MIU

Faculty of Business Administration and International Trade

Department of Accounting

Techniques of Detecting and Preventing Fraud in

Financial Statements
Graduation Project

Prepared by
Nour Ali

Al Mohanad

Emad
Youstina Kout

Nourhan El-

Agizy
Mirna Ismael

Supervised By:
Professor Zakaria Farid
Professor of Accounting
Ain Shams University

Spring 2015

Dedication and Acknowledgment

This research is dedicated to our two accounting professors who have
defined a remarkable work in the field of accounting in Misr International
University from our point of view; Professor Zakaa Khalifa and Professor
Zakaria Farid.

Professor Zakaa Khalifa who is serving as the head of the accounting

department in Misr International University provided us throughout our
academic studies in the university with a prolific knowledge in different fields
of Accounting as well as providing a constructive tips that helped us in our
academic life.

Professor Zakaria Farid who is serving as the professor of Accounting

in Ain Shams University provided us with boundless assistance in our project
as well as fruitful and brand new ideas in finalizing our project observing his
academic contribution in the field of Accounting and Financial Accounting in
Egypt and Abroad.

Not to forget all the staff of Accounting and Teaching assistants who
has provided us with assistance through our academic studies in the
university and to everyone who might find our project useful.

We designed this page to give our thanks for those who shaped
significant differences in our knowledge, personality and attitude and we
wish all readers to have the benefit from this humble work of us.
Page 2 of 100

Table of Content
Pages
1. Dedication and Acknowledgment
2
2. Table of Content
3
3. Chapter 1 (Introduction to Fraud in Financial Statements)
4 - 12
4. Chapter 2 (Literature Review)
13 - 23
5. Chapter 3 (Reasons and Effects of Fraud in Financial Statements)
24 - 42
6. Chapter 4 (Indicators and ways to prevent Fraud in Financial Statements)
43 - 65
7. Chapter 5 (Case Study and Application in Preventing Fraud in Financial
Statements) 66 - 84
8. Chapter 6 (Conclusion)
85 - 86
9. References

87 -

92
Page 3 of 100

Chapter 1
Introduction to Fraud in Financial Statements
I.

Introduction:
Nowadays, Fraud in financial statements becomes mutual as it causes
a serious problem for everyone who is interested users of financial data from
any company, whether to invest in, a competitor, or financial institutions
etc. Fraud has a direct impact on business as companies who commit fraud
shows a manipulation in their financial statement in order to differentiate
themselves from others. Fraud can be caused by many factors to meet
expectations of the owners or creditors, or to obtain more favorable credit
terms, to meet performance criteria set by related companies, or to maintain
an impression of constant economic growth of the company. Not all these are
justifications to commit fraud in financial statements, as fraud is extremely
disastrous to any company, yet it can be easily identified and prevented
through auditing procedures or analyzing the financial statements, which is
very essential to stop this insalubrious act to any company, to its
stakeholders, and to the whole community.

II.

Background:
1. Financial Statements:
A companys financial statements give a lot of financial information
that business owners and creditors use to estimate a companys financial
Page 4 of 100

performance. Financial statements are very essential to a companys top

management because of spreading financial statements; management can
communicate with outside parties about its role to run the company.
Different

financial

statements

focus

on

various

fields

of

financial

performances. Financial statements are important for many reasons, but

here are three significant reasons (Eric Owen, 2013):
a.

Financial statements tell you the performance and the value (sort

of) of your company.

b.
Financial statements are what others are using to measure your
company.
c.

Financial statements and other tools help you manage your

company when you can no longer be hands on with all the details.

2. Types of Financial Statements:

There are three primary financial statements: Balance Sheet, Income
Statement and Cash Flow Statement.
a.

Balance sheet: it is one of the most essential statements used by

accountants to provide the top management and creditors with the
information needed. The balance sheet presents a company's financial
situation at the end of a specified date. Balance sheet consists of three
main elements; they are assets, liabilities and Equity. Assets are the
resources

of

the organization that have been gained

through

transactions, and have economic value that can be measured and

expressed in dollars, such as cash, investments, inventories, land and
equipments etc. Liabilities (obligations of the company) are amounts
owed to creditors for a previous transaction such as accounts payable,
notes payable, salaries payable etc. Owner's equity is actually means
the book value of the company is equal to the reported asset amounts
minus the reported liability amounts.
The Following is an example of the balance sheet.
Page 5 of 100

b.

Income statement: it is one of the main financial statements

referred to as the profit and loss statement (P&L), statement of
operations, or statement of income. The income statement shows the
net results of a company and its operations during the period specified
in its heading.
The Following is an example of the income statement.

Page 6 of 100

c.

Cash flow statement: it shows the cash generated and used during a
specific period of time. It consists from three main categories.
Operating activities converts the items reported on the income
statement from accrual basis of accounting to cash Basis, investing
activities (reports the purchases and sale of long-term investments and
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property, plant and equipment) and financial activities (reports the

issuance and repurchases of the company's own stock and bonds and
the payment of the dividends) and the supplemental information
(reports the exchange of significant items that did not involve cash and
reports the amount of income taxes paid and interest paid).
The Following is an example of Cash Flow Statement.

3.

Users
of

the

Financial Statements:
There are internal and external users of financial statements:

Page 8 of 100

a.

Internal Users: such as Management to analyze the organizations

performance and position and taking appropriate measures to improve
the company results, Employees to assess companys profitability and
its consequences on their future compensation and job security and
Owners for analyzing the viability and profitability of their investment
and determining any future course of action.

b.

External Users: such as Creditors for defining the credit

worthiness of the organization. Terms of credit are set by creditors
according to the assessment of their customers' financial condition.
Creditors include suppliers as well as lenders of finance such as banks,
Tax Authorities for determining the reliability of the tax returns filed on
behalf of the company, Investors for analyzing the feasibility of
investing in the company, Investors want to make sure they can earn a
reasonable return on their investment before they commit any financial
resources to the company, Customers for assessing the financial
position of its suppliers which is necessary for them to maintain a
stable source of supply in the long term and Regulatory authorities for
ensuring that the company's disclosure of accounting information is in
accordance with the rules and regulations set in order to protect the
interests of the stakeholders who rely on such information in forming
their decisions.

4. Accounting Fraud:
Accounting Fraud is one of the major obstacles, which the
companies face. It is a type of manipulation in the financial statements in
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order to make the company looks better in performance or in order to

hide a theft process of the assets, in other words accounting fraud can be
described a situation when an employee of a business entity steals,
misappropriate or misuse money or other resources. Anybody in the
position of stealing ranging from unit managers to accounting clerks or
chief financial officer can commit this kind of fraud. Factors like elevating
oneself, covering for errors, and covering for loved one can be the motive
behind the commission of accounting fraud. The interesting stuff about
accounting fraud is that small discovery usually lead to massive exposure
of fraud.
The accounting fraud, which happens in the financial statements,
is always high and is mostly prepared by top management staff. The main
motive behind this is to present a failing company being profitable, as this
will greatly influence the money that the managers will collect at the end
of the day. This type of fraud could happens in the three types of the
financial statements, they manipulate the balance sheet in order to raise
their earnings power and assets .Justin Kuepper says in his article
Spotting

Creative

Accounting

On

The

Balance

Sheet

at

www.investopedia.com '' Companies that manipulate their balance sheet

are often seeking to increase their earnings power in future periods (or
the current period) or create the appearance of a strong financial
condition. After all, financially-sound companies can more easily obtain
lines of credit at low interest rates, as well as more easily issue debt
financing or issue bonds on better terms''.
For the income statement, companies manipulate it for two
reasons; they maximize the net profit in order to make the company looks
like gaining more profits or minimize it for paying fewer taxes. Fraud in
the cash flow statement could happen by allocating dividend and interest
payments to financing rather than operating cash flow and allocating

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dividends and interest received to operating rather than investing cash

flow.

5. Famous Accounting Scandals:

According to Barry Ritholtz he published on the big picture magazine
a.

about the most famous scandals

The Global financial services firm Hided over $50 billion in loans
hidden as sales. Lehman executives and the company's auditors, Ernst &
Young were the main players. : Allegedly sold poisonous assets to Cayman
Island banks with the understanding that they would be bought back
eventually. Created the impression Lehman had $50 billion more cash and
$50 billion less in toxic assets than it did really did. They were caught
because of the bankrupt. This was one of the largest bankruptcies in U.S.
history. SEC did not sue due to lack of evidence. The funny fact was that
In 2007 Lehman Brothers was ranked the #1 "Most Admired Securities
Firm" by Fortune Magazine.

b.

Madoff Investment Securities LLC was a Wall Street investment firm

founded by Madoff. They had tricked investors out of $64.8 billion through
the largest Ponzi scheme in history. The main players were Bernie Madoff,
his accountant, David Friehling, and Frank DiPascalli. Investors were paid
returns out of their own money or that of other investors rather than from
profits. Madoff told his sons about his arrangement and they reported him
to the SEC. He was arrested the next day. That has resulted in 150 years
in prison for Madoff + $170 billion repayment and prison time for Friehling
and DiPascalli. Madoff's fraud was revealed just months after the 2008
U.S. financial collapse.

c.

In

the

Indian

IT

services

and

back-office

accounting

firm,

Founder/Chairman Ramalinga Raju boosted revenue by $1.5 billion. They

did it by fabricating revenues, margins and cash balances to the tune of
50 billion rupees. They were caught by admitting the fraud in a letter to
Page 11 of 100

the company's board of directors. Raju and his brother charged with
breach of trust, conspiracy, cheating and falsification of records. They
were released after the Central Bureau of Investigation failed to file
charges on time. In 2011, Ramalinga Raju's wife published a book of his
existentialist, free-verse poetry.

III.

Project Objective:
The objective of this project is to:
1. Examine the association between fraud in financial statements and
other variables: Employee salary, the economic situation of the
country, and rules and obligations of the organization through
conducting a survey and collecting opinions.
2. Analyzing manufacturing company financial statements in a certain
area to identify a margin of fraud that has occurred in their financial
statements.

IV.

Research Methodology:
The current research is an applied research. Different types of
qualitative methodologies will be used in order to find out the causes,
characteristics, the consequences and the lessons learned from the fraud
in the financial statements.
Data collection of the research depends on the following:
1. Questionnaire.
2. Professional Interview.
3. Case Study.
The questionnaire is an important tool to understand and collect
different opinions from different cultures and environments about fraud in
financial statements and understand the impact of fraud in other variables.
The professional interview will be very beneficial in order to get in a
direct contact with a professional who has been in a company that
committed a fraudulent act and understand his opinion about fraud and how
to prevent it.
Page 12 of 100

The case study is one of the most important tools in this project. It will
show the margin of fraud in a financial statement providing that the usage of
financial statements analysis ratios is necessary.

V.

Limitations of the Study:

The current research is limited to:
1. A technological manufacturing industry rather than service or
merchandising

industries.

That

is

because

such

industry

has

many

opportunities in its transactions to face fraud in its financial statements.

2. Financial statements for years 2011, 2012, and 2013.
3. A South Korean company.

Chapter 2
Literature Review
Page 13 of 100

1. Scott L. Summers and John T. Sweeney Study (1998):

Fraudulently misstated financial statements and insider trading: an
empirical analysis...
In their abstract, they stated, This study investigates the relationship
between insider trading and fraud. We find that in the presence of fraud,
insiders reduce their holdings of company stock through high levels of
selling activity as measured by either the number of transactions, the
number of shares sold, or the dollar amount of shares sold. Moreover, we
present evidence that a cascaded logit model, incorporating insider
trading variables and firm-specific financial characteristics, differentiates
companies with fraud from companies without fraud.
They also mentioned, The purpose of this study was to analyze the
relationship between financial statement fraud and insider trading activity
to determine whether auditors could enhance financial statement fraud
risk assessment by including insider trading activity in their model. Using
a matched sample of fraud and no-fraud companies. They also stated,
The results of this study indicate that i nsider trading and
financial

statement

factors

are

useful

in

model

which

distinguishes companies where fraud is found from companies

where fraud is not found. This is a significant contribution to both
auditors attempting to detect fraud and to regulators monitoring
insider trading.
At the end of their research, they stated the limitations of the
articles as they mentioned, There are a number of limitations to
this study. First, this study examines the population of companies
for which fraud was discovered after an audit. Hence, two types of
fraud are not included in the fraud sample: undiscovered fraud and
fraud discovered during the audit. Second, this study may have a
newsworthiness bias Third; this study did not use a hold out sample
to validate the models that are presented. Further research with
larger samples will be necessary to validate these results. Finally.
Page 14 of 100

This study is limited in that it does not address finer classifications

of fraud. Turner (1980) proposes classification of management
fraud into four classes, according to whether the distortion of the
financial statements is the vehicle for the fraud or a disguise of the
fraud. In addition, according to who benefits from the fraud: the
company or the perpetrator? Our model does not assess the
likelihood of a particular class of fraud.
2. Charalambos T. Spathis (2002):
Detecting false financial statements using published data: some
evidence from Greece
He stated that This paper examines published data to develop a model
for detecting factors associated with false financial statements (FFS) Most
false financial statements in Greece can be identified on the basis of the
quantity and content of the qualifications in the reports filed by the auditors
on the accounts. A sample of 76 firms includes 38 with FFS and38 non-FFS.
Ten financial variables are selected for examination as potential predictors of
FFS. Univariate and multivariate statistical techniques such as logistic
regression are used to develop a model to identify factors associated with
FFS. The model is accurate in classifying the total sample correctly with
accuracy rates exceeding 84 per cent. The results therefore demonstrate
that the models function effectively in detecting FFS and could be of
assistance to auditors, both internal and external, to taxation and other state
authorities and to the banking system.
In the introduction of his paper, he concluded by defining and
explaining FFS, as References to false financial statement (FFS) are
increasingly

frequent

over

the

last

few

years

Falsifying

financial

statements primarily consists of manipulating elements by overstating

assets, sales and profit, or understating liabilities, expenses, or losses.
The data used in this research is extracted from Books, newspapers
and financial reports from firms.
Page 15 of 100

Worth mentioning this is an applied research because he used financial

statement ratios analysis to apply FFS.
3. Niamh Brennan and Mary McGareth (2007):
Financial statement fraud: some lessons from US and European case
studies.
They stated that '' This paper studies 14 companies, which were
subject to an official investigation arising from the publication of
fraudulent financial statements. The research found senior management
to be responsible for most fraud. Recording false sales was the most
common method of financial statement fraud. Meeting external forecasts
emerged as the primary motivation. Management discovered most fraud,
although

the

discovery

was

split

between

incumbent

and

new

management''.
Fourteen companies are analyzed in the research nine US and five
European. The nine US companies were selected following a search of the
SECs Accounting and Auditing Enforcement Releases (AAER) relating to
violations of Rule 10-b of the Securities and Exchange Act 1934 and
Section 17(a) of the Securities Act 1933.These are the main rules relating
to

financial

statement

fraud. The

AAER

are available on-line at

www.sec.gov.The European cases are UK companies with the exception of

Lernout and Hauspie (L&H), a Belgian company. The main source for the
European cases was the financial press. The SFO website, www.sfo.gov.uk,
provided a summary of the results of successfully prosecuted cases.
The approach to assessing the case studies is that suggested by Ryan
et al (1992).Cases were deemed suitable for inclusion in the research
where information about methods and motives was on the public record
and where persons involved in the fraud had been publicly identified. The
main source was documented evidence from SEC and SFO reports.
Secondary evidence such as newspaper reports and articles was also
used.
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4. Alfred Bridi reviewed by Robin Hodess 2010):

Corruption

in

tax

administration

and

its

effect

on

financial

statements.
The draft project document does not fully integrate and analyze aspects
related to anti-corruption and how aspects related to anti-corruption could be
included in the different activities proposed in the project and/or in the risk
assessment. The main components included in the project are (1) taxpayer
services (2) tax audit (3) efficiency in management (4) tax statistics.
He stated that in his summary '' Revenue administration is often
ranked as one of the poorest performing public sectors in terms of
corruption and, as Transparency Internationals latest Global Corruption
Barometer (TI 2009) illustrate, corruption continues to affect the sector in
2009. This sector is very important to a states development and
economic health as it significantly affects its capacity to spend on public
projects and programs, thus making problems of inefficiency and revenue
leaking especially damaging. Corruption in tax administration also
dissuades honest taxpayers by rendering them less competitive and
making the black-market a more attractive alternative. Tax administration
is an attractive sector for corruption to take place as the opportunities and
incentives to engage in illicit activity are numerous. The complexity of tax
laws, the high discretionary powers of tax officials, the low cost of
punishment are only some factors creating opportunities for corruption in
revenue administration''
The author used the qualitative method in this research, which is used
to reveal a target audiences range of behavior and the perceptions that
drive it with reference to specific topics or issues (tax corruption).
The author got most of his data from the internet and from several
books and by reviewing many on fraud financial statements.
He used many of samples as a case study for him; the Mexican
experience, The Bulgarian experience, The Tanzanian experience and The
Bolivian experience.
Page 17 of 100

5. Javiriyah Ashraf (2011):

The Accounting Fraud @ WorldCom: The Causes, The Characteristics, The
Consequences, and The Lessons Learned
He stated

that '' The economic prosperity of the late 1990s was

characterized by a perceived expansive growth that increased the

expectations

of

company's

performance.

