.
The following example illustrates how early recognition of revenue not only leads to financial statement misrepresentation but also encourages further fraud.
EXAMPLE
The management of a retail chemist chain began recognizing profit before it was earned. The impression given was that the chain was much more profitable than it actually was. When this came to light and was investigated, several embezzlement schemes, fictitious expense schemes and cases of credit card fraud were also uncovered.3
EXAMPLE
Time Energy Systems, Inc. developed, promoted, and marketed energy conservation systems including hardware and software for managing power supply use in buildings. The company formed limited partnerships to raise capital for its operations. Interests in the limited partnerships were sold to provide the funds to purchase equipment from Time Energy. Time Energy needed to report good profits: (1) to encourage investment in the limited partnerships and (2) to obtain bank loans. As the limited partnerships were Time Energy's primary customers, there were few sales from which it could otherwise generate profitability. It decided to create fictitious profits by charging management fees for research and development work to the limited partnerships. These were charged before the services were performed. Time Energy also failed to make a provision in its accounts for the costs it would incur in providing the services.
There are many reasons for premature recognition. Profit may be just one reason for recording profit before it is actually received.
EXAMPLE
The chief executive of a charity attempted to maximize donations by manipulating its books. As future donations were dependent upon its success so far, he recorded promised donations before they were actually received. The scheme had been in existence for more than four years before it was discovered3
Recording expenses in the wrong period
The correct recording of expenses is often influenced by pressures to meet budget projections and goals. This may be facilitated by lack of proper accounting controls. The charging of costs to periods other than the one in which they actually relate may cause them not to be matched against the profit that they have produced.
EXAMPLE
Here supplies were purchased and charged against the current year's budget, but were actually to be used in the following accounting period A manager at a publicly traded company completed 11 months of operations remarkably under budget. He therefore decided to get a 'head start' on the next year's expenditures. He bought £30, 000 of unneeded supplies and charged them against the current year's budget.
The internal auditors noticed the increase in expenditure and investigated the situation. The manager explained that he was under pressure to meet budget goals for the following year. Because he was not attempting to defraud the company for personal gain, no legal action was taken.
The correct recording of the above transactions would be to debit stock for the original purchase and subsequently charge the items out of that account as they are used. The example journal entries below show the correct treatment by charging the supplies over time.
Concealed liabilities
As discussed earlier, understating liabilities and expenses is one of the ways in which financial statements may be dishonestly manipulated to make a company appear more profitable or more valuable than what it would otherwise appear. Understating liabilities has a positive effect on the balance sheet, in that the equity and net assets are increased by the amount of the understatement. Understating expenses, on the other hand, has the effect of inflating net profit. Overstated profit has the effect of overstating shareholders' equity.
Concealed liabilities and expenses can be difficult to detect because often there is no audit trail. There are three common methods for concealing them: liability and expense omissions, capitalized expenses, and failure to disclose warranty costs and liabilities.
Liability and Expenses Omissions
The easiest method of concealing liabilities and expenses is simply not to record them. They may or may not be recorded at a later time, but this does not change the fraudulent effect on the financial statements.
Because they are easy to conceal, omitted liabilities are probably one of the most difficult to discover. A thorough review of all balance sheet date transactions, such as increases and decreases in creditors, may help in the discovery of omitted liabilities in financial statements.
Often, perpetrators believe they can perpetuate the fraud into future periods. They often plan to compensate for the omitted liabilities with other profit such as increased profits from future price Increases.
EXAMPLE
The owner of a publicly traded retailer falsified financial statements by concealing liabilities and inflating stock. The objective was to increase profitability, thereby attracting new investors. He planned to conceal the fraud by increasing selling prices when the expenses were charged. However, a tip-off by an employee to the company's audit committee caused an investigation.3
Fraudulent Capitalization of expenses
The distinction between capital and revenue expenditure arises out of the matching concept. Capital expenditure is expenditure that produces benefits to the company over a future accounting period (probably more than one). Manufacturing equipment costs are an example. Revenue expenditure, on the other hand, is expenditure matched with current revenue whose benefits only extend to the current accounting period. An example of this is wages, which are costs for work done in the current accounting period, which is either billed during the period or carried forward with stock as work in progress.
Capitalizing revenue expenditure is a way of increasing profits and assets as it is charged against future profits rather than immediately. The effect is that profit for the current period is overstated and for subsequent periods, it is understated.
Often generally accepted accounting principles are not always clear about the capitalization of costs so abuses may occur. The fraud examiner should be diligent in ascertaining whether it is appropriate to capitalize expenditure and consult relevant accounting standards.
