FRAUD DIAMOND ANALYSIS AND AUDITOR’S ABILITY TO DETECT

FRAUDULENT FINANCIAL REPORTING: AN EMPIRICAL STUDY OF

MANUFACTURE COMPANY LISTED IN THE INDONESIA STOCK EXCHANGE

PROPOSSED BY:
DWI RAHMADANI DAVIS
1710533005
 I. Preliminaries
1.1 Abstract
At this time, it is common knowledge for management or certain parties to commit fraud
in financial reporting that aim to eliminate certain obligations for the company or to obtain
profits for related parties. Therefore, this paper aims to examine the ability to detect fraud to find
out the factors that influence fraudulent financial reporting through fraud diamond analysis and
also auditor’s ability to detect fraud. Fraudulent financial reporting is known as an effort to
intentional material misstatement or negligence of the amount or disclosure by the provider to
deceive the user. Fraud diamond includes pressure, opportunity, rationalization and capability.
This study utilizes earnings management to find the possibility of fraudulent financial reporting.
This study uses the archival data method by using secondary data. Data collection method used
in the form of content analysis is analyzing data of manufacturing companies listed on the
Indonesia Stock Exchange period 2017-2019. This study is quantitative study which use multiple
regression, t test, f test coefficient of determinantion for tersting the hypothesis. The findings of
this studies reveal that the opportunity, pressure, and rationalization has significant influence in
detecting the possibility of fraudulent financial reporting. Meanwhile, other variables have no
influence in detecting the possibility of fraudulent financial reporting.
 1.2 Table of Contents
I. Preliminaries..........................................................................................................2
1.1 Abstract..................................................................................................................2
1.2 Table of Contents...................................................................................................3
II. Text........................................................................................................................4
2.1 Introduction............................................................................................................4
2.2. Main ....................................................................................................................6
2.2.1 Fraud............................................................................................................6
2.2.2 Auditor’s Ability to Detect Fraud...................................................................7
2.2.3 Fraud Triangle Theory................................................................................................9
2.2.4 Fraud Diamond Theory.............................................................................................10
2.2.5 Earning Management................................................................................................11
2.2.6 Previous Study..........................................................................................................12
2.2.7 Theoretical Framework.............................................................................................13
2.3 Conclusion.........................................................................................................................14
III. Reference Materials...........................................................................................................15

ii. Text
 2.1 Introduction
Financial statements are an important instrument for the company as long as the company
is still operating because in the financial statements there are important information about the
company's financial condition. Such information can identify a company's position whether
stable or not. That is what investors will use to make investment decisions. These financial
statements are not only used to make investment decisions but can also be used for companies to
conduct internal evaluations such as management performance appraisal, tax calculations to be
issued and accountability to the public (Nurbaiti & Hanafi, 2017). Therefore, financial
statements are not presented haphazardly but must have criteria that meet such financial
statements must be relevant, clear, complete, easily understood by users, and easily accessible to
users, and the most important is the financial statements must be verifiable because many parties
can use financial statements to commit fraud in financial reporting (Sihombing & Rahardjo,
2014).
Fraudulent financial reporting is often done by top-level managers or people who have
more power in the company so they are easy to commit fraud. The fraud was carried out by
means of increasing income through eliminating debt or other obligations. However, sometimes
the company also deliberately reduces revenue in the current year to be reserved in the following
year so that the company's financial position is considered stable by investors. This practice is
often called earnings management. One form of earnings management is income smoothing,
namely by way of expenditure and income is transferred between periods to reduce income
fluctuations. One way of income smoothing is to reduce the value of inventories and other assets
acquired from other companies at the time of acquisition, then sell those assets at a high price so
that the company will get a profit. This has been practiced by Worldcom and Enron but
apparently it has also been done by several manufacturing companies in Indonesia such as PT
Waskita Karya, PT Kimia Farma, etc. Therefore the role of the auditor profession must be more
effective so fraud can be detected as early as possible before developing (Arens et al, 2011).
Because of that, AICPA publishes SAS no 99 which can provide guidance to auditors to
be able to detect factors that cause someone to commit fraud. One of the researcher found that
there are 3 factors that cause someone to commit fraud, namely pressure, opportunity, and
rationalization, known as fraud triangle (Puspitadewi & Sormin, 2014). According to Wolfe and
Hermanson (2004), the fraud triangle will succeed in detecting factors that result in fraud if
added to the capability factor as known as fraud diamond. There have been many uses of the
fraud diamond theory used by researchers to detect factors that cause someone to commit fraud
in a manufacturing company.
There are still some differences between one research with another such as Sihombing &
Rahardjo (2014) states that only the opportunity factor that encourages cheating but Puspitadewi
& Sormin (2014) states that the factors that encourage cheating on manufacturing companies are
rationalization, etc. Therefore, research on this still needs to be done. So, this study aims to
analyze the factors that drive fraudulent financial reporting through diamond fraud which consist
of some elements, namely, financial stability, external pressure, financial targets, nature of
industry, ineffective monitoring, audit opinion and change of directors. Based on the introduction
of the diats, the formulation of the problem in this paper is how the influence of diamond fraud
in detecting factors that falsify financial statement fraud on manufacturing companies listed on
the Indonesian stock exchange.