WorldCom,

telecommunications company, was a victim of these expectations that led

to the evolution of a fraud designed to deceive the public until the
economic outlook improved. Through understanding what led to the fraud,
how the fraud grew, and what its effects were, lessons can be derived to
gain a better understanding of the reasons behind a fraud and to prevent
future frauds from occurring or growing as big as the WorldCom fraud
did''.
This is a web based research by using the applied method which he
made not for just be an informative research but to find out the causes ,
characteristics, the consequences and the lessons learned from the fraud
in the financial statements.
The author also used the case study analysis as purpose of the study
involves in depth, contextual analysis about WorldCom as it was provider
of long distance phone services to businesses and residents. It started as
a small company known as Long Distance Discount Services (LDDS) that
grew to become the third largest telecommunications company in the
United States.
As was mentioned before the source of his collected data was from the
internet and by reviewing some of the company financial statements
reports. Gene Morse, the internal auditor at WorldCom when all this
happened, for his internal insight into the case, which was a face-to-face
interview.
6. Mariana vlad, Mihaela tulvinschi and Irina Chirita (2011):
The consequences of fraudulent financial reporting
Page 18 of 100

They stated, Financial reporting frauds are a serious threat for the
investors confidence in the financial information. The side effects of the
financial frauds are affecting the integrity, quality and confidence in
published financial reporting. Criminals who carry out such fraud, from
management to employees, must understand that the interference of
records is a crime that will be judged. Qualitative financial reporting,
including reliable financial statements without mistakes, can be made
when there is well-planned corporate governance. Although participants
in corporate governance responsibilities vary depending on their level of
preparation and on the presentation form of financial reporting, a welldefined working relationship among these participants should reduce the
probability of financial fraud.
After conducting their research they concluded by saying that
Although the achievement of financial reporting by so-called "fraudulent
scheme" refers to short-term achievement of "management earnings ",
they may draw the following consequences in time: undermines the
credibility, quality, transparency and integrity of financial reporting
process;

endangers

the

integrity

and

objectivity

of

the

auditing

profession, especially auditors and audit firms; diminishes the confidence

in the capital markets, as well as in market participants and in the
reliability of financial information; makes capital markets less efficient;
adversely affects economic growth; huge lawsuit costs; destroys the
careers of people involved in fraudulent financial statements; they cause
bankruptcy or substantial economic losses for companies involved in
financial statement fraud; encourages regulatory intervention; erodes
public confidence and trust in accounting and auditing profession.
7. Ovidia Doinea and Gheorghe Lapadat (2012):
Deterring Financial Reporting Fraud .
They stated that The mainstay of the paper is formed by an analysis
of the relationship between the importance of RPTs in auditing and in
Page 19 of 100

detecting fraud, the widespread adoption of Web-based financial and

business reporting, the risk of fair value accounting fraud, the process of
detecting fraud, and opportunities for fraudulent financial reporting based
on misapplication of fair value accounting concepts. This research makes
conceptual and methodological contributions to the role of the external
auditor in detecting and deterring fraudulent or misleading financial
reporting, increased globalization of financial and product markets, the
pervasiveness

of

technology

within

the

corporate

financial

data

transmission structure, and managements involvement in the fraudulent

financial reporting activity.
They Concluded by saying that This paper seeks to fill a gap in the
current literature by examining different aspects of the relationship RPTs
conditional on the existence of fraud, the importance of accurate and
credible financial reporting, the prevention or executive of fraudulent
financial reporting, the flexibility of the Web as a medium for corporate
disclosure, and the risk of financial reporting fraud. Our paper contributes
to the literature by providing evidence on top managements ability to
override internal controls, the content and presentation attributes of Webbased

financial

information,

the

likelihood

of

fraudulent

financial

reporting, industry as a potential inherent risk indicator in a financial

statement audit, and properties of reported financial information.
8. Rajan Jupta and Nasib Singh Gill (2012):
"Financial statement fraud detection using text mining".
They stated that Data mining techniques have been used enormously
by the researchers community in detecting financial statement fraud.
Most of the research in this direction has used the numbers (quantitative
information) i.e. financial ratios present in the financial statements for
detecting fraud. There is very little or no research on the analysis of text
such as auditors comments or notes present in published reports. In this
study we propose a text mining approach for detecting financial
Page 20 of 100

statement fraud by analyzing the hidden clues in the qualitative

information (text) present in financial statements".
They presented a text mining approach for detection of financial
statement fraud. Fraud detection model presented in their paper begins
with collection of financial statements for both fraud and non-fraud
organizations followed by preprocessing which involves lexical analysis of
text present in financial statements. At the next step, bag of words
approach has been selected for extracting information hidden in the text
that results in vector spaces for both fraudulent and non-fraudulent
organizations.
They stated, Companies may present a rosy picture to the investors
by manipulating the financial measurements and qualitative narratives of
financial statements. These disclosures (qualitative narratives) may not
contain fraud indicators explicitly; however, indicators of fraud can be
constructed by understanding the syntactic as well as semantics of any
natural language because perpetrators of fraud may camouflage the
indicators by using semantic arsenal of the language. Therefore, in order
to detect fraud, it is necessary to examine the qualitative disclosures in
the footnotes in the financial statements, as well as the numbers
(quantitative information) associated with financial statements.
9. Anuj Sharma and Prabin Kumar Panigrahi (2012):
A Review of Financial Accounting Fraud Detection based on Data Mining
Techniques.
They stated that With an upsurge in financial accounting fraud in the
current economic scenario experienced, financial accounting fraud
detection (FAFD) has become an emerging topic of great importance for
academic, research and industries. The failure of internal auditing system
of the organization in identifying the accounting frauds has led to use of
specialized procedures to detect financial accounting fraud, collective
known as forensic accounting. Data mining techniques are providing great
Page 21 of 100

aid in financial accounting fraud detection, since dealing with the large
data volumes and complexities of financial data are big challenges for
forensic accounting. This paper presents a comprehensive review of the
literature on the application of data mining techniques for the detection of
financial accounting fraud and proposes a framework for data mining
techniques based accounting fraud detection. The systematic and
comprehensive literature review of the data mining techniques applicable
to financial accounting fraud detection may provide a foundation to future
research in this field. The findings of this review show that data mining
techniques like logistic models, neural networks, Bayesian belief network,
and decision trees have been applied most extensively to provide primary
solutions to the problems inherent in the detection and classification of
fraudulent data.
10.

Rajan Jupta and Nasib Singh Gill (2012):

A Data Mining Framework for Prevention and Detection of Financial

Statement Fraud .
They stated that Financial statement fraud has reached the epidemic
proportion globally. Recently, financial statement fraud has dominated the
corporate news-causing debacle at number of companies worldwide. In
the wake of failure of many organizations, there is a dire need of
prevention and detection of financial statement fraud. Prevention of
financial statement fraud is a measure to stop its occurrence initially
whereas detection means the identification of such fraud as soon as
possible. Fraud detection is required only if prevention has failed.
Therefore, a continuous fraud detection mechanism should be in place
because management may be unaware about the failure of prevention
mechanism. In this paper we propose a data mining framework for
prevention and detection of financial statement fraud.

Page 22 of 100

They assumed the framework to conduct their research as collecting

data from financial statements about a certain financial ratios 62 financial
ratios.
They also reprocessed data through data reprocessing techniques
including

normalization

of

the

input

variables

and

resolving

inconsistencies in the dataset, now data are ready to be mined.

11.

Rajan Jupta and Nasib Singh Gil (2012):

A Solution for Preventing Fraudulent Financial Reporting using

Descriptive Data Mining Techniques.

They stated that In the present age of scams, financial statement
fraud

represents

enormous

cost

to

our

economy.

The

deliberate

misstatement of numbers in the accounting books with the help of wellplanned scheme by an intelligent squad of knowledgeable perpetrators in
order to deceive the capital market participants is termed as financial
statement fraud. In order to reduce fraud risk which comprehends both
detection and prevention of financial statement fraud, this paper
implements descriptive data mining techniques such as Association rules
and clustering as opposed to predictive data mining techniques used in
the literature. Each of these techniques is applied on dataset obtained
from financial statements namely balance sheet, income statement and
cash flow statement of 114 companies.
They collected data about the 114 companies in their research coming
from www.wikinvest.com In order to identify companies accused of
financial statement fraud, Accounting and Auditing Enforcement Releases
published by S.E.C. (U.S. Securities and Exchange Commission) between
2007 and 2012, they also have removed all incidents of violation of the
Foreign Corrupt Practices Act (FCPA) from their sample because FCPA
prohibits the practice of bribing foreign officials and most of the AAERs
issued because of FCPA do not reflect which financial statement, balance
sheet or income statement, is affected.
Page 23 of 100

They also identified 29 fraudulent organizations by analyzing AAERs.

Out of these 114 firms, 85 firms have not reported their financial
statements fraudulently, however, absence of any proof does not
guarantee that these firms have not falsified their financial statements or
will not do the same in future. In order to identify organizations with
probability of fraud.
12.

Holger Rootzn (2012):

The Enron Scandal.
He stated that From the 1990's until the fall of 2001, Enron was

famous throughout the business world and was known as an innovator,

technology powerhouse, and a corporation with no fear. The sudden fall of
Enron in the end of 2001 shattered not just the business world but also
the lives of their employees and the people who believed that their soar
to greatness was genuine. Their collapse was followed by a series of
revelations on how they manipulated their success.
Showing up some recommendations such as Incentives must be paid
after a project is done or at least when the company is really profiting
from that certain project, Operational Risk should be minimized and there
should be some sort of checkup, Careful selection of accounting approach
and financial structures to use, Minimized payment in stocks.
13.

Hawariah Dalnial, Amrizah Kamaluddin, Zuraidah Mohd Sanusi,

and Khairun Syafiza Khairuddin (2014):

Detecting Fraudulent Financial Reporting through Financial Statement
Analysis.
They stated that Fraudulent financial reporting is a major concern for
two primary regulators of Malaysias capital market - the Securities
Commission (SC) and Bursa Malaysia. Both authorities continue to refine
the parameters that will ensure rigorous surveillance over public listed
Page 24 of 100

firms. The objective of current study is to examine the association

between financial statement analysis and fraudulent financial reporting.
Many researchers found indication of financial ratios to detect fraudulent
financial reporting but others also have concluded otherwise. Most of
these studies were conducted outside of Malaysia. The sample comprises
of the Malaysian Public Listed firms and data used ranged between year
2000 to 2011. The result indicated that several financial ratios such as
total debt to total asset, and receivables to revenue were found to be
significant predictors to detect fraudulent financial reporting. This reflects
that, financial ratios maybe helpful in the detection of fraudulent financial
reporting. These findings add to the extant literature on the ability of
financial ratios to detecting fraud.
In their study, they used a sample method as they stated, This study
examined 130 samples consisting of 65 samples for fraudulent firms and
65 samples of non-fraudulent firms from the Malaysian Public Listed Firms
available between the years 2000 and 2011 with financial data collected
from DataStream. Moreover, they used a selection of fraudulent financial
reporting firms as stated, Firms involving in fraudulent reporting are
obtained from the Bursa Malaysia media center. This list summarizes firms
according to the offences made against the Listing Requirements of Bursa
Malaysia Securities Berhad, most of which were reporting material
misstatements in the financial reports. This assessment resulted in 91
preliminary sample firms.
14.

Anita R. Morgan and Cori Burnside (2014):

Olympus Corporation Financial Statement Fraud Case Study: The Role

That National Culture Plays On Detecting And Deterring Fraud.

They stated that Recent cases provide insight into the role that an
unethical corporate culture plays in financial statement fraud. The case of
financial statement fraud in Olympus Corporation, a Japanese firm,
provides the opportunity to examine how national culture plays a role in
Page 25 of 100

corporate governance and fraud detection. This case study focuses on the
impact of Japanese culture on the corporate culture of The Olympus
Corporation, and how that corporate culture resulted in financial
statement fraud.

Chapter 3
Reasons and Effects of Fraud in Financial Statements
I.

Types of financial statement frauds and technical solutions:

There are three types of the businesses fraud; corruption, asset
misappropriation, and financial statements fraud. Corruption means
dishonest behavior by those in positions of power, such as managers or
government officials. Corruption can include giving or accepting bribes or
inappropriate

gifts,

double

dealing,

under-the-table

transactions,

manipulating elections, diverting funds, laundering money and defrauding

Page 26 of 100

investors. Asset misappropriation involves third parties or employees

abusing their position to steal from an organization through fraudulent
activity. Finally the financial statements fraud, which will be discussed in
the current study. It means intentional misrepresentation, misstatement
or oversight of financial statement in order to mislead the reader and to
create a wrong impression of an organization's financial position.
Public and private businesses do financial statement fraud in order to
secure investor interest or obtain bank agreements for financing, as good
reason for bonuses or increased wages and salaries or to meet
expectations of the owners. Top management is usually the responsible of
financial statement fraud because financial statements are made at the
management level. The financial statement fraud will be divided into two
types; overstatements and understatements according to the following
diagram:

1.

The over statements means that recording the assets and the
revenues of the company more than its main value in order to show that
the company is gaining profits to raise the price of its stocks in the stock
market. As an example if an asset is overstated, the balance sheet shows
assets as higher as they should be. For example, a bank might value a
mortgage-backed security at $1M when it properly should be evaluated at
$750K. There are also many types of the over statements including timing
differences,

fictitious

revenues,

cancelled

liabilities

and

expenses,

improper asset valuation and improper disclosures.

