Issues of Financial Statement Frauds Finance Essay

Frauds using erroneous financial information have straight association with accounting standards. False information is moreover made-up information with no support from authentic projects or relates to accounting standards and codes. Given that the commencement of modification, China has made growth in improving accounting codes. Actually, the designing and accomplishment of accounting codes can manipulate information openness and give increase to the opportunities to generate false information. A ("Journal Ratings List" Australian Business Deans Council)

Accounting codes is a very scientific concern. Numerous think the accounting codes as a "steel ruler" that allows no imprecision. On the other hand, the complication of modern wealth has put some areas of accounting theme to prudence and understanding or even personal partiality, which result in a ruler with suppleness. The subject of accounting codes did not draw much consideration at the commencement of the transformation. It was not in anticipation of 1993 that reforms were witnessed in business accounting and regulations.A  Throughout the Asian financial disaster more solid improvement was made in improving the account rules, which should be documented and appreciated. Simultaneously, that more is necessary to be done to bring our accounting rules up to the international standards. Several people still think in China there are too complex an accounting system as well as a corporate accounting system and also distinguishing accounting systems for dissimilar industries. For example, some business accounting rules need enterprises to construct value-loss reserves based on the recoverability of assets. Even though accounting rules of dissimilar industries have comparable requirements, they are all insufficient in terms of dependability comparing to business rules. Another subject is that, given that there was no comfort of a well-built accounting industry and exterior auditing facilities, when banks assessed the dependability of enterprises financial information, they did not need borrowers to offer exterior auditing results. In the prospect, banks may believe acquiring financial information audited by accounting firms and evaluation on enterprise's observance and borrowing conditions made by law firms, and assessment of collaterals made by assessment firms and bond classes given by rating firms.A  On the other hand, it may take years for the exceeding transitional services to develop, and the proficiency, reputation, brand-name, service excellence also take tens of years to build. Are the audited statements trustworthy? It actually depends and relates to the expertise and internal control of the firms. The development of intermediate financial service providers is exaggerated by market liberalization as well. If all of these issues cannot be dealt with successfully, likelihood of enterprises' providing false information and engaging in financial frauds will persist to be high.A ("Journal Ratings List" Australian Business Deans Council)

This circumstance is not about stock assessment, product quality or whether or not Microsoft has domination power in its markets.A Nor is it part of a pro or anti-Microsoft movement.A  This position is instead an unblemished instance of financial fraud and dishonesty enabled by bad government policy.A  Still the finest are manipulating the financial statements. This is the cause why it is significant to stop treatment of financial statements.

There are lots of reasons why persons dishonestly manipulate their organizations' financial statements. It may perhaps be to look company's earning better. It may be as well to disguise the embezzlement of company money and other management frauds. A few of the most general reasons why employees commit financial statements frauds are:

To give confidence to investment in the company

To reveal augmented earnings per share, thus encouraging increased dividend payments

To cover depressing cash flows

To attain new finances or to attain it in more positive terms than would otherwise be provided

To attain higher purchase price in conquest

To reveal fulfillment with financing covenants

To meet corporation goals and objectives

To obtain presentation related bonuses

It should be noted from this list that the inspiration for financial fraud does not essentially engage personal gain. Fraudulent financial statements often happen from the pressures moreover the organizations or its managers to 'perform' jointly with the conviction that the deception will not be detected. These pressures may act as "red flags" to the auditor and fraud examiner. ("Journal Ratings List" Australian Business Deans Council)

Examples of such pressures are:

Unexpected decreases in the company's sales or market share

Unrealistic budget pressures, chiefly for short term results

Financial pressures arising from extra plans that depend on short term economic presentation.

