¶ … Sarbanes-Oxley Act of 2002 in reducing fraudulent financial reporting
Introduction to Fraudulent Financial Reporting
Available research on financial statement fraud relies mostly on anecdotal evidence (for example, Wells, 2001, 2002, 2004a, and 2004b; Rezaee, 2003). This evidence offers advice on how mechanisms related to the fraud triangle can be curtailed. It leads to theoretical sense to reduce factors which lead to more instances of fraud. However, deterrence and established deterrence methods in place within organizations have not been examined in proper detail. Neither have the secondary issues which can influence a person's chance of committing financial statement fraud. But there are multiple researches where deterrence models have been tested on other types of fraud e.g. tax fraud, fraudulent reports of environmental violations etc. Generally speaking, a clear consensus regarding the level of effectiveness of prevention mechanisms, such as those stated in GDT, is not present. There are two key parts of GDT: certainty and the intensity of punishment.
Fraud Triangle
Under audit regulation, the auditor is interested in corporate and accounting fraud. Fraud is defined in SAS No. 99 (AICPA, 2002, Para. 5) as intentional misstatement of financial statements on which the audit takes place. There are two forms of misstatements as far as audit consideration is concerned; one is the misstatement that occurs due to deceptive financial reporting and the other by misuse or stealing of assets (AICPA, 2002, Para. 6; Cohen, 2010).
As per the statement on Auditing Standards (SAS) No. 99, fraud within financial statements takes place due to three major conditions. The first condition is the pressure or the motivation to commit fraud. The second condition is the availability of an opportunity, which means that whenever there are weak controls in the organization or the management does not abide by strict rules and regulations then there are chances for the fraud to take place. The third situation behind the fraudulent activities is the attitude to commit fraud. These three conditions are commonly known as fraud triangle. We have gone through the research work which showed the existence of these three conditions in fraudulent activities related to financial statements.
Supporting researches include the one conducted by Bell and Carcello (2000) where they examined the presence of fraud triangle for a specimen of financial fraud entities. The two of them have designed a logic regression model; this model has predicted the occurrence and frequency of occurrence of fraud and has also indicated numerous risk factors which are linked with fraud. Risk factors include the presence of weak internal controls, growth at a faster pace, ownership status, and management's attention increasingly focused on the anticipated forecasts and misstatement of facts to auditors by the management.
In addition to this, dealings of control environment with that of management's outlook towards financial reporting is also a risk factor contributing to fraud which will increase the percentage of negativity on corporate earnings as well as decrease shareholder confidence. The work of Bell and Carcello (2000) has failed to reveal the relationship between the financial fraud and few of the conventional risk factors, like; fast growing industry or dilapidated state of the industry, rapid turnover of management, unusual related party transactions which are also of significant amount and even the arrangements related to compensation in connection with reported earnings. As per the conclusions of Hernandez and Groot (2007b), it is assessed by the audit partners that the usage of incentive systems and existence of opportunities result in much advanced fraud hazards. However, the factors that contribute to the greatest extent towards fraud are the attitude of the senior management and transference of dishonest facts to the auditor by the management. Within his scrutiny of five fraud cases, Rezaee (2005) found the existence of the fraud triangle inside the audit firms. There are many other research works which have focused each of the components of fraud triangle. These works are brought is discussion below.
Incentives/Pressures
Earnings are misstated in order to meet the predicted forecasts; or to meet the need of outer financing; or to hide the poor performance that has taken place in the mean time and even the incentive structure propels the related persons to perform fraudulent activities. There was a research conducted by Dechow et al. (1996), where he used a sample ninety two firms, who were subject to accounting enforcement release throughout the phase of 1982-1992. Through this research he found out...
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