Impact Of Financial Statement Fraud And Prevention Measures

Rationale

The main purpose of this research proposal is to assess the impact of frauds on financial statement and analyze how management can prevent such frauds from taking place. The research proposal would be considering the situation due to which frauds arise in first place in a reporting process. The research would be collecting information from various journal articles relating to impact on frauds on business organization (Cohen et al., 2013). The research would be analyzing the basic causes for frauds in the first places, overall consequence of financial reporting frauds on the business and preventive measures which can be applied by businesses for the purpose of early detection and prevention of frauds in the first place. The methodology which be consisting of secondary data collection and analysis which can be collected from various journal articles and the same is to be considered for this research.

In this era of globalization, the financial information is the basis on which the performance of a business is highly depended. Therefore, any fraud in financial reporting would affect the reliance on the financial information included in the annual report of the business. The role of accountants, auditors and other finance experts has increased significantly in a business organization as they need to ensure that the information which are included are showing true and fair view of the situation displayed (Warren, Reeve & Duchac, 2013). The cases of Enron, World.com also has alerted the society and therefore, the role of the auditor has increased and the auditor needs to ensure that the financial statement are free from an misstatement and does not involve any incidence of frauds.

In recent years the frauds in financial statements have increased in many business and examples can be given of Enron, Worldcom. Most of the businesses try to manipulate the financial information in order to show a favorable financial statement of the business. The impact of such frauds affects the reputation of the business and the creditability of the business. The practice of manipulating the financial statements results in showing favorable results to the clients with the help of which the business can attract more investors. The case of Enron and World.com are relevant examples of how cooking of profits in the books of account affect the creditability of the business (Young & Peng, 2013). The impact on the frauds in financial statement has serious consequence on the profitability of the business. The changes in the business environment and economic recession in the market has forced the top-level management to effectively focus on paying more attention to the genuineness of financial statement of the business and ensure that the financial statement is showing correct information. The research paper aims to establish the impact which frauds in financial statement has on the business.

The main purpose of this research is to conduct an analysis on the impacts which frauds in financial statements has on the entire business. The fraud can be identified as manipulation in the books of accounts so that the financial statement is showing true and fair view. The implication of the fraud is that the business needs to incurs costs of such frauds and the reputation of the business is also affected by such frauds. The research paper also aims to identify the solutions which is available to the business. The research considers measures which can be taken by a business for the purpose of improving the misrepresentation in financial statement of the business. The research also aims to conduct secondary analysis for the purpose of bringing out the exact results of the research. The research also aims to identify what are the counter measures which can be taken by the management of company in retaliation of such frauds in the financial statement of a business.

Research Objectives

Financial statement frauds can be identified as deliberate misrepresentation in the books of account of a business with a view point of making the financial statement look more favorable.  Any omission of material information in the financial statement of a business which is of deliberate nature can be treated as act of frauds. Such frauds are undertaken by the management with a view of manipulating the financial information which will result in favorable financial statement. The main causes due to which frauds in financial statement occur are situational pressure on the managers of the business and the opportunity to commit frauds (Sharma & Panigrahi 2013). The sudden decrease in the revenue of the business and also the pressure of the shareholders and industry causes situational pressure on the business. In addition to this, weakened internal controls system or lack of appropriate supervision in the business is another cause, which can create an opportunity for committing frauds. As the technological level in the world increases, the reliance on financial information has increased significantly and simultaneously the risk of financial frauds in a business environment has increased (Peecher, Solomon & Trotman, 2013). Various acts can bee taken as an act of fraud but in general terms intentional misleading of any person or deception of any individual which can result in some kind of losses to that individual comes under the purview of fraud. In the case of financial reporting fraud, the users of the financial statements take their decisions on the basis of the information which are contained in the annual reports of the business. If the financial information are misrepresented than the same would result wrong investments on the part investors which might result in financial losses of a business.

The global economy is undergoing rapid changes as new technologies and innovations are taking place and due to this a series of economic and financial crises is common. This can create an environment of distrust among the employees and also create some doubts in the mind of potential buyers (Siregar & Tenoyo, 2015). This gives rise to manipulation in the books of accounts in order to ensure that the financial statements are shown favorable and the business can retain the investors. The cooking of profits is mostly done by the management that in the next year, the performance of the business would be better and therefore necessary adjustments can be made.  However, the losses just keeps on piling and sooner or later the same affects the business adversely which is precisely the case which happen with Enron.