FRAUD DETECTION USING FINANCIAL STATEMENTS

As a forensic accountant, you may perhaps not for all time have to rebuild financial statements, but you should not obtain the ones given on face value.A  It's more a state of mind than a technique.A  The analysis of accounting records with no such a state of mind is called auditing. Looking for symbols of fraud is forensic accounting.A An auditor, on the other hand, may help offer an exploratory lead by discovering the nonexistence of a business reason for a transaction.A  Otherwise an auditor might find an inadequate amount of certification for a transaction.A All these inconsistencies and out-of-ordinary transactions will be fraction of any standard audit report.A  Forensic accountants will be looking additional into these matters for "suspect" transactions, and may wonderfully start with the journals or ledger to analyze the "Explanation" segment of books. For instance, a capital investment account might declare the name of someone outside to the organization, and securitization of the books might set up that Malik Bashir is also like mad involved in cash disbursements for supplies or subcontracted services.A The examination then proceeds from securitization to comparison, looking for similar vendors or subcontractors to see from such benchmarking if incredible is out of the ordinary with him.A  The innovative basis documents cancelled checks written to him might be analyzed to see which bank they were cashed at.A  Those foundation documents might disclose that the bank transferred the deposit to an additional account or name that was on the State Department's Entities list.A 

Fraud is frequently exposed when a number of small events, taken jointly, point to a probable pattern of dishonesty, and the following indicators are the classic "red flags", according to the IRS (1999), which speak about to deception throughout financial statements and accounting systems: ("Journal of Forensic Accounting (JFA)". R.T. Edwards)

Maintaining two sets of books and records (and/or destruction of books and records)

Camouflage of assets (distorted entries in advantage categories)

Great or recurrent cash transactions (or common utilize of cashier's checks)

Payments to invented companies or persons

false invoices or billings (unnecessary billing discounts or double billing)

purchase of over-valued assets (excessive spoilage or defects)

Huge company loans to employees or other persons

Using photocopies of basis documents instead of originals

Personal expenses paid with shared funds

Payee names left blank on checks and filled out later

Second or third-party endorsements on shared checks

Needless employ of compilation accounts

Too much use of exchange banks or clearing accounts

The basic difficulty is that Microsoft is incurring huge losses and only by accounting illusions that they are able to explain a profit.A  Particularly, Microsoft is giving way to extreme amounts of stock options that are allowing the company to understate its costs. What would ensue to Microsoft's stock price if the communal unexpectedly realized that they lost $10 billion in 1999 somewhat than earning the reported $7.8 billion?A  If 80 percent of its stock worth or approximately $400 billion is the result of a pyramid method, one might also ask what type of consequence this could have on the departure system. It is also significant to note that this is a comparatively new situation that did not happen before 1995.A  Microsoft has always been a extremely valued stock and that might have been defensible earlier to 1995. ("Journal of Forensic Accounting (JFA)". R.T. Edwards)

There are many fundamental reasons for financial risks. Foremost, the speedy global economic, technological and financial development has made it hard to concentrate on new problems with presented theories and experiences. Between these are the uncertainties in financial constancy. Second, in the changeover from designed to market economy, some aspects of institution building is still in a formless, non-planned and non-market, or conflicting stage. Third, actuality has proved that all kinds of problems in the economy are reflected in the workings of the financial system, which was mainly obvious throughout the Asian financial crisis. Financial risks if not addressed in a appropriate manner, could carry on to raise and expand into economic and financial disaster. We must put more stress on understanding the financial risks and the doubts involved. Simply by taking appropriate measures, could possible risks to be removed. It is a worldwide knowledge that the longer the risks are left unattended, the harder it is to solve them.

METHODS OF COMMITING FRAUD THROUGH FINANCIAL STATEMENTS

Deception includes the offensive practice of resources and the distortion of details to obtain gain. It is connected to the misallocation of resources, or the indistinct reporting of the continuation and accessibility of resources. Fraud is a leech that maims and ultimately kills an organization. After some time, its infectious consequence would find its way to another host organization.

