Motivation and Signals of Financial Reporting Fraud

According to the data from the Treasury Department's Financial Crimes Enforcement Network, over 730,000 counts of suspected financial wrongdoing were recorded in America in 2008, Institutions such as banks, insurers and casinos are required by law to report suspicious activities to federal authorities under 20 categories. Financial institutions filed nearly 13% more reports of fraud compared with 2007, accounting for almost half of the increase in total filings. Every time the exposure of financial reporting fraud heavily reduces investors’ confidence. The authenticity and fairness of financial reports is the key to the effective functioning of security markets. Research of the financial reporting fraud could date from long time ago.
(1) Motivation
The first factor affecting the motivation of fraud is the pressure. When people pursue an interest or are under some kind of pressure, the motivation of fraud will come out. But this interest or pressure must be large enough since people know the cost of being caught of the fraud is quite high. Managers in high levels and ordinary employees have different fraud motivations.
For the management board, they prepare fraudulent financial reporting mainly to reach the intended target. The pressures could be external or internal. External pressures come from the stock market. For example, market’s expectation of the company’s performance, the need to increase the investment will both greatly affect management board’s behavior. Boards of Directors are under pressure from shareholders, so they need to make every effort to increase company’s value. Then the pressure is passed to senior managers, forcing them to achieve the objective, so that the company could show consistent growth and prosperity. The senior managers then pass these pressures to their subordinates through daily management. Therefore, when the performance of the company degrades or the industry is in the downturn, the management board will have the motivation of fraud.
The internal pressures mainly come from the fact that managers’ economic interests are closely related to their job performances. Nowadays most companies maximize shareholders’ wealth by involving management board in the distribution of profits.
But all things have advantages and disadvantages, when a considerable proportion of managers’ income is tied to the company’s performance. Their motivation to manipulate the profit will become stronger.
For the ordinary staff, greed is the primary motivation of fraud. But only greed is not enough to generate the idea of fraud. There are some other reasons, for example dissatisfaction with the existing work or facing extreme financial difficulties.
Fraud is often carefully planned. When people find the possibility of being caught is rather small, they will implement it. So when the company’s organizational structure, internal control and accounting systems have some problems, the likelihood of fraud will increase.
Another important factor to determine people’s behavior is their values. People often tend to behave legally but in some special conditions people will go beyond the legal limit to do some illegal things and even have sufficient reasons to explain their actions. For example, when the company’s corporate culture is not opposed to some of the illegal actions, employees will gradually form dishonest values. When under enormous pressure, it’s easy for them to choose fraudulent actions and think it’s the only way to solve the problem. For example, when facing the situation that the sales of new products can’t meet the target or a huge marketing cost leading the shortage of the company’s fund, the management board will find reasons of fraud. Therefore when people justify their own illegal acts that they do not violate their own values, fraud will easily happen.
(2) Signals
Fortunately, when these factors exist, they will show through a