It can be seen from the research objectives and the research questions that the main aim of this research is the analysis and evaluation of different aspects of the effects of financial frauds on the performance as well as other aspects of the business organizations. Over the years, the presence of many instances can be seen where the managements of the business organizations were caught in the process of falsify their financial statements with the aim to gain some personal benefits. Thus, frauds in the financial statements of the companies indicate towards the situation when the managements of the companies intentionally provides the false and manipulated financial information to the users of the financial statements like investors and other stakeholders (Kanapickien? & Grundien?, 2015). The occurrence of the financial statements frauds can be seen with the aim that that the auditors of the companies ensure that there is not any material misstatements in the financial statements as a result of frauds and errors. The aim of the present study is the exploration of three major aspects of financial fraud in the companies; that they are the exploration of the areas that are affected by the frauds in the financial statements; the processes that help the companies in the prevention of these frauds in the financial statements; and the persons as well as procedures that the companies use for the reduction of the frauds in the financial statements (Amara, Amar & Jarboui, 2013). As the topic of the research is a common one, there have been many researchers conducted on this particular research area.

Literature Review

The overall impacts of frauds on a business is immense and adverse in nature and the same can directly impact the financial statement of a business. The corporate frauds of a business which can be identified are financial reporting frauds, misappropriation of assets of a business and corruption. These are the most common frauds which can be identified in a business organization. In this research the focus is mainly fixed on financial reporting profits which includes manipulation of entries and cooking of profits in the books of account of a business. As per Association of Certified Fraud Examiners (ACFE), financial reporting frauds are most costly for a business as per the global fraud study which was conducted in 2016. In addition to this, the scandal which has taken place in the cases of Enron, WorldCom, Xerox, Lehman Brothers has increased the concerns for impact on fraudulent activities of the business. The financial reporting frauds not only results in financial losses for a business but also impacts the morale of the investors of the business and in most cases results in loss of confidence. Moreover, there is a general decline in the reputation of the business in the market which would result in the fall in the market share value of the business. In case of a big fraud, the government also might impose certain regulations on the business or even charged penalty on the business for frauds. The incidence of fraud leaves a business on the brink of financial crisis and can even affect the going concern principle of a business.

There is not any scope to deny the fact that fraud in financial statements is a negative aspect and it has many negative impacts on the overall business organizations. The companies have to suffer from downfalls in the presence of financial frauds like major financial losses, loss in the confidence of the external stakeholders, decrease in the company morale, increase in audit costs and others. There are examples of many companies that were impacted from different aspects due to fraud in the financial statements and the case of Satyam Computer is one of them. According to Bhasin (2015), financial frauds can have major impact on the companies along with their shareholders and public confidence in the capital market. As opined by Bhasin (2015), financial frauds can lead to loss in reputation, loss in goodwill along with the customer relations. Bhasin (2015) has also mentioned the fact that the presence of financial frauds has the ability to question the transoerecny as well as integrity of the company’s financial reporting. As mentioned by Okoye & Gbegi (2013), the presence of frauds in the financial statements of the companies has broader effects in the economic system as it can negatively affect the foreign investors as they become doubtful in doing business with the countries. In addition, frauds in the financial statements of the companies can affect the gross domestic product (GDP) of the economy of the countries (Okoye & Gbegi, 2013).  

Causes of Financial Statement Fraud

Some of the fraud cases which have recently turned up and increase the significance on financial reporting fraud controls are the cases of Enron, World.com, Lehman brother. In the case of Enron, the management of the company has deliberately manipulated the profits of the business and effectively understated the profits of the business. On the basis of favorable financial statement of the business, the management then took a lumpsum loan. When the manipulation in the financial statement was revealed the business collapsed. Similarly, in the case of World.com as well a material amount of expenses roughly around $ 3.8 million was hidden from the general investors and not disclosed appropriately in the financial statements of the business. This resulted in overstatement of net profit in the financial statement for 2001. When the company collapsed, it left great depression in the economy and the country had to face a situation of financial crisis. In addition to the losses to businesses and economy, there are other consequences as well such as it undermines the reputation of accounting profession by not considering the financial reporting framework. The frauds in financial statement has a impact on the overall growth of the nation and thereby should be dealt with a priority.

Prevention of frauds in the financial statements is a major initiative for the companies and the managements can use different tools and techniques to prevent the frauds in the financial statements. The presence of different kinds of tools can be seen that the companies can use for the deletion and prevention of financial frauds in the financial statements. According to Gray & Debreceny (2014), there has been major increase in the use of data mining as a major tool for the detection frauds in the company financial statements. One crucial aspect is also mentioned by Gray & Debreceny (2014) that auditors of the modern business environments are using the tools of data mining with the aim to detect the frauds in the financial statements. Under the process of data mining, the auditors can use both the internal data sources and external data sources in the process of data mining. On the other hand, according to Petra?cu & Tieanu (2014), the processes and procedures of internal audit play a crucial role in the process of the prevention as well as detection of frauds in the financial statements. As opined by Petra?cu & Tieanu (2014), under the mechanism of internal auditing, the responsibility for the detection and prevention of financial statements is divided between the external audit committee, internal audit committee and executive board. For this reason, there is not any scope to avoid the fact that all the business organizations must have effective internal control mechanism to increase the efficiency of the financial statements of the companies (Petra?cu & Tieanu, 2014).