It erodes the base lines and in the end or eventually the very continuation of any organization is unenthusiastically impacted. No matter what an organization is, be it non-profit or profit/business in nature, it cannot stay healthy to endure and be aggressive if fraud continues to go unobserved and unrestricted because clearly any organizational resource that is misallocated or "misused" threatens the sustained continuation of an organization. Several of the methods through which financial frauds are committed are mentioned below: ("Journal of Forensic Accounting (JFA)". R.T. Edwards)

Fictitious revenues

Fictitious or made-up income involves the recording of the sale of goods or services that did not take place. Fictitious sales typically engage fake or fictitious customers, but they may engage lawful customers. For instance, a fictitious invoice may be equipped for a rightful customer where the goods are not delivered or the services are not rendered. At the start of the next accounting era, the sale is then upturned. Another technique of using lawful customers' accounts is to change invoices to comprise higher amounts or quantities than are in fact sold.

Profit and revenue appreciation is based upon the subsequent criteria:

Definition

Measurability

Relevance

Reliability

The term 'revenue' is not distinct either in the Companies Acts or in any current accounting standard. The adjoining position to it is in SSAP2 regarding the carefulness concept:

'... revenue and profits are not probable, but are renowned by addition in the profit and loss account only when realized in the appearance either of cash or of other assets the definitive cash realization of which can be assessed with sensible 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'.

Further than one method may be used concurrently in order to exaggerate sales. In the following instance, the corporation used fabricated sales, premature or untimely gratitude of revenue.

EXAMPLE

A person required to lift its financial standing and engineered conjured 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. On the other hand, 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 entrance is made to trace the purchase of fabricated fixed assets. This debits fixed assets for the quantity of the acquisition and credits cash for the payment in the common way. A fictitious sales admission is then made for the same quantity as the false purchase, debiting debtors and crediting sales.

The result of this totally fabricated succession of events is to augment both the company's assets and revenue.

Pressures are located on owners and top management to carry out by bankers, shareholders, and even families and the community. The subsequent examples are instances in which they succumbed to the enticement to influence 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 entrust deception sometimes come from inside the organization. Departmental budget requirements counting profit and profit goals also support financial declaration 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.

Uncompleted sales

These engage sales that are made on convinced conditions that have not been met or not finished, by the end of the accounting period and possession has not yet accepted to the purchaser. They should not be documented as profits until finished. The most common examples of this are provisional 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. ("JFA: Editor-in-Chief". R. T. Edwards)

The income account would necessitate correcting to fulfill with the income recognition standard.

In addition, a provision needs to be finished for the undeserved sales on Project C. An entry needs to be made on the subtraction side of the Sales account to reduce the sales for the period by £17,000 and carried down as a credit balance to symbolize unearned sales. This equilibrium should then cancel the £17,000 debtor on the balance sheet.

In January, the project is started and finished. The entries below show the accurate recording of the £15,500 of costs linked with the project:

The outcome of these book keeping entries is to identify revenue and expenses for the period to which they really relate, i.e. January, thus matching them. This instance illustrates how effortlessly the non-adherence to the matching principle may cause a material misstatement in annual Profit and Loss Accounts.

Premature income recognition and the problem of long term contracts

Normally, revenue should be documented in the accounting records when a sale is absolute; that is, when title is approved from the seller to the buyer. Transmit of ownership completes the sale and is typically not final until all obligations surrounding the sale are complete.

This raises the difficulty of long-term contracts, particularly construction contracts. A contract which extends for more than one year will typically require to be accounted for as a long term contract under SSAP 9 (para. 22). At this point, revenue should be ascertained in a manner both appropriate to the stage of the agreement and to the business in which the industry operates (para. 28). For example, if the outcome of a long-standing contract can be assessed with sensible assurance before its termination, the reported income should be the dissimilarity among the reported revenue and the related costs for the contract (para. 29).