Everette Colby stated that "Financial statement fraud can take many
different forms, but there are several methods that are considered most
common. These include fictitious revenues, timing differences, concealed
Page 27 of 100

liabilities or expenses, improper disclosure of related-party transactions,

and improper asset valuations. From an accounting perspective, revenues,
profits, or assets are typically overstated Overstating revenues, profits, or
assets reflects a financially stronger company".
2.
Fictitious revenues mean that recording sales that did not happen in
real. Colby stated that '' fictitious revenues involves the creation or
manipulation of transactions to enhance the organizations reported
earnings. Fabricating revenue typically involves creating fake or phantom
customers and sales. Artificial sales can also involve legitimate customers
by creating phony invoices or increasing quantities or prices''.
Fictitious revenues could be done by making many of fake customers'
accounts in the company system, which deceives any auditor by thinking
that this company has many customers so it makes big revenues. Actually
the purpose of this type of fraud is to have a big number of the net
income in order to raise the company stock market shares. Another
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reason for the top management they do the fictitious revenue in order to
prove that for the business owners that they are performing well so they
keep their position. For the person who is concerned about the matter he
should compare the sales invoices with the real one to be sure that
everything is okay.
Colby also mentioned that '' there are several questions should the
examiner ask himself such as: Can sales be confirmed with the
customers? Were invoices at year end unusually high? Were there any
sales to related parties in the last quarter? Related-party transactions are
much more prone to manipulation. Have any documents been altered or
forgeted and are they originals or photocopies? If management has
created fictitious sales, they usually have to create phony documents
(type of business papers which are fabricated to proof a kind of a fraud as
it is real) to support those sales or alter legitimate documents to reflect
the increased sales amount''.
We should also examine the latest transactions and adjustments
because they have a big potential possibility of manipulation. Making
gross margin ratio analysis (a profitability ratio that compares the gross
margin of a business to the net sales, gross margin ratio = gross margin /
net sales) will help also to prevent the fictitious revenues. Colby says that
this ratio will often be out of line with other periods if this is the first year
fictitious revenues were created. One of the most known cases of fictitious
revenues is Cendant Corp.
Jamal Ahmad, David Jansen and Jonny J. Frank stated that '' Created
$35 million in inappropriate restructuring reserves in 1996 that were
reversed in 1997 to inflate income thus creating the illusion of a rapid
turnaround. In 1997, reported over $70 million of revenue from bill and
hold sales, channel stuffing and other inappropriate accounting practices.
That's resulted in restating 1997 income from $109 million to $38 million.
CEO charged with violating federal securities laws by misrepresenting
Page 29 of 100

material information about the company. CEO settled by paying a piece

of a $141 million fine. Former controller and chief accounting officer each
agreed to pay $100,000 in fines. Former Arthur Anderson partner also
settled for undisclosed amount''.
3.

Timing differences, (overstatement) is another way of creating

overstatement revenues. It involves the recording of revenue and/or
expenses in the wrong period. Recording revenue early, before it is made,
will immediately increase the enterprises income using lawful sales,
rather than making fake sales. The top management has several methods
for using the time differences method to capitalize the revenue.
Colby also stated that '' Recording expenses in the wrong period is
another way of increasing the organizations income. Expenses would
typically be capitalized or recorded in the subsequent period so the
effects are not taken into account on the income statement. Depreciating
or amortizing assets too slowly is another method of delaying expense
recognition". There are many methods to stop the timing differences
fraud, one of them is to examine if the invoices are made in the true
period or not. Examine the real time of purchases from the suppliers and
the real time of selling from the clients.

Examine the organizations

capitalization policies. Examine changes in depreciable assets lives. Recompute the depreciation and amortization for all assets. One of the most
known cases of timing differences is Xerox company which Overstated
revenue for over 4 years by accelerating the recognition of $3 billion in
revenue and inflating earnings by about $1.5 billion. That's resulted in Co.
agreed to pay $10 million in fines and restate its income for the years
1997-2000.
4.

Concealed liabilities or expenses are made in order show that

company has a big net profit and a stable financial position condition.
Colby mentioned that '' Users of financial statements tend to look
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unfavorably at companies with significant amounts of debt. When

liabilities or expenses are concealed, the companys equity, assets, and/or
net earnings are inflated. Understating liabilities involves not recording
accounts payable or accrued liabilities, recording unearned revenues as
earned, not recording warranty or service liabilities, not recording loans or
keeping liabilities off the books, and not recording contingent liabilities ".
In order to discover the concealed liabilities or expenses the auditor
should examine the all liabilities and record the unrecorded liabilities by
using

the

cut-off

method

including

vendors

invoices,

receiving

documents, and cash disbursements to know if these liabilities are

recorded or not. Using the current ratio is also so helpful to detect the
concealed liabilities

or expenses

(liquidity ratio that measures

company's ability to pay short-term liabilities, current ratio = current

assets / current liabilities). If it is unordinary has high volume, it may be a
sign of hidden liabilities.
In July 2002, the SEC filed suit against the Rigas family. Founders of
Adelphia Communications, the suit alleged that between mid-1999 and
the end of 2001, Adelphia fraudulently excluded from the Companys
annual and quarterly consolidated financial statements over $2.3 billion in
bank debt by deliberately shifting those liabilities onto the books of
Adelphias off-balance sheet, unconsolidated affiliates. Failure to record
this debt violated GAAP requirements and laid the foundation for a series
of misrepresentations about those liabilities, including the creation of: (1)
sham transactions backed by fictitious documents to give the false
appearance that Adelphia had actually repaid debts when, in truth, it had
simply shifted them to unconsolidated Rigas-controlled entities, and (2)
misleading financial statements by giving the false impression through
the use of footnotes that liabilities listed in the Companys financials
included all outstanding bank debt.

Page 31 of 100

5.

Improper disclosure is actually based on not real presenting of the

company and making wrong representations in documents and other
company filings. Making wrong information in the attachment sections of
annual reports of other filings are another purpose for improper
disclosures. Many of wrong disclosures are intentionally made by top
management and other improper disclosures are just errors and don't
have prior intention to be made with illogical reasons. Examples of
improper disclosure would include liability omissions, failure to disclose
loan covenants, loan defaults or contingent liabilities, significant events;
related-party transactions (include inflating inventory by purchasing from
an affiliate at a price that is higher than market. Companies can also
transfer liabilities to a related affiliate. Some of the methods to detect
improper related-party transactions are to examine minutes of the board
meetings), and changes in accounting policy methods.

6.

Improper asset valuation (overstatement) simply it is maximizing

the assets in the balance sheet of a company. The enterprises are usually
use assets to pay their debts and their expenses that they are actually
valued as inventory, accounts receivable, and fixed assets.

7.

Manipulating

in

inventories is a well-known improper asset

valuation.
Colby said that '' Inventory is also typically dispensed from several
locations and is normally comprised of a large number of items. This
makes it easier to create improper estimates for obsolete or slow-moving
goods, to manipulate physical inventory counts, to create fictitious
inventory, to fail to record the purchase of inventory, and for improper
inventory capitalization ''.
Detecting inventory fraud needs the auditor to be more experienced.
He can detect it by using several methods, Identify changes in
Page 32 of 100

organization operations that might have led to the neglected or slowmoving inventory. Watch the inventory itself. Examine the inventory detail
in purchase and other inventory papers. Inventory turnover ratio (A ratio
showing how many times a company's inventory is sold and replaced over
a period, inventory turnover = sales / inventory) analysis to determine if
the results are what is expected. Any variances should be followed up for
explanation. One of the most noticeable red flags of unrecorded inventory
is that the cost of goods sold is too low in relation to recorded revenues.
This can be detected by using gross margin ratio analysis. The gross
margin will typically be too high. Search for unrecorded liabilities that
relate to inventory purchases and perform tracing from physical inventory
count to inventory records.
8.

Accounts receivable are typically falsified or manipulated in the

same manner as revenue and inventory. MR Cobles says that accounts
receivable fraud includes fabricated receivables and the failure to write off
accounts receivable for bad debts. Accounts receivable are also prone to
manipulation as a result of fraudulent revenue schemes because the
fraudster will often create fictitious accounts receivable when creating
fictitious revenues. Methods for detecting fictitious accounts receivable
are to examine the accounts receivable aging report compare the
yearend balance with the rest of the year and the previous month for
unusual changes. Examine unusual sales and adjustments as well as
subsequent period credit memos. Examine previous write-offs. Confirm
accounts

receivable

with

the

purchasers.

Calculate

the

accounts

receivable turnover ratio (An accounting measure used to quantify a firm's

effectiveness in extending credit as well as collecting debts, accounts
receivable turnover = net credit sales / average accounts receivable ) . A
slow turnover rate would be indicative of amounts that are uncollectible.
9.

Fixed assets improper: valuation of fixed assets can occur in

several

ways.

These

include

booking

Page 33 of 100

fictitious

fixed

assets,

misrepresenting

the

asset

value,

improper

capitalization,

or

the

misclassification of assets.
Colby stated that '' The most common offset account when booking
fictitious assets is owners equity. Land and building flips between related
parties are often used to increase the value of the assets. Misclassification
or the improper capitalization of fixed assets occurs when non- asset
items are included in the fixed asset total''.

Detecting the improper

valuation of fixed assets can be accomplished using several techniques.

You can see the documentation supporting the asset having, examine the
title of assets, examine appraisers reports on value, trace assets on the
floor to those in the books, and compute the current ratio since
misclassification is typically done to improve current ratio. As an
example for improper asset valuation In August 2002, it was revealed that
the rot at WorldCom went even deeper than previously thought. The
company reported that an internal audit had discovered that US$3.3
billion in profits were improperly recorded on its books from 1999 to the
first quarter of 2002. That was in addition to the US$3.8 billion in
expenses that had been improperly reported as capital investments in
2001.
10.

The

second

type

of

the

accounting

fraud

is

the

understatements means that recording the assets and the revenues of

the company less than its main value in order to minimize the taxes which
the company pay to the government. The IRS has detected the fraudulent
activities that companies stating that underreporting or omitting income,
Overstating the amount of deductions, Keeping two sets of books, Making
false entries in books and records, Claiming personal expenses as
business expenses, Claiming false deductions and Hiding or transferring
assets or income are considered as criminal activities in violations of tax
low. As an example if an asset is understated, the balance sheet shows
assets as lower as they should be. For example - a bank might value a
Page 34 of 100

mortgage-backed security at $750K when it properly should be evaluated

at $1M. There are also many types of the understatements including
timing differences, understated revenues, overstated liabilities and
expenses, improper asset valuation.
11.
Understated revenues mean that lowering the revenues of the
company in order to reduce their tax liability or keep some money for the
bad performance years that expected to happen in the future which is
known as cookie-jar accounting.
Arthur Pinkasovitch stated that '' cookie-jar accounting is disingenuous
accounting practice in which periods of good financial results are used to
create reserves that shore up profits in lean years. A company to smooth
out volatility in its financial results, thus giving investors the misleading
impression that it is consistently meeting earnings targets, uses Cookie
jar accounting. Investors, who assign the company a premium valuation,
generally reward this reliable earnings performance. Regulators frown on
the practice since it misrepresents a companys performance, which may
be very different in reality from what it purports to be''
One of the best-known cases of cookie jar accounting in recent years
was that of computer giant Dell, which in July 2010 agreed to pay a $100
million penalty to the Securities and Exchange Commission (SEC) to settle
SEC allegations that it used cookie jar reserves. The SEC maintained that
Dell would have missed analysts earnings estimates in every quarter
between 2002 and 2006 had it not dipped into these reserves to cover
shortfalls in its operating results. The cookie jar reserves were created
through undisclosed payments that Dell received from chip giant Intel in
return for agreeing to use Intels CPU chips exclusively in its computers.
(Intel made these payments to Dell to lock out rival chipmaker Advanced
Micro Devices from Dell computers.). For the person who is concerned
about the matter he should compare the sales invoices with the real one
to be sure that everything is okay.
Page 35 of 100

12.

Timing differences (understatement), Expenses would typically

be capitalized or recorded in the subsequent period so the effects are not

taken into account on the income statement. If the objective is to
decrease income to minimize the organizations taxes payable, it might
accelerate expenses into the current period. This could involve increasing
the rate of depreciation or amortization on assets. It can also include
expensing capital expenditures. There are many methods to stop the
timing differences fraud, one of them is to examine if the invoices are
made in the true period or not. Examine the real time of purchases from
the suppliers and the real time of selling from the clients. Examine the
organizations capitalization policies.

13.

Overstated liabilities and expenses the flusters use this

method by maximizing the liabilities and expenses in order to do the tax

evasion (Tax evasion is the illegal act of not paying the taxes that you
owe, Tax evasion carries stiff penalties in practically every country in the
world. In many countries, tax evasion will result in prison time and/or stiff
penalties) so at the end of the day the company has a low net profit in its
income statement. In addition, the Australian Taxation office stated, Tax
evasion generally occurs when companies don't report all of their income,
or they overstate their deductions. Companies do this to reduce the
amount of tax they need to pay to gain a personal benefit''. . In order to
discover the understated liabilities or expenses the auditor should
examine the all liabilities and unrecorded the recorded liabilities. Using
the current ratio is also so helpful to detect the understated liabilities or
expenses. If it is unordinary has low volume, it may be a sign of
capitalized liabilities.
14.

Improper

asset

valuation (understatement) simply it is

minimizing the assets in the balance sheet of a company to pay low taxes.
As we said before any type of lowering the taxes is called tax evasion,
Page 36 of 100

which is illegal act arises when companies whether overstating their

expenses and underestimating their assets to gain personal benefit that is
faced by governments through penalties that might lead to prison or
paying high damages. As a result of the assets could be converted to
cash, lowering it would low the cash also. This could be done by
minimizing the number of its inventories, receivables and fixed asset
values.
15.

Detecting inventory fraud needs the auditor to be more

experienced. He can detect it by using several methods, Identify changes

in organization operations that might have led to the capitalized or fastmoving inventory. Watch the inventory itself. Examine the inventory detail
in purchase and other inventory papers.

Auditors should do inventory

turnover r ratio analysis to determine if the results are what is expected.

Any unexpected high amounts should be followed up for explanation.
About

the

receivables

they

should

examine

unusual

sales

and

adjustments as well as subsequent period credit memos. Confirm

accounts

receivable

with

the

purchasers.

Calculate

the

accounts

receivable turnover ratio. A fast turnover rate would be indicative of

amounts that are highly collectible.

16.

Detecting the improper valuation of fixed assets can be

accomplished using several techniques. You can see the documentation

supporting the asset having, examine the title of assets, examine
appraisers reports on value, trace assets on the floor to those in the
books, and compute the current ratio since misclassification is typically
done to decrease current ratio.

Page 37 of 100

II.

The role of government to reduce tax fraud:

Governments should act together to stop the immoral tax evasion
done by taxpayer in different jurisdictions in the world, so we decided to
give different solutions to minimize tax evasion and also that will not
affect the profitability of governments and will be sensibly with the
taxpayer not to make tax fraud in order to evade taxes and here are some
recommendations:
1.

Government should require companies and individuals to provide

transparent country-by-country accounts. In addition, the accounting and
tax deduction for the assessment and validity of charges would be strict

sharing of national sales and actual costs.

2.
Government should automate information exchanges with other
countries.
3.
Government should Change the strict culture. Leaders and government
should be taking vital action. Not paying proper taxes and reconciling
avoidance should cause explicit censure and sanctions.
III.

Famous Tax Evaders:

Daniel Bukszpan prepared a short list for famous celebrities who
evaded taxes. This list includes::
1.

Wesley Snipes: He failed to file tax returns between 1999 and 2006,
and prosecutors claimed that during those years, $38 million worth of
income had gone unreported. Snipes justified the nonpayment in a 2006
statement in which he claimed he was a nonresident foreign of the
United States. In reality, he was born in Florida. He also stated the U.S.
government had "no legal authority to impose any kind of criminal
sanctions" and that he had no income for the U.S. government to
legitimately tax. The courts did not see it that way, and on Feb. 1, 2008,
he was convicted of three crime charges of failure to file income tax
returns.

2.