2.2 Main Body

 2.2.1 Fraud
Fraud is a common way carried out by humans based on intelligence they have either
done by themself or through other people to benefit through misrepresentation. Fraud can not be
detected basically because fraud is a bad behavior that exists in humans that is used to cheat
others (Skousen & Twedt, 2009). Fraud is common in the business world or the world of work in
various forms which are sometimes difficult to detect. All forms of fraud are used to harm one
party but give benefit to the other party. Therefore, to make it easier to detect fraud, the
Association of Certified Fraud Examines in 2016 created a chart that illustrates the fraud scheme
that often occurs in the world of work. The scheme is known as a fraud tree consisting of
corruption, misappropriation of assets and fraudulent financial reporting (Suryandari & Yuesti,
2017). They are :
1. Corruption is the most difficult act of fraud detected by the auditor because basically
corruption upholds the principle of cooperation which means that corruption is usually
not committed by one person but has involved other parties. The cooperation can be in
the form of misuse of power held in a company through violation of personal duties or
duties of superiors, bribery, accepting gifts with any intentions and objectives as well as
coercion from the authorities that require a person to commit corruption based on
instructions given to him. It aims to get personal benefits both directly and in cooperation
with other parties.
2. Missappropriation asset is an act of fraud on a small scale or the amount being cheated is
not material for financial statements. This cheating is easily detected because it is
physical so it can be calculated. This form of fraud is usually done by employees within
the company by means of abusing the tasks assigned to gain profits in the form of
company assets or assets. Although this fraud is small-scale, it is still a concern of
management because a small fraud if done continuously will be a large amount. This
fraud is not only committed by employees, some cases can also involve top management
in the search for company assets as did the former CEO of Tyco International who was
charged by the SEC for stealing more than $ 100 million in company assets. Therefore,
auditors must be more careful in calculating asset theft by both employees and top
management (Arens et al, 2011)..
 3. Fraudulent financial reporting is an action taken by top-level managers to cover the actual
financial condition of a company. This is done by top-level managers by engineering
financial statements to obtain profits from the company's operating income. not only
financial statement engineering, fraudulent financial reporting can also be in the form of
embezzlement of company assets that can cause financial statements to be inconsistent
with the actual situation because they are not guided by IFRS so that embezzlement can
produce attractive profits. This practice is known as window dressing (Siddiq &
Hadinata, 2016). According to SAS No.99, financial statement fraud can be done by
(Susanto, 2018) :
a) Manipulation, falsify or make changes to the information in accounting records,
as well as supporting documents from the prepared financial statements.
b) Accidental errors or omissions in important information on financial statements.
c) Intentional misuse of principles relating to numbers, classifications, ways of
presentation or disclosure.

