Fraudulent Financial Reporting Research Articles

A case study on fraudulent financial reporting: evidence from Malaysia

Purpose This paper aims to examine cases of fraudulent financial reporting (FFR) which were subject to published enforcement actions by the Securities Commission Malaysia (SC) from 1998 to 2012 for reasons of alleged financial misreporting. It investigates the main attempts used (how) and sensible motives (why) for these fraudulent reporting. Design/methodology/approach This study undertakes a close examination of the financial reports manipulated – annual accounts, interim reports and financial reports in listing proposals, initial public offering prospectuses and corporate restructuring proposals. Due to the limited number of FFR published, a close examination of these cases is the best way to reach a more comprehensive and detailed understanding of “how” FFR takes place, rather than performing large sample statistical analyses. This study also collects data which provide evidence for the possible motivations in resorting to the FFR. Findings The most common attempt used by the sample companies was to overstate their reported revenue by recognising fictitious sales from bogus customers. Sample companies who attempted this initial manipulation often followed with consequential manipulations and in some cases also embarked on masking manipulations. Sensible motives for the sample companies to manipulate their financial statements include capital raising exercises, closeness to defaulting on debt repayments and sustaining equity overvaluations. Research limitations/implications The primary limitation of this study is its lack of breadth due to the limited number of reported cases available. Moreover, taking the sample companies used from enforcement action releases published by the SC presupposes that the SC has diligently and correctly identified all the FFR cases – whereas there is a possibility that some companies involved in FFR may not yet have been detected or publicly revealed. Notwithstanding these limitations, our findings provide a comprehensive insight, which is sufficient in depth, into the operational aspects of FFR in Malaysia. Practical implications One practical lesson from the findings on “how” within the chain of manipulations is that auditors ought to review the effectiveness of their analytical and substantive procedures, as a number of the FFR cases remained undetected by the audit process. A second is that accounting standards setters may wish to reconsider the amount of discretion given to managers in financial reporting. On the one hand, some managers have used this discretion to provide useful information to the market; however, others have opportunistically used it for personal gain. Social implications From the societal perspective, it is time for managers, as agents of capital providers, to self-review their responsibilities and stewardship in financial reporting. There needs to be a paradigm shift in their attitudes towards the perceived incentives of, and opportunities for, FFR. Managers’ wrongdoings in these accounting scandals have had significant adverse consequences for society – including minority shareholders, investor confidence, future accountants and managers in the making. Originality/value This study provides direct and practical evidence on the “how” and “why” of FFR in the context of a developing country – Malaysia. Such evidence is limited in the existing literature and relevant to practitioners.

Earnings Management and Fraudulent Financial Reporting: The Malaysian Story

Earnings management research has a long and rich history. The agency conflict, incentives, rationalization, opportunity plus having the capability among the managers to manipulate the financial statements lead them to commit fraud. The loopholes in the standards or the deviation from real operational activities promote this situation to prolong. In relation to this issue, this study examines the earnings management behavior among fraud firms in Malaysia. Further, this study examines the relationship between accruals earnings management as a proxy variable for discretionary accruals and real earnings management as the proxy variable for discretionary cash flow. Sample of 57 alleged fraud firms was selected based on the fraudulent financial reporting offences announced in Bursa Malaysia website. The sample data are collected from public firms which committed fraud from 2001 to 2013. This study found a significant negative relationship between accruals earnings management and real earnings management among the fraud firms in Malaysia suggesting that these firms aggressively manage earnings downwards or upwards essentially to avoid regulators scrutiny apart from aiming to achieve personal incentives. The study significantly finds evidence that fraud firms manage earnings on a sequential basis between accruals earnings management and real earnings management prior to fraud year. The findings indicate that firms opt for real earnings management and make full use of its distinguished features of not easily traceable to continue managing earnings immediately subsequent to fraud year. This study may assist regulators, auditors, and policymakers to curb earnings management patterns that have high likelihood of becoming part of fraud antecedent.

