Can Corporate Governance Mechanism Prevent Corporate Fraud?

The word “fraud” was magnified in the business world around the end of 2001 and the beginning of 2002. No one had seen anything like it. Enron, one of the country’s largest energy companies, went bankrupt and took down with it Arthur Andersen, one of the five largest audit and accounting firms in the world. Enron was followed by other accounting scandals such as WorldCom, Tyco, Freddie Mac, and HealthSouth, yet Enron will always be remembered as one of the worst corporate accounting scandals of all time. Enron’s collapse was brought upon by the greed of its corporate hierarchy and how it preyed upon its faithful stockholders and employees who invested so much of their time and money into the company. Enron seemed to portray that the goal of corporate America was to drive up stock prices and get to the peak of the financial mountain by any means necessary. The “Conspiracy of Fools” is a tale of power, crony capitalism, and company greed that lead Enron down the dark road of corporate America.

Following the several financial scandals of the early 2000s involving the former notorious companies such as Enron and WorldCom corporations, the Sarbanes-Oxley Act of 2002 emerged. Indeed, SOX required that every publicly traded company CEO and CFO endorse the accuracy of their organizations financial statements prior to the official release. Obviously, the idea behind this decision is certainly a way to ensure the integrity of the upper management which dismisses the existence fraud on the financial statements. However, a discovery of fraudulent information on certified financial statements is subject to civil liabilities and criminal prosecutions.

In 2001, it struck everybody as odd when a blue chip stock went bankrupt less than a year after it paid its top 5 executives a total of $282.7 million. The stock market is notorious for being seductively tricky; being the sole contributor to the making and breaking of many men. However, this time it was clear that this wasn’t an ordinary unexpected decline. Enron Corporation, a former American energy company, had to have had something going on behind the scenes to cause the largest chapter 11 bankruptcy of its time. As the house of cards collapsed, it became clear that investors were blindsided by one of the largest instances of pump and dump stock fraud the market had ever seen.

Fraudulent, erroneous, and illegal acts committed by a public company, usually at a managerial or executive level, have been a very serious problem for many years and have prompted development of strict and updated regulations, such as the Sarbanes-Oxley Act, in an attempt to prevent these occurrences. Unfortunately, these new or updated regulations are not enough to prevent these acts from happening, thus not alleviating the auditors of their responsibility to detect fraud. Some methods that management and auditors can employ to prevent and detect fraud, errors, and illegal acts are: improving knowledge, improving skills,

Financial statement fraud is something that has become more commonplace than it should be. Many different events will often lead up to a rash of companies participating in financial statement fraud. Between the year 2000 and 2002 there were a number of factors that led to what appeared to be a perfect fraud storm according to our text (Albrecht, Albrecht, Albrecht, & Zimbelman, 2012). Nine of those will be looked at here. It will also be discussed as to what some of the common ways financial statement fraud is concealed while looking at some of the common motivations for such fraud. With this, a look at ways of financial statement fraud exposures can be identified along with who usually will commit this type of fraud.

According to Mitric, Stankovic, and Lakicevic, (2012) financial fraud and embezzlement are clearly two distinct configuration, however share several common characteristics and qualities. Mitric et al. also indicated that company top executives and managers or owners normally are responsible for putting its own company in financial troubles and damaging its organization’s reputation (p.44).

Financial statement fraud is any intentional or grossly negligent violation of generally accounting principles (GAAP) that is undisclosed and materially effects any financial statement. Fraud can take many forms, including hiding both bad and god news. Research shows that financial statement fraud us relatively more likely to occur in companies with assets of less than $100 million, with earnings problems, and with loose governance structures (Hopwood, Leiner, & Young, 2011).

Enron, a multinational company avoided showing their true financial statements for several years with the help of their auditor. Arthur Anderson, the company’s auditor signed off on the validity of the company’s accounts despite the inaccuracies in the financial statements (Accounting ethics, 2011, para. 12). As a result of Arthur Anderson engaging in unethical practices, Enron’s shareholders lost their money when the company went into bankruptcy, Arthur Andersen employees lost their jobs, and the company went out of business (Accounting ethics, 2011, para. 12). Another example is Adelphia founder, and former CEO John Rigas. He was found guilty of looting Adelphia in 2005. (Mallor, Barnes, Bowers, & Langvardt, 2010). Rigas, along with his son, and CFO Scott, was accused of using the company as their on private ATM to provide fifty million dollars in cash advances, buy 1.6 billion in securities, and repay 252 million in margin loans. As a result of their crimes Rigs received fifteen years in prison, and his son, and former CFO Scott, received twenty years in prison (Mallor et al., 2010).

