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Models of Corporate Fraud - Model 2: The Fraud Triangle



Fraud Triangle (a micro-model):


Fraud detection requires understanding the psychology and personal character traits of fraudsters and how they react to opportunities.



Three key factors are present when an ordinary person commits fraud: rationalization, opportunity, and motivation or pressure:


1. Pressure

2. Opportunities

3. Rationalization



Pressure


  • The incentive to misstate earnings can arise due to pressure to meet analysts' forecasts, compensation and incentive structures, the need for external financing, or poor performance.

  • Motivation to manipulate earnings is the desire to attract external financing at low cost.

  • Equity Incentives ~ no relation with fraud but the likelihood of a misstated financial statement increases when the CEO has a sizable amount of stock options "in-the-money."

  • They also find that misstatements are more likely for firms constrained by debt covenants, firms raising new debt or equity capital, or firms that have a CEO who serves as the chairman of the board

  • Beneish (1999a) finds that, for a group of firms subject to accounting enforcement actions by the SEC, managers are more likely to sell equity holdings and exercise stock appreciation rights in periods when earnings are inflated, suggesting insider trading behavior may be informative about earnings overstatements.

  • A Glass Lewis & Co. (2006) report states that about half of the companies implicated in backdating their stock options have restated their financial statements

  • Rosner (2003) findings suggest that the behavior of failing firms that do not appear distressed on the basis of accrual data, but nonetheless show significant decreased cash flows, is consistent with material earnings overstatements in non-going-concern years that are followed by overstatement reversals in going-concern years


Opportunities


  • Some of risk factors include the nature of the industry or the entity's operations such as significant complex or related party transactions, ineffective monitoring of management, a complex organizational structure such as one that involves several legal entities, and ineffective controls due to a lack of monitoring of controls or circumvention of controls.

  • Do they company have strong internal control systems?

  • Several studies have shown that ineffective monitoring of management in the form of weak corporate governance is associated with a higher likelihood of fraud.

  • Firms manipulating earnings are more likely to have less independent boards, unitary structure for chairman and CEO. More likely to be the founder of the company, less likely to have audit committee and less likely to have outside blockholders.

  • Abbott et al. (2004) address the impact of audit committee characteristics (independence, activity level, and financial expertise) on the likelihood of financial statements being restated (and also fraud).

  • McMullen and Raghunandan (1996) also document that compames with financial reporting problems are less likely to have an audit committee composed of independent directors

  • Smith et al. (2000) examine a model where the strength of internal controls is inversely related to the propensity of a manager to commit fraud. In their model, the auditor's assessment of the control system affects their allocation of effort between control testing and substantive testing, but the likelihood of detecting the fraud does not increase when the auditor exerts effort to assess controls.Smith et al. (2000) examine a model where the strength of internal controls is inversely related to the propensity of a manager to commit fraud. In their model, the auditor's assessment of the control system affects their allocation of effort between control testing and substantive testing, but the likelihood of detecting the fraud does not increase when the auditor exerts effort to assess controls.

  • Bernardi (1994) finds that managers outperform seniors in a fraud detection case when they are exposed to an initial evaluation of client integrity and competence; however, this finding is attributable to managers with a high level of moral development.



Rationalizations



  • Accounting standards can contribute to reducing both the opportunity and attitude toward fraudulent financial reporting.

  • Researchers fount that when accounting standards are precise, managers are more likely to attempt earnings management with transaction structuring (such as structuring a lease in a particular way to avoid a capital lease classification or by opportunistically timing sales of available-for-sale securities), and auditors are less likely to adjust those attempts.

  • Managers were more likely to make attempts that decrease income with unstructured transactions (such as increasing or decreasing estimates involving judgment) when standards were imprecise.

  • Managers are more likely to make attempts to increase earnings, but auditors are more likely to require adjustment in those cases, particularly if the amount is material.


Symptoms of Fraud


Symptoms of fraud can be separated into six main groups:


1. Accounting anomalies,

2. Internal control weaknesses,

3. Analytical anomalies,

4. Extravagant lifestyle,

5. Unusual behavior,

6. Tips and complaints.



1. Accounting Fraud


Irregularities in Source Documents


• Missing documents

• Stale items on bank reconciliations

• Excessive voids or credits

• Common names or addresses of payees or customers

• Increased past-due accounts

• Increased reconciling items

• Alterations on documents

• Duplicate payments

• Second endorsements on checks

• Document sequences that do not make sense

• Questionable handwriting



2. Internal control weaknesses


• Lack of segregation of duties

• Lack of physical safeguards

• Lack of independent checks

• Lack of proper authorization

• Lack of proper documents and records

• Overriding of existing controls

• Inadequate accounting system



3. Analytical Fraud Symptoms


• Unexplained inventory shortages or adjustments

• Deviations from specifications

• Increased scrap

• Excess purchases

• Too many debit or credit memos

• Significant increases or decreases in account balances, ratios, or relationships

• Physical abnormalities

• Cash shortages or overages

• Excessive late charges

• Unreasonable expenses or reimbursements

• Excessive turnover of executives

• Strange financial statement relationships, such as:

  • Increased revenues with decreased inventory

  • Increased revenues with decreased receivables

  • Increased revenues with decreased cash flows

  • Increased inventory with decreased payable

  • Increased volume with increased cost per unit

  • Increased volume with decreased scrap

  • Increased inventory with decreased warehousing

  • costs

4. Extravagant Lifestyle



  • Most people who commit fraud are under financial pressure. Sometimes the pressures are real; sometimes they merely represent greed. Once perpetrators meet their financial needs, they usually continue to steal, using the embezzled funds to improve their lifestyles.


5. Unusual Behavior






6. Tips and Complaints


  • The types of fraud committed are - Concealment, theft and conversion.

  • Usually Company employees are in the best position to detect fraud.

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