No definition of revenue is given in SSAP9. It simply states that turnover is ascertained in a way suitable to the phase of conclusion of the contract, the business and the industry in which it operates. It is left to individual firms to choose according to their own circumstances. On the other hand, the amount of profit taken in an accounting period would usually relate to divide or measurable parts of the contract completed within that period.

for this reason, even though accounting for long-term contracts represents an exception to the usual definition of sales (their occurrence being determined by the fleeting of ownership), it is based on conservatism and sound conclusion leading to true and fair financial reports. Misrepresentation occurs when these principles are not functional.

The subsequent instance illustrates how untimely appreciation of proceeds not only leads to financial declaration distortion but also encourages additional 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 essentially was. When this came to light and was investigated, several embezzlement schemes, fictitious expense schemes and cases of credit card fraud were also uncovered.

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 achievement so far, he recorded promised donations before they were actually received. The scheme had been in continuation for more than four years before it was discovered.

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 months of operations remarkably under budget. He therefore decided to get'head start' on the next year's expenditures. He bought £30, 000 of unneeded supplies and charged them against the current year's budget. ("JFA: Editor-in-Chief". R. T. Edwards)

The interior auditors noticed the augment in expenditure and investigated the situation. The manager explained that he was beneath pressure to meet budget goals for the following year. Since he was not attempting to deceive 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. ("JFA: Editor-in-Chief". R. T. Edwards)

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 just not to record them. They may perhaps or may not be recorded at a later time, but this does not change the deceitful effect on the financial statements.

For the reason that they are easy to conceal, omitted liabilities are most likely one of the most difficult to discover. A methodical 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.

Frequently, perpetrators believe they can complete the deception into future periods. They frequently plan to recompense for the omitted liabilities with other revenue such as increased profits from future price Increases. ("JFA: Editor-in-Chief". R. T. Edwards)

EXAMPLE

The owner of a widely traded retailer falsified financial statements by concealing liabilities and inflating stock. The purpose was to increase productivity, thereby attracting new investors. He intended to obscure the fraud by increasing selling prices when the expenses were charged. On the other hand, a tip-off by an employee to the company's audit committee caused an exploration.

Fraudulent Capitalization of expenses

The difference between capital and revenue expenses arises out of the matching sense. Capital expenditure is spending that produces benefits to the company over a future accounting period (most likely more than one). Manufacturing equipment costs are an illustration. Revenue expenditure, on the other hand, is expenditure matched with present revenue whose benefits only enlarge to the current accounting period. An instance 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 growth. ("JFA: Editor-in-Chief". R. T. Edwards)

Capitalizing revenue expenditure is a method of mounting profits and assets as it is charged against future profits rather than straight away. The result is that profit for the present period is overstated and for succeeding periods, it is understated.

Often normally accepted accounting principles are not always clear regarding the capitalization of costs so abuses may happen. The fraud examiner should be conscientious in ascertaining whether it is suitable to capitalize expenditure and discuss with applicable accounting standards.

Fraudulent charging of capital expenditure against profits

Immediately as capitalizing expenses is incorrect, so is charging to the Profit and Loss Account costs that should be capitalized. A company may perhaps desire to reduce its net profit for to tax reasons. Charging alongside profits an item that should be depreciated above a period of time may assist accomplish lower net profits and, consequently, less tax to be paid, Internal budget constraints also put stress on accounting staff into misallocating capital items as revenue costs.

Fraudulent accounting for returns, allowances and warranties

An incorrect responsibility for these will happen if the company fails to correctly account for possible product returns or repairs. It is expected that a convinced percentage of products sold will, for one motivation or another, be returned. It is the job of administration to try to precisely approximation what this will be and make stipulation for it. ("JFA: Editor-in-Chief". R. T. Edwards)

In warranty responsibility fraud, the problem is either misplaced in general or significantly understated. A comparable case is accounting for the liability arising from substandard products (product liability).

EXAMPLE

A manufacturing company produced government weaponry. Some did not meet up stipulation and the company was responsible for resolving this. Management decided to distinguish the cost as items were returned and the work was performed which would be conducted over a substantial future period.

