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Charles Lundelius
Charles Lundelius

What Is Financial Fraud?

Detecting financial fraud in the world of IFRS.

September 8, 2011
by Charles Lundelius, Jr., CPA, ABV

Financial reporting fraud involves the alteration of financial statement data, usually by a firm’s management, to achieve a fraudulent result. These altered financial statements are the tools then used by a company’s managers to obtain some reward. The reward may consist of direct compensation, such as receiving a bonus that otherwise would not be paid without using altered, incorrect financial data to embellish management’s operating performance.

On the other hand, the compensation may be less direct, in that managers avoid being fired for failing to achieve promised results. Compensation may also be indirect (for example, management may use fraudulent financial statements to raise additional capital that, in turn, allows a firm to expand and, presumably, enhance the value of shares held by management).

Financial Fraud in the World of IFRSs

Effective March 4, 2008, the U.S. Securities and Exchange Commission (SEC) allowed foreign private issuers to meet U.S. filing requirements using IFRSs financial statements without having to reconcile those financial statements to U.S. Generally Accepted Accounting Principles (GAAP). This SEC decision opened the door to the use of IFRSs in the United States and laid the groundwork for the roadmap later adopted by the SEC that would require the use of International Financial Reporting Standards (IFRSs) in place of U.S. GAAP for more U.S. registrants in future years. Although the roadmap sets out tests and requirements before the SEC mandates conversion to IFRSs, it is becoming ever more likely that U.S. financial fraud examiners will encounter IFRSs, if they haven’t already.

IFRSs are less detailed in their guidance than U.S. GAAP in that their standard setter, the International Accounting Standards Board (IASB), chooses to use simplified, broad-based standards in place of more detailed prescriptions whenever possible. Simplicity is one of the IASB’s guiding principles, and the IASB will succeed in maintaining simplicity if it can resist pressure to promulgate detailed guidance for specific circumstances. IFRSs will purposely provide less detailed guidance to accountants, allowing for a wider range of presumably equally valid interpretations of a given standard. In other words, two separate reporting entities in the same industry could more readily reach different conclusions on the same standard and report different financial results under IFRSs.

Fraud Under U.S. GAAP Versus IFRSs: An Insurance Accounting Example

There are areas to which the CPA should pay closer attention as IFRSs become more widely used in the United States. Definitions will change, and applications of the new (to U.S. users) IFRSs accounting terms may open the door to more creative fraud. Insurance accounting provides a good example.

Under U.S. GAAP, as well as IFRSs, insurance contracts must transfer a sufficient amount of risk in order to qualify for insurance accounting. With risk transfer, the insurance company, often referred to as a carrier, takes in periodic payments (called premiums) from the insured and assumes, or carries, a risk of having to pay a significant amount back to the insured if a certain event occurs (such as death for a life insurance contract or a natural disaster for a property insurance contract). The premium is considered revenue to the insurance company when earned. Without risk transfer, the purported insurance contract may be nothing more than
a deposit arrangement whereby the insurance company takes in money over time and then pays it back, perhaps with interest, on a later date (that is, little risk is assumed by the insurance company, and the cash flows coming in and going out are rather certain). The periodic cash inflows to the company under a deposit arrangement are not revenues but are recorded as deposit liabilities on the insurance company’s balance sheet, similar to a bank deposit. The presence or absence of risk transfer determines whether the insurance company recognizes income from a contract, and the impact on earnings can be significant.

Risks can be transferred from one insurance company to another through reinsurance, and some carriers prefer to retain some risk while transferring other risk. For example, a property and casualty carrier may be willing to carry the first $100,000 of risk on a given type of policy while transferring, or ceding, any claims risk over $100,000 to reinsurers (the assuming carriers). If the policy limit on claims is $1 million then the carrier issuing the policy retains $100,000 of risk and reinsures $900,000. Several reinsurers may assume the $900,000 of risk transferred, with one, perhaps, assuming a “layer” of risk from $100,001 to $500,000 in claims and another assuming risk from $500,001 to $1,000,000 in claims. The assumption of risk by a reinsurer is accomplished by a contract known as a reinsurance treaty.

