Accounting and Corporate Governance How can managers fraudulently manipulate financial statements?

Managers can manipulate financial statements in a variety of ways. One approach involves inflating earnings on the income statement for the current reporting period by artificially inflating revenue and gains or by deflating expenses. This approach results in making the financial condition of the company look better than its actual condition and allows the company to meet established expectations. Another approach to financial statement manipulation does the opposite, that is, deflating earnings by deflating revenue or by inflating expenses. This approach makes the company look worse than it actually is. This tactic may be used to make the company look less appealing to potential acquirers, or it may be used to push all the negative financial information into the current period to make the company look stronger going forward.

The following list describes general categories of financial statement manipulation and the accounting processes that enable manipulation and violation of U.S. GAAP regarding revenue recognition. (1) A company may record revenue prematurely, or it may record revenue of questionable quality. This type of manipulation includes recording revenue prior to completing services or shipping product, and also includes recording revenue for products that are not required to be purchased. (2) A company may record fictitious revenue, either for sales that did not take place, or for investment income that should be reported as revenue, or for loan proceeds. (3) A company may increase income by reporting one -- time gains as revenue. This tactic includes increasing profits by selling assets and recording the proceeds as revenue or by classifying investment income or gains as revenue. (4) A company may shift current expenses to either an earlier or later period. This tactic includes amortizing costs too slowly, switching accounting standards, capitalizing normal operating costs so as to reduce expenses by moving them from the income statement to the balance sheet, or failing to write down or write off impaired assets. (5) A manager may fail to record or improperly reduce liabilities, which can be done by failing to record expenses and liabilities when future services remain or by changing accounting assumptions. (6) A manager may shift current revenue to a later period by holding back revenue or creating a rainy day reserve to be used as a revenue source to augment future performance. (7) A manager may shift future expenses into the current period or change accounting standards by way of provisions for depreciation, amortization, and depletion (Adkins, 2009).

What are some inherent risk factors that increase the potential for financial reporting fraud?

The American Institute of CPAs (AICPA) discusses examples of risk factors presented in an appendix to Statement on Auditing Standards (SAS) No. 99 (2006). Risk factors relating to misstatements arising from fraudulent reporting include risks that result from incentives and financial pressures. Such conditions occur when a firm's financial stability or profitability is threatened by economic, industry, or business operating conditions, such as competition, market saturation, technology changes, product obsolescence and so forth.

Excessive pressure that can lead to misstatements can also result from a desire to meet profitability or trend level expectations of analysts, the need to obtain additional equity or debt financing, the need to meet exchange listing requirements, or concern over the effects of reporting poor financial results on pending transactions such as contract awards or business combinations. Additional risk factors may occur if management's or the board of directors' personal financial situation is threatened by the entity's poor performance. This risk may occur because they personally guaranteed the entity's debt, they own significant financial interests in the entity, or significant portions of their compensation are contingent upon meeting aggressive targets for operating results, cash flow, stock price or financial position (AICPA, 2006).

What are some key control risk factors that increase the potential for financial reporting fraud?

Control risk factors that contribute to a firm committing financial reporting

SAS No. 78 and 99 assist in identifying internal control components and fraud and its characteristics. The following factors impact how well the organization has considered the need for fraud prevention in the design and maintenance of its system of internal controls:
Integrity and ethical values

Commitment to competence

Role of the board of directors and audit committee

Philosophy and operating style

Organizational structure

Assigning authority and responsibility

Human resource policies and procedures (AICPA, 2012)

What is the importance of effective corporate governance for overseeing the actions of top executives?

Effective corporate governance and its role in overseeing actions of top executives is one of the most critical issues facing many companies following the passage of Sarbanes-Oxley legislation. More effective corporate governance is necessary to address a crisis in investor confidence and resolve the most common issues associated with previous corporate governance regulation. These issues include executive compensation which is grossly disproportionate to corporate results, misuse of corporate funds, insider trading particularly by managers exercising stock options that reward short-term thinking, misrepresentation of the true earnings and financial condition of their companies, and obstruction of justice by destroying evidence or concealing activities (Guerra, 2004).

The U.S. Securities and Exchange Commission (SEC) has recently addressed a number of corporate governance issues raised by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 951 of the Act requires advisory votes of shareholders about executive compensation and golden parachutes. It further mandates that institutional investment managers report their votes on executive compensation and golden parachute arrangements at least annually. Section 952 of the Act requires disclosure about the role of compensation consultants and potential conflicts of interest (U.S. SEC, 2011).

Section 953 requires further disclosure on executive compensation matters including pay-for-performance as well as the ratio between the CEO's total compensation and the median total compensation for all other company employees. Section 954 requires that the SEC direct exchanges to prohibit the listing of securities of firms that have not implemented compensation claw-back policies. Such policies could allow boards to force executives to pay back some of their compensation for wrongdoing, such as involvement in fraudulent accounting activities. Section 955 requires disclosure about whether directors and employees are allowed to hedge a decrease in the market value of the company's stock (U.S. SEC, 2011).

How does SOX (Sarbanes-Oxley Act) address the issue of corporate governance? What section(s) address it and what are the major issues addressed?

SOX attempts to protect investors from failures of corporate governance by improving the accuracy and reliability of corporate disclosures that are made pursuant to securities laws or for other purposes. SOX addresses corporate governance issues by establishing new standards for corporate accountability along with new penalties for acts of wrongdoing. SOX also changes how corporate boards and executives must interact with each other and with corporate auditors. The Act eliminates the defense by CEOs and CFOs of claiming that they were unaware of financial issues by holding them accountable for financial statement accuracy. The Act also specifies new financial reporting responsibilities that include adhering to new internal controls and procedures designed to ensure the validity of financial records (Thomas & Klutz, 2006).

In addition to establishing new, stricter standards for affected U.S. publicly traded companies, the Act also created a new agency, the Public Company Accounting Oversight Board (PCAOB). The PCAOB is in charge of overseeing, inspecting, regulating and disciplining accounting firms in their roles as auditors of public companies.

Section 201 covers Prohibited Auditor Activities and is intended to end the practice of auditing firms providing management consulting and internal auditing services to clients and thereby compromising the auditor's independence . Section 302 addresses new responsibilities of CEOs and CFOs with respect to corporate reports. This section requires officers to sign an attestation for each annual or quarterly report, in which they assert that they have reviewed the report and that it fairly and accurately represents the company's financial condition. Officers must further assert that…