Detecting Financial Reporting Fraud: The Impact And .
Detecting Financial Reporting Fraud: The Impact and Implicationsof Management Motivations for External Auditors – Evidence fromthe Egyptian ContextByRasha KassemA thesis submitted in partial fulfilment of the requirements for the awardof the degree of Doctor of Philosophy at Loughborough University Rasha Kassem 2016
AbstractFinancial reporting fraud is a concern for investors, regulators, external auditors, and the public. Althoughthe responsibility for fraud detection lies upon management and those charged with governance, externalauditors are likely to come under scrutiny if fraud scandals come to light. Despite the audit regulators’ effortsin fighting fraud, evidence from prior literature revealed that external auditors still need guidance in assessingand responding to fraud risks. Hence the current study aims at helping external auditors properly assess andrespond to the risk of financial reporting fraud in an effort to increase the likelihood of detecting it. In orderto achieve this, the current study sought to explore the significance of various fraud factors in assessing therisks of financial reporting fraud and examined how external auditors could assess these fraud factors. Thecurrent study also explored the likely motivations behind management fraud, the impact of managementmotivations on the financial statements, and how external auditors could assess the impact of managementmotivations.The data for the current study was collected from external auditors working at various audit firms in Egyptvia the use of mixed research methods, namely through an online questionnaire and semi-structuredinterviews. The findings of the current study revealed that management motives are the most significantfactor in assessing the risk of financial reporting fraud. Hence the current study suggests that external auditshould be viewed in terms of management motivations rather than just the audit of financial statements’figures and disclosures. The current study offers detailed guidance to external auditors in this area. Thefindings of the current study also revealed that management integrity is a significant factor in assessing therisk of financial reporting fraud and that rationalisation of fraud should be assessed as part of managementintegrity rather than a separate fraud risk factor. The current study found that fraud perpetrators’ capabilitiesare equally significant to the opportunity to commit fraud factor yet it is currently ignored by the auditstandards and thus should be assessed as part of opportunity to commit fraud. The current study was the firstto explore financial reporting fraud and the extent by which external auditors comply with ISA 240 in theEgyptian context. The current study offered recommendations to external auditors, audit firms, auditregulators, and the Egyptian government on how to combat financial reporting fraud. Potential areas forfuture research were also identified by the current study.Keywords: Financial reporting fraud; management motivations; Egypt; external audit; ISA 240; ESA 240;the audit expectation gap; the audit of management motivations; the fraud triangle factors; managementintegrity; fraud perpetrators’ capabilities; financial reporting fraud detection; corporate governance; fraudrisk assessments; audit procedures.i
AcknowledgmentsI would like to show my sincere gratitude to my supervisor Dr Andrew Higson for his support and guidancethroughout the PhD process. Dr Higson’s support did not only help me to pursue my research but also todevelop as an academic. Many thanks Andrew for your priceless supervision, I was quite fortunate to haveyou as my supervisor and mentor. I would also like to thank Dr Rhoda Brown for her guidance and supportduring the panel meetings.To my loving and supporting parents, I am grateful to all your support throughout my life. You both believedin me and without your love, support, and prayers, this journey would have been so difficult. I am very luckyto have such loving, caring, and supporting parents.I would also like to thank all external auditors in Egypt that kindly participated in this research and facilitateddata access. Many thanks to my examiners, Professor Ian Fraser and Dr Petros Vourvachis, for theirconstructive feedback and for making my PhD viva an enjoyable experience.To Loughborough University, I had a great experience studying for my PhD and this experience will neverbe forgotten.ii
Table of ContentsPage NoIntroduction11.1Introduction11.2Research aims, motivation, and questions31.3Research methodology and methods61.4Research contribution61.5Structure of the PhD thesis91.6Summary of chapter one10Overview of financial reporting fraud112.1Introduction112.2The meaning, nature, and cost of financial reporting fraud112.3The categories of financial reporting fraud- Methods and concealment132.4Corporate governance and financial reporting fraud232.5The audit expectation gap262.6Summary of chapter two29Financial reporting fraud detection techniques – a critical review313.1Introduction313.2Analytical procedures and financial reporting fraud detection313.3The use of red flags and financial reporting fraud detection363.4The use of statistical and data mining techniques and financial40Chapter 1:Chapter 2:Chapter 3:reporting fraud detection3.5The fraud triangle model and financial reporting fraud detectioniii47
