Financial misrepresentation and creative accounting

There are a number of definitions about financial statement fraud from different organizations or bodies like the ACFE, ISA, etc. According to the ACFE, Financial Statement Fraud is “the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the Financial Statements in order to deceive financial statement users.”

Types of financial misrepresentation
A forensic accountant is often called on to provide an internal investigation about an incident or an alleged wrongdoing but there are times that they are called on to provide an external investigation. Forensic accountants’ focus is not only on financial misrepresentations but also on omissions.
The two types of financial misstatement fraud are (a) misstatements arising from fraudulent financial reporting and (b) misstatements arising from misappropriation of assets.
(a) Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statements users and the effect causes the financial statements to be materially misstated and not in conformity with generally accepted accounting principles. The management of the company is responsible for misstatements due to fraudulent financial reporting because they are the ones who have access to all records.
(b) Misstatements arising from misappropriation of assets, involves theft of business assets where the effect of the theft causes the financial statements not to be presented in all material respects and in conformity with generally accepted accounting principles. The employees (and not the management) of the firm are usually responsible for financial misstatements arising due to misappropriation of assets.
Note, however, that material misstatement in the financial statements can arise from fraud (inclusive manipulation)/omission (exclusive manipulation) and/or error. The distinguishing factor between fraud and error is whether the underlying action that caused the misstatement in the financial statements was intentional or unintentional.
Intention to materially misstate financial statements is most times difficult to prove, particularly in issues involving accounting estimates and the application or accounting principles. For example, unreasonable accounting estimates about the Provision of Doubtful Debts may be unintentional or may be the result of an intentional attempt to misstate the financial statements.
The intention of fraud is most of the times a matter of piecing together different elements of evidence such as minutes, e-mails, interviews, internal memos, public statements, etc.
In order to prove intentional Financial Statement Fraud the event or action suspected of fraud must have been done repeatedly and must have not been an act of error or accident. There must also be present a clear and objective benefit from the event and deviation from accounting rules and principles.

The Materiality Issue
Even though audits are not designed to establish intention for fraud, auditors have a responsibility to plan and perform the audit to obtain reasonable assurance whether the financial statements are free of material misstatement, whether the misstatement is intentional or not. The assessment of what is material is a matter of professional judgment. However, it is generally accepted that information is considered material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Although there are no quantitative guidelines for determining materiality, in practice the following could qualify as material misstatements and may require further investigation:
– Percentage change of pretax income or net income in excess of 0,5% of average pretax income using a 3 year average;
– Percentage change of Gross Profit margin in excess of 1% – 2%;
– Percentage change of total assets by more than 0,5% – 1%;
– Percentage change of total revenue of more than 2%,
– Percentage change of equity by more than 1%.
Hybrid methods could also be developed using some or all of the above methods. Methods varying above percentages with respect to size could also be developed.
One rule of thumb considers as immaterial any item that falls below a certain percentage, for example 5%, of income or assets.

On September 19, Rakis Christoforou will be delivering a seminar/workshop on “Creative Accounting” at CIIM Nicosia. For information contact CIIM at 22 462246.
In the next issue of the Financial Mirror we will deal with more sophisticated Creative Accounting Schemes and examples.