Richard Hatch: In September 2005, IRS accused him on charges of

failing to report the money he had won in his 2000 tax return. The
Page 38 of 100

accusation was not only listed his unreported revenues but also
unreported money from rental properties he owned, the car he won on a
show and false statements that he had knowingly given about all of the
above. In 2006, he was found guilty of tax evasion and sentenced to 51
months in prison.
3.
Leona Helmsley: Leona Helmsley and her husband, Harry, were New
York real estate tycoons whose huge hotel empire included the Helmsley
Palace on Madison Avenue in Manhattan. They had their Connecticut
mansion; five years later, they were accused on charges of evading $4
million in income taxes for fraudulently billing work on the mansion to
their hotels as business expenses. Leona Helmsley was finally convicted
of evading $1.2 million worth of federal income taxes. Her husband was
4.

found not mentally competent to stand trial. They both have since died.
Pete Rose: In 1990, Rose was sentenced to five months in prison and
fined $50,000 for tax evasion, according to The Associated Press. He had
failed to report more than $350,000 of income from autograph signings,

5.

sales of souvenirs and even the gambling that had cost him his career
Kwame Kilpatrick: The youngest person ever elected mayor of
DetroitKilpatricks

durationwas

famous

for

its

many scandals

and

corruption claims, according to The New York TimesThe former mayor had
created a charitable organization that received tax-exempt status, but
authorities accused him of using the fund to pay for personal expenses,
political consulting, On June 23, 2010, Kilpatrick was accused on multiple
federal charges, including filing false tax returns. Each of the five tax
amounts carried a possible sentence of five years and a $250,000 fine.
The former mayor has arguednot guilty, and his case goes to trial in
6.

September 2012.
Willie Nelson: In 1990, the IRS had served Nelson with a bill for $32
million in back taxes, one of the largest ever presented to an individual,
because his accounting firm, PriceWaterhouse, had put his money into tax
shelters of suspicious validity instead. The singer settled his debt with the
IRS in 1993.
Page 39 of 100

IV.

Reasons of Financial Statement Fraud:

There are many reasons leads to the financial statements frauds
including

many

indicators.

Fraud

triangle,

human

greed,

lack

of

transparency, company culture, lack of the internal controls and the Nonindependent internal audit department are the most common reasons for
the financial statement fraud.
Fraud triangle is a model for knowing the indicators that cause
someone to do intentional fraud it is originated from Donald Cressey's
hypothesis in 1973. It consists of three main important components,
which, together, lead to fraudulent behavior. According to Romney &
Steinbart (2008), three conditions exist in the occurrence of fraud:
pressure, opportunity, and rationalization. Albrecht & Albrecht (2004)
state that auditors focus more on the elimination of opportunity by
ensuring strong internal controls, however, they often fail to focus on the
motivation or rationalization of the perpetrators.

Page 40 of 100

1.

Rationalization is a crucial component in most frauds. Rationalization

involves a person reconciling his/her behavior (stealing) with the
commonly accepted notions of decency and trust. Some common
rationalizations for committing fraud are:
a.
The person believes committing fraud is justified to save a family
b.

member or loved one

The person believes they will lose everything family, home, car,
etc. if they do not take the Money; the person believes that no help

c.

is available from outside.

The person labels the theft as borrowing, and fully intends to
pay the stolen money back at some point; the person, because of
job

dissatisfaction

(salaries,

job

environment,

treatment

by

managers Believes that something is owed to him/her).

d.
The person is unable to understand or does not care about the
consequence of their actions or of the accepted notions of decency
and trust are also one of them.

2.

Pressure or motivation is what makes a person to commit fraud.

Pressure can include almost everything or anything including medical
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bills, expensive tastes, addiction problems, etc. always and most of the
time; pressure comes from a significant financial need/problem. Often this
need/problem is non-sharable in the eyes of the fraudster. That is, the
person believes, for whatever reason, that their obstacle must be solved
in secret. However, some frauds are committed simply out of greed alone.
Denise R. Tessier, regarding the fraud triangle theory, stated that ''
Motivation or pressure is the second angle in examining what is driving
the individual to commit the act. Just as with rationalization, the
perception of a need or a pressure is the key factor, and it does not
matter whether or not the motivation makes sense to others or is based in
reality. Individuals may be facing financial or other personal problems
such as gambling, drugs, alcohol addiction, or extreme medical bills. Pure
greed also can factor into the equation but may be flavored with a sense
of injustice. For example, the perpetrator may feel like the company
should have paid me what my car was worth.
3.

Opportunity is the ability to commit fraud. Because fraudsters do not

wish to be caught, they must also believe that their activities will not be
detected. Opportunity is created by weak internal controls, poor
management oversight, and/or through use of ones position and
authority. Failure to establish adequate procedures to detect fraudulent
activity also increases the opportunities fraud for to occur. Of the three
elements, opportunity is the leg that organizations have the most control
over. It is essential that organizations build processes, procedures and
controls that do not needlessly put employees in a position to commit
fraud and that effectively detect fraudulent activity if it occurs.
Denise R. Tessier also said that "Finally, fraudsters must find an
opportunity. This is defined as an environment or temporary circumstance
that allows the fraud to be committed, typically with little perceived
chance of being caught or penalized. Windows of opportunity exist for
Page 42 of 100

wrongdoing when companies have poor internal controls, weak processes

and procedures, unauthorized or unchecked access to assets by
employees, or a lack of management review and oversight.''
The second indicator of the financial statement fraud is the human
greed and arrogance. Human greed is excellent old-fashioned human
nature have hand when an individual, or group of individuals, sees an
opportunity to make a fast buck. A wonderful example being those cases
where people adjust their expense claims upwards. Arrogance is when
some people believe that they are better than the system, and that they
can

get

away

with

anything.

The

late

Robert

Maxwell

(was

Czechoslovakian-born British media proprietor and Member of Parliament

(MP). He rose from poverty to build an extensive publishing empire. His
death revealed huge discrepancies in his companies' finances, including
the

Mirror

Group

pension

fund,

which

Maxwell

had

fraudulently

misappropriated) plundered his company pension scheme, arrogantly

assuming that since he was chairperson of the company he could get
away with it; he almost did!
Lack of transparency leads to direct financial statement fraud.
Transparency term is the extent to which investors have ready access to
any required financial information about a company such as price levels,
market depth and audited financial reports. Classically defined as when
"much is known by many", transparency is one of the silent prerequisites
of any free and efficient market. Transparency helps to prevent the
corruption that inevitably occurs when a select few have access to
important information, allowing them to use it for personal gain. Reduced
price volatility also tends to be a byproduct of a transparent market
because all the market participants can base decisions of value on the
same idea. Complex financial transactions that are difficult to understand
are an ideal method to hide a fraud. The Barings fraud was perpetrated by
use of an accounting dump account that no one understood.
Page 43 of 100

Lack of the internal controls of the company is one of the most famous
reason leads to the financial statement fraud. Internal controls are policies
and procedures that will protect your business assets and reduce the risk
of fraud. They can be simple, little to no cost ways that may prevent or
minimize financial problems. Where are the accounting controls, such as a
monthly reconciliation (Reconciling an account often means proving or
documenting that an account balance is correct. For example, we
reconcile the balance in the general ledger account Cash in Checking to
the balance shown on the bank statement) of the bank account, are lapse
the signals that a fraud has occurred will be missed.
The corporate governance is one of the important tools of the internal
controls. The system by which companies are directed and controlled, it is
also the process by which corporations are made responsive to the rights
and wishes of stakeholders. Corporate governance is also the manner in
which management and those charged with oversight accountability meet
their obligations and fiduciary responsibilities to stakeholders.
Company culture can lead to the frauds in several ways. Managers can
unknowingly create an environment where fraud runs highly. To protect
the organization from the fraud, it is important that management
understands their role in fostering an ethical, healthy work environment.
Robyn Barrett says in her article how company culture can lead to
fraud '' Establishing a positive company culture is a key component in
keeping fraud at bay. It begins with cultivating a company culture that fits
the values most vital to the companys success. This can be achieved by
clearly defining what behaviors will be accepted and encouraged within
the company and which will not.''
According to the CPAs Handbook of Fraud and Commercial Crime
Prevention, a guide published by the American Institute of Certified Public
Accountants, there are certain elements of a companys culture that can
Page 44 of 100

make it more susceptible to fraud. Amongst these are autocratic

management

styles,

centralized

distribution

of

authority

and

overwhelmingly negative feedback.

Autocratic managers often make decisions without involving the
employees in the decision-making process and put unnecessary pressure
on employees to perform. According to the AICPA, this pressure can lead
to internal fraud.
Robyn Barrett

stated that '' Much like companies with autocratic

managers, companies who implement a centralized distribution of

authority harbor an environment for fraud by taking power away from
employees and allowing all decisions to be made by higher-ups. Stripping
employees of their ability to offer any insight or feedback makes it easier
for employees to rationalize internal fraud''.
Lack of clear moral direction from senior management where the
senior management indulges them in semi corrupt behavior, e.g. This
won't give the employees the green light to work in environment full of
the morals and ethics. This will make them more liable to the fraud
behavioral more than other organizational environment which have clear
moral and ethical standards from the high management staff.
The last reason of the fraud is the Non independent internal audit
department where an organization's internal audit department is not
independent, e.g. where it does not report to a truly independent audit
committee but to the Finance Director, the more likely that when there are
signals that a fraud is occurring the more likely they will be ignored. It is
indeed interesting to note that Cynthia Cooper (Head of Internal Audit at
WorldCom) had to bypass her boss (the CFO) and go directly to the audit
committee to report the discovery of the capital expenditure fraud.
V.

Consequences and Effects of Financial Statement Fraud:

Page 45 of 100

Financial statement fraud will have an effect on the employees or the

organization that includes a monetary interest within the success or
failure of an organization. A manipulation of the corporate reported
earnings or assets will have an effect on a bank that extends credit to the
company, a shareowner who invests cash within the company, and the
employees who actually work in the company.
1.

Banks lose lots of money, which affects other bank customers and
clients who always make up for those losses and affects the banks
investors. Creditors can lose large sums of money, which may not have
been risked if the creditors knew the true financial condition of the
company. Many of top management who make frauds leads their
companies to collapse at the end of the day, those companies after
collapsing can't pay back their loans to the banks and this has a
dangerous effect on the national economy itself.

2.

Financial statement fraud will cause shareholders to overpay for their

investment in the company and they will get less value for their money
than they are aware. They may lose part or all of their investment if the
company ultimately fails or has to go through some sort of reorganization
in order to remain viable. Shareholders also lose the opportunity to invest
their money in other companies which may have better actual financial
results or which may be more honest in their operations.

3.

The manipulation of financial statements additionally affects staff. It is

the ability to place staff out of work once the fraud is exposed or
collapses. It additionally has the ability to complement staff principally
those concerned with in the fraud, however probably people who are not.
Sensible financial results (actual or fabricated) will be coupled to
promotions, raises, increased profit packages, bonuses, and therefore the
value of stock option awards. Another important effect that the
employees will lose their moral and ethics towards to their company and
this will badly affect the organization itself.
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There are also many other effects of the financial statement frauds
have a direct effect on the company itself including financial loss, External
Confidence, Company Morale and increased audit costs according to John
Freedman, Demand Media in their article How Fraud Hurts You & Your
Organization.
1.

Financial Loss: Financial loss is an obvious effect of both types of

fraud. When someone misappropriates company assets, the loss is easy
to quantify. For example, if a cashier takes $60 from the cash register, the
company loses $60. The costs of fraudulent financial reporting are harder
to determine. If a small-business owner perpetrates financial statement
fraud, an explicit dollar figure might not be obvious. However, fines
assessed for misleading investors, civil suits to recoup investor and
creditor losses and the unwillingness of companies to extend credit to the
business in the future all add up to a severe financial loss for the
company.

2.

External Confidence: Once a fraud has been uncovered, the

company faces an ongoing problem of public trust in the organization.
While a small business scandalized by fraud might never be the victim or
perpetrator of another fraud, its public image might be irreparably
tainted. Consequently, the company may have to pay a higher price for
credit, may be refused membership in trade associations or might not be
considered for a strategic alliance.

3.

Company Moral: The effect of fraud on a company's culture and

morale can be shattering. Any association with a company that has
perpetrated or suffered fraud can be troubling and embarrassing for the
people who work there. This may be especially true in a small-business
setting where workers feel more connected with one another. Even if
employees leave the company, they may carry an association with a

Page 47 of 100

fraudulent company into their next place of employment, even if they

were not involved with the fraud at all.
4.

Increased Audit Costs: Small businesses that are subject to audit

and have experienced fraud, especially if the fraud was perpetrated by
company management, are likely to be assessed as a high audit risk. That
means auditors will more closely scrutinize company books before signing
off on a company's financial statements. When an auditor is required to
perform more procedures, the cost of the audit will increase. This can
often be mitigated by demonstrating that the offending managers or
employees have left the company and the company has instituted strict
procedures to thwart future attempts at fraud.
Chapter 4
Indicators and ways to prevent Fraud in Financial Statements
As Albert Einstein has said meanwhile We cannot solve our problems

with the same thinking we used when we created them. We will adopt this
approach in trying to understand the indicators and ways to solve the
existing problem of fraud and to understand the behavioral aspects of
fraudsters through understanding the behavioral red flags and business
indicators and reviewing ingenious solutions to this problem.
I.

Behavioral Red Flags:

Behavioral red flags; means there are many attitudes done by the
fraudster when these attitudes happen it make doubts about the fraudster.
According to the article "Theft, Fraud and Dishonest Employees Do
you really know whats happening in your business?" By Erika Lucas, stated,
"Of course the vast majority of employees are upstanding, honest citizens.
However, if you are concerned that there might be some rogues in the pack,
there are some red flags to look out for. Warning signs include people who
appear to be living beyond their means (flash cars, big houses, five star
holidays) although there can of course be rational explanations for this,
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such as a family inheritance or win on the lottery!

Other signs to look out

for are people who are always first and last in the office, rarely take holiday
and are overly protective of their workload.

An unhealthy closeness with

customers, suppliers or competitors is another sign that something may be

amiss. None of these mean that anything untoward is definitely taking place
but they are signs that can indicate you ought to be taking a closer look at
whats happening ".
Another warning signs to look for is when the person who is the first
one who goes to the office and also he is the last one who leaves it, he goes
first one and leaves last one in order not to give a chance to get doubted.
In addition, when the person rarely takes holidays, the perpetrator will
often exhibit unusual behavior, which is one of the strongest indicators of
fraud. The fraudster may not ever take a vacation or call in sick in fear of
being caught. He or she may not attribute out work even when overloaded.
That individual does not want anyone of his employees nor manager to
identify how the discs are being manipulated, by granting others the chance
to over review his own study in this absence. There are other signs to look
for like:
1.
Refuses or does not seek promotion or rotation and gives so
reasonable explanation: Career progression or work rotation is highly
desirable for the majority, but if an employee refuses this on more than
one occasion, it could be another indicator that something is going on.
Management must take the time to see how their employees play with
others in the department, if an employee insists on playing in isolation
when this is not always appropriate this is a solid indicator of fake.
2.

Suspected to have over-extended personal finances or excessive

lifestyle: Selfishness and greed is one of the key motivations for
committing fraud. Management should be alert to the fact that overnight
inheritances, newly established luxury lifestyles and excessive personal
consumption may all point to fraudulent conduct. Most people who
Page 49 of 100

perpetrate fraud are under fiscal pressure and sometimes these pressures
are real. The minority of the perpetrators steals and save most
immediately spends everything they steal or in better language,
everything they embezzle. As they become more positive in their fraud
schemes, they slip and spend increasingly larger amounts until they are
living lifestyles far beyond what they can reasonably afford, for examples
getting new cars, exotic vacations, home improvements or they even
move into a more expensive home, purchase of expensive jewelers or
clothes.
3.