2.2.2 Auditor’s Ability to Detect Fraud

Because so many types of fraud that can be done by employees and management both
caused by the misuse of company resources and improper corporate financial reporting that
requires auditors to have the ability to detect fraud in the financial statements (Suryandari, 2017).
The ability that must be possessed by an auditor include :
1. Ability in the form of technical skills which include audit competence, information
technology, and investigative expertise. Audit competence is a basic skill that must be
possessed by auditors which includes good personalit. So that, it requires an auditor to
have a broad mind in solving problems, not easily influenced by any party in making
decisions and able to appreciate differences between fellow auditors. In addition, the
auditor must have sufficient knowledge to conduct audits and expertise in information
technology that will be useful for investigating if there is fraud in the financial
statements.
2. In doing a job, the auditor does not work alone but is accompanied by several other
auditors. therefore, the auditor must have the ability to work together in a team so that the
auditor can easily accept ideas from other colleagues, and be able to acknowledge the
 knowledge and expertise of other auditors followed by good communication skills and be
open-minded towards the diversity of opinions that occur among peers auditor. So that
the results of the audited financial statements can be justified.
3. In addition to the ability that mentioned above, auditors are also required to be able to
provide advice to juniors who still have minimal experience, especially during the
investigation process. this ability can also be used when giving advice to clients. So that
the client feels satisfied with the work done by an auditor.