3.6The audit of management motivations and financial reporting fraud62detection3.7Chapter 4:Summary of chapter three64Management motivations – its impact on the financial statements66and implications for external auditors4.1Introduction664.2Streams of research into the motivations behind management fraud664.3Streams of research into the impact of management motivations on the88financial statements4.4The audit of management motivations904.5Summary of chapter four91An overview of the Egyptian context925.1Introduction925.2Overview of Egypt’s profile and economy935.3The development of the accounting and audit profession in Egypt965.4External audit and governance issues in Egypt1045.5The main regulatory audit professional bodies in Egypt1075.6Financial reporting fraud in Egypt1125.7Fraud research in Egypt1155.8Summary of chapter five116Research methodology, design, and methods1186.1Introduction1186.2Research aims and questions119Chapter 5:Chapter 6:iv
6.3Research paradigm and philosophy1226.4Research approach and design1296.5Research methods and data collection techniques1326.6Data analysis1526.7Addressing ethical issues1546.8Summary of chapter six156Analysis of questionnaire data and discussion of results1587.1Introduction1587.2Type of questionnaire data, variables, and measurement scales1587.3Statistical analysis techniques1597.4Editing and coding of questionnaire data1607.5Respondents’ demographic details1617.6Data analysis, and discussion of results1647.7Summary of chapter seven208Interviews data analysis and discussion of results2108.1Introduction2108.2Demographic details of interviewees2118.3Interview mode, duration, and data analysis2148.4Data analysis and discussion of results2168.5Summary253Findings and contribution of the current study2549.1Introduction2549.2The main research findings256Chapter 7:Chapter 8:Chapter 9:v
9.3The contribution of the current study2929.4Summary of chapter nine296Conclusion and ture studies30510.6Summary of chapter pter 10:List of TablesPage NumberTable 2.1How revenue manipulation and timing difference schemes are16committedTable 2.2How improper assets valuation scheme is committed17Table 2.3How concealed liabilities and concealed expenses schemes are20committedTable 4.1Prior studies into the motivations behind management fraud80Table 4.2List of management motivations behind financial reporting fraud88Table 4.3The impact of management motivations on the financial89statementsTable 6.1Summary of research questions and methods of data collection121Table 7.1Test of normality160vi
Table 7.2Questionnaire respondents’ audit experience162Table 7.3Questionnaire respondents’ type of audit firm163Table 7.4Questionnaire respondents’ professional qualifications164Table 7.5The use of ISA 240 by external auditors in Egypt165Table 7.6The use of ESA 240 by external auditors in Egypt166Table 7.7Familiarity of questionnaire respondents with fraud factors166Table 7.8Consideration of the fraud factors by external auditors in Egypt167Table 7.9Cross tabulation – the use of ISA 240 and audit experience168Table 7.10Cross tabulation – the use of ESA 240 and audit experience168Table 7.11Cross tabulation – the use of ISA 240 and the type of audit firm168Table 7.12Cross tabulation – the use of ESA 240 and the type of audit firm168Table 7.13Management fraud cases in Egypt169Table 7.14Cross tabulation - Likelihood of detecting financial reporting170fraud and audit experienceTable 7.15Phi test – relationship between likelihood of financial reporting170fraud and audit experienceTable 7.16Cross tabulation - Likelihood of detecting financial reporting171fraud and type of audit firmTable 7.17Techniques for detecting improper revenue recognition and173timing difference schemesTable 7.18Actions taken by external auditors in Egypt in the financial177reporting fraud casesTable 7.19Most significant fraud risk factor(s)177Table 7.20Significance of fraud risk factors180Table 7.21Consideration of fraud perpetrators’ capabilities181Table 7.22Traits for assessing management’s capabilities to commit182financial reporting fraudTable 7.23Cross tabulation - appreciation of management motives and audit183experienceTable 7.24Correlations - appreciation of management motives and auditexperiencevii183
Table 7.25Cross tabulation - appreciation of management motives and type184of audit officeTable 7.26Correlation - appreciation of management motives and type of184audit officeTable 7.27Assessment of management motivations187Table 7.28Assessing management integrity190Table 7.29Assessing rationalization of fraud193Table 7.30Assessment of fraud perpetrators’ capabilities194Table 7.31The motivations behind management fraud in Egypt196Table 7.32The most likely motivations behind management fraud in Egypt201Table 7.33The extent of impact of management motivations on the financial203figuresTable 7.34Frequency of impact of management motivations on financial203disclosureTable 7.35The audit of management motivations206Table 8.1Interviewees’ job title211Table 8.2Interviewees’ age211Table 8.3Interviewees’ type of audit firm212Table 8.4Interviewees’ audit experience213Table 8.5Interviewees place of professional audit training213Table 8.6Interview mode214Table 8.7Usefulness of ISA 240217Table 8.8Likelihood of financial reporting fraud in Egypt220Table 8.9Examples of alleged financial reporting fraud cases in Egypt223Table 8.10Significance of fraud factors232Table 8.11Difficulty of assessing the fraud factors233Table 8.12Other motives behind management fraud239Table 8.13External auditors appreciation of management motives and its240impact on the financial statementsTable 8.14External auditors success in auditing management motivesviii242