Defensive Mechanism: Perpetrators use the defense mechanisms, or

manners in which they behave or think in certain ways to better protect or
defend themselves. Although this is an area slightly controversial,
managers should be able to utilize their best assessment. There have
been many examples of employees inventing illnesses as a mechanism to
behave as a buffer to question.

If an employee is creating defense

mechanisms to prevent questioning over transactions or performance,

there may be reason to be extra careful and observant. This is especially
the case where answers to straightforward questions are ever shifting and
inconsistent.
4.

Senior managers with unusual spheres of influence: When the CFO

Banks cash takings or a senior manager is required in purchasing
decisions outside of his function, ask the question: Why? In recounting to
the first of these, it is important that all businesses can trace all fund
inflows

from

source

to

bank

with

appropriate

segregation

of

responsibilities.
II.
1.

Business Indicators:
Accounts not reconciled to underlying records: The most recent Fraud
Barometer attests, that 55% of the management fraud were performed at
senior levels. One of the common management frauds is introducing the
business as performing in the best image and better than it is truly is. It is
Page 50 of 100

frequently the case in such situations that key accounting reconciliations

are set aside to enable the manipulation to pass undetected.
2.

Elsewhere in the industry: As mentioned or as known that complete

performance against peers is generally good news, however, independent
directors and the board must get comfortable as to estimate how this has
been accomplished.

3.

Excessive secrecy about a role and its operations: Certain business

leaders deliver a mysterious habit of avoiding or postponing scrutiny,
such as internal audit reviews, for credible reasons. Such avoidance
activity should not be accepted on a repeated or continuous basis.

4.

Posting to vulnerable balance sheet accounts: When funds are stolen

or accounts are manipulated the perpetrator will need to process an
accounting entry to cover the underlying transaction. In every lawsuit or
on every social function, certain balance sheet accounts are utilized such
as suspense accounts or other histories (such as VAT or PAYE) that are
rarely fully reconciled. Unexpected buildup of balances on such accounts
requires a challenge.

III.

Other miscellaneous indicators:

As mentioned in studies done by PwC "A business is placed at risk for
fraudulent activity if an in-house accountant works without proper
supervision on every aspect of the businesss financial operations, e.g.
payroll, receivables, deposits, payments etc.
In house accountant works without supervision : if the accountant
takes his work to do it in his house without supervision in his work so it is
Page 51 of 100

high risk to do fraud and also if the accountant does his job in his office
but without supervision there is also high risky.
Accountant insists on handling activities that other department: other
cases shows that the accountant can be handling more than one jobs on
accounting department and on another department and this increase the
doubts towards this person.
IV.

Internal Auditor Responsibility:

The internal audit activities inside a firm should be done in a
professional way, and according to recognized standards of practice
within the internal audit industry. To make sure that the level of
performance is achieved all auditors in the internal audit department
must share responsibility for the accomplishment of all delegated jobs in a
professional manner.
1. Main Internal Auditor Responsibility:
a. Declaring any deficiency to independence or objectivity that may exist.
b. Performing assigned jobs in an independent and self-directed way.
c. Completing assigned jobs in a timely, detailed, accurate and welldocumented way.
d. Submitting all completed work papers to the Director of Internal Audit
for final evaluation and approval.
e. Conducting oneself in a professional manner at all times; evading
those situations that would lead to criticism by the area being audited,
or by the public.
f. Assuming a friendly and cooperative behavior with the audited areas
staff. Disagreements should be reported to the Director of Internal
Audit.
g. Conducting work to reduce disruption of the audited areas workflow or
ability to service their customers.
h. Advising oneself with the premises, responsible employees, and the
location of records early in the audit.
i. Requesting any documents that may be needed. Management of the
audited area should be made conscious that the Internal Auditor has
those documents.
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j. Protecting all files / records that have been assigned to the Auditors
control.
k. Returning all files / records to the person or area, they were obtained
from.
l. Maintaining all records in the same or better condition than that in
which they were found.
m. Retaining all records on premises - never removing vital documents
from the premises.
n. Returning all documents taken to the Internal Auditors work area to
the records custodian by the end of the day if such return is requested.
2. Additional Internal Auditor Responsibility:
a. Developing a knowledge with the organization and functions of the unit
to be audited.
b. Pre-planning the audit in accordance with the opportunity and difficulty
of the area under review.
c. Guaranteeing that an assessment of risks is combined into, or forms
the basis of all audit work planned and performed.
d. Accepting responsibility for the audit work performed on assigned
assignments.
e. Managing the audit in relation to time and resource budgets.
f. Ensuring that audit results and recommendations made during the
course of the audit are on time communicated to management.
g. Ensuring that all Worksheets issued are correctly constructed,
supported, and communicated.
h. Ensuring that all objectives

have

been

accomplished

and

all

conclusions are properly supported.

i. Ensuring that the audit or review is conducted with the least amount of
disturbance to the audited area as is possible.
j. Conducting an Exit Review or briefing at the conclusion of fieldwork.
k. Drafting and seeking approval for a formal Audit Report.
l. Finalizing the audit files and ensuring that all supporting
documentation is properly taken.
m. Performing follow-up work as necessary successive to the audit.
3. The Auditors Responsibility to consider Fraud and Error in an
audit of financial statement:
After reading a report called The Auditors Responsibility to Consider
Fraud and Error in an Audit of a Financial Report, we discovered that
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there are some essential limitations of audit the report stated, An audit
does not guarantee all material misstatements will be detected because
of such factors as the use of judgement, the use of testing, the inherent
limitations of internal control and the fact that much of the evidence
available to the auditor is persuasive rather than conclusive in nature.
For these reasons, the auditor is able to obtain only reasonable
assurance that material misstatements in the financial report will be
detected. And The risk of not detecting a material misstatement
resulting from fraud is higher than the risk of not detecting a material
misstatement

resulting

from

error

because

fraud

may

involve

sophisticated and carefully organized arrangements designed to hide it,

such as forgery, deliberate failure to record transactions, or intentional
misrepresentations being made to the auditor. Such attempts at
concealment may be even more difficult to detect when accompanied by
complicity.
Complicity may cause the auditor to believe that evidence is
persuasive when it is, in fact, false. The auditors ability to detect a fraud
depends on factors such as the skillfulness of the perpetrator, the
frequency and extent of manipulation, the degree of collusion involved,
the relative size of individual amounts manipulated, and the seniority of
those involved. Audit procedures that are effective for detecting an error
may be ineffective for detecting fraud.
The risk of the auditor not detecting a material misstatement resulting
from management fraud is greater than for employee fraud, because
those charged with governance and management are often in a position
that assumes their honesty and enables them to prevail the formally
established control procedures. Certain levels of management may be in a
position to prevail control procedures designed to prevent similar frauds
by other employees.

Page 54 of 100

The report includes by stating that The auditors opinion on the

financial report is based on the concept of obtaining reasonable
assurance; hence, in an audit, the auditor does not guarantee that
material misstatements, whether from fraud or error, will be detected.
Therefore, the succeeding discovery of a material misstatement of the
financial report resulting from fraud or error does not, in and of itself,
indicate: a failure to obtain reasonable assurance, inadequate planning,
performance or judgement, the absence of professional competence and
due care; or, a failure to comply with Auditing Standards.
V.

Setting up a Financial Reporting System:

Two famous accounting professors Dr. Zabihollah Rezaee and Dr.
Richard Riley wrote a valuable book called Financial statement fraud
prevention and detection. The book is very important especially in the
part of the financial reporting system, which is a complex process that is
influenced by a variety of factors, including technological, political,
cultural, economic and business environments. The national committee on
fraudulent financial reporting better known as the way commission has
broken down the financial reporting system into three fundamental
element:
1. Companies and their directors and officers.
2. Independent public accountants.
3. Oversight bodies.
Financial Reporting System
Public
Compan

Independen
t Public
Accountant

1.
2.

Financia
l Report
3.
Users of
Page 55
of 100
Financial
Reports

4.
5.

Oversight of
financial reporting
Securities and
Exchange
commissions (SEC)
Financial
institutions
regulatory
agencies.
Financial
accounting
standards board
(FASB)
State authorities.
National

The diagram describes the relationship of the three fundamental

elements of the financial reporting system and their interaction with the
users of the system. A company and its directors as well as senior
management play an important role in the financial reporting system and
process. They are primarily responsible for fair and true presentation of
financial reports conforming to established criteria known as reporting
standards.

The

quality

of

financial

reports

reflects

management

commitment and intent in preparing reliable, relevant and useful

information about the companys financial position, results of operations,
and cash flows. The board of directors and the audit committee oversee
the financial reporting process even though management actually
prepares and certifies the financial statements. Executives of large public
companies in compliance with the Sarbanes-Oxley acts prepare and
certify the companys internal control over financial reporting in addition
to certification of financial statements.
Independent public accountants are engaged under to render an
opinion regarding the fair presentation of financial reports on the
companys financial position and the results of operations in conformity
with GAAP.
Several oversight bodies influence a set of financial reporting
standards for public companies and enforce compliance with those
standards.
1. Annual Financial Reporting Requirements:
Companys

annual

report

is

the

primary

means

of

communication with current and potential investors and creditors.

Therefore, management tries to use this vehicle to portray the

Page 56 of 100

company in a favorable manner by adding gloss to the annual report

while complying with the reporting requirements set forth by SEC.
SEC requires that annual reports provided to the shareholders in
connection with

the annual meeting of shareholders include the

following:
a. Income Statement.
b. Audited financial statements consisting of balance sheet as of the
two most recent fiscal years.
c. Cash flows Statement.
In addition, additional information should be included in the annual
report to shareholders:
a.
b.
c.
d.

Selected Quarterly Financial data.

Summary of Selected Financial data for last five years.
Segment information.
Managements discussions, analysis of financial condition and

results of operations.
e. Quantitative and qualitative disclosures about market risk.
f. Market price of companys common stock for each quarterly period
within the two most recent fiscal years.
g. Description of business activities.
h. Disagreements with accountants on accounting and financial
disclosures.
2. High Quality Financial Reports:
The main role of the SEC is to protect investors through a fair and
orderly operation of the capital markets. High quality and transparent
financial reports prepared based on full and fair disclosure promote
efficient capital markets. There are certain qualitative aspects of financial
information that are important in producing high quality and transparent
audited financial statements that are prepared in conformity with GAAP.
The financial reporting model that has been established through the
continued efforts of both the public and private sectors is designed to
Page 57 of 100

provide users with useful, reliable, relevant, comparable, consistent and

transparent information that is necessary to make informed and educated
financial decisions. Its the responsibility of the management of any
company especially the CFO to have a fair presentation of the financial
statements in conformity with GAAP that portray the companys
performance, cash flows, and financial position to investors, creditors, and
other users of financial statements.

The ten qualities and characteristics that make financial information

useful for decision making by all users of financial statements are:
a. Relevance: the financial information is viewed to be relevant if it
makes a difference to the decision makers and help them to:
a) Assess past performance.
b) Predict future performance.
c) Confirm or correct expectations.
b. Timeliness: timeliness is about providing financial information to
decision makers when they need it and before it loses its capacity and
capability to influence decisions.
c. Reliability: the financial information is viewed to be reliable when
investors and creditors consider it reflects economic events that it
purports to present.
d. Verifiability: Different individuals using the same measurement
material arrive at the same amount or conclusion to the extent.
e. Representational faithfulness: it is the degree of correspondence
between the reported accounting numbers and the resources or events
those number purports to represent. The representational faithfulness
of published audited financial statements means the extent to which
they reflect the economic reality, resources and obligations of the
Page 58 of 100

company, as well as the transactions and events that change those

resources and obligations.
f. Neutrality: neutrality means that financial information should be free
from bias towards a predetermined result. Neutrality implies that
management can choose among a set of acceptable accounting
methods, should select the method that reports the economic reality of
the transactions or events.

g. Comparability and Consistency: high quality financial statements

require the use of standardized and uniform accounting standards and
practices foe measuring, recognizing, and disclosing similar financial
transactions or economic events. The reported financial information of
a company can be useful for a decision maker if they can compare it
with similar information about other companies and with similar
information about the same company in a different period.
h. Materiality: an amount or a disclosure is considered material if it
influences or makes a difference to a decision maker materiality affects
the quality, integrity and reliability of financial statements.
i. Feasibility or cost and benefits: high quality financial information
or

disclosure

must

be

feasibly

practical

and

cost

effective,

management evaluate whether the perceived benefits to be derived

from the decision exceeds the perceived cost associated with it.
j. Transparency: high quality financial information must be transparent
in the sense that it provides the complete reporting and disclosure of
transactions, which portray the financial conditions and operational
results of the company in conformity with GAAP. It enables financial
statements users to obtain the right information and ensure that it is
factual and objective.

Page 59 of 100

3. Six-legged stool of the financial reporting process:

High quality financial reports, including reliable financial statement free
of material misstatements caused by errors or fraud, can be achieved
when

there

is

well-balanced

functioning

system

of

corporate

governance. This system comprises six participants:

a. Board of Directors
b. Audit Committee
c. Top Management Team
d. Internal Auditor
e. External Auditor
f. Governing Bodies, including SEC, PCAOB, AICPA, NYSE and NASD.
These participants develop a six-legged stool that supports responsible
corporate governance and reliable financial reports. Although the
responsibilities of these participants will vary regarding preparation of and
dissemination of financial statements, a well-defined cooperative working
relationship among these participants should reduce the probability of
financial statement fraud.
4. Anti-fraud environment:
Anti-fraud controls are typically implemented by organizations to deter,
prevent and provide early fraud detection, controls include:
a.
b.
c.
d.
e.
f.
g.

Establish an appropriate tone at the top.

Maintain an adequate and effective system of checks and balances.
Develop effective corporate governance.
Ensure a responsible and accountable board of directors.
Hire an objective and independent auditing firm.
Establish an independent whistle-blower system.
Maintain an independent and effective internal audit.
Some argue about the ability of fraud being prevented as it can only be

deterred. The explanation is that fraud cannot be prevented because it would

be too costly to develop a system of checks and balances to prevent every
type of fraud. There are too many potential schemes and fraudsters
dedicated to their craft for the benefits of fraud prevention to exceed the
associated costs. Generally, deterrence is centered on two concepts:
a. The perception and fear of being caught.
Page 60 of 100

b. The perception and fear of disciplinary, criminal and civil actions being
taken against perpetrators.

VI.

Implementing Internal Controls:

1. Importance of internal control:
Internal control is the method for guaranteeing the success of an
organization's objectives in operational effectiveness and efficiency,
consistent financial reporting, and compliance with laws, regulations and
policies. Internal control involves everything that controls risks to an
organization.
The internal control system covers policies, practices, and procedures
employed by the organization to achieve four objectives:
a.
b.
c.
d.

Protecting the assets of the firm.

Guaranteeing the accuracy and reliability of accounting records and information.
Promoting operational efficiency in the firm's operations.
Measuring compliance with managements arranged policies and
procedures.

2. Elements of Internal Control:

Internal control includes the following aspects: Control Environment,
Risk Assessment, Control Activities, Information, Communication, and
Monitoring.
a. Control Environment:
The control environment represents the overall control consciousness of an entity.
The expression tone at the top is sometimes used in reference to certain important
elements of the control environment. The control environment establishes a structure
and theme for other elements of internal control. Specific control environment factors
that are most relevant to financial statement fraud include the following:
1)
The philosophy and operating style of management and
the board of directors, especially as it relates to risktaking
and aggressiveness of financial reporting.
Page 61 of 100

2)

The operation of a trusted whistleblower system, whereby

employees would feel comfortable in reporting violations of

3)

the code of conduct without fear of retaliation.

