Specialisation: Fraud Triangle

The Determinants and Consequences of Accounting Fraud

Abstract

The business community demands open corporate reporting for investment choices to be made without being based on significantly falsified financial accounts. This indicates that it is vital for business executives, auditors, the board of directors, investors, and regulatory organizations to recognize and stop possible profit fraud. To increase our ability to identify and prevent fraud, the literature study aims to understand better the anatomy of false financial statements and the causes, reasons, and motives behind them. Therefore, it is claimed that the “fraud triangle” and “fraud diamond” are effective models for comprehending fraud’s causes. Consequently, in agreement with Zahra et al. (2005), the report recommends more investigation into the motivations behind fraud behavior and the use of forensic accounting tools to increase the likelihood of finding fraud in a timely, efficient way.

Additionally, this article examines existing research to clarify the critical characteristics of accounting fraud while reviewing the environment and various fraud prevention strategies. The study will examine the stages involved in how corporate governance, moral conduct, accounting fraud, detection strategies, and forensic accounting are connected to fraud. The most pertinent academic research on the subject was studied. It became clear that setting up an ethical education program for executives and staff was the most effective way to prevent corporate fraud. This paper will also focus on determining how governance components like the board, CEO, or compensation affect the prevalence of fraud inside corporations.

Key Words: Accounting Fraud, Corporate Governance, Fraud Prevention, Fraud Detection, Forensic Accounting, Accounting frauds, fraud triangle, fraud diamond, financial fraud

Introduction

To prevent fraud and wrongdoing, businesses must abide by a system of rules, laws, and policies called corporate governance. Through a regulatory framework, the states themselves attempt to impose certain limits. Moreover, the organization and the board of directors are the subjects of these measures businesses choose to implement. It is also worth noting that recent literature has emphasized managers’ and CEOs’ roles in accounting fraud. In their article, Troy et al. (2011) examined how some CEOs could be more likely than others to perpetrate fraud could. They noted that a particular sort of managing director, sharing the same traits (less functionally experienced and lacking a business degree), is more likely to justify an accounting deception.

Furthermore, the association between CEO experience and the likelihood of accounting fraud is not moderated by CEO stock options, a measure frequently used to regulate managers’ attitudes and bond the company’s stock values and some rewards. Hence, the findings indicate that stock options and accounting fraud are directly related. However, research by Armstrong et al. (2010) has demonstrated no proof between CEO stock incentives with anomalies in accounting. Consequently, the findings support the idea that stock incentives help managers align their interests with those of shareholders.

Accounting frauds happen when figures are fabricated for the accounts or when accounting rules are improperly applied and willfully misinterpreted. Management consciously creates financial statement frauds to meet pre-set financial objectives. Now, auditing methods only sometimes find copies. Therefore, auditors and other interested parties must understand the relative frequency of different forms of fraud. Thus, with an understanding of the frequency and patterns of fraud schemes, auditors, forensics, regulators, investors, and academics, among others, could better comprehend the management fraud’s commission and concealment processes, assisting in the assessment of the overall fraud risk and the risk associated with different types of fraud schemes.

In addition, the compensation of CEOs affects other issues with corporate governance, such as the prevalence of accounting fraud. According to Jensen et al. (2004), equity-based pay schemes, standard pay plans, and bonus plans may allow CEOs to manipulate earnings to reduce value and deceive investors. Therefore, operational governance, formal cross-company communication, and performance-based remuneration for the board all considerably lower the chance of criminal incidents, according to Schnatterly (2003).

After the accounting fraud exposure, the directors may be subject to labor market sanctions. Hoi and Robin (2010) examined the sanctions for executive and non-executive directors, examining the likelihood of losing an internal board seat and the possibility of losing an external board seat. Therefore, according to the inquiry findings, executive directors have a greater chance of losing their seats than non-executive ones after the accounting fraud is exposed. They have a greater chance of losing at least one external board seat than non-executive directors do as well.