The prevention of frauds in the financial statement is the responsibility of the management of the business for which the business must have a strong internal control system. Some of the popular techniques which can be applied by businesses in preventing frauds in the first place is by incorporating proper supervision of different activities of the business which would ensure that the financial reporting for the business is done appropriately. The first step in prevention of frauds in financial statements is by detecting the frauds in the first place. The frauds in the annual reports of the business can be appropriately detected by analyzing the changes which have occurred in the books of accounts from past year changes (Omar & Rizuan, 2014). The management can use tools such as Horizontal and Vertical analysis and also ratio analysis for the purpose of detecting changes in the annual reports of the business in comparison to previous year analysis. The management of companies need to identify the areas of reporting which are most likely to be misstated and therefore exercise more scrutiny in the area so that there is no scope of fraud in the area. The management of the business can also place senior accounting professionals who will be reviewing the work of accountants and ensure that all necessary disclosures and notes to accounts are included in the financial statements of a business. This research recognizes the counter measures which are taken by Public Company Accounting Oversight Board (PCAOB) for the purpose of ensuring that the financial statement of a business shows true and fair view of the financial position of the business. In addition to this, various accounting standards are introduced so that no scope of material misstatement in the financial statement should be present. The passage of the Sarbanes-Oxley Act (2002) and the American Institute of Certified Proceedings of the International Conference on Accounting Studies, Public Accountants Statement on Auditing Standards (SAS) No. 99 have further enhanced the role of auditors and they cannot ignore any fraud in the financial statement.

Consequences of Financial Statement Fraud

Reduction of Financial Frauds in the Organizations

In every business organizations, the presence of some specific persons as well as mechanism can be seen that help the managements of the companies in the reduction of the financial frauds in the financial statement. According to Halbouni (2015), the companies need to consider the auditors for the reduction in the financial statements frauds as the auditors perceive frauds fraud as a major concern for the business organizations. In addition, the auditors also consider the fact that the auditors perceive that the presence of financial statement fraud can create negative impact on the users of the financial information. According to Halbouni (2015), one important aspect is that there can be opportunities of the occurrence of frauds when an employee reaches a level of trust in the company or when there is the presence of weak internal control in the companies (Halbouni, 2015). According to Shi, Connelly & Hoskisson (2017), the agency theory suggests towards the fact that the external governance mechanism can discourage the managers of the companies from operating in the opportunistically manner. As per Shi, Connelly & Hoskisson (2017), the presence of effective corporate governance policies can reduce the possibility in the occurrence of financial frauds in the financial statements. As opined by Shi, Connelly & Hoskisson (2017), with the impose of strict external monitoring and control can decrease the possibility for the managers to manipulate the financial statements.

There are variety of tools which are available to the management of a company for the purpose of reducing incidents of frauds in financial statement of a business. One of the most effective tool which is available to the management of the business is the different types of audits which can be conducted for the purpose of ensuring that there are no frauds in the business. There is a statutory audit which needs to be conducted on a yearly basis for all businesses and in addition to this, the management can also conduct internal checks in order to assess that the reporting framework is being ethically handled by the business (Donelson, Ege & McInnis, 2016). The management can also strengthen the internal control system for the purpose of detecting such frauds which would automatically reduce the opportunity to engaged in fraudulent activities. As per Olaoye and Dada (2014), the financial statement of banks are susceptible to risks of material misstatement which is deliberate in nature and the same can affect the financial stability of a business. In such cases, early discovery and detection of the fraud helps the management of the bank to take quick and corrective actions in the business.

The research would be applying a deductive approach for the purpose of collecting information and analyzing the same. The deductive approach of a research would allow the research to develop an appropriate hypothesis on the basis of which the research analysis would be conducted. The research would be conducted considering the testing of hypothesis of a business. Deductive approach can be explained by the means of hypotheses, which can be derived from the propositions of the theory. In other words, deductive approach is concerned with deducting conclusions from premises or propositions. Deductive approach would allow the researcher test every theory and thereby appropriately help in collecting all relevant information for satisfying the research questions.

Preventive Measures for Financial Statement Fraud

The data which can effectively be collected for this research should be primary in nature and the same can be effectively be collected from various journal articles and research work of different authors. The secondary data can be collected from various journal articles. The collection of secondary data in research would increase the sampling size which would further assist in future research of the business. The major benefit of utilizing secondary data is that mostly the preliminary work is already done and therefore the research would be easily carried out on the basis of expertise work of other authors. The researcher also has scope for applying primary data for any further research in the topic. The secondary data analysis would not be appropriate in case a more through research is to be conducted on the topic.