2.2.3 Fraud Triangle Theory

In 1950, Donald Cressey began research on fraud. The research was based on the assumption
that behind a fraud committed by someone there must be an underlying reason. Therefore, he did
research to find out what factors are the reasons for someone to commit fraud. to find out these
factors he collected data by interviewing 250 criminals to ascertain these factors. After
conducting an interview, he learned that there are three factors that cause someone to commit
fraud, namely non-shareable financial problems, opportunities to commit the trust violation, and
rationalization by the trust violator. Then, according to Arens et al (2011) which explains the
factors found by Cressey become clearer. These three factors are factors that encourage someone
to commit fraud known as the fraud triangle which includes :
1. Pressure
Fraud committed by someone can be caused by pressure from outside or inside the
company. The pressure obtained in the form of financial and non financial pressures.
Financial pressure is caused when someone needs money to meet the needs of his
family's life or is only done to provide self-satisfaction. While the non-financial
pressure is put on someone when self-esteem or performance is at stake. Especially
for a manager who wants to maintain the performance of his performance in the
presence of shareholders so that a manager will be given an offer in the form of a
promotion of a higher rank. Both of that pressures are what causes someone to
commit fraud. This pressure comes when some of these conditions are met . The
condition consists of (Indriani & Terzaghi, 2017) :
a. Financial Stability
 the manager of a company will get pressure that can encourage managers to
take fraudulent financial reporting actions when the financial condition of a
company is unstable due to unhealthy economic conditions. So, managers will
always try to stabilize the company's financial statements by doing fraud to
make the performance of managers and the company remains stable in the
eyes of the shareholders
b. External Pressure
Extenal pressure is excessive pressure received by a top manager to meet the
requirements or expectations of a third party. To overcome this pressure,
managers need additional costs in the form of debt or other loans that come
from inside and outside. So that the company can still compete with other
companies. Fraud caused by this pressure can be in the form of debt relief or
liability by the manager.
c. Financial Target
In carrying out its performance, company managers are required to perform
the best performance so as to achieve the planned financial targets.
Comparison of earnings to total assets or Return on Assets is a measure of
operational performance that is widely used to show how efficiently an asset
has worked.
2. Opportunity
Besides pressure, opportunity can play a role in causing fraud. this is due to state controls
that can be manipulated for use in the context of fraud. within a company, weak internal control
can also be used by perpetrators to commit fraud. Therefore, opportunity is the most anticipated
factor through the process, procedure, and detection of fraud as early as possible due to internal
controls that exist in the company. according to SAS No. 99 which states that there are three
factors that drive the opportunity to create fraud. these three factors consist of (Indriani &
Terzaghi, 2017) :
a. Nature of industry in a company is usually in the form of subjective
assessments conducted by management of the possibility of uncollectible
receivables and absolute inventory. Subjective assessments can be used by
 perpetrators to commit fraud because subjective judgments cannot be
calculated and are not physically shaped so they can be manipulated
b. The creation of opportunities to commit fraud can also be caused by weak
supervision or monitoring within the company. Fraud by exploiting the
weaknesses of this monitoring can be minimized by increasing the
effectiveness of company supervision conducted by an independent board of
commissioners in order to oversee management in committing fraud
c. Organizational structure that is not in accordance with what it should also
cause opportunities for fraud. this is due to the multiple tasks performed by
managers making it possible to utilize the position they have to commit fraud.
3. Rationalization
Rationalization is justification done by someone for unethical actions they do. this arises
when a person has a sense of ownership of company assets assuming that it is innocent to only
borrow company assets for the benefit of many people on the condition that the borrowed assets
will be returned later. But it does not rule out the possibility that someone who has these
assumptions is caused by pressure and coercion from a party. This rationalization can be caused
by several factors which include (Abdullahi, Mansor & Nuhu, 2015) :
a. Auditor change can be categorized as a factor that drives someone to commit
a fraud. This auditor change can result in a transitional period and a stress
period so that management is used to commit fraud. aauditor changes are
considered an attempt by the company to exclude auditors who are considered
aware of fraud committed by the company so that if there is a change in
auditors then it is likely that the company has committed fraud a replacement
auditor who has worked with him so that it can be manipulated.
b. Audit opinion can lead to the intention of cheating if an auditor has a direct or
indirect relationship with the company such as the owner of the company is
his family or the auditor has worked before in the company. It can affect the
audit opinion that will be given by the auditor
 2.2.4 Fraud Diamond Theory
According to Wolfe and Hermanson (2004) which states that fraud triangle theory cannot
be implemented by someone to commit fraud unless followed by strong capability. So that in the
fraud triangle capability factors must be added as a way for someone to do an audit. Fraud is
done first because of the pressure that makes him look for opportunities that can be utilized and
then justifies himself that his actions will not cause sin because it aims for the benefit of many
people (Yendrawati, Aulia, & Prabowo, 2018). After that, someone needs to have the ability
either in the form of knowledge or strategies so that the fraud plan is implemented properly. The
capability that must be possessed by someone to commit fraud consists of :
a. The position and position of someone in the company can provide the ability
to commit fraud because it has full power over the company that can not be
prevented by his subordinates
b. Someone's intelligence and creativity also determine the success of a fraud
because someone who will commit fraud must first study the company's
financial statements and then create creative ways to manipulate financial
statements so they are not easily detected.
c. Big faith and ego to guarantee that cheating will be carried out according to
plan is difficult to detect because it is subjective.
d. Someone's expertise in order to influence others is very much done by
someone in order to find friends to commit cheating together. This is done so
that when fraud is detected, the perpetrators of the fraud can blame their
colleagues.
e. The ability to influence someone must be followed by the ability to lie
skillfully in order to convince someone who will be influenced.
f. After that, the perpetrators of fraud must be able to keep themselves from
stress because if the perpetrators experience stress can make it easier for
someone to detect something that should not be done

2.2.5 Earning Management

Earning management is one of the ways used by management to benefit from the
company's operating income. Full responsibility given to management for presenting financial
statements can be utilized by management to commit fraud by hiding the state of the company's
actual reports through efforts to increase or reduce reported profits by using expertise in
accounting policy. Financial reporting that is actually based on this basis is initially expected to
be more rational and fairer than cash basis. but, in fact, it is used to commit fraud. this is done by
management in order to reduce obligations such as tax payments or due to a conflict of interest
between management and shareholders (Sunardi & Amin, 2018).
Management earnings can be done through income smoothing where the company's
income and expenses are diverted by management between periods to reduce revenue
fluctuations so that the company's income is considered stable by shareholders. So, shareholders
will believe in management's performance because it can generate profits for shareholders and
can attract the attention of other investors to invest their money in the company. in the end, as a
result of the management's good performance appraisal from shareholders, management will get
an incentive for its performance even though it comes from fraud (Arens et al, 2011).

