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IFRS And the Increase of Fraudulent Financial Statements

IFRS And the Increase of Fraudulent Financial Statements. By Neftali C. Adame. Introduction/Thesis.

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IFRS And the Increase of Fraudulent Financial Statements

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  1. IFRS And the Increase of Fraudulent Financial Statements By Neftali C. Adame

  2. Introduction/Thesis • Since the stock market crash of 1929 known as the Great Depression, the United States has passed laws and regulations to secure the integrity of financial reporting and to protect public investment from the fraudulent businesses. • Currently the principles that govern accounting procedures in the U.S. are the Generally Accepted Accounting Principles or GAAP. However, the Securities and Exchange Commission or SEC, which is the governmental entity responsible for establishing the accounting principles, is already making plans to convert the US GAAP to the international standards known as the International Financial Reporting Standards or IFRS. • In effect, the SEC hopes this conversion will lead to a better prevention in fraud and promote global interest. However, I argue that conversion to IFRS will increase the risk of fraudulent financial statements because of its principles-based system, revenue recognition flaws, and the perspective of auditors.

  3. Principles-Based System IFRS is a principles-based system that is open to many interpretations and therefore an increase of fraudulent financial reports is to be expected after its adaptation in the US. Given the nature of IFRS, companies can decide how they want to approach their accounting procedures because there are no rules but rather boundaries that they must obey. Lance J. Phillips compares the principles-based system to a relaxed method of parenting. When a parent tells the child to arrive home at a reasonable hour and then decides what reasonable is by taking into account factors such as weather, the child’s age, and next day activities , it can be understood that the parent governs under a principles bases system (Phillips 617). This comparison reveals how IFRS governs with a liberal method that allows companies to report freely as long as it is reasonable. However, what is considered reasonable for one company may not be for another.

  4. Principles-Based System In 2000, shareholders won a lawsuit over Coca-Cola for allegedly selling “excessive, unwanted, and unneeded” beverages to bottling companies with the “right of return,” which, in violation of GAAP, was reported as final sales on their financial statements. In effect their financial value rose under false pretenses but later fell after returns were being exercised (Phillips 629). The lawsuit was won because there was a direct violation of an accounting rule but that may not be the case under IFRS. IFRS sets up parameters of how to report certain activities of business but it does not provide specific guidelines that can be used in determining financial reporting violations.

  5. Revenue Recognition Flaw Revenue recognition is flawed under IFRS because it enables companies to state inappropriate gains of revenue in their financial reports. Business transactions can involve any combination between the delivery of a good or service and the collection of payment with either being completed immediately after the transaction or in the future. Hana Bohusova and DanuseNerudova reveal how, under IFRS, a company can “recognize amount of revenue in their financial statements that do not faithfully represent” the company’s transactions (16). This suggest that companies can expose the flaws of revenue recognition by reporting gains in revenue without the related expenses. For example, a store can report a net gain or loss of income after a product is bought within the store because revenue can be related to the expenses incurred during the sale. However, it is not that simple when the delivery of a product or service is not instantly.

  6. Revenue Recognition Flaw Sidney J. Grey et al compare income from companies that reported in both IFRS and GAAP and reveals that income reported in IFRS are “statistically significantly higher than US GAAP” (443). This suggests that companies under IFRS are taking advantage of the revenue recognition flaw are report higher revenue in their financial statements. This short term appeal will eventually be discovered when the expenses that were postponed are reported and there are no revenues during that period to counter that loss. Under IFRS, companies can report false gains in revenue which in turn gives them a deceptive appeal that enables them to take investors’ money without the proper authorities to prove otherwise.

  7. Auditor Perspective Auditors from foreign counties have acknowledged the increase of fraudulent financial reports after the adaptation of IFRS. It is known that one indicator of increased audit risk is the increase of audit fees since there is more work involved to assure the integrity of financial statements. Emmanuel T. De George et al study how the audit fees of Australian companies changed after the adoption of IFRS. De George and his colleagues conclude that there was an “increase in the mean level of audit cost of 23 percent” because greater auditor effort is required to “ensure adequate compliance” (457). Auditors are paid for the amount of effort they put into reviewing and correcting financial statements. If the financial statements are more likely to be influenced by fraudulent activities then the auditor has to spend more time detecting and correcting the issues before it worsens.