A board of directors, audit committee, and finance
committee

that

are

independent

from

management,

empowered with the tools necessary to discharge their duties,

and properly engaged in and committed to fulfilling their
oversight roles.
4)
Managements respect for the functions of internal and
external auditors and those charged with the responsibilities
of
5)

setting

accounting

policies

and

preparing

financial

statements.
Clear assignment of job duties and establishment of

organizational structure.
6)
Human resources policies and practices that include proper
background screening of employees involved in all key
accounting and financial functions.
7)
A commitment to ongoing training for all employees
involved in the accounting and financial reporting functions to
ensure a high level of technical competence.
b. Risk Assessment:
Risk assessment is the process of identifying and assessing
relevant risks to the achievement of an entitys objectives. As it
relates to financial reporting, factors involved in risk assessment
include the following:
1)

Proper assignment of responsibilities for the identification

and assessment of risks involving financial reporting.

2)
Identification and assessment of the applications

of

estimation (e.g., fair value measurements, establishment of

useful lives, etc.) in the financial statements.
3)
Identification and assessment of external factors that could
affect financial reporting, such as declines in quoted stock

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prices, introduction of new competitors or new products of

4)

competitors, new technology, and so on.

Identification and assessment of

changes

in

laws,

regulations, or accounting standards that could influence

5)

financial reporting.
Identification and assessment of risks associated with the
introduction of new personnel, including outside contractors,
or information systems that affect accounting and financial
reporting systems.

c. Control Activities:
Control activities are the policies and procedures applied to carry
out the specific functions of an organization. This is the element of
internal control that most people think of when they are asked
about internal controls. Specific factors involving control activities
pertaining to financial reporting include the following:
1)

Segregation of duties, such as the separation of functions

involving the determination of fair value, the estimation of
percentage of completion, inventory, and the review of

2)

financial statements.
Controls designed to make sure that management could

3)

not override established controls.

Procedures in place to implement new accounting standards issued by

FASB and IASB.

4)
Procedures in place to review significant new transactions (such as
business acquisitions and mergers, joint ventures, and so on) for proper
application of relevant accounting standards.
5)
Requiring proper supporting documentation for all accounting entries,
6)

especially all nonstandard (nonrecurring) journal entries.

Periodic review of nonfinancial assets for signs of impairment.

Page 63 of 100

7)

Review and approval of the selections of methods used in

the determination of fair value, as well as the application of

8)

those methods.
Information technology hardware and software controls
designed to prevent unauthorized access to all systems and

9)

leave an appropriate audit trail.

Due diligence in the selection and monitoring of outside
consultants and vendors used in any accounting or financial
reporting

capacity

(e.g.,

third-party

specialists

such

as

appraisers).
10)
Verifying the independence of thirdparty valuation
specialists used by the entity.

d. Information and Communication:

Information and communication consist of the processes utilized
to record and report transactions and to maintain accountability
over assets and liabilities of an entity. Important elements of
information and communication include the following:
1)

Retention of proper supporting documentation for all

2)

transactions and journal entries.

Accurate and timely information is available to those who
need it in making determinations regarding accounting
estimates,

such

as

fair

value

measurements,

asset

impairments, collectability of receivables, percentage of

completion, and so on.
3)
Critical accounting issues (e.g., fair value accounting issues
and other estimates) and their treatment are properly
disclosed and explained to the finance committee, audit
committee, and/or board of directors.
4)
Adequate resources are provided for the thorough research
of external data useful in accounting and financial reporting.
Page 64 of 100

5)

Adequate channels of communication are provided for the

reporting of claims of accounting improprieties, such as

6)

financial reporting fraud, by whistleblowers.

Employees are properly informed regarding the information
they are requested to provide to those in charge of accounting

7)

and financial reporting.

Accounting system provides for the proper collection and
reporting of information needed to comply with accounting
standards, including all information necessary for disclosure in

the notes to the financial statements.

8)
Proper record retention and destruction policies and
practices.

e. E-Monitoring:
Monitoring represents the process of assessing the quality of
internal controls over time. Monitoring assesses both the design and
the operation of internal controls over financial reporting. Important
elements of monitoring may include the following:
1)
2)
3)

Ongoing account reconciliations and reviews of reconciliations.

Comparisons of financial results with budget.
Benchmarking of financial performance against entities with similar

operations.
4)
Ongoing ratio and trend analysis.
5)
A robust internal audit function that assesses the performance of internal
6)
7)

controls over financial reporting.

Proper ongoing communication with the entitys external auditors.
Periodic special studies of internal controls, especially in connection with
specialized aspects of accounting, such as fair value measurements,
assessment of inventory obsolescence, and so on.

Page 65 of 100

8)

Periodic special audits of procurement involving the selection of vendors

used in any accounting or financial reporting function (e.g., valuation

9)

specialists).
Periodic special audits of IT security relevant to accounting and financial

reporting.
10)
Monitoring the performance of third parties that are relied upon for
accounting or financial reporting functions.
11)
Monitoring the performance of joint ventures partners that are not
consolidated or part of the entitys own internal control system.

VII.

Monitor Vacation Balances:

Vacation periods especially in the summer or the spring is a good
periods for monitoring our accounting personnel vocational schedules.
Having a job rotation program or mandatory vacation for accounting
personnel and others in management is a key control to preventing fraud,
and is one that is simple to implement. Articles have pointed to the
benefits of vacation for employees related to improved health, employee
morale, and overall happiness. While these will benefit your Organization
by having a happy, productive employee, mandatory vacations can also
help to detect the occurrence of fraud.
The Association of Certified Fraud Examiners reports that when
comparing the median loss due to fraud between companies that did and
did not have job rotation or mandatory vacations at the time the fraud
occurred, the losses were $100,000 with this control compared to
$188,000 without this control. That is almost a 50% reduction of fraud
losses just by requiring vacation for your employees. Similarly, the
duration of the fraud occurring decreased from 18 months to 12 months
when companies had this control in place.

Page 66 of 100

If an employee is committing fraud, one of the easiest ways to detect

this is to have someone else perform their duties while they are on
vacation. This can identify any unusual transactions, incorrect payroll data
being processed, or vendors that do not appear legitimate. While it is
great to have a loyal employee who cares about your Organization,
vacations must be required so that there is break to the transactions
processed each day. If you have a loyal employee who never takes a day
off, consider requiring them to take vacation for a one or two week period,
with the days being taken consecutively and not distributed throughout
the year.
While

there

are

other

more

significant

controls

that

can

be

implemented to reduce fraud, including segregation of duties, monitoring

and

reviewing

by

management,

fraud

trainings,

and

hotlines,

implementing mandatory vacations may be the least costly of these

methods and will increase your prevention of fraud.

VIII.

Human Resources Responsibility:

1. The Role of Human Resources in Fraud Prevention:
Human Resources managers are on the front lines in the battle against organizational
fraud. Bar is the best defense against fraud, and there is no better defensive action than
making a good hire. However, no HR manager can be perfect in hiring decisions, and
sometimes primarily good employees turn against their employers, or even against their own
Board or partners in the commercial enterprise. Changes in employees circumstances are
often invisible or their employer simply does not try to know about them. In addition,
employees attitudes toward the employer evolve depending on how they are handled,
particularly in comparison with others in the system.
2. Human Resources four Key Fraud Prevention Practices:
a. Background Screening:

Page 67 of 100

To begin at the beginning, HR managers do struggle to make good

hires. This is a process of engaging an applicant through interviews and
data collection with the aim to get the most objective relevant information
possible about the things that matter. More or less of the things that
matter most will be those characters that correlate with excellence, which
we usually find through an organized process of talent acquisition.
Talent acquisition can help your organization in a positive way, but HR
is too responsible for clearing out the bad apples if possible. Thither is a
wealth of objective information available through background screening
that is sound and helpful. In handling the background screening process,
HR directors need to be highly versed in the regulatory requirements
governing discrimination, applicant notification, and the two-step adverse
action process. For optimum impact, the screening procedure should be
designed to target facts about applicants life stories that are relevant to
the business in question.
It is significant to keep a consistent number of background screening over time, such as
when an employee is being studied for a significantly different purpose in the system.
Similarly, marketers or other collaborators that can import risk into the organization should
be sorted.
b. Anti-fraud Training:
The message about fraud begins at the top and it is resounded at every level of the system
in an act of ways. Top managers set the tint, and HR managers amplify that tone through
formal training, brochures, tip hotlines or whistleblower policies, and periodic messages
via newsletters or the company blog. We urge a zero tolerance policy on fraud, and HR
needs to apply this for even minor violations.
c. On-going Performance Evaluations:
Most employees in most societies are subject to evaluations, at least on a yearly base.
These evaluations are an opportunity for HR to identify mismatches between employees
beliefs or expectations and the true circumstances. We know that potential fraudsters can gain
motivation from what they perceive as slights or oversights, and the company needs to be
Page 68 of 100

alert to that. Fair compensation is always a crucial issue. At the same time, you may be able
to learn about changes in an employees life circumstances that could affect his or her
attitudes toward the company.
It is important to remember that most fraudsters are made, not born. They start out as
good employees, and continue to be regarded as good employees even while they are stealing
from the company. We are not counseling you to spy on your employees. In fact, a fully
transparent and enforced fraud policy can serve to establish confidence in the system.
However, you need to verify what your employees are feeling around the company as
early as possible in order to help them remain within the melodic phrases.
d. Exit Interviews:
HR managers should try to conduct exit interviews with employees who are leaving the
organization, even though that can sometimes be uncomfortable. Masses who are leaving
may in some sense be freed from fears of backlash from colleagues or of misplaced loyalties
and therefore be able to tell you about issues in the society. Again, you do need verifiable
information before anything you learn should lead to action. Chitchat and personal vendettas
may emerge in interviews, and they should be ignored.
Fraud prevention requires eternal vigilance, best provided by a good policy framework
and the support of top management. With these in place, HR contributes greatly to
organizational success through fraud prevention.

IX.

Forensic Accounting and Fraud Detection:

Fatma Ulucan Ozkul from Bahesehir University collaborated with Ayse Pamukcu
Marmara University to make a research called Fraud Detection and Forensic Accounting.
They stated that:
1. Forensic Accounting versus Fraud Examination:
Forensic accounting and fraud examination are different but interrelated. Forensic
accounting work is performed by accountants in anticipation of litigation and can include
fraud, valuation, bankruptcy, and a horde of other professional inspection and repairs. Fraud

Page 69 of 100

examinations can be taken by either accountants or non-accountants and refer only to

antifraud matters.
2. Forensic Accounting and the Accounting Profession:
Forensic accountants, as well mentioned to as forensic auditors or investigative auditors,
often have to give expert evidence at the eventual trial. All of the larger accounting firms as
well as many medium-sized and boutique firms have specialist forensic accounting
departments. Inside these groups, there may be some further sub-specializations: some
forensic accountants may, for instance, just specialize in insurance claims or personal injury
claims, fraud construction, or royalty audits.
Forensic accountants utilize an understanding of business information and fiscal reporting
systems, accounting and auditing measures and procedures, evidence gathering and
investigative techniques, and litigation processes and processes perform their study. Forensic
accountants are also increasingly playing more proactive risk reduction roles by designing
and performing extended procedures as part of the statutory audit, acting as advisers to audit
committees, fraud deterrence engagements, and assisting in investment analyst research.
The skeptical mindset is something that has long been inherent in forensic accountants
and other internal investigators when looking for evidence of fraudulence.
The investigator historically has asked a set of different questions from those of
conventional auditor, who is monitoring the financial statements to see whether they are in
compliance with generally accepted accounting principles (GAAP) and thereby fairly
represent the financial conditions of the company.
What turns a well-educated and experienced accounting professional into a good
financial investigator, however, is the knowledge of human behavior, a sixth sense for red
flags, and a good intuitive feel for the significance of evidence. The skeptical mindset should
raise doubts about the rationality of all transactions and the evidence that underlies them.
Since the magnitude of the amounts involved in a long-term fraud, for instance, is often
invisible except for a little irregularity in the reports, the financial investigator must be funny
and persistent enough to follow up even the most initially unpromising clues. The judicial

Page 70 of 100

decisions made through this skepticism will open up new hypotheses or close down old ones
by examining them against the gathering evidence until only one explanation is left.
Fraud auditing, forensic accounting, and/or fraud investigation (i.e., Forensic accounting)
puts things together rather than take them apart, as is the case in financial classical auditing
or modern method of systems analysis. The process of forensic accounting is also sometimes
more intuitive than deductive, although both intuition and deduction play important roles.
Financial auditing is procedural in many regards and is not meant to act as effectively as the
tenets of fraud auditing and forensic accounting.
Traditional auditing has a focus on error identification and bar. Bar is the consequence of
an efficient home control system. The auditor reviews the effectiveness of the internal control
system by sampling transactions and not by a complete revaluation of all proceedings. The
procedure can discover faults. Not all mistakes are considered equal.
Some are important and are mentioned to as material. For example,
omission of a million dollar loan that is not entered in the accounting
records might be a material error. Other faults are not material. An
instance of an erroneous belief that might not be material would be an
arithmetic error due to rounding that causes the reported amount to be
ten dollars more or less than the real total. These lessons are not intended
to mean that there are absolute dollar amounts that denote the difference
between cloth and not cloth.
Forensic accounting profession has some demands. Certified fraud
examiner (CFE) is a designation awarded by the ACFE. The ACFE is a
41,000 member-based global association dedicated to providing antifraud
education and training. In order to become a CFE, one must meet the
following requirements:
a.
b.
c.
d.

Be an associate member of the ACFE in good standing.

Meet minimum academic and professional requirements
Be of high moral character
Agree to abide by laws and code of professional ethics of the ACFE

Page 71 of 100

Chapter 5
Case Study and Application in Preventing Fraud in Financial
Statements
I.

Questionnaire:
The questionnaire was sent to 86 professionals whom were contacted
in a direct and indirect ways, only 40 answered the questionnaire, their
results were meeting the expected moral of the project, and here are
some statistics about the candidates:
1.
By regions the 40 candidates were classified as follows:
Region
No. of

MENA
20

EU
5

Asia

USA &

Latin

Canada
10

America
3

Candida
2.

tes
By job titles the 40 candidates were classified as follows:
Job Title

No. of

Assoc.

CPA

Assoc.

Audit

Auditor

Consulta

Director

27

nt
7

CFE

Candida
Page 72 of 100

tes
3.
By companies the 40 candidates were classified as follows:
Compani

Deloitt

es
No. of

EY

KPMG

BDO

Mazars

PwC

U-Turn

Tax

Refund
13

10

Candida
tes
The questionnaire results to the agreement questions were classified
as follows:
1.
Financial Statements Fraud is immoral act in its nature.
2.
Financial Statements Fraud is common in countries with High Tax
3.

Rates.
Weak internal control on Financial Statements can lead to fraudulent

acts.
4.
Financial Statements Fraud is a trend in manufacturing companies.
5.
Companies with an independent and reliable external audit firm tend to
6.

have lower fraudulent acts in their financial statements.

Financial Statements Fraud is common in the MENA (Middle East and

North Africa) regions.

7.
Financial Statements Fraud is exceptionally acceptable in case of
bankruptcy.
Results
Level

of

Agreement
Question 1
Question 2
Question 3
Question 4
Question 5
Question 6
Question 7

Agree

Neutral

Disagree

92.5%
72.5%
67.5%
50%
85%
72.5%
5%

7.5%
15%
20%
20%
12.5%
22.5%
20%

0%
12.5%
12.5%
30%
2.5%
5%
75%

The questionnaire results to the (YES / NO/ Prefer not to say) questions
were classified as follows:
Page 73 of 100

1.