In society, there have always been differing characteristics such as failure and fraud that have been linked through time. However, although failure and fraud are connected in several various ways, one tends to come before the other. Generally failure is the absence of achieving success and fraud is committing an unlawful act that is driven by failure or to result in failure. Failure has driven fraud for countless reasons either for financial prosperity or personal supremacy. In many cases the direction of failure and fraud is mainly subjected to the individual’s personal objective. Conversely, there have been many situations in which corporations too big to fail have succumbed to failure and fraud due to a destructive corporate objective. In 2001, Enron, the seventh largest company in the U.S participated in fraudulent activity. The fraudulent activity committed by Enron was the beginning of an inevitable ripple of failure in the company’s future. Although Enron performed the major scandal, the auditing agency Arthur Andersen was highly responsible for their negligence and their participation in the deception of the financial investors. The general public didn 't easily predict the downfall of Enron because it was one of the most thriving establishments in the corporate world. In many cases, companies as substantial as Enron are sometimes used as a measurement to gauge how the economy is preforming in the current market. The financial fraud

16 3 Financial Statement Fraud: Earnings Management and Revenue Recognition .............................................................................................. 17 3.1 Introduction ................................................................................ 17 3.2 Definition – Financial Statement Fraud ..................................... 18 3.3 The Auditor’s Responsibilities for Detecting Fraud.................. 19 3.4 Assessing Risks of Fraud ........................................................... 21 3.5 Definition – Earnings Management ........................................... 27 3.6 Earnings Management – Revenue Recognition......................... 28 3.7 Summary .................................................................................... 31 4 Case Analysis. Why Auditors Have Not Detected Fraud? ............... 33 4.1 Introduction to Three Case Studies............................................ 33 4.2 Analysis of the Three Cases....................................................... 35 4.3 Reasons Why Auditors Have Not Detected Fraud .................... 48 4.4 Summary .................................................................................... 60 5 Recommendations For Improving the Audit Process....................... 65 5.1 Introduction ................................................................................ 65 5.2 Empirical Findings

The regulators, SEC, U.S. GAAP, SOX of 2002, together with AICPA, PCAOB, and COSO concentrate on fraudulent reporting mechanisms and ways to lessen its occurrence. Inventors, public, and officials expect auditors detecting fraud to protect third parties interests. The auditors’ core responsibility is to confirm that financial statements are prepared fairly in accordance with U.S. GAAP. Therefore, auditors should comprehend real-world techniques to identify financial statement manipulation.

Corporate scandals and accusations of fraud have amplified intensely over the last decade. The cost of fraud has reached over $400 billion dollars a year, not to mention the loss of investments and jobs. Corporation fraud involves creative, complex methods in which to overstate revenues, understate expenses, over value assets, and underreport liabilities. To hide financial problems, management will manipulate stock prices, minimize taxable income, and maximize compensation. “It 's been my experience… that the past always has a way of returning. Those who don 't learn, or can 't remember it, are doomed to repeat it” (Berry, p. 417, 2009). Enron Corporation, WorldCom, Incorporated, and Global Crossing Limited all claimed bankruptcy

We have analyzed the characteristics of this fraud case, its consequences, and the events following Enron’s collapse. This was the biggest ever business bankruptcy in the history of USA spotlighting corporate America’s greed and moral failings. It shows how greed of few leaders led to the fall of the company at the expense of so many stakeholders and led to destruction of wealth and injuring all who went for a ride along with it.

There are various measures they can take in order to see that the fraud or the misconduct does not happen in the future. They have to assess the risks and design protocols, then implement the policies as per the plan and evaluate the amount of damage is done to the company and its shareholders. Bill Witherell also focused on this and he commented that “Achieving good corporate governance is not solely the responsibility of the directors, inventors and regulators; it should be a core objective of senior management. Poor corporate governance weakens a company’s potential and at worse can pave the way for financial difficulties and even fraud.”

The association between corporate governance and financial reporting quality is a fundamental topic in accounting research. Corporate governance is defined as the set of internal and external monitoring mechanisms designed to mitigate the agency costs inherent in the corporate form of ownership (Jensen and Meckling 1976). Financial reporting quality refers to the accuracy and precision with which financial statements convey information about a firm’s operations (Biddle et al. 2009). Previous studies use various indicators of financial misreporting (such as restatements, discretionary accruals, and Securities and Exchange Commission (SEC) enforcement releases) as proxies for financial reporting quality (Dechow et el. 2010). These studies