Factors That Motivate Preparers Of Financial Statements To Engage In Accounting Fraud, And Safeguards Available In Preventing Accounting Fraud: Essay Fountain

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The aim of this paper is to identify factors that motivate preparers of financial statements to engage in accounting fraud and also identify safegaurds available in preventing such frauds. investors and analysts look at company earnings to determine the attractiveness of stock that is measured by the present value of its futeure earnings. Earnings indicate the allocation of direct resources in the capital market and also represents the extent to which the company can engage in value adding activities. Several companies therefore use earnings management to maintain steady growth and gradually end up deliberatly manipulating the company’s earning to reach a predetermined target.

Keywords: Earning Management, Accounting Fraud, impression management, aggressive creative accounting. Factors that motivate preparers of financial statements to engage in accounting fraud, and safeguards available in preventing accounting fraud. Introduction. Fraud is defined in Webster’s New World Dictionary as ‘’the intentional deception to cause a person to give up property or some lawful right. In the Accounting sense, fraud refers to stepping outside the regulatory framework to give false results outside the accounting regulation framework. Depending on the classes of perpetrators, fraud can be committed by individuals such as embezzlement which are usually distinguished from frauds perpetrated by corporations known as financial statement fraud.

Association of certified Fraud Examiners (ACFE) defines financial statement fraud as;intentional, deliberate, misstatement or omission of material facts or accounting data which is misleading and when considered with all the information made available would cause the reader to change or alter his or her judgement or decision. Fraud can be carried out through;Impression management and Creative accounting. Impression management refers to using the flexibility of accounts to convey a more favourable view than is warranted of financial results in the interest of preparers. managers are assumed to strategically ‘select. . . the information (in corporate narrative documents) to display and present. . . that information in a manner that is intended to distort readers’ perception of corporate achievements’ (Godfrey et al. , 2003, p. 96). Creative accounting refers to using the flexibility within accounting to manage the presentation and measurement of results so that they fulfill the interests of the preparers. Aggressive earning management refers to attempts by management to influence, manipulate or distort reported earnings by use of specific accounting methods to recognise a one off non recurring item or accelerating expenses or revenue transactions.

According to Roman (2009) ‘’Earnings management occurs when firm management has the opportunity to make accounting decisions that change reported income and exploit those opportunities. ’


The reasons for creative accounting and fraud are several in nature and may range from personal impression to incentives to realize bonuses and or to maintain a stock position in the share market. Companies that carry out earnings management are expected to adjust their reports and statements in line with financial reporting standards most especially GAAP. Matsumoto 2002 argues that companies with high growth prospects have a lot to lose and therefore would rather not engage in creative accounting. However, those companies that believe that the benefits are definitely higher than the risks will practice it. Their reasons will include any or all the following;

Stock market incentives

A market is a vast array of buyers and sellers; usually investors and analysts who trde in the stock deciding whether the price goes up or down in a period. Beating a stock market price or expectation means a high return for the company and huge compensations for the CEO. Missing the earnings benchmark on the other side has negative implications. If the pre managed earnings made are rather too high compared to the forecast, managers chose between increasing income earnings management and not managing it at all hoping for an increase in stock return. it was for the same reason that Ebbers had to doctor his company’s books to massively alternate the company accounts to cover up falling margin calls of their share ;price. If had ignored this pressure and told the truth about the accounts, World Com could have probably been around today and Ebbers would not be in prison.

Personal incentives

There are several personal reasons a manager may want to cook accounts of his company. A new manager for instance may want to lower accounts in his first years in office and use aggressive management in the next years to up results and register growth in accordance to changes in the system he may have made. A retiring CEO may use upward earnings management to hit it hot in the final years, leave in an unforgettable way that will always be an example to the rest and probably even save himself a seat on the board of directors. In the case of WorldCom, Ebbers’ very apparent desire to build and protect his personal financial condition led him to alternate financial accounts and use company money to run his personal businesses and when the accounts started to fail in early 2000, he convinced the board of directors to lend him millions of dollars to deposit in the shares to avoid margin calls on his own WorldCom stock that he had pledged to secure loans.