The board of directors, consisting of internal and external members, may influence the prevalence of accounting fraud. The likelihood of financial statement fraud is minimal when the board contains a more significant proportion of outside members. Moreover, the general counsel position in a company is associated with less accurate financial reporting and more aggressive accounting techniques, in contrast to independent directors on the board. As a result, Hopkins et al. (2015) hold that this is more likely to occur when a professional person is well-paid and exhibits a limited amount of aggressive behavior.

It is also critical to appreciate that organizational variables are linked to a lack of fraud. Based on the survey replies of hundreds of CFOs in Hong Kong for the research by Law (2011), it is emphasized that a lack of fraud is related to the efficacy of the audit committee, internal audit effectiveness, ethical rules, and top management team tone. Thus, corporate governance is critical in the accounting fraud study because it impacts internal organizational structures and corporate policy decisions. However, there is a link between corporate governance and financial performance that should be carefully studied to prevent fraudulent actions. Better than loan quality, corporate governance factors might be utilized to highlight the course taken by U.S. banks that resulted in the 2008 financial crisis. In reality, things that transpired within financial organizations were significantly influenced by CEO duality, executive incentive compensation, and board size.

Furthermore, board size benefits financial success since a giant board has more experience and enhances the likelihood of forming relationships with new clients. On the other side, an overly big board of directors runs the danger of being unable to oversee all operations effectively, which worsens agency issues. At the same time, CEO dualism is recognized as a significant contributor to agency disputes. Consequently, combining these two responsibilities in one person would make it more difficult for the chairman to exercise control over CEO activities because the chairman of the board is in charge of regulating the hiring, remuneration, and firing of the CEO as well as monitoring the CEO decision-making (Grove et al., 2011).

A strong motivation and sound business rationale to present a more favorable picture of a company’s financial performance than would have been shown if accounting rules had been followed is likely what led to fraudulent financial reporting. Even while financial incentives are most frequently used, other sorts of motivations, such as psychotic, egotistical, or ideological ones, can play a big part. In this context, Dechow et al. (1996) discovered that the need to get finance cheaply and evade debt covenant constraints is an incentive to manipulate earnings.

On the other hand, auditor suspicion of false accounting or management’s lack of explanation regarding transactions and balances can lead to the discovery of fake financial reporting. However, it is more frequently discovered because of the firm’s precarious financial situation, which could result in its demise. Because of this, an academic study has concentrated on identifying the behavioral traits shared by fraud businesses that may serve as markers for fraud detection and identification. For instance, a methodology created by Bell and Carcello in 2000 can help auditors assess the risk of financial statement fraud by estimating the likelihood of fraud. However, a weak control environment, rapid growth, insufficient or inconsistent profitability, management’s undue emphasis on meeting earnings forecasts, ownership status of the company, and managers lying to auditors or being overly evasive were the critical risk factors noted in this model.

Financial ratio analysis is another technique for fraud detection. Financial leverage, asset composition, profitability, and capital turnover are significant indications of financial statement fraud, according to research by Zainudin and Hasmin (2016). A similar study has determined a company’s ability to fudge earnings. Gross Margin Index, Asset Quality Index, Sales Growth Index, and Total Accruals to Total Assets were the financial ratios considered in this model. However, the subjectivity in selecting the proportions that probably indicate fraud is one of the limits of ratio analysis. Accounting fraud has been challenging to uncover using traditional analytical examinations involving financial ratio analysis.

The authors of comparative investigations did not recognize financial ratios, such as the one by Kaminski et al. (2004), as essential fraud indicators. This further emphasizes how ineffective it is to detect fake financial reporting just by using financial measures. However, developing new technology-based tools, such as data-mining software, continuous auditing, and pattern-recognition software, can help academics find more successful and efficient instruments to spot accounting fraud.