Do you think Creative / Forensic Accounting can solve the issue of

2.

Financial Statements Fraud?

Do you think employee salary has a direct impact to the high

fraudulent acts in financial statements?

3.
Do you think companies and their management have an excuse to
commit fraud in their Financial Statements?
4.
Do you think poor management can lead employees to Fraud in
5.

Financial Statements?
As an employee, have you ever committed a deliberate Financial

6.

Statements Fraud?
As an External Auditor, have you ever discovered a fraud in Financial
Statements?

Level of
Agreement
Question 1
Question 2
Question 3
Question 4
Question 5
Question 6

Yes

No

N/A

85%
70%
15%
65%
0%
15%

10%
10%
75%
12.5%
87.5%
22.5%

5%
20%
10%
22.5%
12.5%
62.5%

The questionnaire results to the open questions were classified as

follows:
1.
Which of the Financial Statements often contains the highest
proportion of fraud? Income Statement Balance Sheet Cash Flow
Statement Retained Earnings Statement Stock Holders Equity
Statement.
Results

Income

Balanc

Cash

Retaine

Stockhold

Statem

Flow

ers Equity

Page 74 of 100

ent

Sheet

Statem

Earning

Statemen

ent

Statem
Percentage
2.

27.5%

55%

10%

ent
2.5%

0%

Which of the following items in the Balance Sheet can be easily

manipulated in? (Double Checking) Cash A/R Inventory Plant &
Equipment Depreciation Intangible Assets Others (State)

Results
Percent

Cash

A/R

Invento

10

ry
28%

25%

age
3.

P&E

Depreciati

Intangible

15%

on
18%

Assets
14%

%
Which of the following items in Income Statement can be easily

manipulated in? (Double Checking) Sales - COGS G&A Income

Tax Expense Interest Expense others (State)
Results

Sales

COG

G&A

Income Tax

Interes

Expense

t
Expen

Percentag

36%

34%

24%

5%

se
21%

e
II.

Professional Interview:
The professional interview was with Mr. Sherif El-Sabakhawy (Tax
Manager at Schneider Electric), he is strongly agreeing about the fact that
fraud in financial statements is immoral act, he agrees that countries with
high tax rates tend to have high fraudulent acts cases.in addition, he
agrees that weak internal control can lead to fraudulent acts, he is
strongly agreeing that manufacturing entities has a high fraud cases.

Page 75 of 100

He disagree that MENA region has a rare fraud cases, he also disagree
that bankruptcy is a road cause for fraud cases and as an employee in
one of the Big4 Audit firm he discovered fraud case in one of the
companies he audited and He also agree that the usage of creative
accounting can lead to more fraudulent acts.
The interview was helpful and he provided us with different kinds of
information that helped us in the project itself and he recommended
different people to take our questionnaire and we contacted them and we
met directly and indirectly to discuss the questionnaire.

III.

Case Study:
In order to start the application on financial statements there was a
precise search for financial statements in different areas, after contacting
some practitioners from the accounting industry in Egypt, and abroad until
there was a financial statements provided for LG Electronics Inc. Separate
Financial statements from Helen Hyo-Sun Lim Tax Director in Samil
PricewaterhouseCoopers Seoul, Korea, the contact was done through the
professional social network LinkedIn.

Page 76 of 100

The Audit Report stated that, In our opinion, the separate financial
statements referred to above present fairly, in all material respects, the
financial position of the Company as of December 31, 2013 and 2012, and its
financial performance and cash flows for the years then ended, in conformity
with International Financial Reporting Standards as adopted by the Republic
of Korea (Korean IFRS).
The Report gave a general information about the company LG
Electronics Inc. was spun-off from LG Electronics Investment Ltd. on April 1,
2002. The Companys shares are listed on the Korea Exchange, and some of
its preferred shares, in form of global depositary receipts (DRs), are listed
on the London Stock Exchange as of the reporting date. The Company is
domiciled in Korea at Yeoui-daero, Yeungdeungpo-gu, and Seoul.
As of December 31, 2013, LG Corp. owns 33.7% of the Companys total
shares, excluding preferred shares, while financial institutions, foreign
investors and others own the rest.
The Company is engaged in the manufacture and sale of electronic
products including mobile phones, TV, air conditioners, refrigerators, washing
machines and personal computers and of core parts. As of December 31,
2013, the Company operates manufacturing facilities mainly in Pyeongtaek,
Changwon and Gumi in the Republic of Korea.
Following in the next page, we are analyzing the Income Statement
and Balance Sheet in order to discover whether this company has committed
any fraudulent act in their financial statement or not by analyzing the
financial statement.

Income Statement (Vertical Analysis)

Page 77 of 100

Vertical Analysis = Item /

Separate Income Statements of operations Year Ended December 31,
Sales
2011
2012
2013
2011
2012
2013
KRW
KRW
KRW 100.00 100.00 100.00
Sales
28,097,139
25,427,205
28,078,895
%
%
%
Cost of Sales
(23,052,881)
(19,988,148)
(22,649,510) 82.05% 78.61% 80.66%
Gross Profit
5,044,258
5,439,057
5,429,385 17.95% 21.39% 19.34%
Selling &
Marketing
Expenses
2,604,983
2,650,250
2,642,024 9.27% 10.42% 9.41%
Administrati
ve Expenses
527,534
459,970
524,675 1.88%
1.81%
1.87%
Research &
Development
Expenses
1,667,056
1,790,948
1,930,008 5.93%
7.04%
6.87%
Service Costs
540,739
495,116
546,555 1.92%
1.95%
1.95%
Operating
Income
(Loss)
(263,881)
42,773
(213,877) -0.94% 0.17% -0.76%
Financial
Income
320,115
250,366
180,934 1.14%
0.98%
0.64%
Financial
Expense
558,755
463,760
380,797 1.99%
1.82%
1.36%
Other NonOperating
Income
1,116,716
1,093,532
1,163,318 3.97%
4.30%
4.14%
Other NonOperating
Expense
1,016,588
1,165,919
996,723 3.62%
4.59%
3.55%
Loss Before
Income Tax
(402,393)
(243,008)
(247,145) -1.43% -0.96% -0.88%
Income Tax
Expense
(Benefit)
(124,474)
111,752
(58,068) -0.44% 0.44% -0.21%
Loss for the
year
(277,919)
(354,760)
(189,077) -0.99% -1.40% -0.67%

Page 78 of 100

Income Statement (Horizontal Analysis)

Separate Income Statements of operations Year Ended December 31,

2011
2012
2013
KRW
Sales
KRW 28,097,139
25,427,205 KRW 28,078,895
Cost of Sales
(23,052,881)
(19,988,148)
(22,649,510)
Gross Profit
5,044,258
5,439,057
5,429,385
Selling &
Marketing
Expenses
2,604,983
2,650,250
2,642,024
Administrativ
e Expenses
527,534
459,970
524,675
Research &
Development
Expenses
1,667,056
1,790,948
1,930,008
Service Costs
540,739
495,116
546,555
Operating
Income (Loss)
(263,881)
42,773
(213,877)
Financial
Income
320,115
250,366
180,934
Financial
Expense
558,755
463,760
380,797
Other NonOperating
Income
1,116,716
1,093,532
1,163,318
Other NonOperating
Expense
1,016,588
1,165,919
996,723
Loss Before
Income Tax
(402,393)
(243,008)
(247,145)
Income Tax
Expense
(Benefit)
(124,474)
111,752
(58,068)
Loss for the
year
(277,919)
(354,760)
(189,077)

Page 79 of 100

Horizontal Analysis = Year

New - Year Old / Year Old
2011 2011-12 2012-13
0.00%
0.00%
0.00%

-9.50%
-13.29%
7.83%

10.43%
13.31%
-0.18%

0.00%

1.74%

-0.31%

0.00%

-12.81%

14.07%

0.00%
0.00%

7.76%
10.39%

0.00%

7.43%
-8.44%
116.21%

-600.03%

0.00%

-21.79%

-27.73%

0.00%

-17.00%

-17.89%

0.00%

-2.08%

6.38%

0.00%

14.69%

-14.51%

0.00%

-39.61%

1.70%

0.00%

189.78%

-151.96%

0.00%

27.65%

-46.70%

Income Statement (Trend Analysis)

Separate Income Statements of operations Year Ended December 31,

2011
2012
2013
Sales
KRW 28,097,139 KRW 25,427,205 KRW 28,078,895
Cost of Sales
(23,052,881)
(19,988,148)
(22,649,510)
Gross Profit
5,044,258
5,439,057
5,429,385
Selling &
Marketing
Expenses
2,604,983
2,650,250
2,642,024
Administrativ
e Expenses
527,534
459,970
524,675
Research &
Development
Expenses
1,667,056
1,790,948
1,930,008
Service Costs
540,739
495,116
546,555
Operating
Income (Loss)
(263,881)
42,773
(213,877)
Financial
Income
320,115
250,366
180,934
Financial
Expense
558,755
463,760
380,797
Other NonOperating
Income
1,116,716
1,093,532
1,163,318
Other NonOperating
Expense
1,016,588
1,165,919
996,723
Loss Before
Income Tax
(402,393)
(243,008)
(247,145)
Income Tax
Expense
(Benefit)
(124,474)
111,752
(58,068)
Loss for the
year
(277,919.00)
(354,760.00)
(189,077.00)

Page 80 of 100

Trend Analysis = Current Year /

Base Year
2011
2011-12 2011-13
100%
90.50% 99.94%
100%
86.71% 98.25%
100%
107.83% 107.63%
100%

101.74% 101.42%

100%

87.19%

100%
100%

107.43% 115.77%
91.56% 101.08%

100%

-16.21%

81.05%

100%

78.21%

56.52%

100%

83.00%

68.15%

100%

97.92%

104.17%

100%

114.69%

98.05%

100%

60.39%

61.42%

100%

-89.78%

46.65%

100%

127.65%

68.03%

99.46%

Balance Sheet (Vertical Analysis)

Common Size = item / total
assets
2011
2012
2013

Separate Statements of Financial Position December 31,

2011
2012
2013
Assets:
Current assets
Cash and cash
equivalents
Financial deposits
Trade receivables
Loans and other
receivables
Other financial
assets
Inventories
Current income tax
assets
Other current assets
Assets classified as
held for sale
Total Current
Assets:
Non-current assets
Financial deposits
Loans and other
receivables
Other financial
assets
Property, plant and
equipment
Intangible assets
Deferred income
tax assets
Investments in
subsidiaries,
associates and joint
ventures
Investment property
Other non-current
assets
Total Non-Current
Assets:
Total Assets

KRW 1,364,211
150,000
5,077,362

KRW 1,114,246 KRW 1,298,349

50,000
65,000
4,693,196
4,697,202

5.64%
0.62%
20.98%

4.68%
0.21%
19.69%

5.20%
0.26%
18.81%

269,017

328,652

433,888

1.11%

1.38%

1.74%

885,730

53,555
921,828

916,581

3.66%

0.22%
3.87%

3.67%

3,276
400,508

3,274
382,876

2,446
439,757

0.01%
1.66%

0.01%
1.61%

0.01%
1.76%

3,670

0.02%

8,153,774

7,547,627

7,853,223

33.69%

31.67%

31.45%

40,962

14,321

4,759

0.17%

0.06%

0.02%

414,462

407,037

410,385

1.71%

1.71%

1.64%

112,056

32,530

31,823

0.46%

0.14%

0.13%

5,190,881
915,977

5,437,210
962,002

6,045,037
1,085,867

21.45%
3.79%

22.81%
4.04%

24.21%
4.35%

658,424

752,226

875,503

2.72%

3.16%

3.51%

7,964,549
5,360

7,950,178
8,254

8,006,190
2,979

32.91%
0.02%

33.36%
0.03%

32.06%
0.01%

742,785

720,791

655,316

3.07%

3.02%

2.62%

16,045,456
24,199,230

16,284,549
23,832,176

17,117,859
24,971,082

66.31%
100.00

Page 81 of 100

68.33% 68.55%
100.00% 100.00%

%
Liabilities:
Current liabilities
Trade payables
Borrowings
Other payables
Other financial
liabilities
Current income tax
liabilities
Provisions
Other current
liabilities
Total Current
Liability:
Non-current
liabilities
Borrowings
Other financial
liabilities
Defined benefit
liability
Provisions
Total Non-Current
Liabilities:
Total Liability:
Equity:
Paid-in capital:
Capital stock
Share premium
Retained earnings
Accumulated other
comprehensive
income
Other components
of equity
Total Equity
Total Liability &
Equity

3,853,528
1,701,658
2,697,795

3,995,679
1,057,585
1,629,416

4,327,403
1,391,805
1,798,292

15.92%
7.03%
11.15%

16.77%
4.44%
6.84%

17.33%
5.57%
7.20%

12,699

9,090

0.05%

0.04%

169,196

9,437
192,306

212,710

0.70%

0.04%
0.81%

0.85%

436,315

1,476,538

1,607,031

1.80%

6.20%

6.44%

8,871,191

8,360,961

9,346,331

36.66%

35.08%

37.43%

4,124,188

4,206,740

4,550,437

17.04%

17.65%

18.22%

13,889

9,891

0.06%

0.04%

363,617
345,373

467,598
760,033

413,825
817,778

1.50%
1.43%

1.96%
3.19%

1.66%
3.27%

4,833,178
13,704,369

5,448,260
13,809,221

5,791,931
15,138,262

19.97%
56.63%

22.86%
57.94%

23.19%
60.62%

904,169
3,088,179
6,534,129

904,169
3,088,179
6,059,062

904,169
3,088,179
5,857,083

3.74%
12.76%
27.00%

3.79%
12.96%
25.42%

3.62%
12.37%
23.46%

1,203

4,364

16,208

0.00%

0.02%

0.06%

(32,819)
10,494,861

(32,819)
10,022,955

(32,819)
9,832,820

0.14%
42.06%

0.13%
39.38%

24,199,230

23,832,176

24,971,082

0.14%
43.37%
100.00
%

Page 82 of 100

100.00% 100.00%

Balance Sheet (Horizontal Analysis)

Horizontal Analysis = Year

New - Year Old / Year Old
2011 2011-12 2012-13

Separate Statements of Financial Position December 31,

2011
2012
2013
Assets:
Current assets
Cash and cash
equivalents
Financial deposits

KRW 1,364,211

KRW 1,114,246 KRW 1,298,349

0.00
%
0.00
%
0.00
%
0.00
%
0.00
%
0.00
%
0.00
%

150,000

50,000

65,000

5,077,362

4,693,196

4,697,202

269,017
-

328,652
53,555

433,888
-

Inventories
Current income tax
assets

885,730

921,828

916,581

3,276

3,274

2,446

Other current assets

Assets classified as
held for sale

400,508

382,876

439,757

3,670

8,153,774

7,547,627

7,853,223

40,962

14,321

4,759

414,462

407,037

410,385

112,056

32,530

31,823

5,190,881

5,437,210

6,045,037

915,977

962,002

1,085,867

658,424

752,226

875,503

0.00
%
0.00
%
0.00
%
0.00
%
0.00
%
0.00
%

7,964,549

7,950,178

8,006,190

0.00
%

Trade receivables
Loans and other
receivables
Other financial assets

Total Current Assets:

Non-current assets
Financial deposits
Loans and other
receivables
Other financial assets
Property, plant and
equipment
Intangible assets
Deferred income tax
assets
Investments in
subsidiaries,
associates and joint
ventures

