Prevention and deterrence of financial statement fraud consists of those actions taken to discourage the perpetration of fraud and limit the exposure if fraud does occur. Since financial statements are the responsibility of management, preventing financial statement fraud requires minimising the pressures, incentives, and opportunities unique to management for manipulating the company’s financial position.
Management and the Board of Directors
Financial statements are management’s presentation of the financial position of the entity. Setting the ethical tone of the organisation is the responsibility of management and the board of directors. As with other types of occupational fraud and abuse, reducing the three factors that contribute to fraud (the fraud triangle) as they specifically relate to management and the board can mitigate the risk of financial statement fraud. Reducing existing pressures
to commit fraud, removing potential opportunities to commit fraud, and relieving possible rationalisations for committing fraud will greatly aid in the prevention of financial statement fraud.
Reduce the Situational Pressures that Encourage Financial Statement Fraud
- Avoid setting unachievable financial goals.
- Eliminate external pressures that might tempt accounting personnel to prepare fraudulent financial statements.
- Remove operational obstacles that block effective financial performance, such as working capital restraints, excess production volume, or inventory restraints.
- Establish clear and uniform accounting procedures that do not contain exception clauses.
Reduce the Opportunity to Commit Fraud
- Maintain accurate and complete internal accounting records.
- Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who interface in the transactions between financial units.
- Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items.
- Segregate duties between employees, ensuring that no single individual has total control of one area.
- Maintain accurate personnel records, including background checks (where permitted by law) on new employees.
- Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures.
Reduce the Rationalisation of Fraud—Strengthen Employee Personal Integrity
- Managers should set an example by promoting honesty in the accounting area. It is important that management practise what it preaches. Dishonest acts by management, even if they are directed at someone outside of the organisation, create a dishonest environment that can spread to other business activities and other employees, both internal and external.
- Honest and dishonest behaviour should be defined in company policies. Organisational accounting policies should clear up any ambiguity in accounting procedures.
- The consequences of violating the rules, including the punishment of violators, should be clear.
Internal auditors are responsible for helping to deter fraud by examining and evaluating the adequacy and effectiveness of controls, commensurate with the extent of the potential exposure in the various segments of an entity’s operations. The internal auditing standards state that the principal mechanism for deterring fraud is internal control. Primary responsibility for establishing and maintaining internal control rests with management. The Treadway Commission addresses this issue by recommending that internal audit departments or staffs have not only the support of top management, but also the necessary resources available to carry out their mission. The internal auditors’ responsibility is to aid management in the deterrence of fraud by evaluating the adequacy and effectiveness of the company’s internal control system, as well as the company’s potential exposure to fraud, with particular consideration given to the five elements of internal control laid out by COSO.
External auditors inspect clients’ accounting records and independently express an opinion as to whether financial statements are presented fairly in accordance with the applicable accounting standards of the entity, such as GAAP or IFRS. They must assert whether financial statements are free of material misstatement, whether due to error or fraud.
Independence is the cornerstone of the auditing function. The only way external auditors can uncover and rectify instances of fraud is if they view the financial statements objectively. However, external auditors are not required to uncover all instances of fraud that might be occurring, as this would be an onerous and nearly impossible task.
The responsibilities of the external auditor as they relate to fraud detection are clearly outlined in International Standard on Auditing (ISA) 240, The Auditor’s Responsibility Relating to Fraud in an Audit of Financial Statements. According to this guidance: the auditor is responsible for maintaining professional skepticism throughout the audit, considering the potential for management override of controls, and recognising the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud. The requirements in [ISA 240] are designed to assist the auditor in identifying and assessing the risks of material misstatement due to fraud and in designing procedures to detect such misstatement.
Audited financial statements are examined by a variety of external users, including investors, creditors, and government bodies. These users depend on the integrity of the statements for a variety of decision-making purposes. Therefore, external auditors have a professional obligation to evaluate the financial statements as thoroughly and objectively as possible. Furthermore, if management and the accountants know that external auditors conduct prudent audits, they might be deterred from committing financial statement fraud.