It can be argued that the offenders face social and financial, and legal repercussions. For instance, Fich and Shibdasani (2007) discovered that external directors’ reputations suffer even if they are not implicated in a fraud case. Due to the significant danger it poses to the market’s trust in financial information and the high costs involved, fraudulent financial reporting is still a worry for the business community and accounting professionals. However, despite fraud’s adverse effects and high costs, the severity of the sanctions does not appear to be a strong enough deterrent. Therefore, a greater comprehension of the compelling factors that drive people to engage in criminal behavior is required.

Numerous studies have examined the effects of fraud committed by various players, including managers, directors, entities, and even dishonest businesses. They assert that fraud organizations are punished following the disclosure of fraud to investors; the decline in stock prices and the rise in the bid-Ask spreads suggested that more significant capital costs for fraud enterprises might result from a company’s lack of trustworthiness. Other academics have examined how deceptive companies regain investor and capital market trust. Their findings are congruent with earlier research showing that financial statement fraud is more likely to occur in environments with weak governance. Hence, findings suggest that the capital markets still question the legitimacy of fraudulent enterprises since institutional holdings and analyst interests are unchanged before and after fraud detection.

Finally, some researchers have attempted to merge different accounting fraud investigations using text analysis. They have proposed a thorough analysis of the research using data mining techniques to spot accounting fraud. Moreover, they have thoroughly analyzed the research on data mining algorithms pertinent to automated accounting fraud.

Literature Review

In their research, Sorensen and Miller (2017) not only examined how the Enron and Parmalat scandals developed in the U.S. and Italy, as well as their regulatory frameworks before and during the incidents, but also emphasized the parallels between E.U. and U.S. law. The Sarbanes-Oxley Act of 2002, which the United States passed in response to the Enron financial disaster, supplied most of the governance and audit measures currently being implemented in our organizations. We and foreign corporations listed on the American stock exchange must follow the SOX regulations. Therefore, a European firm that had its shares listed on an American stock market in the past had to abide by European Law before doing so with the Sarbanes-Oxley Act.

Additionally, given the diversity of fraud schemes used to conduct accounting fraud, it is crucial to investigate the frequencies and patterns of each one to understand fraud perpetration better and, as a result, support the creation of measures to thwart prospective fraudulent acts. According to a study by Beasley et al. (2010), understating costs and liabilities and inaccurate revenue recognition were the two techniques most commonly utilized in fraudulent financial statement misstatements. Sham sales, conditional sales, premature revenues before all terms were fulfilled, improper sales cutoff, unauthorized shipments, and consignment sales are techniques used to create fictitious revenue transactions or prematurely record revenues. Overvaluing existing assets or capitalizing items that should be considered costs were the main methods used to overstate assets.

Financial statements must accurately reflect the performance and financial status of publicly listed firms in order to be prepared and issued. Fraud still occurs, as seen by the well-known frauds at Enron, among other public firms, even though most of them submit financial reports without serious misstatements. Two categories of accounting fraud distinguished in the literature are the fraud committed by top management to keep up the appearance of solid performance by the business to attract capital for their firms and deceive customers. Those frauds committed by top or middle management for personal gain, to obtain bonuses and higher compensation. Moreover, it is worth noting that the business sector is very concerned about accounting fraud, which includes actions like auditors hired to provide an opinion on whether the financial reports correctly depict the company’s financial status and operating performance following established standards.

While theft of assets is perpetrated against an entity by workers, accounting fraud is different from other frauds in that management to fool financial statement users typically conducts it. Accounting fraud is the deliberate, significant misrepresentation of financial statements or financial disclosures or the commission of illegal conduct materially affecting financial statements or disclosures (Beasley et al., 2010). Depending on the intent, an action may or may not be categorized as fraudulent. Young (2000) asserts that the primary driving force behind accounting fraud may not be dishonesty but rather a pressure to meet financial objectives and concern that failure to do so will be viewed as irreversible. Furthermore, instead of being motivated by pressure from the corporation, a fraudster can be motivated by dishonesty and personal benefit. This aligns with Cressey’s fraud triangle, which names three elements: the ability to explain fraud, contextual opportunities to conduct fraud, and private, non-shareable incentives or pressure. As a result, most accounting fraud schemes revolve around earnings management, which does not necessarily include blatant breaches of accounting standards. Businesses frequently manage earnings by selecting accounting procedures that flout the rules to meet earnings objectives. Thus, there is little difference between earnings management, which does not go beyond accounting laws or standards, and earnings manipulation, which is equivalent to false accounting.