Because risks are defined and limited for each of the reinsurers in this example, the contracts for each of the reinsurers are called finite risk reinsurance. The issuing carrier will have to pay some of the premium it receives to the reinsurers to compensate the reinsurers for the finite risks they assume.

Finite risk reinsurance became the focus of regulatory investigations in the early 2000s when certain insurers and reinsurers transferring risks to others in outbound treaties made promises to make whole other reinsurers that assumed those risks. Such a promise would negate risk transfer from the ceding carrier because if the assuming reinsurer suffered a loss under its inbound treaties, the ceding carrier would be obligated to reimburse the assuming reinsurer. The make whole promises typically came in the form of side letters or e-mails that were outside the reinsurance contracts and were thus harder to detect.

IFRSs Impact on Fraud and Regulation

What do simpler IFRSs standards imply for fraud detection and regulatory enforcement? For the CPA, simpler standards allow for more straightforward and, hopefully, clearer directives to apply. Consider the CPA working for a major international insurance carrier with multiple reinsurance agreements. Under U.S. GAAP, the CPA must thoroughly examine how reinsurance treaties may interrelate to assess risk retention. In doing so, the CPA most likely would have to drill down to the underlying insurance contracts under each treaty, become familiar with the extent of risk ceded or assumed relating to those underlying contracts, and assess interrelationships. Under IFRSs, the CPA would have greater certainty that the relevant contract is the one in his or her hands and does not include others that may reside in other divisions or subsidiaries of the same company or other treaties that have yet to be written.

Under IFRSs, the CPA may still have to search for evidence of other simultaneous contracts, which would include a review of correspondence and other agreements executed in close proximity, but an analysis of previous treaties would likely not be as comprehensive.

Under IFRSs, regulators can focus on important and clearer violations. It should be less likely that regulators would snare someone who inadvertently violates an IFRS standard if the standard is simpler. If an insurance company CPA applying U.S. GAAP fails to detect an old treaty that negates risk transfer, he or she has exposure to regulatory punishment; if that same CPA is applying IFRSs, he or she may likely not be held accountable for the old treaties at all when deciding whether to use insurance or deposit accounting.

However, the CPA using IFRSs does not get a free pass when it comes to disclosure. Because IFRS standards are simpler (that is, fewer words), transparency of financial reporting rises in importance to better explain decisions made by management when implementing IFRSs. For insurance contracts, paragraphs 38–39 of IFRS 4 state [a]n insurer shall disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from insurance contracts.

Conclusion

Disclosure will be front and center on the CPA’s fraud battleground of the future. Disclosure has always been important, but simpler standards, such as IFRSs, will place greater emphasis on adequacy of disclosure within the total mix context of U.S. securities laws. The total mix will likely take into account the accounting policies implemented within an industry by and among members of a peer group of firms. If a given firm, utilizing the flexibility afforded by IFRSs, adopts a policy that is different from the peer group without disclosing the departure, that difference may be material if its disclosure would affect the total mix of information evaluated by investors in making buy and sell decisions. Without disclosure, the investor may assume the firm implements accounting policies similar to those of its peers when, in reality, it does not. In the IFRSs environment, the CPA will probably have to evaluate the adequacy of disclosure in the context of disclosures and policies adopted by peer firms. With the coming of IFRSs, disclosure (actually comprehensive disclosure) will be of paramount importance.

This article has been excerpted from Financial Reporting Fraud: A Practical Guide to Detection and Internal Control. This publication is available on CPA2Biz.

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Charles R. Lundelius, Jr., CPA, ABV, CFF, has worked in forensic accounting for 20 years. He assisted in the investigation of the failure of the SEC to uncover Bernard Madoff’s Ponzi scheme.