TOPIC 5: FRAUD AND

EARNINGS
MANAGEMENT
DR.NOORAISAH KATMON@KATMUN
WEEK 7
overview

In the last class, we study about the CODE OF BUSINESS ETHICS &
CONDUCT that firms have to established following the Malaysian
Code on Corporate Governance (as in page 20-21).
Why firms need to have the CODE OF BUSINESS ETHICS & CONDUCT?
One of the biggest aim of all of this CODE OF BUSINESS ETHICS &
CONDUCT are primarily to mitigate conflict of interest that might
eventually lead to FRAUD or earnings management activities.
So now, we are going to learn about FRAUD and EARNINGS
MANAGEMENT activities that managers might engage in their daily
business activities.
CONTENTS

FRAUD DEFINITION
3 KEY ELEMENTS FOR FRAUD TO OCCUR
SYMPTOMS OF FRAUD
EARNINGS MANAGEMENT DEFINITION
MOTIVES OF EARNINGS MANAGEMENT
HOW EARNINGS MANAGEMENT IS PERFORMED?
Fraud definition

Fraud is the generic term, and embraces all the multifarious means
which human ingenuity can devise, which are resorted to by one
individual, to get an advantage over another by false
representation. No definite and invariable rule can be laid down as
general proposition in defining fraud, as it includes surprise, trickery,
cunning and unfair ways by which another is cheated. The only
boundaries defining it are those which limit human knavery.
Unintentional error is
not a fraud
Someone mistakenly enters
incorrect numbers in the financial
statement. THIS IS NOT FRAUD
Someone purposely enters
incorrect numbers on a financial
statement to trick investors. THIS IS
FRAUD.
Management fraud or financial
statement fraud: INVOLVES TOP
MANAGEMENTS DECEPTIVE
MANIPULATION OF FINANCIAL
STATEMENT
EXAMPLE: ENRON, WORLDCOM, PARMALAT, ETC.
Who commits fraud?
Research shows that anyone can
commit fraud.
Most fraud perpetrators have profiles
that look like those of honest people
3 key elements for fraud to occur

1. Perceived pressure
2. Perceived opportunity
3. Rationalization
Perceived pressure

1. financial pressures
Greed
Living beyond ones means
High bills or personal debt
Poor credit
Personal financial losses
Unexpected financial needs
2. vices gambling, drugs, alcohol and expensive extramarital
relationship
 3. work-related pressures
Getting little recognition for job performance
Having a feeling of job satisfaction
Fearing losing ones job
Being overlooked for a promotion
4. other pressures
To improve lifestyle
A challenge to beat the system
Perceived opportunity

1. Lack of controls that prevent and/or detect fraudulent behaviour

2. Inability to judge quality of performance
3. Failure to discipline fraud perpetrators
4. Lack of access to information
5. Ignorance, apathy and incapacity
6. Lack of an audit trail
Rationalization

Those who involved in fraud keep rationalizing their crimes in their

mind.
The organization owes it to me
I will just do it once
I believe other people are also doing the same thing
I am only borrowing the money and will pay it back
Nobody will get hurt
I deserve more
It is for a good purpose
We will fixed the books as soon as we get over this financial difficulty
Symptoms of fraud

1. Accounting anomalies
2. internal control weaknesses
3. analytical anomalies
4. extravagant lifestyle
5. unusual behaviour
Accounting anomalies

Irregularities in source documents/ journal entries/ ledgers

Missing documents
Alterations on documents
Duplicate documents
Document sequences that do not make sense
Journal entries without supporting documents
Journal entries that do not balance
Unexplained adjustments to receivables, payables, revenues or
expenses
etc
Internal control weaknesses

Lack of segregation of duties

Lack of physical safeguards
Lack of independent checks
Lack of proper authorization
Lack of proper documents and records
Overriding existing documents
Inadequate accounting system
Analytical fraud symptoms

Analytical fraud symptoms are procedures or relationship that are

unusual or too unrealistic to be believable. Examples include
Unexplained inventory shortages or adjustments
Deviations from specifications
Increased scrap
Excess purchases
Physical abnormalities
Excessive late charges
Excessive turnover of executives
 Strange financial statement relationships, such as:
Increased revenues with decreased inventory
Increased revenues with decreased receivables
Increased revenue with decreased cash flows
Increased inventory with decreased payables
Increased volume with increased cost per unit
Increased volume with decreased scrap
Increased inventory with decreased warehousing costs
Extravagant lifestyle

Fraud perpetrators often live beyond their means since their income
does not support their lifestyle. Lifestyle changes are often easy
fraud symptoms for coworkers, managers and other employees to
observe. These includes:
New cars/ expensive cars
Expensive toys
Expensive houses
Expensive jewellery or clothes
Expensive vacation
Expensive daily spending e.g. eat in expensive restaurant daily.
Unusual behaviours

Guilt
Fear
Stress
Behaviour changes
Insomnia
Increased drinking
Taking drugs
Inability to relax
Unusual irritability and suspiciousness
Lack of pleasure in things usually enjoyed
Fear of getting caught
 Behaviour changes..cont:
Inability to look people in eyes
Showing embarrassment around friends, coworkers and family
Defensiveness or argumentativeness
Thinking of excuses and finding scapegoats
Sweating
Increased smoking
Obsessively contemplating possible consequences
EARNINGS MANAGEMENT
DEFINITION
Earnings management occurs when managers use judgement in
financial reporting and in structuring transactions to alter financial
reports to either mislead some stakeholders about the underlying
economic performance of the company or to influence contractual
outcomes that depend on reported accounting numbers (Healy &
Wahlen, 1999, p. 368)
2 forms of earnings
management:
(a) income increasing
earnings management
(b) income decreasing
earnings management
MOTIVES OF EARNINGS
MANAGEMENT (income increasing)
To avoid reporting loss
To meet or beat the earnings forecast by the financial analyst
To increase BOD potential in receiving high bonus or compensation
To get the contract from the government or other firms.
To increase the profit, so it will eventually increase the share price
If managers hold the firms share, increase in the share price will also
increase their own wealth.
High share price increase the reputation of the firms as well as the
shareholders wealth.
Motives of earnings management
(income decreasing)
To avoid high taxes
To avoid paying high salary or bonus to the employees
How managers manage earnings?

A choice from a menu of treatments that are acceptable under

GAAP, such as
LIFO to FIFO
The full cost method vs successful effort method in oil and gas industry
Depreciation method from straight line to reducing balance method.
Revenue recognition policy manipulate the difference between
revenue and cash flows (i.e., accruals).
Earnings management is the
manipulation of accounting rules,
within accounting standard
boundaries.
Fraud is the manipulation of
financial accounting beyond the
accounting standard boundaries.
Both fraud and earnings
management have a bad
implication to the firms and to
stakeholders