It is also critical to note that accounting fraud has many different definitions, but it often refers to deliberate financial statement manipulation done to misrepresent a company’s financial standing. Employees (such as accountants) or the organization, with the senior management team, are the major players in the process. In order to secure more advantageous funding or avoid debt responsibilities, accounting fraud is sometimes perpetrated in addition to misleading stakeholders.

Fraud Triangle

Cressey (1953) proposed the first version of the fraud triangle hypothesis. According to this idea, fraud combines the three factors of opportunity, pressure, and reasoning. To begin, even while not everyone has a criminal disposition when faced with the correct necessity or pressure (financial, environmental, or personal), an individual might still be able to commit fraud. Furthermore, along with pressure, there is an opportunity related to personal skills and rationalization. Rationalization is crucial since it enables the fraudster to attribute his actions to the system or another individual. Hence, the fraud triangle may be used to spot the red flags that, when placed together, could indicate fraudulent behavior throughout the detection process. Finally, according to the Fraud Triangle, a deception that is purposeful and committed by a company or personnel for financial advantage is called fraud. In other words, fraud is dishonest behavior to obtain an advantage or make money illegally. The unlawful conduct also serves the perpetrator’s interests while causing harm to others.

Components of the Fraud Triangle

  • Opportunity

According to the concept, Opportunities are situations that make fraud possible. The fraud triangle’s sole component a company has complete control over is this one. In order to guarantee the accuracy of accounting and financial information, internal controls are created. There is potential for fraud because of weak internal controls, such as a lack of monitoring, proper task separation, and inadequate process documentation. Further, a company’s susceptibility to fraud is influenced by the tone at the top, which refers to upper management and the board of directors’ dedication to upholding moral principles, acting with integrity, and being truthful. Finally, it is worth noting that accounting principles describe how things are recorded for the financial statements. Poor accounting procedures might allow staff members to tamper with the data.

  • Incentive

Incentives, often known as pressure, describe a worker’s disposition toward committing fraud. Revenues and net income are typical financial indicators used to evaluate an employee’s performance. Employees who get bonuses based on financial metrics are under pressure to accomplish goals, which might lead them to fraud. Further, pressure to commit fraud might arise from the desire to maintain or enhance stock prices while meeting or exceeding investor and analyst expectations. Finally, personal motivations such as the desire to make more money, the need to pay for personal expenses, and a gambling addiction might lead to fraud.

  • Rationalization

This refers to an individual’s rationale for committing fraud. When deciding to conduct fraud, a person may use justification to support their choice. For instance, they could offer arguments for why they ought to do it or why it will not be a problem. Moreover, people are remarkably good at justifying their behavior. Even the vilest offenders do not think they are guilty of anything. It should not be surprising that fraud victims can defend their acts. Desperation frequently disguises this justification. Many people think their acts are legitimate because they are in a challenging situation and do not see any other choices. Some people could convince themselves that since everyone is doing it, it is okay for them to conduct fraud.

Fraud Diamond

The fraud diamond hypothesis states that pressure, opportunity, rationalization, and capacity are the four factors that motivate someone to commit fraud (Wolfe & Hermanson, 2004). According to Wolfe and Hermanson (2004), pressure and motivation (incentives) drive someone toward fraud, whereas opportunity drives someone to commit fraud. Capability permits a person to recognize an opportunity given by an open door and seize it by passing through it once more.

  • Capability

In this situation, a person has the qualities, skills, or qualifications necessary to commit fraud. At this point, the fraudster knew the precise opportunity for fraud and the tools necessary to take advantage of it. Position, intelligence, ego, compulsion, deceit, and stress are supporting elements of capacity. Not everyone with the desire, opportunity, and realization to commit fraud will be able to do so due to the incapacity to carry it out or conceal it.