Page 83 of 100

0.00
%

-18.32%

16.52%

-66.67%

30.00%

-7.57%

0.09%

22.17%
-

32.02%
-

4.08%

-0.57%

-0.06%

-25.29%

-4.40%

14.86%

-7.43%

4.05%

-65.04%

-66.77%

-1.79%

0.82%

-70.97%

-2.17%

4.75%

11.18%

5.02%

12.88%

14.25%

16.39%

-0.18%

0.70%

Investment property
Other non-current
assets
Total Non Current
Assets:
Total Assets
Liabilities:
Current liabilities

5,360

8,254

2,979

742,785

720,791

655,316

16,045,456

16,284,549

17,117,859

24,199,230

23,832,176

24,971,082

0.00
%
0.00
%
0.00
%
0.00
%

53.99%

-63.91%

-2.96%

-9.08%

1.49%

5.12%

-1.52%

4.78%

3.69%

8.30%

-37.85%

31.60%

-39.60%

10.36%

13.66%
238.41
%

10.61%

-5.75%

11.79%

2.00%

8.17%

-28.79%

28.60%
120.06
%

-11.50%

12.73%

6.31%

0.77%

9.62%

0.00%
0.00%

0.00%
0.00%

0.00
%
0.00
%
0.00
%

Trade payables

3,853,528

3,995,679

4,327,403

Borrowings

1,701,658

1,057,585

1,391,805

Other payables
Other financial
liabilities
Current income tax
liabilities

2,697,795

1,629,416

1,798,292

12,699

9,090

9,437

169,196

192,306

212,710

436,315

1,476,538

1,607,031

8,871,191

8,360,961

9,346,331

0.00
%
0.00
%
0.00
%

4,124,188

4,206,740

4,550,437

0.00
%

13,889

9,891

363,617

467,598

413,825

345,373

760,033

817,778

4,833,178

5,448,260

5,791,931

Total Liability:
Equity:
Paid-in capital:

13,704,369

13,809,221

15,138,262

0.00
%
0.00
%
0.00
%
0.00
%

Capital stock
Share premium

904,169
3,088,179

904,169
3,088,179

904,169
3,088,179

0.00
%
0.00

Provisions
Other current
liabilities
Total Current
Liability:
Non-current
liabilities
Borrowings
Other financial
liabilities
Defined benefit
liability
Provisions
Total Non-Current
Liabilities:

Page 84 of 100

8.84%

7.60%

Retained earnings
Accumulated other
comprehensive
income
Other components of
equity
Total Equity
Total Liability &
Equity

6,534,129

6,059,062

5,857,083

1,203

4,364

16,208

(32,819)

(32,819)

(32,819)

10,494,861

10,022,955

9,832,820

24,199,230

23,832,176

24,971,082

%
0.00
%
0.00
%
0.00
%
0.00
%
0.00
%

-7.27%

-3.33%

262.76
%

271.40
%

0.00%

0.00%

-4.50%

-1.90%

-1.52%

4.78%

Balance Sheet (Trend Analysis)

Separate Statements of Financial Position December 31,

2011
2012
2013
Assets:
Current assets
Cash and cash
equivalents
Financial deposits
Trade receivables
Loans and other
receivables
Other financial assets
Inventories
Current income tax
assets
Other current assets
Assets classified as
held for sale
Total Current Assets:
Non-current assets
Financial deposits
Loans and other

KRW 1,364,211
150,000
5,077,362

Trend Analysis = Current

Year / Base Year
2011 2011-12 2011-13

KRW 1,114,246 KRW 1,298,349 100%

50,000
65,000 100%
4,693,196
4,697,202 100%

81.68%
33.33%
92.43%

95.17%
43.33%
92.51%

269,017
885,730

328,652
53,555
921,828

433,888 100% 122.17%

- 100%
916,581 100% 104.08%

161.29%
103.48%

3,276
400,508

3,274
382,876

2,446
439,757

3,670
8,153,774

7,547,627

40,962
414,462

14,321
407,037
Page 85 of 100

100%
100%

99.94%
95.60%

74.66%
109.80%

- 100%
7,853,223 100%

92.57%

96.31%

34.96%
98.21%

11.62%
99.02%

4,759
410,385

100%
100%

receivables
Other financial assets
Property, plant and
equipment
Intangible assets
Deferred income tax
assets
Investments in
subsidiaries,
associates and joint
ventures
Investment property
Other non-current
assets
Total Non-Current
Assets:
Total Assets
Liabilities:
Current liabilities
Trade payables
Borrowings
Other payables
Other financial
liabilities
Current income tax
liabilities
Provisions
Other current
liabilities
Total Current
Liability:
Non-current
liabilities
Borrowings
Other financial
liabilities
Defined benefit
liability
Provisions
Total Non-Current
Liabilities:
Total Liability:
Equity:
Paid-in capital:

112,056

32,530

31,823

5,190,881
915,977

5,437,210
962,002

658,424

29.03%

28.40%

6,045,037
1,085,867

100% 104.75%
100% 105.02%

116.45%
118.55%

752,226

875,503

100% 114.25%

132.97%

7,964,549
5,360

7,950,178
8,254

8,006,190
2,979

100% 99.82%
100% 153.99%

100.52%
55.58%

742,785

720,791

655,316

100%

97.04%

88.22%

16,045,456
24,199,230

16,284,549
23,832,176

17,117,859
24,971,082

100% 101.49%
100% 98.48%

106.68%
103.19%

3,853,528
1,701,658
2,697,795

3,995,679
1,057,585
1,629,416

4,327,403
1,391,805
1,798,292

100% 103.69%
100% 62.15%
100% 60.40%

112.30%
81.79%
66.66%

12,699

9,090

100%

71.58%

169,196

9,437
192,306

436,315

1,476,538

1,607,031

100% 338.41%

368.32%

8,871,191

8,360,961

9,346,331

100%

94.25%

105.36%

4,124,188

4,206,740

4,550,437

100% 102.00%

110.34%

13,889

9,891

363,617
345,373

467,598
760,033

413,825
817,778

100% 128.60%
100% 220.06%

113.81%
236.78%

4,833,178
13,704,369

5,448,260
13,809,221

5,791,931
15,138,262

100% 112.73%
100% 100.77%

119.84%
110.46%

Page 86 of 100

100%

212,710 100% 113.66%

100%

125.72%

Capital stock
Share premium
Retained earnings
Accumulated other
comprehensive
income
Other components of
equity
Total Equity
Total Liability &
Equity

904,169
3,088,179
6,534,129

904,169
3,088,179
6,059,062

904,169
3,088,179
5,857,083

1,203

4,364

16,208

(32,819)
10,494,861

(32,819)
10,022,955

24,199,230

23,832,176

100% 100.00%
100% 100.00%
100% 92.73%

100% 362.76% 1347.30%

(32,819) 100% 100.00%

9,832,820 100% 95.50%
24,971,082

100.00%
100.00%
89.64%

100%

98.48%

100.00%
93.69%
103.19%

Financial Ratios

Ratios
Liquidity
Ratios

Turnover
Ratios

Leverage
Ratios
Profitabilit
y Ratios

Current Ratio
Working Capital
Acid-Test Ratio
Cash Ratio
Sales / Working Capital
A/R Turnover
Inventory Turnover
Days to A/R Turnover
Days to Inventory
Turnover
Operating Cycle
Time Interest Earned
Debt Ratio
Debt / Equity Ratio
Debt to tangible net worth
Fixed Assets Equity
Net Profit Margin
Operating Income Margin
Total Assets Turnover
Return on assets

2011
0.919129573
(KRW 717,417)
0.774139121
0.153779915
39.16430611
5.533806532
26.02698452
65.95821482

2012
0.902722426
(KRW 813,334)
0.746675292
0.133267695
31.26293134
5.986781502
21.68316432
60.96765012

2013
0.840246617
(KRW 1,493,108)
0.695126783
0.138915367
18.80566911
5.981675687
24.71086571
61.01969065

Industry
Average
2.32
N/A
0.39
N/A
N/A
N/A
30.72
52.1

14.0239066
79.98212142
-2.43978643
56.63%
130.58%
143.07%
49.46%
-0.99%
-1.88%
1.161075745
-1.15%

16.83333644
77.80098656
-0.569709754
57.94%
137.78%
152.40%
54.25%
-1.40%
-0.52%
1.066927544
-1.49%

14.77083014
75.79052079
-1.342291826
60.62%
153.96%
173.07%
61.48%
-0.67%
-1.09%
1.124456481
-0.76%

N/A
N/A
N/A
35.24%
158%
N/A
N/A
5.64%
N/A
0.95
1.38%

Page 87 of 100

Cash
Conversion
Cycle

Return on Investments
Return on Equity
Days in Inventory
Days in Receivables
Days in Payables
Cash Gap

-3.44%
-2.65%
15 days
66 days
59 days
22 days

-0.85%
-3.54%
17 days
68 days
73 days
12 days

-1.95%
-1.92%
15 days
62 days
70 days
7 days

N/A
11.62%
N/A
N/A
N/A
N/A

Results of the analysis

1.

By analyzing the Income Statement, finding that the company

especially in year 2012 it was discovered that despite the company has
an operating income of 42,773 KRW yet it occurred one of its big losses by
(354,760) KRW and here we should as the question, how could a company
have a well operating income and yet have a huge loss?

2.

In addition, in year 2012, the company occurred an income tax

expense by 111,752 KRW in 2012 while there is a question should be
asked, what is the meaning of Tax Benefit? Is it a sort of deferred taxes or
tax liability for the future or not?

3.

The net income is decreasing rapidly recording 1.14%, 0.98%, and

0.64% in 2011, 2012 and 2013 respectively. That shows an indicator for a
few financial income in the next years, which means continuous losses in
the future, the question that should be asked, why the net income is
decreasing with these huge amounts?

4.

In the Balance Sheet, the other current liability increased in unjustified

way recording 1.80%, 6.20% and 6.44% in 2011, 2012 and 2013

Page 88 of 100

respectively while the auditors report has not shown or find an

explanation for such increase in this matter.
5.

The current ratios of the company is below the industry average level
which is 2.32 that means the company is not being able to settle the short
term debts by their current assets which shows a very unfavorable
position to the company.

6.

The working capital of the company is Negative through the three

chosen years so the company is expecting a liquidity problem especially
in the short-term cash flows there should be a working capital
management in this company to cover or at least find solutions for such
problems.

7.

The acid-test ratio is higher than the industry average of 0.39 and the
company can convert their current assets easily to cash for meeting the

8.

short-term liability.
The companys cash ratio is decreasing through years 2011, 2012 and
2013 by 0.15, 0.15 and 0.13 which means that the company cant pay its
current liability without relying on the sale of inventory and without
relying on the receipts of the accounts receivables and the percentage
should be equal to at least 1 not as an industry average but as a logical
ratio.

9.

Sales / working capital turnover shows a tremendous decreasing of

39.16, 31.26 and 18.80 in 2011, 2012 and 2013 respectively because of
the working capital that is decreasing through the years.

10.

The accounts receivables turnover is increasing through the

years showing up a favorable position of the company compared to the

years not the industry average ratios.
11.

The Inventory turnover is unfavorable compared to the industry

average turnover ratio, despite the fact that it is not stable and to be clear

Page 89 of 100

the company should increase it next years to meet the industry average
by 2019.
12.

The days to Accounts receivables turnover is decreasing through

the years 2011, 2012 and 2013 yet it did not reach the industry average
days to A/R and might reach it by 2017.
13.

The days to Inventory turnover is low which shows a favorable

position of the company and there is no industry average to compare to.

14.

The operating cycle of the company is decreasing showing up a

favorable position of the company.

15.

The time interest earned is negative that of course shows up an

unfavorable position to the company and the company will absolutely

earn enough money to cover the interest expense of their debts so the
company should increase their net income and decrease the expenses or
losses.
16.

The debt ratios is very high recording 56.63%, 57.94% and

60.62% in year 2011, 2012 and 2013 results in an internal unfavorable

position and compared to the industry average of 35.24% the company is
way far in a very unfavorable position the company should either
decrease their liability and increase their assets to some extent to
balance the equation to the industry average.
17.

The debt equity ratios is very high in this industry as 158% and

the company still operates under the umbrella of the industry average yet
its recommended that the company should lower its debt equity ratio by
decreasing liability at least to balance.
18.

The fixed assets equity records 49.46%, 54.25% and 61.48% in

years 2011, 2012 and 2013 with no accurate industry average in this
industry the stockholders equity is more than the fixed assets and that
means that the stockholders equity is financing not just the fixed assets
Page 90 of 100

but also a part of the working capital which is negative as mentioned

early in our analysis.
19.

The net profit margin records -0.99%, -1.40% and -0.67% in

years 2011, 2012 and 2013 showing up a negative percentage than the
industry average of 5.64% which is so unfavorable position that means in
order to perform well again the company should gain more revenues or
keeping expenses constant or lower expenses but we cannot tell that this
is going to be easy or going to be soon either.
20.

The asset turnover shows up good indications of 1.16, 1.06 and

1.12 in years 2011, 2012 and 2013 compared to industry average of 0.95
and this means that the company uses its assets efficiently.
21.

The company is suffering from a negative return on assets (ROA)

compared to a positive industry average and that means that the

company is not sufficiently able to convert the money used to purchase
assets into net income or revenues.
22.

The company is suffering from a negative return on investment

(ROI) that means the company has no ability to reward those who
provided long-term funds and will not attract providers of future funds and
this is so risky.
23.

The company is suffering from a negative return on equity

because of the negative net income.

Page 91 of 100

Chapter 6
Conclusion
I.

Questionnaire:
The conclusion of the questionnaire will be explained in the following
points:
1.

The selection of the candidates were conducted on international

basis to understand how different cultures consider fraud in financial

2.

statements.
The selection of the candidates were conducted on professional
basis to understand how professional consider fraud in financial
statements that is why segmenting professional firms was important to

3.

the questionnaire.
The majority of the candidates agrees that fraud is an immoral
act, companies with an independent external audit firm tend to have

Page 92 of 100

lower fraud cases and fraud is exceptionally acceptable in case of

4.

bankruptcy.
High percentage of the candidates agrees that fraud occurs in
countries with high tax rates, weak internal control can lead to
fraudulent act, financial statement fraud is common in manufacturing

5.

companies and financial statement fraud is common in the MENA.

The majority of the candidates thinks that creative accounting
can solve the issue of financial statement fraud and majority have not

6.

committed a deliberate financial statement fraud.

High percentage of candidates thinks that employees salaries
has a direct impact in fraud and companies and their management do

7.

not have an excuse to commit fraud in their financial statements.

High percentage of candidates did not commit a deliberate
financial statement fraud and as external auditors did not answer

8.

whether they discovered fraud in financial statements or not.

To conclude, the balance sheet and income statement are the
highest statements where fraud occurs and external auditors clients
confidentiality did not assist us in getting information about the fraud
in their clients financial statements.

II.

Case Study:
1.
In year 2012, the other current liability increase by 1 Billion
Korean Won compared to year 2011 with an unexplained reason in the
financial statements, which is a sign for fraudulent acts in the liability
section of the company.
2.

In year 2012, the provisions in the non-current liability increased

by 414,660 Million Korean Won compared to year 2011 even though
the borrowing increase by 82,552 Million Korean Won and other
financial liability by 13,889 Korean Won and defined benefit liability by
103,981 Korean Won which indicates that there might be a fraud of
214, 238 Korean Won in year 2012 in the Non-Current liability section
of the financial statement.
Page 93 of 100

3.

The operating income occurred a loss of nearly 397,533 Million

Korean Won in year 2012 even though the company is operating under
almost same conditions of year 2011 and 2013.

4.

Total Fraud detected in year 2012 in the balance sheet worth

1,214,238 Million Korean Won.

5.

Total Fraud Detected in year 2012 in the income statement worth

397,533 Million Korean Won.

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