Malfunction to estimate and record the whole warranty cost resulted in a material understatement of costs and exaggeration of profits for the periods in which the contract revenues were received and the accountability was not recorded.

Misleading disclosure

While it was discussed previously, accounting principles need that financial statements and related notes comprising the entire information essential to put off the user from being misled. Management has a compulsion to divulge all significant information in a suitable way. If not disclosed in the financial statements, the essential information should emerge in the footnotes or elsewhere in the report. ("JFA: Editor-in-Chief". R. T. Edwards)

The information that is disclosed should also not be confusing. Fraud during incorrect or deceptive disclosure typically involves one of the subsequent: liability omissions, significant event omission, related-party transactions, and accounting changes.

FINANCIAL STATEMENT ANALYSIS

The assessment of financial statements provides significant information for the fraud examiner. Absolute values in the accounts offer only a limited amount of information. The conversion of these numbers into ratios or percentages allows the assessor of the statements to scrutinize relationships between accounting numbers and assist comparisons with data for other companies of a dissimilar range. Accounting ratios adjusts for differences in size as the denominator is typically a measure of size.

In deception discovery and exploration, the determination of the reasons for the relationships between accounting numbers and changes in these may be significant. These are potential red flags that may point an examiner in the direction of a deception. If large sufficient, a fraudulent misstatement will influence the financial statements in such a way that relationships among the numbers become questionable. Many schemes are detected since the financial statements, when examined intimately cannot be supported. ("JFA: Editor-in-Chief". R. T. Edwards)

Alternatively, some management frauds may engage a whole cover-up in the financial statements and a scrutiny of the reported aggregated data will not present any indication of fraud.

In cases where financial statement study may propose areas for investigation by the fraud examiner, he should accept one of the two approaches:

An inductive approach: This involves an entire analysis of the financial statements in an effort to recognize inconsistencies and anomalies in the reported data that may recommend fraud.

A deductive approach: This presumes that the fraud investigator has received a proposal of fraud. As a consequence, he may be capable to theorize as to how the financial statements should be affected if the fraud has been committed. His task is basically to test the premise.

Financial statement analysis comprises what are identified as:

Vertical analysis

Horizontal analysis

Ratio analysis

Percentage analysis

There are usually two methods of percentage scrutiny of financial statements: vertical and horizontal analysis.

Vertical analysis

It is a method for analyzing the relationship flanked by the items on the financial statements (the Profit and Loss Account, Balance Sheet, or Statement of Cash Flows) by expressing components as percentages. This technique is frequently referred to as "common sizing". In the vertical analysis of a Profit and Loss Account, turnover is allocated 100%; for a Balance Sheet, total assets are assigned 100%. All other items in each of the sections are uttered as a percentage of these numbers. ("JFA: Editor-in-Chief". R. T. Edwards)

Vertical analysis emphasizes the relationship of statement items inside an accounting period. These relationships can be used with historical averages to conclude anomalies in the accounts.

Horizontal analysis

It is a method for analyzing the percentage change in personage financial statement items from one year to the next. The first period in the scrutiny is considered the base, and the changes to following periods are computed as a percentage of it. As with upright analysis, this method will not work for frauds connecting small amounts of money.

It is significant here to believe the amount of the change in addition to its percentage. A 5% change in a very huge item in the accounts may in fact be greater than a 50% change in a much slighter item.

In this piece I have discussed what are the frauds are dedicated throughout financial statements how they are dedicated and what procedures are followed to reveal them. All this information not only helps us to know that their deceitful 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 current financial principles.

The thing to observe is these gaps can be uninvolved to put off and confine these fraudulent practices but it is not being done and the deception through finance and accounting is escalating.

Entirely I can say is that the companies them selves should support ethical practices in their culture to nip the difficulty in the bud. We know it is probable that the honest man not produce rich as fast as the deceitful one; but the achievement will be of the truer kind, earned lacking fraud or injustice. And even though a man should for a moment be ineffective still.

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