  • Pressure

This phrase “pressure” describes conditions that support immoral action. Every con artist feels some compulsion to behave unethically. Further, it might be pecuniary or not, depending on the pressure. For instance, when there is a non-shareable financial need, pressure can be felt in various ways. Financial pressure is considered the most common cause of harmful deeds by an institution. More specifically, it is logical to note that financial demands on the fraudster cause a better percentage of all fraud instances.

  • Opportunity

The third prerequisite for fraud is the notion of opportunity. Someone may engage in corporate fraud when a control or governance structure fails, and an opportunity arises. In the accounting sector, this is called “internal control vulnerabilities.” A perceived opportunity is analogous to a felt pressure in that the change does not always have to be realized. Nonetheless, the offender’s views and beliefs give a chance. In general, fraud is more likely to happen the lower the danger of detection.

  • Rationalization

Before engaging in immoral behavior, the offender must cultivate a few morally virtuous ideas. Rationalization is the term for the arguments and defenses used to separate immoral action from illegal activity. Fraud is less likely to be committed if a person cannot justify the illegal activity. Therefore, rationalization is challenging to spot since it is difficult to understand a fraudster’s thought process. The thinking of fraudsters allows them to defend or explain their fraudulent actions.

Consequences

  • Bankruptcy

Fraud committed before or during bankruptcy may have substantial repercussions, such as a discharge being denied, a fine, or even a criminal conviction. Fraud can happen before the bankruptcy filing. Thus, it does not necessarily take place during the bankruptcy. This issue frequently occurs when someone uses bankruptcy to cover up previous wrongdoing. Moreover, most people who declare bankruptcy honestly and openly disclose their assets. However, this is not always the case, and giving in to the desire to conceal assets might result in a bankruptcy fraud charge. Hence, protecting oneself and the integrity of the bankruptcy system requires knowing the many forms of bankruptcy fraud, its penalties, and the best ways to avoid and expose it.

Types of Bankruptcy Fraud

The hiding of assets is one of the most widespread types of bankruptcy fraud. This happens when a person or business conceals assets that should be part of the bankruptcy estate. Before declaring bankruptcy, a person can, for instance, shift assets to a friend or family member or neglect to reveal income from a second job or a rental property. The repercussions of hiding assets can be severe, including being denied release, paying fines, and facing criminal prosecution.

Further, making misleading assertions is a different kind of bankruptcy fraud. This happens when a person or business supplies false information on bankruptcy applications or during bankruptcy. For instance, someone can exaggerate their income or obligations, or they might alter paperwork to make it seem like they owe more money than they do. False statements may result in refusing a discharge, penalties, and legal action.

Bribery is a type of bankruptcy fraud that occurs when a person or business gives cash or other benefits to a bankruptcy official in return for favorable treatment. This might involve paying off a bankruptcy judge to provide a particular decision or giving a bribe to a bankruptcy trustee in exchange for their plan acceptance. Bribery is a severe crime that carries penalties and maybe jail time.

Finally, when someone files for bankruptcy more than once quickly or in more than one jurisdiction, it is referred to as multiple filings. If the person tries to hide assets or takes advantage of the bankruptcy procedure, this might be considered bankruptcy fraud. A bankruptcy case may be dismissed after many filings, and there may be penalties and legal repercussions.

Fraud in bankruptcy can have serious repercussions, including civil fines, criminal accusations, and incarceration. Fines, debt payback, and refusing to grant a discharge are all examples of civil penalties. Depending on the seriousness of the violation, criminal charges can result in fines and imprisonment, with sentences that can last anywhere from a few months to several years. Fraudulent bankruptcy filings can have a long-lasting effect on someone’s credit rating and financial reputation and have legal repercussions.