The researcher need to determining the time frame in which appropriate data can be collected and also break down the research process in to steps. The steps for the breakdown of the research and its respective time frame can be shown in the chart which provided below:

Figure 1: (Chart Showing time frame for various segments of the Research)

Source: (Created by the Author)

Conclusion

The above research shows that the impact of Fraud in financial reporting and how the same can impact the organization as a whole. The research shows that there is a need for collecting significant information from various journal articles for the purpose of analyzing the same. The research considers the deductive approach which would enable the business to collect and form hypothesis which can be further test out. The research aims at establishing that a fraud in the financial reporting framework has far reaching impacts on a business organization. The financial reporting frauds not only results in financial losses for a business but also impacts the morale of the investors of the business and in most cases results in loss of confidence. In addition to this, the analysis of different articles also reveals that the overall reputation of the business is also impacted due to fraud financial reporting. This is easily justified from collapses of Enron, World.com.

One of the research objective is to ascertain what are the corrective measures which can be taken by an organization of the purpose of preventing and reducing incidences of frauds in financial reporting process in a business. The assessment shows that the role of auditors, forensic accountants and accounting professional has become significantly important in this new era and in the wake of Enron, World.com the role has become more prominent. The research points out certain preventive measures which could be adopted by companies for the purpose of early detection and prevention of frauds in a business.

There is a further scope of research for the topic as the topic has depth and further analysis can be undertaken by considering a particular company manipulation of the books of accounts of the business. In addition to this, the research questions itself can be explored in depths and therefore, it can be said that there is sufficient scope for future work.

Reference

Amara, I., Amar, A. B., & Jarboui, A. (2013). Detection of fraud in financial statements: French companies as a case study. International Journal of Academic Research in Accounting, Finance and Management Sciences, 3(3), 40-51.

Bhasin, M. L. (2015). Corporate accounting fraud: A case study of Satyam Computers Limited.

Cohen, J. R., Hoitash, U., Krishnamoorthy, G., & Wright, A. M. (2013). The effect of audit committee industry expertise on monitoring the financial reporting process. The Accounting Review, 89(1), 243-273.

Donelson, D. C., Ege, M. S., & McInnis, J. M. (2016). Internal control weaknesses and financial reporting fraud. Auditing: A Journal of Practice & Theory, 36(3), 45-69.

Gray, G. L., & Debreceny, R. S. (2014). A taxonomy to guide research on the application of data mining to fraud detection in financial statement audits. International Journal of Accounting Information Systems, 15(4), 357-380.

Halbouni, S. S. (2015). The Role of Auditors in Preventing, Detecting, and Reporting Fraud: The Case of the U nited A rab E mirates (UAE). International Journal of Auditing, 19(2), 117-130.

Kanapickien?, R., & Grundien?, Ž. (2015). The model of fraud detection in financial statements by means of financial ratios. Procedia-Social and Behavioral Sciences, 213, 321-327.

Okoye, E. I., & Gbegi, D. O. (2013). An evaluation of the effect of fraud and related financial crimes on the Nigerian economy.

Omar, N., & Rizuan, S. (2014). Financial deceitful trick through dividend smoothing. Procedia-Social and Behavioral Sciences, 145, 300-307.

Peecher, M. E., Solomon, I., & Trotman, K. T. (2013). An accountability framework for financial statement auditors and related research questions. Accounting, Organizations and Society, 38(8), 596-620.

Petra?cu, D., & Tieanu, A. (2014). The role of internal audit in fraud prevention and detection. Procedia Economics and Finance, 16, 489-497.

Sharma, A., & Panigrahi, P. K. (2013). A review of financial accounting fraud detection based on data mining techniques. arXiv preprint arXiv:1309.3944.

Shi, W., Connelly, B. L., & Hoskisson, R. E. (2017). External corporate governance and financial fraud: Cognitive evaluation theory insights on agency theory prescriptions. Strategic Management Journal, 38(6), 1268-1286.

Siregar, S. V., & Tenoyo, B. (2015). Fraud awareness survey of private sector in Indonesia. Journal of Financial Crime, 22(3), 329-346.

 Warren, C., Reeve, J. M., & Duchac, J. (2013). Financial & managerial accounting. Cengage Learning.

Young, S. M., & Peng, E. Y. (2013). An analysis of accounting frauds and the timing of analyst coverage decisions and recommendation revisions: evidence from the US. Journal of Business Finance & Accounting, 40(3-4), 399-437.

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