Impact of Sarbanes Oxley Act of 2002 in Reducing Fraudulent Financial Reporting 'Literature Review' chapter

Excerpt from 'Literature Review' chapter :

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 that manipulation of figures is done in order to attract external finance at a relatively lower cost. There was an investigative study carried out by Erickson et al. (2006) as well. The purpose of this work was to investigate as to whether the equity incentives are linked with accounting fraud or not. A sample was examined by them in the period of 1996-2003 but they did not find any link between financial reporting fraud and equity incentives. On the contrary, Efendi et al. (2007) work on the samples of entities that reaffirmed their financial statements showed that the chances of misstatement of finances increase when the CEO has a substantial stock options amount. They also discovered that the firms which are undergoing fraudulent activities are those who are in need of some external finance, or are under huge debts or have a person who is playing the role of both CEO and Chairman of the board.

Stock options serve as a very attractive feature due to which fraudulent misrepresentation takes place because option turns CEOs wealth into a convex function of stock price. Beneish (1999a) researched on a group of firms who were subject to accounting enforcement proceedings by SEC. Through the research it was found out that the managers tend to sell equity and also exercise rights during the periods when the earnings are inflated. This suggests that the insider trading actions will possibly be helpful about matters related to income overstatements. Similar findings related to the connection between fraud and insider trading was reported by Summers and Sweeney (1998). Recent studies have revealed that a number of firms have been mixed up in intentional backdating of stock options (Lie 2005). Thus, revealing the fact that stock options reward works as an incentive for the deceptive behavior. A report submitted by Glass Lewis & Co. (2006) clearly mentions that almost half of the entities which have backdated their stock options have even restated their statement of financial position.

Rosner (2003) carried out research on unsuccessfully performing entities to find out whether the companies manipulate their earnings because they are on a declining phase or whether the auditors are more likely to find fraud in companies which they recognize to be deteriorating. The results of Rosner's research indicate that the performance of deteriorating firms do not appear distraught on the foundation of accrual data. While on the other hand, significantly reduced cash flows are seen to be consistent with the material income overstatements during the time when the company is not in a risky situation, while in the upcoming years, the reversal of overstatements is seen when the company is in a risky situation. These entities accrual behavior is similar to that of the firms which were sanctioned by SEC due to fraud. Hence, the wrong incentives can and do increase the percentage of negativity on corporate earnings as well as decrease shareholder confidence.

Opportunities

Examples of risk factors which enhance the chances to commit fraud are provided in Statement on Auditing Standards No. 99 (AU Section 316) (AICPA 2002). Nature of industry, related party transactions, company's operations, in effective controls, lack of supervision on the part of management and complex structure of the organization, which for example involves a number of legal entities are some of the risk factors which will increase the percentage of negativity on corporate earnings as well as decrease shareholder confidence. The factors which enhance the chances for the commencement of fraud are discussed by Albrecht and Albrecht (2003) as well. The point to remember is that the chances of fraud can only be minimized when there are strong controls in existence within an entity.

There are a number of researches that have revealed that a company is under the influence of fraud mainly because of poor corporate governance, which exist in the company in the form of managements' monitoring or supervision. The research done by Dechow et al. (1996) clearly indicates that fraud takes place more frequently and openly in those firms which have one individual who plays the role of chairmen as well as CEO (and/or is the founder), or in those firms which have directors who are not at all independent or in other words are under the influence of seniors. It also shows the same patterns for those firms which do not have audit committees or external auditors to keep a check on their work. The firms which have non-independent board of directors are more likely to be found conducting fraud than those firms whose directors' are independent, narrates Beasley (1996). Farber (2005) further supports the above…

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