2.2.6 Previous Study

The first factor is Pressure, pressure consist of financial target, financial stability and
external pressure. Puspitadewi & Sormin (2014) states that financial targets do not have a
significant effect on fraudulent financial reporting because ROA is used only to measure how
assets owned by companies in generating profits and cannot detect earnings management actions.
However, this research contradicts Sihombing & Rahardjo (2014), Nurbaiti & Hanafi (2017)
which states that financial targets have a significant effect on fraudulent financial reporting
because ROA can increase company profitability in the face of shareholders. The second variable
of pressure is external pressure. Sihombing & Rahardjo (2014).
The second factor is opportunity which consist of variable nature of industry and
ineffective monitoring. According to Sihombing & Rahardjo (2014) the variable of nature of
industry have significant influence on fraudulent financila reporting because an increase in
receivables owned by the company can be used by companies to reduce the amount of cash in
financial reporting so that there is a manipulation of receivables in order to attract investors. The
next variable is ineffective monitoring. Puspitadewi & Sormin (2014) states that ineffective
monitoring has a significant influence on fraudulent financial reporting because ineffective
supervision from an independent board of commissioners can bring opportunities for outsiders to
exert pressure in order to encourage fraud. However, this study was not supported by Sihombing
& Rahardjo (2014).
The next factor is rationalization which consists of audit changes and opinion audits.
Puspitadewi & Sormin (2014) states that rationalization has a significant influence on fraudulent
financial reporting because changes in auditors and opinions given by auditors can manipulate
revenue by providing reasonable opinions when management will make a recording error when a
transaction occurs even though cash has not been received. However, this study contradicts
Nurbaiti (2016), Sihombing & Rahardjo (2014). The last factor is capability, Puspitadewi &
Sormin (2014) states that capability cannot be used to detect fraudulent financial reporting.

2.2.7 Theoretical Framework

Based on the background and previous studies described above. In this study the
researchers established several hypotheses which include :
H1: Financial targets can be used to detect fraudulent financial reporting
H2 : External pressure can be used to detect fraudulent financial reporting
H3 : Financial stability can be used to detect fraudulent financial reporting
H4 : Nature of industry can be used to detect fraudulent financial reporting
H5 : Ineffective monitoring can be used to detect fraudulent financial reporting
H6 : Auditor changes can be used to detect fraudulent financial reporting
H7 : Auditor opinion can be used to detect fraudulent financial reporting
 2.3 Conclusion
In detecting fraudulent financial reporting can be done using fraud diamond analysis
followed by the auditor's ability to detect fraud. Diamond fraud is a theory used to identify the
factors that drive a person to commit fraud. This fraud diamond theory was put forward by David
T. Wolfe and Dana R. Hermanson which is the development of the fraud triangle theory which
consists of pressure, opportunity, rationalization and by adding capability factors. Pressure
factors can be identified by financial target variables, financial stability, and external pressure.
The opportunity factor is identified by the variable nature of industry and ineffective monitoring.
while the rationalization factor is identified by the auditor change variable and audit
opinion.Fraudulent financial reporting is often done by top-level managers or people who have
more power in the company so they are easy to commit fraud. The fraud was carried out by
means of increasing income through eliminating debt or other obligations.
However, sometimes the company also deliberately reduces revenue in the current year to
be reserved in the following year so that the company's financial position is considered stable by
investors. Fraudulent financial reporting is usually done by management through earnings
management because earning management is a way that managers do to modify income by
reducing or increasing revenue. This is done by using income smoothing in the form of income
adjustments in the years during which the company operates to be considered stable by
shareholders so that it does not eliminate investor interest in investing. Earning management
practices are expected to be detected by the auditor with the capabilities they have and made
easier by fraud theory diamonds. Fraud theory diamond is expected to be used as a detection
factor that can predict earnings management practices in a company
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