So he showed continually growing net worth. Signalling or concealing private informationWhen Worldcom started failing, the CFO Sullivan concealed all information related to this fact. Failing firms would not want their decline paraded out in the open just as yet most especially when the fraud perpetrators have hope of reviving the company back to stability. Sullivan and Ebbers believed that WorldCom would survive the decline most especially after the acquisition of several well performing firms. Managers therefore try to hold onto the prestige reputation that would soon be stained, the numerous loss of jobs to come and possible conviction and life in jail for the fraudsters. It is therefore for this reason that they will decide to conceal information without thinking of stock price and/ or CEO compensation.

Management compensation

The bonus plan hypothesis contends that managers remuneration mainly the yearly bonuses are tired to the financial performances of a company. therefore CEOs and managers therefore resort to using earnings management to increase income and improve their compensation. This may be done by reporting accruals that defer income once the bonus awards cap is reached. this is because there’s nothing else to gain and would rather have the excess reported as the following years income. This is at par with the big bath technique of earnings management that believes in the same motive. Deshow & Sloan (1995) found out that managers will reduce funding on research and Development on their way out simply to increase their final bonus. political costs.

Lending contracts motivations

This is based upon the debt covenant theory that states that creditors will always provide credit based on the reported data of a financial company and will therefore restrict payment of dividends, share buybacks and additional debt unless there is assurance of the repayment of early debts. Companies therefore use earning management and accounting fraud techniques to ensure they do not breach their debt covenants. SafegaurdsAs a measure of safeguard against aggressive earnings management and company fraud, the Sarbanes Oxley Act was established in July 2002. This act emphasised disclosure requirements and penalties for fraudulent accounting. It is also known as the “Public Company Accounting Reform and Investor Protection Act”. The bill contains eleven sections which mandate articles that act as safeguards;

  • Creation of the Public Company Accounting Oversight Board (PCAOB). This is a comitte that provides independent oversight of public accounting firms that provide auditing services. this ended over 100 years of self regulation by such companies. This board is tasked with registering auditors and laying out the rules, processes and proceedures in quality control,compliance audits and inspection.
  • Strict standards for auditor independence to remove conflicts of interest. There is to be new auditor approval requirements, audit partner rotation within every five years, tighter auditor reporting requirements and prohibiting auditing firms from providing non-audit services for the same clients. Auditor quality is highly expected and they are expected to know the various ways inwhich earnings management occurs and how the different accounting practices pave way for related frauds. For instance, they should understand transactions that allow mangers to make adjustments or estimates and to understand available choices in the use of Generally Accepted Accounting Priciples (GAAP), IFRS and the use of Fist In First Out (FIFO) or Last In Fast Out(LIFO)
  • Enhanced corporate social responsibility by providing that: senior executives take individual responsibility for the accuracy and completeness of corporate financial reports; For example, Section 302 requires that the company’s “principal officers” (typically the chief executive officer and the chief financial officer) certify and approve the integrity of their company financial reports quarterly.
  • New financial disclosure requirements, most especially in regard to off-balance sheet transactions, proforma figures and information on stock transactions of corporate officers. it also emphasises internal controls and audits for these requirements. it also require that companies disclose names of their clients, fees and as operation proeedures for the first time. Corporate governace practices such as directors placing overall policies that offer oversight to operating activites and managers fully taking responsiblilities for the results of the prepared financial statements of the cooporation.
  • Adequate internal controls to be in place as a basis for the preparation of financial statements and for securing the accuracy of financial reporting and disclosures, including certification by the responsible officers, and auditing and reporting on them by the external auditors. Confict of interset should also be avoided by ensuring that chief audit executives do not report to the Chief Financial Officers who will determine their compensation at the end of it all. This was emphasised by Cooper…. in an interview for CFO Magazine in February 2008. She also emphasised both functional and adminstrative reporting relationships to the audit committe and CEO. The introduction of innternationally accepted accounting principles, standards and practices.
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