Table 9.1Techniques used by external auditors to detect financial reporting263fraud cases in EgyptTable 9.2The motivations behind management fraud in Egypt277List of FiguresPage NumberFigure 2.1 Categories of financial reporting fraud14Figure 3.1 The current fraud triangle model48Figure 6.1 Strategy for gaining access to participants135Figure 8.1 Pie chart for interviews duration214Figure 9.1 The new fraud triangle model or the fraud pyramid271ix
Chapter OneIntroduction1.1 Introduction:Financial reporting fraud is a concern for various stakeholders including investors, regulators, externalauditors, and the public. It could result in serious consequences to investors, employees, and the wider society(Chen et al., 2013). Fraud in general involves intent, deceit, breaking the law or violating regulatoryframework(s), and harm to its victim(s) (Johnson and Rudesill, 2001; O’Gara, 2004; Alleyne and Howard,2005; Wells, 2009; Lord, 2010; Jones, 2011). Corporate fraud was defined by Wells (2005, p.5) as “The useof one's occupation for personal enrichment through the deliberate misuse or application of the employingorganisation's resources or assets".Corporate fraud has three main categories which are financial reporting fraud, asset misappropriation, andcorruption (Wells, 2005; ACFE, 2002). However, the focus of the current research is only on “financialreporting fraud” for various reasons. First, financial reporting fraud is the most costly type of corporate fraudas reported by the Association of Certified Fraud Examiners (ACFE) in its global fraud study in 2016 wherethe median loss caused by financial reporting fraud was 975,000. Second, following the scandals in largecompanies like Enron, WorldCom, Xerox, Lehman Brothers, AIG, and Freddie Mac, investors’ concernsabout fraudulent financial reporting in particular has increased (Kassem and Higson, 2012a). Third, the costof financial reporting fraud goes beyond financial losses. For instance, financial reporting fraud could leadto loss of investors’ confidence in the audit profession and the capital market. The dismissal of executiveswho were accused of financial reporting fraud could lead to loss of productivity especially when they arereplaced with less-informed executives (Rezaee and Riley, 2010). Financial reporting fraud could also affectthe employees who will lose their jobs, as well as the economy and the society as a whole (Kalbers, 2009;Centre for Audit Quality, 2010).Fraud detection requires the efforts of corporate governance professionals, including the board of directors,the audit committee, top management, internal auditors, and external auditors (Dorminey et al., 2012).However external auditors are likely to be blamed if a financial reporting fraud case goes undetected (Cooperand Fargher, 2011; Kassem and Higson, 2016).1
Although external auditors are not directly responsible for fraud detection, they are expected to play asignificant role in it. This is because external audit serves a fundamental purpose in promoting confidenceand reinforcing trust in the financial information issued by firms (ICAEW, 2005; Chen et al., 2013). Thereis a difference in the expectations of the public and that of external auditors with regards to external auditors’responsibility for fraud detection. This difference is called “the audit expectation gap” (Porter, 1993; Monroeand Woodliff, 1993; Humphrey et al, 1993; Epstein and Greiger, 1994; Koh and Woo, 1998; Gay et al, 1998;Dewing and Russell, 2002; Alleyne and Howard, 2005). As a result of this audit expectation gap and theincreasing number of fraud scandals, there are tremendous pressure on the audit profession to enhance auditquality and to exert more efforts in fraud detection (The Institute of Chartered Accountants in England andWales (ICAEW), 2005).The International Auditing and Assurance Standards Board (IAASB) issued the International AuditStandards (ISAs) number 200 and 240 that detailed the responsibility of external auditors with regards tofraud. ISA 200: Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordancewith International Standards on Auditing stated that external auditors are responsible for detecting materialmisstatements in the financial statements whether due to errors or fraud. ISA 240: the Auditor’sResponsibility Relating to Fraud in an Audit of Financial Statements requires external auditors to assess andrespond to the risk of financial reporting fraud while taking into consideration management integrity and thethree fraud triangle factors (i.e. motives to commit fraud, existing opportunity to commit fraud, andrationalisation of fraud). However, despite the efforts of audit regulators in combating fraud, evidence fromprior research showed that external auditors