Financial Fraud: The Fraud Triangle Theory

The fraud triangle is a theory that consists of perceived pressures, perceived opportunity, and rationalization. It gives us the different pressures placed on individuals that would make them consider “cooking the books. It also demonstrates where the possible opportunity lies so that we may take precautions to eliminate the opportunity. Last, it demonstrates how a roadster rationalizes with themselves to make committing the fraud okay. Donald Crosses believes all three elements must be present for fraud to occur. Upper management is usually the focus of financial statement fraud because financial statements are done at the management level. So in this case financial statement fraud was committed by the Chief Executive Officer and Chief Financial Officer.

A person in such positions as CEO and SCOFF can be motivated to commit financial statement fraud because of perceived personal or corporate pressures such as maintaining personal income or wealth that stems from paving beyond their means, preserving status or control- whether it be the company or a department within the company, particularly if bad performance will lead to termination, or to conceal true business performance especially if the company isn’t performing well. Another pressure could be financial goals placed on the company as a whole or through its departments.

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The most consistent pressure for top executives is that they sometimes find it hard to meet Wall Street expectations. Instead of admitting they are unable to meet the expectations they “cook the books” to make it appear as if the company reached its financial goals. Perceived opportunity occurs when the fraudster thinks that they can commit the crime without being caught. Opportunities can stem from a variety of places in the work industry. Fraud opportunity will only exist with the knowledge of general information and technical skill.

General information can come from the fraudster knowing the ends and outs of the company. Technical skills can be more difficult and be done through the company’s financial statements from top executives such as the CEO and SCOFF. There are numerous fraud schemes that are committed these days and they all give the roadster that perceived opportunity. Under such circumstances, a fraudster can rationalized why committing such a crime is justifiable. The fraudster may believe that money is owed to them for doing such a great job, its their company, it’s only for a short period of time and it isn’t hurting anyone.

A fraudster may commit financial statement fraud do to pressures from Wall Street and may justify his actions because he believes that the company cannot let investors and the public down. They want to believe that what they are doing is in the best interest for the stakeholders. These corporate officials may also be carrying around big egos that won’t allow them to fail. When it comes to financial statement fraud, I think public companies that try to meet Wall Street expectations feel a certain pressure to commit fraud if they cannot meet the goals that are set. The average estimate of a public company’s quarterly earnings and revenues, derived from forecasts of securities analysts who provide research coverage on the company. The Street expectation is a closely watched number that assumes prominence during the period when most public companies report their results. ” The investors use these factors to influence their choices. So with this being a deciding factor in their decisions as whether to invest or not could be pressure to “cook the books” if a company isn’t performing well. And in the fraudsters mind it justifiable.

Their rationalization is that they are keeping the company afloat. Financial reporting fraud is defined as an intentional misrepresentation, misstatement or omission of a company’s financial reporting information for the purpose of misleading the public, its investors and Wall Street analysts by creating a false impression of the company’s financial health. Financial statement fraud will generally include improper revenue recognition, manipulation of liabilities, manipulation of expenses, improper disclosures on financial statements or overstating assets.

Every company should strive to have a high level of corporate governance and effective oversight. But the stakeholders play a very important role in preventing and deterring fraud. Stakeholders includes customers, suppliers, employees, the community and the government. Each play an important role since they have an interest in the integrity of financial reports of the publicly- rated company. Employees have a vested interest in the company’s success and they have a responsibility to protect their interest. Their roles may start from the bottom but they are key players in the company.

To help deter or prevent financial statement fraud, the employee must report financial reporting fraud if it is detected. This can be done byway of a vigorous whistler’s program of some other tip line provided by the company. The community and its members, including the news media, can play a regulator role by confirming that the company is a good citizen with fair business raciest. Shareholders should make sure that any company in which theft like to invest is in compliance with standards of oversight and ethics.

Investors need to play and active role also. They should be actively involved by monitoring the companies in which they invest. They should attend shareholder’s meeting regularly to discuss concerns and check the books of the company. This will allow them to stay current with what is going on within the company. Shareholders should always remain vigilant and make sure that upper management is held accountable for their actions and also make sure hat there is a compliance system in place. Shareholder activism should help prevent and deter fraud.

In my opinion, to produce financial reports that are free and clear of material misstatements there needs to be effective corporate governance aboard along with internal controls that are effective and used on a daily basis. Now in regards to corporate governance and its efforts to prevent, deter and detect financial statement fraud there are plenty involved such as management, governing bodies, internal auditors, external auditors, board of directors and the audit committee. Corporate governance keeps the company honest and works diligently to protect stakeholders from financial reporting fraud.

The responsibilities include the designing of internal controls, the implementation of internal controls and the testing of the effectiveness of the controls that are placed. Upper Management should prevent and deter financial reporting fraud by first setting a tone at the top environment for the rest of the company. The CEO is responsible for demonstrating a positive ‘tone at the top” and establishing accountability at all levels. Management has a primary duty of insuring that the financial reports are free of material misstatements.

This starts with creating an accounting system that is in conformity with Generally Accepted Accounting Principles. They should be using appropriate and reasonable estimates in regards to the financial reporting process and make all of these reports available to the auditors. It is the duty of the top managers to ensure that the company is in compliance with all rules and regulations by designing and maintaining a system of internal controls that are effective and efficient. They should ensure that all documents are recorded in accordance tit accounting practices and policies.

Management should provide leadership that is needed to establish an integrated internal control structure. They are responsible for implementing the procedures that lower identified fraud risks. Internal auditors have a responsibility to be proactive and not just reactive in the prevention and deterrence of financial reporting fraud. They are in a position where they can effectively monitor the company’s internal controls and identify red flags as they develop. They are responsible for reporting any red flags to the audit committee. The internal auditors are required to work and and hand with management and the audit committee.