Auditor Tenure and Financial Reporting Fraud: Pre and Post Sarbanes-Oxley Act of 2002

We use a comprehensive and unique fraud database from the Institute for Fraud Prevention (IFP) to test the relationship between audit firm tenure and fraudulent financial reporting pre and post Sarbanes Oxley Act of 2002 (SOX 2002). Overall, short tenure is only marginally related to the likelihood of fraud. Also, only tenure of nine years or more is positively associated with the likelihood of fraud. We also find that compared with other audit firms, the Big-N are less likely to be associated with fraud, while client size is marginally positively associated with fraud, possibly reflecting larger clients’ bargaining power with auditors in contentious audit situations (c.f., Nelson et al. 2002). The results hold for the pre-SOX period but not for the post SOX period.

The Effect of Top Management Team Diversity and Board Diversity on Fraudulent Financial Reporting

This study examined how demographic diversity present in the top management team and in the board of directors may influence the likelihood of a firm’s fraudulent financial reporting. It also evalu...

The Role and Responsibility of Auditors in Prevention and Detection of Fraudulent Financial Reporting

Abstract This research examines the roles and the responsibilities of the key stakeholders of the financial reporting in the prevention and detection of fraud. The methods used and types of transactions most vulnerable to fraudulent financial reporting are examined. For the need of the empirical part of the paper, the questionnaire survey was conducted. The respondents, external auditors, evaluated how often they encounter circumstances indicating the possibility of fraud. In accordance with the conducted research the most common technique used to fraudulent financial reporting involved overstatement of assets.

Prediction of Business Failure and Fraudulent Financial Reporting: Evidence from Malaysia

Fraud has been of concern for many corporate managers and regulators since many businesses have been victim of business failures. Business failure corporations have reported and become an element of fraudulent financial reporting.Therefore, the first aim of this study is to examine whether a collective prediction tool can be used to predict business failure and fraudulent financial reporting.The second and more important objective of this study is to examine whether business failure companies are associated with fraudulent financial reporting. The collective prediction tool is based on ratio analysis, Beneish M-score model and Z-score model. Using publicly available information in the annual reports of 24 failed firms matched with 24 non-failed firms listed on Bursa Malaysia, relevant information are extracted and applied in the three models to assist in predicting business failure and detecting fraudulent financial reporting. A total of 10 ratios, cash conversion cycle, Beneish M-score model and Altman's Z-score model were identified for examination as potential predictors of business failure and fraudulent financial reporting. Based on the results, the model was accurate in classifying the total sample of approximately 96 per cent as predictors of business failure and approximately 83.3 per cent as predictors of fraudulent financial reporting as well as predicting the relationship between business failures and fraudulent financial reporting. Hence, it can be concluded that these model functions effectively and can be adopted by regulators, bankers, management, internal and external auditors and to the forensic accountants so that proper preventive or corrective action can be taken to mitigate fraud at its inception.

They Protect Us from Computer Fraud: Who Protects Us from Them? SafeNet, Inc.: A Case of Fraudulent Financial Reporting

ABSTRACTThis case focuses on fraudulent financial reporting as related to the tone at the top, primarily the chief operating officer, Carole Argo, of SafeNet, Inc. (SafeNet). This case provides students a real-world example by which to apply basic fraud concepts including the fraud triangle, fraud prevention, and red flags (fraud symptoms). Students analyze SafeNet to identify deficiencies and prevention methods, from the perspective of COSO's (2013) Internal Control—Integrated Framework's internal control objectives, components, and principles. Students also analyze SafeNet's corporate governance structure by comparing SafeNet's Board of Directors and its subcommittees pre- and post-SOX. Students learn of stock options as a form of compensation. However, this case does not focus on the details of accounting for stock options. This case is appropriate for students with the financial accounting principles course background. This case was classroom tested in a basic fraud examination course and an internal auditing course. Students' responses in both courses support the use of the case as a learning tool.