  8. Auditor Perspective During the auditor’s evaluation of financial statements, financial data of similar companies can be compared. For example, hardware stores Home Depot and Lowes can be compared and if there is a significant difference in their financial data then that leads auditors to believe that fraudulent activity is taken place. However, in a survey of auditor evaluation over the effects of companies adopting IFRS, Vicky Cole finds that more than half of the auditors surveyed “realize that IFRS financial statements are not as comparable as they seem to be at first glance” (123). Since IFRS is expected to change the way companies report their financial statements according to their interpretations, there will be no trends across multiple financial statements to determine fraud.

  9. Counterargument • However, many believe that by adopting IFRS in the US, fraudulent financial statements will be prevented and global interest will be promoted. • Many share the ideas of Michael G. Alles and SrikantDatar when they state in their article that a principles bases system is “more responsive to emerging issues” because it “requires financial reporting to reflect the economic substance” and not just the transaction (123). • Reporting financial statements that reflect emerging issues may seem like a good idea at first, however, emerging issues can have a positive effect on current financial statements and negative effects on future statements. • Such was the case of Coca-Cola where their false increase of sales was quickly negated in the future because of the returns.

  10. Counterargument • Given that IFRS is exercised by many European counties and is gaining popularity, it is believed that a unified accounting standard will promote global interest. • While this may be the case, there is a sense of division in the way companies can approach their accounting procedures such as revenue recognition which can be abused to commit fraud and in a world with a unified accounting standard, fraudulent companies will be hard to distinguish from the honest ones.

  11. Conclusion • IFRS is a principles-based system that gives little guidance over accounting procedures which leads to an increase of fraudulent financial reports. • Under IFRS, companies are encouraged to act according to their business activities while providing honest reports. • However, in the event where a company is not honest, such as recognizing revenue under false pretenses, it will be difficult for an auditor to detect the fraud and much less be proven in a court of law because of the flexibility that is allowed under IFRS. • While the idea to unify the world under the same accounting standards seems to be achievable under IFRS, there is a sense of division that is created from the various approaches in accounting procedures that can be done under IFRS. • The SEC plans to eventually convert to IFRS and after the adoption of new accounting standards, careful evaluation of company financial statements should be assessed when considering any type of investment in the company to assure a higher quality in investing.

  12. Alles, Michael G., and SrikantDatar. "How Do You Stop The Books Being Cooked? A Management-Control Perspective On Financial Accounting Standard Setting And The Section 404 Requirements Of The Sarbanes-Oxley Act." International Journal Of Disclosure & Governance 1.2 (2004): 119-137. Academic Search Complete. Web. 25 July 2014. Bohusova, Hana, and DanuseNerudova. "Us Gaap And Ifrs Convergence In The Area Of Revenue Recognition." Economics & Management (2009): 12-19. Business Source Complete. Web. 25 July 2014. COLE, Vicky, et al. "The Illusion Of Comparable European Ifrs Financial Statements. Beliefs Of Auditors, Analysts And Other Users." Accounting & Management Information Systems / Contabilitate Si Informatica De Gestiune 10.2 (2011): 106-134. Business Source Complete. Web. 25 July 2014. De George, Emmanuel T., et al. "How Much Does IFRS Cost? IFRS Adoption And Audit Fees." Accounting Review 88.2 (2013): 429-462. Business Source Complete. Web. 25 July 2014. Gray, Sidney J., et al. "Have 'European' And US GAAP Measures Of Income And Equity Converged Under IFRS? Evidence From European Companies Listed In The US." Accounting & Business Research (Wolters Kluwer UK) 39.5 (2009): 431-447. Business Source Complete. Web. 25 July 2014. Phillips, Lance J. "The Implications Of Ifrs On The Functioning Of The Securities Antifraud Regime In The United States." Michigan Law Review 108.4 (2010): 603-631. Business Source Complete. Web. 25 July 2014. Works Cited

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