Companies can manipulate their financial statements to make their financial performance appear different from what it actually is. The reasons for businesses’ involvement in such fraud are varied and may include the attempt to hide the firm’s true performance, preserve status, maintain personal income, or meet business goals to obtain bonuses. For example, Enron, an energy company, involved in financial fraud to conceal its financial losses by means of mark-to-market accounting. By using this scheme, the company could include projected profits from trading contracts in its income statement.
If the real profit appeared to be less than the projected one, the loss was put on the balance sheet of a special purpose entity and was not reported in the company’s balance sheet. This practice eventually led to Enron’s collapse as its shares dropped from $90.75 to $0.67 (Connell, 2017). This paper will discuss what financial statements and accounts are key targets of manipulation, how to prevent and identify fraud, and why the SOX section 404 is important for preventing deceitful accounting reporting.
Target Statements and Accounts for Fraud
Many documents reflect the firm’s financial situation. However, the three key statements that are often manipulated are the income statement, the balance sheet, and the statement of cash flows (Association of Certified Fraud Examiners [ACFE], 2017). The balance sheet provides data about the company’s liabilities and assets and owners’ equity. The income statement shows the business’s profits and losses.
The cash flow statement reflects the company’s sources of cash and how it uses cash. Among the accounts found in these statements, the key targets of fraud are liabilities, sales, inventory, profit margins, accounts receivable, and the cost of goods sold (ACFE, 2017). For example, the company may want to manipulate liabilities to conceal that it relies heavily on borrowed money for its operations. Profit margins can be fraudulently reported because the company may feel pressure from competitors, forcing it to reduce prices and, consequently, decrease profit margins. Overall, these statements and accounts provide a clear insight into the firm’s financial problems, which is why they are the most likely to be manipulated.
Prevention and Identification of Financial Statement Fraud
One way to prevent accounting fraud is by monitoring employees. Employees should be provided with strict guidelines regarding what to do regardless of the situation, and any suspicious behavior should be noticed and addressed. Further, internal controls with the segregation of accounting duties should be established to ensure that different people perform the procedures of transaction authorization, custody of assets, record keeping, and reconciliation of assets with records (Connell, 2017). Finally, the organization should develop a code of conduct discouraging employees from unethical behaviors and perform background checks when hiring employees to avoid recruiting unethical individuals.
Fraud detection measures are necessary when preventive actions appear to be unsuccessful. The manipulation of financial statements is revealed through the process of internal and external audits. Internal auditors should be independent and possess the qualities of objectivity, integrity, competency, and confidentiality (Connell, 2017). During an audit, specialists should review various financial relationships, such as assets versus liabilities and sales versus accounts receivable (ACFE, 2017). In addition, several analytical procedures are used to detect fraud: cash flow analysis, ratio analysis, and vertical and horizontal percentage analysis (ACFE, 2017). Unusual and unexpected results of these analyses may indicate that financial statements have been manipulated.
The Importance of SOX Section 404
The Sarbanes-Oxley Act was developed in 2002 in response to the scandalous fraud in which Enron was involved. SOX section 404 obliges companies to have adequate internal controls and report on the effectiveness of these internal controls (Connell, 2017). In addition, the external auditor should confirm the company’s evaluation of the effectiveness of its internal controls (Connell, 2017). This section is significant because it increases the reliability of business financial reporting. It makes the management accountable for the quality of its financial information and obliges it to disclose any shortcomings in its auditing procedures.
Association of Certified Fraud Examiners. (2017). How to detect and prevent financial statement fraud. Web.
Connell, M. (2017). The fall of Enron and the creation of the Sarbanes-Oxley Act of 2002 (Publication No. 19) [Honors project, La Salle University]. HON499 projects. Web.