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Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting

AbstractUsing samples of restating and nonrestating U.S. firms, the study empirically investigates the relationship between the incidence of fraudulent financial reporting and accounting‐based performance outcomes. The outcomes are framed as gains and losses relative to a reference point, defined as the mean performance of industry peers. Consistent with cumulative prospect theory (CPT), the findings show that fraud incidence is positively (negatively) related to the probability of a loss (gain); more (less) sensitive to the probability of a loss (gain) (i.e., loss‐aversion); and more (less) sensitive to an extra unit of the probability at a high‐ or low‐ (medium‐) probability level (i.e., nonlinear probability weighting function). The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual‐level behavioral implications on firm‐level archival data, the study reconceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real‐world setting of fraudulent financial reporting.

Disclosure of Corporate Governance Structure and the Likelihood of Fraudulent Financial Reporting

The purpose of this study is to examine the relationships between corporate governance structure and the likelihood of fraudulent financial reporting. Likelihood of fraudulent financial reporting is based on an integration of Beneish M-score model and Altman's Z-score model. These relationships are examined based on content analysis of annual reports of 227 Public Listed Companies in Malaysia for the year 2010-2011. Results of this study provide evidence that the effectiveness of corporate governance structure reduces the likelihood of fraudulent financial reporting. These results indicate that effective corporate governance structure is paramount in enhancing the credibility of financial reporting.

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Topological pattern discovery and feature extraction for fraudulent financial reporting

Fraudulent financial reporting (FFR) involves conscious efforts to mislead others regarding the financial condition of a business. It usually consists of deliberate actions to deceive regulators, investors or the general public that also hinder systematic approaches from effective detection. The challenge comes from distinguishing dichotomous samples that have their major attributes falling in the same distribution. This study pioneers a novel dual GHSOM (Growing Hierarchical Self-Organizing Map) approach to discover the topological patterns of FFR, achieving effective FFR detection and feature extraction. Specifically, the proposed approach uses fraudulent samples and non-fraudulent samples to train a pair of dual GHSOMs under the same training parameters and examines the hypotheses for counterpart relationships among their subgroups taking advantage of unsupervised learning nature and growing hierarchical structures from GHSOMs. This study further presents (1) an effective classification rule to detect FFR based on the topological patterns and (2) an expert-competitive feature extraction mechanism to capture the salient characteristics of fraud behaviors. The experimental results against 762 annual financial statements from 144 public-traded companies in Taiwan (out of which 72 are fraudulent and 72 are non-fraudulent) reveal that the topological pattern of FFR follows the non-fraud-central spatial relationship, as well as shows the promise of using the topological patterns for FFR detection and feature extraction.

FEATURE EXTRACTION OF FRAUDULENT FINANCIAL REPORTING THROUGH UNSUPERVISED NEURAL NETWORKS

The objective of this study is to apply an unsupervised neural network tool to analyze fraudulent financial reporting (FFR) by extracting distinguishing features from samples of groups of companies and converting them into useful in- formation for FFR detection. This methodology can be used as a decision support tool to help build an FFR identification model or other financial fraud or financial distress scenarios. The three stages of the proposed quantitative analysis approach are as follows: the data-preprocessing stage; the clustering stage, which uses an unsupervised neural network tool known as a growing hierarchical self-organizing map (GHSOM) to cluster sample observations into subgroups with hierarchical re- lationships; and the feature-extraction stage, which uncovers common features of each subgroup via principle component analysis. This study uses the hierarchal topology mapping ability of a GHSOM to cluster financial data, and it adopts principal component analysis to determine common embedded features and fraud patterns. The results show that the proposed three-stage approach is helpful in revealing embedded features and fraud patterns, using a set of significant explana- tory financial indicators and the proportion of fraud. The revealed features can be used to distinguish distinctive groups.

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