NATIONAL COLLEGE OF BUSINESS AND ARTS

Bachelor of Science in Business Administration Department

Fairview, Quezon City

WRITTEN REPORT
Subject Code: GBERMIC Description: Fraud and Error Term: Second Semester
Period: Midterm Period Academic Year: 2021 - 2022 Prepared by: Group 14

FRAUD

➢ It is an intentional act involving the use of deception that results in a material misstatement of

the financial statements.

TWO TYPES OF MISSTATEMENTS:

1. Misstatements arising from misappropriation of assets

2. Misstatements arising from fraudulent financial reporting

Misstatements arising from misappropriation of assets

➢ Asset misappropriation occurs when a perpetrator steals or misuses an organization’s assets.

Asset misappropriations are the dominant fraud scheme perpetrated against small businesses
and the perpetrators are usually employees.

Asset misappropriation commonly occurs when employees:

1. Gain access to cash and manipulate accounts to cover up cash thefts.

2. Manipulate cash disbursements through fake companies.

3. Steal inventory or other assets and manipulate the financial record to cover up the fraud.

Misstatements arising from Fraudulent Financial Reporting

➢ The perpetrator of such a fraud generally seeks gain through the rise in stock price and the
commensurate increase in potential wealth. Sometimes the perpetrator does not seek direct
personal gain, but instead uses the fraudulent financial reporting to “help” the organization
avoid bankruptcy or to avoid some other negative financial outcome.

3 Common ways in which Fraudulent Financial Reporting can take place:

1. Manipulation, falsification, or alteration of accounting records or supporting documents.

2. Misrepresentation or omission of events, transactions, or other significant information.

3. Intentional misapplication of accounting principles.

FRAUD TRIANGLE

INCENTIVES OR PRESSURES TO COMMIT FRAUD

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

Relating to fraudulent financial reporting include:

● Management compensation schemes

● Other financial pressures for either improved earnings or an improved balance sheet

● Debt covenants

● Pending wealth tied to either financial results or survival of the company

● Greed

OPPORTUNITIES TO COMMIT FRAUD

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 inconsistency involving subjective judgements regarding assets or accounting

estimates

● Simple transactions that are made complex through an unusual recording process

● Weak or nonexistent internal controls

RATIONALIZING THE FRAUD

Common rationalizations for asset misappropriation:

● Fraud is justified to save a family member or loved one from financial crisis

● No help is available from outside

● This is “borrowing”, and we intend to pay the stolen money back at some point

● Something is owned 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

Common rationalizations for fraudulent financial reporting:

● This is one-time thing to get us through the current 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

Can be accompanied in a variety of ways including:

1. Embezzling receipts
2. Stealing physical or intellectual assets

3. Causing an entity to pay for goods and services not received

4. Using an entity’s assets for personal use

Risk Factors Contributory to Misappropriation of Assets

Can be accompanied in a variety of ways including:

1. Manipulation, falsification (including forgery), or alteration of accounting records or supporting

documents from which the financial statements are prepared

2. Misrepresentation or omission of events, transactions, or other significant information.

3. Intentional misapplication of accounting principles relating to amounts, classification, manner of

presentation, or disclosure.

Fraudulent Financial Reporting

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.

Fraud involves:
A. Incentives / Pressure
To commit fraudulent financial reporting may exist when management is under pressure, from
sources outside or inside the entity.

B. Opportunities
A perceived opportunity to commit fraud may exist when an individual believes internal control
can be overridden.

Fraud can be committed by management overriding controls using such techniques as:
● Recording fictitious journal entries, particularly close to the end of an accounting period, to
manipulate operating results or achieve other objectives.
● Inappropriately adjusting assumptions and changing judgments used to estimate account
balances.
● Omitting advancing or delaying recognition in the financial statements of events and
transactions that have occured during the reporting period.
 ● Concealing, or not disclosing facts that could affect the amounts recorded in the financial
statements.
● Engaging in complex transactions that are structured to misrepresent the financial position or
financial performance of the entity.
● Altering records and terms related to significant and unusual transactions.

C. Rationalizations
Some individuals possess an attitude, character or set of ethical values that allow them knowingly and
intentionally to commit a dishonest act.

Material Weakness In Internal Control

A material weakness is a deficiency, or a combination of deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material misstatement of the
company of the company’s annual or interim financial statements will not be prevented or detected on
a timely basis.

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 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 likelihood of detection and punishment.

Fraudulent Financial Reporting through Earnings Management

Income Smoothing (also known as earnings management, cooking the books and paper
entrepreneurialism) refers to choosing accounting methods and making accounting principles changes
to produce a specified income level or trend. In particular, reducing the volatility of income and
reporting relatively gradual or continual increases in income are alleged to be common company goals.
The implicit assumption is that the investing public values a smooth and predictable income trend.

Motivation for Earnings Management

● Numbers are very important in framing people’s opinions. Rarely do we question how the
numbers are very computed.
● Reported numbers have power to frame opinions in the corporate arena
● This section describes the four reasons for managing reported earnings. These four reasons are
as follows:

1. Meet internal targets

2. Meet external expectations
3. Provide income smoothing
4. Provide window dressing for an IPO or a loan

Meet Internal Targets

To meet the nearly impossible earnings targets set by the CEO of a large business entity, the
employee who sells cartridges for laser printers reportedly resorted to shipping boxes filled with bricks
to meet sales targets at the end of the quarter. Managers of other corporations pressured by corporate
earnings and revenue targets, resorted to relaxing credit standards , reducing estimates of bad debts
and finally fraudulently concealing sales returns.

Meet External Expectations

External stakeholders, which include creditors, suppliers, customers, prospective investors, and
employees are parties who have interest in a company’s financial performance. Employees and
customers want a company to do well so that it can survive for the long run and make good on its long
term pensions and warranty obligations. Suppliers want assurance that they will receive payment and
more importantly that the purchasing company will be a reliable purchaser for many years into the
future.

Provide Income Smoothing

Income smoothing is the practice of carefully timing the recognition of revenues and expenses
to even on the amount of reported earnings from one year to the next.

Provide Window Dressing for a Loan or Initial Public Offering (IPO) of Equity Share
In situations such as a company applying for a large loan or before the IPO of stock, it is critical
that reported earnings look good. There is therefore the tendency of managers to boost their reported
earnings using accounting assumptions that can result in artificially inflating earnings.

Earnings Management Techniques

Earnings management generally involves a series of increasingly aggressive steps. Those steps
include reporting fictitious transactions, strategic matching of one-time gains and losses, change in
accounting methods with either full disclosure or with little or no disclosure or applying an accounting
method which is in violation of the Financial Accounting Standard. The earnings management continuum
(figure 14-1) Illustrates that earnings management can change from savvy timing of transaction to
outright fraud.

The Earnings Management Continuum

A. Strategic Matching
B. And
C. Changes in Methods or Estimates with Full or Little or No Disclosure
D. Fraudulent Reporting (applying accounting method that is not in accordance with Financial
Reporting Standards).
E. Fictitious Transactions.