INDICATORS AND WARNING SIGNS OF FINANCIAL FRAUD: DETECTION DURING FINANCIAL AUDIT

ПРИЗНАКИ И ПРЕДУПРЕЖДАЮЩИЕ ЗНАКИ ФИНАНСОВОГО МОШЕННИЧЕСТВА: ВЫЯВЛЕНИЕ В ХОДЕ ФИНАНСОВОГО АУДИТА

Калиханова Асель Аманкановна

магистрант, ОП ”Учет и аудит”, Школа Экономики и Менеджмента, Университет Нархоз,

РК, г. Алматы

Аппакова Гульмира Несипбековна

научный руководитель, канд. экон. наук, проф. PhD, Университет Нархоз,

РК, г. Алматы

ABSTRACT

The main purpose of this work is to identify the factors that indicate the presence of financial fraud during the audit of financial statements. This paper reveals what indicators need to be paid special attention to when auditing a company. The most effective methods of fraud prevention are described, such as an improved corporate structure, professionalism of internal and external auditors.

АННОТАЦИЯ

Главной целью данной работы является выявление факторов, которые указывают на присутствие финансового мошенничества во время аудита финансовой отчетности. В данной работе раскрывается на какие индикаторы необходимо уделить особое внимание при аудите компании. Описываются наиболее эффективные методы предотвращения мошенничества, такие как усовершенствованная корпоративная структура, профессионализм внутренних и внешних аудиторов.

Keywords: financial fraud, financial statement misrepresentation, effectiveness of internal audit, external audit, corporate structure.

Ключевые слова: финансовое мошенничество, искажение финансовой отчетности, эффективность внутреннего аудита, внешний аудит, корпоративная структура.

In the world of rapid growth and decline of businesses, the investors, government authorities have doubts about the reliability of financial statements. Despite the fact, that financial statements are formed based on accounting records and the goal of financial statement is to transparently show the financial results of the company, but as for now it ceased to fulfill its role. Nowadays, misrepresentation of financial statements – is one of the common types of financial fraud. The necessity to provide the reliable financial statement free from material misstatements became necessary due to new types of raising funds by companies – public offering of shares, bonds, and other financial instruments. Detections of financial fraud in the organizations has been the challenging task for the users of financial statements. Detection of fraud with existing audit tools is not always effective due to new methods of fraud, accounting systems which may hide manipulations with financial statements.

Association of Certified Fraud Examiners, ACFE developed the model which categorize the most common types of fraud. Based on this model there are three main types: fraud of financial statements, misappropriation of property and corruption. According to IAS 240, misappropriation could happen if there are three factors: opportunity, rationalization, and pressure.

Pressure/Motivation. If the management expectations about financial results do not align with actual results. There could be the intention to misrepresent financial statements due to the followings:

• Pressure from investors who expect higher returns from their funds
• Personal motivation of the management to reach the target KPI.

Opportunity. If the company has weak internal control system, requirements for corporate governance standards have not been properly developed, the management has intention to make corrections to financial statements.

Rationalization. During the fraud detection, it is necessary to note that those who commit fraud are not regular criminals. Usually, they are ordinary corporate employees who always will find justification for their illegal actions.

According to Ivanov. S in his book “Financial audit: theory and practice”, he highlights the psychological and behavioral exposures of fraud commitment.  The author mentions it is important for auditors to find the intentions behind fraudulent activities.

Petrova A. in her research “Methods for detection financial fraud” highlights two main methods used by auditors to detect the fraud. These methods include – traditional approaches, usually, analytical procedures, test of details applied by auditors. Modern ways to detect fraud includes data analytics and forensic accounting. In her research, Petrova A. mentions the importance of combining modern and traditional methods to enhance the process.

One of the most common types of misrepresentation with financial statements include misrepresentation of revenue.

Inappropriate revenue recognition. This fraudulent activity reflects future sales in the current period. This approach is effective to manipulate quarterly financial results, but not by year.

Payment deferment. Having shipped goods or provided services with a delay in payment terms, the company has the rights to indicate in financial statements the highest profit and accounts receivable.

Operations with related parties. By conducting fictitious transactions with related parties, companies may increase their profit. Under operations with related parties, companies sell non-existing assets with a condition to buy them back after a specified period of time at the initial price.

Apart from listed methods, there are several common fraudulent activities with recognition of expenses.

Capitalization of expenses is the recognition of expenses as an asset because the income expected to result from these expenses would be realized in prior periods.

Existence of off-balance sheet accounts. Off-balance sheet account refers to the method, when the company removes its assets and liabilities, as well as revenue and expenses from its financial statement. This method can be conducted by creating specialized entities or subsidiaries. With the help of off-balance sheet account, the company transfer its risks and liabilities.

In recent practice, one of the most effective ways to detect and prevent fraud - reliable corporate governance system. Ineffective control system, lack of governing body lead to concealing financial fraud and prevent information about fraudulent activity from leaking to third parties. There are four main types of protecting shareholders from fraudulent and other illegal activities:

1. Creation of reliable corporate governance system starting from top-managers.

Tone at the top set by managers is one of the most effective factors that affect the prevention and detection of illegal activities. Management’s commitment to responsible attitude must become the ethical foundation of the company and the acceptable model of conduct for other employees,

2. Independence and professionalism of Board of Directors. The Board of Directors must consist of well-educated and independent members. The Directors are expected to contribute efforts to create the value for shareholders and protect them from financial fraud.
3. High risk aversion to fraudulent activities. Prevention and detection of general fraud, financial reporting misrepresentation should be the focus of entire corporate governance system, starting from Board of Directors ending to regular employees.

The final participant of corporate governance system, who assesses the fraud prevention and detection process – external auditors. Their main goal is to give reasonable assurance that financial statement is transparent, reliable, and free from material misstatement. To ensure that activities of external auditors are effective, they must be well-educated and independent professionals. During the external audit, special attention must be paid to capitalization of expenses and amortization. Firstly, audit procedures must include the examination of the company’s policy of capitalizing expenses. Further, auditors should review past capitalized expenses and identify whether the company used aggressive capitalization in the past, calculate the average depreciation period of assets.

To sum up, based on the research there are following conclusions:

1. The fact that management can misrepresent financial reporting data for its own purposes by conducting fraudulent activities indicated ineffective corporate governance system.
2. The most effective way to prevent fraudulent activity – establish the system of effective corporate governance system, where actions of all employees, including top-managers, will be the subject to the principles of responsibility, transparency and accountability.

References:

1. Ivanov S. Financial Audit: Theory and Practice. Moscow: Finance and Statistics Publishing House, 2018.
2. Kovalenko E. The Role of Internal Control in Preventing Financial Fraud. Journal of Financial Control. 2021; 3(2): 45-52.
3. Orlov M. Financial Investigations: A Practical Approach to Fraud. St. Petersburg: Piter Publishing House, 2022.
4. Petrova A. Methods for Detecting Financial Fraud. Audit Bulletin. 2020; 5(1): 12-20.
5. Vasiliev P. The Impact of Regulatory Frameworks on Fraud Detection. Financial Journal. 2020; 4(3): 30-37.
6. Sokolov D. Warning Signs of Financial Fraud. Audit and Financial Analysis. 2019; 2(1): 15-22.