Fraudulent charging of capital expenditure against profits
Just as capitalizing expenses is wrong, so is charging to the Profit and Loss Account costs that should be capitalized. A company may want to minimize its net profit for to tax reasons. Charging against profits an item that should be depreciated over a period of time may help achieve lower net profits and, therefore, less tax to be paid. Internal budget constraints also put pressure on accounting staff into misallocating capital items as revenue costs.
Fraudulent accounting for returns, allowances and warranties
An incorrect liability for these will occur if the company fails to properly account for potential product returns or repairs. It is inevitable that a certain proportion of products sold will, for one reason or another, be returned. It is the job of management to try to accurately estimate what this will be and make provision for it.
In warranty liability fraud, the liability is either omitted altogether or substantially understated. A similar case is accounting for the liability arising from defective products (product liability).
EXAMPLE
A manufacturing company produced government armaments. Some did not meet specifications and the company was liable for resolving this. Management decided to recognize the cost as items were returned and the work was performed which would be conducted over a considerable future period.
Failure to estimate and record the total warranty cost resulted in a material understatement of costs and overstatement of profits for the periods in which the contract revenues were received and the liability was not recorded.
Misleading disclosure
As was discussed earlier, accounting principles require that financial statements and related notes include all the information necessary to prevent the user from being misled. Management has an obligation to disclose all significant information in an appropriate way. If not disclosed in the financial statements, the necessary information should appear in the footnotes or elsewhere in the report.
The information that is disclosed should also not be misleading. Fraud through incorrect or misleading disclosure usually involves one of the following: liability omissions, significant event omission, related-party transactions, and accounting changes.
FINANCIAL STATEMENT ANALYSIS
The comparison of financial statements provides important information for the fraud examiner. Absolute values in the accounts provide only a limited amount of information. The conversion of these numbers into ratios or percentages allows the examiner of the statements to examine relationships between accounting numbers and facilitate comparisons with data for other companies of a different size. Accounting ratios adjusts for differences in size as the denominator is usually a measure of size.
In fraud detection and investigation, the determination of the reasons for the relationships between accounting numbers and changes in these may be important. These are possible red flags that may point an examiner in the direction of a fraud. If large enough, a fraudulent misstatement will affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements, when examined closely, cannot be supported.
On the other hand, some management frauds may involve a complete cover-up in the financial statements and an analysis of the reported aggregated data will not provide any indication of fraud.
In cases where financial statement analysis may suggest areas for investigation by the fraud examiner, he should adopt one of the two approaches:
An inductive approach: This involves a complete analysis of the financial statements in an attempt to identify inconsistencies and anomalies in the reported data that may suggest fraud.
A deductive approach: This assumes that the fraud investigator has received a suggestion of fraud. As a result, he may be able to hypothesize as to how the financial statements should be affected if the fraud has been perpetrated. His task is simply to test the hypothesis.
Financial statement analysis includes what are known as:
Vertical analysis
Horizontal analysis
Ratio analysis
Percentage analysis
There are traditionally two methods of percentage analysis of financial statements: vertical and horizontal analysis.
Vertical analysis
It is a technique for analyzing the relationship between the items on the financial statements (the Profit and Loss Account, Balance Sheet, or Statement of Cash Flows) by expressing components as percentages. This method is often referred to as "common sizing". In the vertical analysis of a Profit and Loss Account, turnover is assigned 100%; for a Balance Sheet, total assets are assigned 100%. All other items in each of the sections are expressed as a percentage of these numbers.
Vertical analysis emphasizes the relationship of statement items within an accounting period. These relationships can be used with historical averages to determine anomalies in the accounts.
Horizontal analysis
It is a technique for analyzing the percentage change in individual financial statement items from one year to the next. The first period in the analysis is considered the base, and the changes to subsequent periods are computed as a percentage of it. As with vertical analysis, this technique will not work for frauds involving small amounts of money.
It is important here to consider the amount of the change as well as its percentage. A 5% change in a very large item in the accounts may actually be greater than a 50% change in a much smaller item.
In this paper I have discussed what are the frauds are committed through financial statements how they are committed and what procedures are followed to unveil them. All this information not only helps us to know that their fraudulent practices being carried out there (which I won't follow my self after knowing the way to do them) but also what are the gaps in the present financial principles.
The thing to notice is these gaps can be removed to prevent and restrict these fraudulent practices but it is not being done and the fraud through finance and accounting is increasing.
All I can say is that the companies them selves should induce ethical practices in their culture to nip the problem in the bud. We know it is possible that the honest man not grow rich so fast as the dishonest one; but the success will be of the truer kind, earned without fraud or injustice. And even though a man should for a time be unsuccessful still.