In fact, many of the governing bodies encourage the internal auditors to take an active role in assessing the quality, reliability and integrity of the financial reporting process. External auditors are required by PEPCO auditing standards to provide reasonable assurance that the financial statements are free and clear of any material misstatements which cannot only be caused by fraud but error as well. External auditors must maintain a professional level of skepticism. ASS No. 9 requires external auditors to discuss any issues of fraud or suspected read with management and employees.

This gives employees the opportunity to blow the whistle which can be an effective way to prevent, deter and detect fraud. In regards to the financial statements, the external auditor is required to perform test on the company’s internal controls and also perform risks assessments. ASS No. 99 provides different approaches such as performing the audit closer to the end of the year, changing the approach year to year, investigating possibility transactions and interviewing personnel in the area where financial statement fraud is deemed likely.

If trial weaknesses are discovered during the audit, the external auditor must communicate the findings in writing to management and the audit committee. If the external auditor finds that the oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee is ineffective, the auditor must communicate that conclusion in writing to the board of directors. These Steps are necessary in the prevention, deterring and detection of financial reporting process.

The board of directors are responsible for acting in the best interest of the hardliners and protecting the interest of other stakeholders. In regards to financial reporting fraud, the role of the board of directors is to oversee the whole financial reporting process and provide vigilant oversight of the company’s governance. The board is responsible for monitoring the managerial decisions and they have the ability to replace the CEO if necessary.

The oversight of the board and the audit committee is essential because the upper management designs the internal controls that are put into place which leaves them vulnerable to management override. The board Of directors delegates some responsibilities to the audit committee such as monitoring the effectiveness of the corporate ethics and compliance programs, monitoring management, and working with the internal and external auditors to ensure that the company has effective internal controls in place to deter and detect fraud.

The primary responsibilities of audit committees in the post-SOX era are to understand the implications of significant transactions regarding financial reporting and internal controls. The board places the audit committee at the forefront. They have access to information and are in the best position to identify red flags, or opportunities that stem from weak internal controls. ASIA No. 3 requires the audit committee to notify the appropriate people in the company if they suspect financial statement fraud.

If they believe that upper management is involved, they are to report their findings to the board of directors. Regulators or governing bodies are in place to protect the investors. “Regulatory’ reforms in the United States are aimed at improving the integrity, safety, and efficiency of the capital markets while maintaining their global competence. ” Our governing bodies includes Serbians-Solely Act of 2002, The Securities Exchange Commission, The Public Accounting Standards Board and The Financial Accounting Standards Board.

In regards to preventing and detecting financial reporting fraud, the governing bodies are responsible for establishing regulations and provisions for the company and its subordinates to follow. If the company fails to follow these regulations, fines, penalties, and even prosecution can be brought on. Serbians-Solely was put in place to protect the investors and to restore the investor’s confidence. In regards to preventing and detecting financial statement fraud, SOX ensures that there is o statute of limitations on financial reporting fraud.

It is punishable by law no matter when it is discovered. SOX also holds the CEO and the SCOFF accountable for establishing and maintaining internal controls within a company. In an effort to deter upper management from financial reporting fraud SOX requires the CEO and SCOFF to certify that the financial reports are free of material misstatements and are accurate to the best of their knowledge. The SEC is responsible for enforcing compliance with federal laws and alerting investors when there is a possibility of fraud taking place. The SEC has the authority to enforce companies to comply with GAP.

It has delegated most of its accounting standard-setting authority to the FAST it works hand and hand with to establish GAP. The role of these governing bodies is to ensure oversight is in place to protect the investors and prevent and deter financial reporting fraud. They require financial disclosures to allow the investors to make rational economic decisions on their investments. The SEC also monitors market activity refer cases to the Justice Department for prosecution. In my opinion, to prevent and detect fraud I recommend that the company iris set a “tone at the top” atmosphere.

Tone at the top is a crucial part Of a sustainable ethical culture. Tone at the top is the driving force for the company and it creates a pathway as to where the company is headed. Promoting the correct tone is very important for the company. My next recommendation is that the when the company is preparing its financial statements they are careful to stay within the guidelines of the regulators such as GAP, SOX and the SEC. They create an outline for the preparation of the financial reports and if followed the reports should be free and clear of trial misstatements. Also recommend that internal controls are in place and is tested quarterly to maintain effectiveness and adequacy. An important part of internal controls are the separation of duties. There should be as little overlap as possible in the duties and responsibilities of every employee. Those who process should not approve and vice versa. My next recommendation is for a whistler’s program to be put into place for employees. Having an effective whistler’s program will allow employees to report questionable accounting practices therefore deterring financial reporting fraud.

If it doesn’t deter the fraud it will at least catch the fraud before it becomes out-of-control or massive fraud. I recommend the external auditors be independent and work hand and hand with the internal auditors and the audit committee. This will not only deter but could possibly prevent the fraud altogether. My last recommendation is to establish a competent and well-rounded board of directors. The board of directors should be independent and diverse. This group of individuals should understand business and present leadership qualities that would be effective in preventing financial reporting fraud. NT believe that financial reporting fraud will ever go away. The same as with crime altogether, there will always be individuals who have no regards for others or punishments when it comes to saving themselves and what they feel they are entitled to. Even with the implantation of SOX and the SEC regulations, investing will always be a risky business. Yes, investor’s confidence has been restored but the SEC is not accountable if it fails the investor. There are too many loopholes and too many different accounting methods to throw off the auditors.

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Financial Fraud: The Fraud Triangle Theory. (2018, Apr 09). Retrieved from