  • Market share/stock price

Serious misbehavior like accounting fraud undermines investor trust in the financial markets. It is still uncertain if a firm’s future risk of stock price crashes is influenced by previous accounting fraud disclosures (ex-post) or future fraud likelihood predictions (ex-ante). Accounting fraud revelations do, however, cause drops in stock prices. Although it is evident from earlier studies that the disclosure of accounting fraud can lead to stock price crashes, it is still unknown how firms react to discovered (ex-post) or anticipated (ex-ante) accounting fraud in ways that increase or reduce the risk of future stock price crashes. Accounting fraud is a widespread issue in society, and during the past ten years, it has become much more prevalent. A large number of stakeholders, including investors, employees, and rivals, are negatively impacted by this problem. Notably, the news of the deception will affect the investors of the concerned firm and cause a decline in share prices.

According to studies by Karpoff and Lott (1993), one of the main effects of accounting fraud on market share is reputational damage. In their study of the market’s response to accounting fraud, Karpoff and Lott (1993) noted that the fall in share price was caused by the company’s damaged reputation and investors’ worries that it would continue to engage in dishonest behavior. In addition, Bhasin (2013) said that CEOs are frequently found guilty of accounting fraud, so they must pay hefty penalties or perhaps go to jail. The article said the company’s auditing firm and trustworthy rivals would suffer reputational damage because of the deception.

Conclusion and Recommendations

The link between accounting fraud and its primary causes of it was examined in the literature study. The findings show that accounting fraud frequently stems from unethical behavior on the part of an individual or group of individuals who have not had enough ethical training. However, Albrecht’s fraud triangle hypothesis states that a liar’s primary talents are not their capabilities or ability to rationalize their actions. Additionally, directors and executives are motivated by the desire to advance in an organization, to earn enough money to qualify for bonus pay, or by the goal to “build an empire,” which is the desire to hold a dominant position in the market.

Corporate governance emerged as a crucial factor in accounting fraud, where essential employees in the company are frequently linked to fraud. The findings show that CEOs have consistently been at the center of crises for their frauds over the years. The findings show that CEOs have frequently been at the center of crises for their frauds over the years. Then, it became apparent that audit committees and regulators should tighten restrictions on CEOs through legal provisions and industry best practices. Finally, regarding our analytical findings, public enforcement and prosecutors may decide to employ a forensic accountant in their investigations. Due to the diversity of abilities they possess and the significance of the field in which they operate, forensic accountants may be important figures in the years to come.

According to a study of the accounting fraud literature, previous research has generally looked at the causes, incentives, and precursors of fraud at the social, organizational, and personal levels. Others (Wolfe & Hermanson, 2004) also discussed the fraud triangle and fraud diamond. The fraud triangle (sometimes known as the fraud diamond) is promoted as a helpful paradigm for comprehending fraud’s causes. However, specific frameworks might not wholly capture the causes and contributing aspects of fraud due to the complexity and inventiveness of financial markets and rising white-collar crimes. For instance, new social, psychological, and psychological antecedents for fraud may exist, such as management hubris, personality, and behavioral traits.

This report concurs with earlier experts in recommending more studies to comprehend the driving forces behind fraud behaviors. When it comes to the methodology to be used, the majority of studies are based on data from the USA, including SEC Audit and Accounting Enforcement Releases (AAERs), financial restatements of companies at the General Accounting Office (GAO), and class action lawsuits resulting from SEC actions and financial restatements.

There are variations in institutional structures and legal systems around the world. However, replication of research using publicly accessible data, as in the USA, might not be feasible in other nations. Additionally, findings from the research examined may or may not be applicable in a different setting that does not involve the USA. It could be more beneficial to use the case study technique, which enables a deeper assessment of the circumstances surrounding each fraud case by allowing us to dive into the complex narrative underlying each accounting fraud incident. The review also revealed a hole that needs to be filled by further study: There is no connection between the adoption of forensic accounting practices by financial statement auditors or their collaboration with forensic accountants and the likelihood of identifying financial reporting fraud quickly and affordably, even in the absence of specific fraud allegations.

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