Error and Fraud

Introduction to Fraud and Error

In the previous modules, corporate governance has been described as the process by which the owners and various of
stakeholders of an organization exert control through requiring accountability for the resources entrusted to the
organization.

This module introduces fraud risk and errors and how they can be reduced if not totally avoided by having effective
internal control - a tool of good corporate governance.

Fraud is an intentional act involving the use of deception that results in a material misstatement of the financial
statements. Two types of misstatements are relevant to auditors’ consideration of fraud: (a) misstatements arising from
misappropriation of assets, and (b) misstatements arising from fraudulent financial reporting.

Intent to deceive is what distinguishes fraud from errors. Auditors routinely find financial errors in their client’s books,
but those errors are not intentional.

THE FRAUD TRIANGLE

The Fraud Triangle characterizes incentives, opportunities and rationalizations that enable fraud to exist.

The three elements of the fraud triangle are:

• Incentive to commit fraud

• Opportunity to commit and conceal the fraud
• Rationalization — the mindset of the fraudster to justify committing the fraud.

Incentives or Pressures to Commit Fraud

Incentives relating to asset misappropriation include:

 Personal factors, such as severe financial considerations

 Pressure from family, friends, or the culture to live a more lavish lifestyle than one's personal earnings allow for
 Addictions to gambling or drugs

The incentives include the following for fraudulent financial reporting:

 Management compensation schemes

 Other financial pressures for either improved earnings or an improved balance sheet
 Debt covenants
 Pending retirement or stock option expirations
 Personal wealth tied to either financial results or survival of the company
 Greed — for example, the backdating of stock options was performed by individuals who already had millions of
pesos of wealth through stock

Opportunities to Commit Fraud

One of the most fundamental and consistent findings in fraud research is that there must be an opportunity for fraud to be
committed. Although this may sound obvious — that is, "everyone has an opportunity to commit fraud" — it really
conveys much more. It means not only that an opportunity exists, but either there is a lack of controls or the complexities
associated with a transaction are such that the perpetrator assesses the risk of being caught as low. Some of the
opportunities to commit fraud that the top management should consider include the following:

 Significant related-party transactions

 A company's industry position, such as the ability to dictate terms or conditions to suppliers or customers that
might allow individuals to structure fraudulent transactions
 Management’s inconsistency involving subjective judgments regarding assets or accounting estimates
 Simple transactions that are made complex through an unusual recording process
 Complex or difficult to understand transactions, such as financial derivatives or special-purpose entities
 Ineffective monitoring of management by the board, either because the board of directors is not independent or
effective, or because there is a domineering manager
 Complex or unstable organizational structure
 Weak or nonexistent internal controls

Rationalizing the Fraud

For asset misappropriation, personal rationalizations often revolve around mistreatment by the company or a sense of
entitlement (such as, ’’the company owes me!”) by the individual perpetrating the fraud. Following are some common
rationalizations for asset misappropriation:

 Fraud is justified to save a family member or loved one from financial crisis.
 We will lose everything (family, home, car and so on) if we don’t take the money.
 No help is available from outside.
 This is "borrowing”, and we intend to pay the stolen money back at some point.
 Something is owed by the company because others are treated better.
 We simply do not care about the consequences of our actions or of accepted notions of decency and trust; we are
for ourselves.

For fraudulent financial reporting, the rationalization can range from "saving the company” to personal greed, and may
include the following:

 This is one-time thing to get us through the current crisis and survive until things get better.
 Everybody cheats on the financial statements a little; we are just playing the same game.
 We will be in violation of all of our debt covenants unless we find a way to get this debt off the financial
statements.
 We need a higher stock price to acquire company XYZ, or to keep our employees through stock options, and so
forth.

Risk Factors Contributory to Misappropriation of Assets

Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by employees in relatively small
and immaterial amounts. However, it can also involve management who are usually more able to disguise or conceal
misappropriations in ways that are difficult to detect.

Misappropriation of assets is often accompanied by false or misleading records or documents in order to conceal the fact
that the assets are missing or have been pledged without proper authorization.

A. Incentives / Pressures
a. Personal financial obligations may create pressure on management or employees with access to cash or
other assets susceptible to theft to misappropriate those assets.
b. Adverse relationships between the entity and employees with access to cash or other assets susceptible to
theft may motivate those employees to misappropriate those assets.
B. Opportunities
a. Certain characteristics or circumstances may increase the susceptibility of assets to misappropriation. For
example, opportunities to misappropriate assets increase when following situations exist:
i. large amounts of cash on hand or processed.
ii. inventory items that are small in size, of high value, or in high demand.
iii. fixed assets which are small in size, marketable, or lacking observable identification of
ownership.
b. Inadequate internal control over assets may increase the susceptibility of misappropriation of those assets.
C. Attitudes / Rationalizations
a. Disregard for the need for monitoring or reducing risks related to misappropriation of assets.
b. Disregard for internal control over misappropriation of assets by overriding existing controls or by failing
to correct known internal control deficiencies.
c. Behavior indicating displeasure or dissatisfaction with the entity or its treatment of the employee.
d. Changes in behavior or lifestyle that may indicate assets have been misappropriated.
e. Tolerance of petty theft.

Risk Factors Contributory to Fraudulent Financial Reporting

Fraudulent financial reporting involves intentional misstatements including omissions of amounts or disclosures in
financial statements to deceive financial statement users. It can be caused by the efforts of management to manage
earnings in order to deceive financial statement users by influencing their perceptions as to the entity’s performance and
profitability. Such earnings management may start out with small actions or inappropriate adjustment of assumptions and
changes in judgments by management. Pressures and incentives may lead these actions to increase to the extent that they
result in fraudulent financial reporting. Such a situation could occur when, due to pressures to meet market expectations or
a desire to maximize compensation based on performance, management intentionally takes positions that lead to
fraudulent financial reporting by materially misstating the financial statements. In some entities, management may be
motivated to reduce earnings by a material amount to minimize tax or inflate earnings to secure-bank financing.

A. Incentive / Pressure
Incentive or pressure to commit fraudulent financial reporting may exist when management is under
pressure, from sources outside or inside the entity, to achieve an expected (and perhaps unrealistic)
 earnings target or financial outcome — particularly since the consequences to management for failing to
meet financial goals can be significant.
B. Opportunities
A perceived opportunity to commit fraud may exist when an individual believes internal control can be
overridden, for example, because the individual is in a position of trust or has knowledge of specific
weaknesses in internal control.

Fraudulent financial reporting often involves management override of controls that otherwise may appear
to be operating effectively.

Responsibility for the Prevention and Detection of Fraud

The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of
the entity and management. It is important that management, with the oversight of those charged with governance,
place a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud
deterrence, which could persuade individuals not to

commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a culture
of honesty and ethical behavior which can be reinforced by an active oversight hy those charged with governance. In
exercising oversight responsibility, those charged with governance consider the potential for override of controls or
other inappropriate influence over the financial reporting process, such as efforts by management to manage earnings in
order to influence the perceptions of analysts as to the entity's performance and profitability.

C. Rationalizations
Individuals may be able to rationalize committing a fraudulent act. Some individuals possess an attitude,
character or set of ethical values that allow them knowingly and intentionally to commit a dishonest act.
However, even otherwise honest individuals can commit fraud in an environment that imposes sufficient
pressure on them.