Financial Statement Fraud-Detection, Prevention, Related Regulations Research Paper

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Introduction

There has been increased demand for authentic audit function for services beyond the mere attestation of responsibility. This is because stakeholders have been wondering why fraud could not be detected by auditors. There are a number of major accounting scandals that instill this kind of fear, among them the 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 scandal in finance. There have been broad legislation and Securities and Exchange Commission (SEC) regulation restructuring to address corporate governance and as well as establish internal controls.

In the current context, fraud is the intentional act of a misrepresentation of the financial statements which basically amounts to deliberate dishonesty, cheating and stealing. The public company accounting oversight boards definition is that fraud is deliberate misstatement of financial reports liable for audit. The result of the fraud is suffering financial damages or monetary loss.

Fraud Detection

There has been a very serious concern among stakeholders that they do not understand why auditors cannot be able to detect certain financial frauds before it is too late (Alleyne & Howard 284). Basically, it has traditionally been known that, it is the role of auditors to detect fraud.

External auditors provide crucial service in assuring the stakeholders that the financial; statement provided by the company are true and correct. For this reason, independent parties like shareholders, employees, creditors and other people who are interested in the company depend on the audit report to draw conclusions or make decision (Alleyne & Howard 284).

By and large, stakeholders look for two key characteristics- the independence of the business, and its competence (James 315). However, the problem has been that since its inception, the role of auditors was never clearly defined but the responsibility to detect fraud just developed over years of practices (Chowdhury 895).

According to Boynton, auditors are required to be more proactive in their search for fraud as they do their auditing job as claimed under Revised ISA 240 (Boynton 75). They have to seek incentives and opportunities that can attract fraudulent acts and rationalizing whether fraud is justified. Auditors are also required to interrogate errors of accounting, unusual transactions and reluctance to correct mistakes in financial reports (Alleyne & Howard 287).

Since the fall of Enron, there have been serious changes in auditing standards with increased emphasis on the role of auditors as detection of fraud and not mere verification of financial accounts (Boynton 75). These assertions are founded on the ISA 315 dealing with risk management and ISA 240 addressing responsibilities of auditors (Boynton 76).

Fraud Prevention

There are generally three strategies that can be used in prevention of fraud. 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).

However a good plan to prevent fraud includes the three elements though many firms would typify themselves are one method of the three. In this new millennium, the parties interested in company financial statements are more informed than ever (Chowdhury 898). However, those who prepare these statements are even more sophisticated and can make crucial mistakes or intentional errors that would take time before detection.

Auditors are also important in prevention as they are with detection of fraud (Romas 28). Even though their primary role would be to detect by verification of the financial statements whether they depict 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 despite the fact that 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 take on more responsibilities of assessing and reporting on internal controls (Romas 32).

Prevention of fraud is vested in individual responsible for governing an entity and managing the entity according to 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 alleviate chances of fraud and also apply fraud deterrence by convincing people not to commit fraud (Boynton 77). This can be accomplished by increasing possibility of detection and setting up severe punitive measures for culprits.

Another approach to prevention of fraud is not to consider it as an accounting problem but as a social issue (Rezaee 67a). When financial crimes are striped of the multitudinous differences, then a victim can be separated from money through three unlawful ways; by force, stealth or deception. The first two are more wane but the third one is persistent (Rezaee 67a). This is because there has been strict regulation and deterrence of the first two and people are becoming more educated, informed and crafty.

Fraud is commonly identified as deception aimed at benefiting an individual of group of people and causing the victim to lose 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’s both a state and federal offense to engage in any type fraudulent activity though they are criminality at different levels (Rezaee 69a). In order to prove fraud, the prosecutor have 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 lost 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 recommendation to the way fraud criminals should be charged and sentenced. The guidelines have upward reprimand from standard sentences particularly when the targeted victims were very vulnerable (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 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 perpetrators would face upon conviction.

Despite these laws and the SEC, fraud has been endemic in the wake of 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 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 alleviate possibilities of 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 do investigations into scandals (Ribstein 57). This measure has enhanced compliance with the regulations of SEC because of the harsh penalties that were introduced. A company must create annual financial reports with proper internal controls of preventing and detecting fraud in the financial reports (Ribstein 58). Deficient antifraud programs are serious and imply weak internal control over the financial report.

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, allow open communication and information flow and proper monitoring instruments. Lack of reporting should be faced with dire consequences.

According to the US federal organization sentence guide, adherence to ethical code and compliance to internal programs and efficient internal control can adequately mitigate eventual punishment of the company even when found culpable of the fraud contravening federal laws.

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. Because of its reputation in 2001, Enron used its stock and assets to acquire loans but somehow they were mismanagement and it’s started suffering losses (Healy & Palepu 5).

Since is its CEO, Kenneth Lay was a respected man for his achievement, he was able to continue securing loans through his connections. The company excluded debts from its financial reports and profits were consequently inflated. Arthur Anderson, the accounts manager hid and shredded financial documents. CEO’s Jeffery Skilling and Lay Kenneth were convicted were charged with fraud and insider trading and securities (Healy & Palepu 5).

Enron was closed 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). In regard to this principle, there are 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). 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 in that an auditing firm would not offer any other services to companies they have audited (Healy & Palepu 9).

The impact of the scandal was that it filed for bankruptcy and closes, workers lost their pension benefits in stock, investors (public and some workers) lost over $ 60 billion (Healy & Palepu 4).

Reference List

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 Deterence 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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