still need guidance on how to properly assess and respond to therisk of financial reporting fraud (Glover et al, 2003; Payne and Ramsay, 2005; Zikmun, 2008; Brazel et al,2010; Kassem and Higson, 2012a). This motivated the current study to explore a way that could help externalauditors properly assess and respond to the risk of financial reporting fraud in an effort to increase thelikelihood of detecting it.This chapter thus introduces the aims and motivation of the current study, the current research questions, themethods used for data collection, and the contribution of the current study. The rest of the chapter isstructured as follows. Section 1.2 explains the aims, motivation, and research questions of the current study.Section 1.3 describes the research context, the methods used for data collection and the philosophyunderpinning the current research. Section 1.4 shows the contribution of the current research study. Section1.5 explains how the thesis is structured. Section 1.6 is a summary of chapter one.2
1.2 Research Aims, Motivation, and QuestionsResearch AimsThe current study aims at helping external auditors properly assess and respond to the risk of financialreporting fraud. That is in an effort to increase the likelihood of detecting it. In order to achieve this, thecurrent study sought to explore the significance of the three fraud triangle factors, management integrity, andfraud perpetrators’ capabilities in assessing the risks of financial reporting fraud and how external auditorscould assess these fraud factors. The current study examined the likely motivations behind managementfraud, the impact of management motivations on the financial statements, and how external auditors couldassess the impact of management motivations. The current study was conducted in Egypt and thus it wasalso important to understand the nature of the audit profession and the likelihood of financial reporting fraudin the Egyptian context. Hence the current study explored the extent by which external auditors in Egypt areaware of and are complying with ISA 240. It also explored the nature, likelihood, and types of financialreporting fraud in Egypt as well as alleged financial reporting fraud in the country.Research MotivationThe current study was motivated to fill in the current gaps in knowledge and practice in the area of financialreporting fraud detection. The audit standard (i.e. ISA 240) requires external auditors to considermanagement integrity and Cressey’s fraud triangle model in assessing the risk of financial reporting fraud.However, reviewing prior literature showed limitations in Cressey’s fraud triangle model which raisesconcerns about its effectiveness as a tool for assessing the risk of financial reporting fraud. Identifying fraudrisk is a significant element of assurance services and requires a model that reflects the current thinkingsurrounding the fraud event. This is more likely to make investors believe that external audit is an effectivefraud deterrence and governance mechanism (Dorminey et al., 2012). The limitations of the current fraudtriangle model could have an impact on the quality of fraud risk assessments and thereby the likelihood ofdetecting financial reporting fraud. Hence, this motivated the current study to shed light on these limitationsand look for a more effective technique and/or model that might help external auditors properly assess andrespond to the risk of financial reporting fraud.3
Reviewing prior literature showed mixed results with regards to the significance of the fraud factors thatcould help in assessing the risk of financial reporting fraud and possibly in detecting it. These factors aremanagement’s integrity, motives to commit fraud, opportunity for fraud, rationalisation of fraud, and fraudperpetrators’ capabilities. The international audit standard (ISA 240) also lacked guidance in this area. Thismight mak
in fighting fraud, evidence from prior literature revealed that external auditors still need guidance in assessing and responding to fraud risks. Hence the current study aims at helping external auditors properly assess and respond to the risk of financial reporting fraud in an ef
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Types of economic crime/fraud experienced Customer fraud was introduced as a category for the first time in our 2018 survey. It refers to fraud committed by the end-user and comprises economic crimes such as mortgage fraud, credit card fraud, claims fraud, cheque fraud, ID fraud and similar fraud types. Source: PwC analysis 2
Types of economic crime/fraud experienced Customer fraud was introduced as a category for the first time in our 2018 survey. It refers to fraud committed by the end-user and comprises economic crimes such as mortgage fraud, credit card fraud, claims fraud, cheque fraud, ID fraud and similar fraud types. Source: PwC analysis 2
6 Preventing and detecting fraud: strengthening the roles of companies, auditors and regulators 4 Report to the Nations: 2020 Global Study on Occupational Fraud and Abuse, Association of Certified Fraud Examiners, 2020. 5 Fraud and going concern in an audit of financial statements, IAASB. 6 Consultation on revised auditing standard for the auditor's responsibilities relating to fraud, FRC.
