IFRS and Fraud: More Challenges, More Risks
Three loopholes your firm should look out for.November 3, 2011
by Tracy Coenen, CPA, CFF
Reasonable accountants can disagree about whether a move to International Financial Reporting Standards (IFRS) will improve financial reporting. One key concern is that principles-based financial statements are much more susceptible to fraud. Rather than relying on strict rules, management’s judgment will guide much of the reporting. Clearly this creates a risk of fraud, but how big is the risk?
If we look at companies engaged in financial statement fraud under Generally Accepted Accounting Principles (GAAP) reporting, we often see that the abuse happens in accounts that require judgment in establishing balances. For example, reserve accounts require management to estimate the cost and timing of expenses. Sometimes firms intentionally understate the reserves to boost net income, thereby easily abusing these accounts. Other times, reserves can be overstated to create a cookie jar through which future losses can be concealed.
As IFRS is largely based on judgment in applying principles, it only stands to reason that the risk of fraud in the financial statements will increase with the change.
Fair Value and Judgments
IFRS is geared toward assessing the substance of transactions, and determining what accounting presentation would best reflect the economic reality. Fair value is one of the cornerstones of IFRS, but history has shown us that this basis of accounting is subject to manipulation. Who gets to decide what things are worth? And how do we make those measurements reliable?
IFRS is supposed to bring some sort of uniformity to financial statements across the globe, so that users of the information can make relevant comparisons of data. Unfortunately, the move to a principles based system would seem to create less uniformity, in that it is impossible to know who was making the judgment calls behind numbers, and what factors they considered. To complicate things further, countries around the world are adding their own twists and exceptions to IFRS.
It’s hard not to be skeptical. We want to believe that accountants, managers and executives are using good faith when developing estimates and making judgment calls. That is simply not always the case, as evidenced by the number of cases of errors, restatements and financial statement fraud the U.S. Securities and Exchange Commission (SEC) and financial analysts uncovered with a critical eye. IFRS will likely make it even harder to ferret out the scammers, as there will be few rules against which to measure the assumptions of management.
In the United States (U.S.), the move to IFRS represents a huge change to the accounting and finance functions within companies. Not only will the basis for reporting numbers change, internal controls over financial reporting need to change as well. The old accounting policies and procedures may not be effective in light of the new basis of accounting, and companies must be prepared to make wholesale changes to internal controls if they want their numbers to be credible and reliable.
Technology changes will have to be made as well, and if Europe is any indicator, companies will significantly underestimate the cost for such changes. Increasing the cost of implementation are short-term fixes. Using workarounds such as spreadsheets may seem like a viable answer to technology challenges, but such solutions are not sustainable or reliable, and will probably cost more in the long run.
Special challenges and risks that could increase the risk of fraud as companies implement IFRS reporting standards include:
In particular, accountants and auditors must be on the lookout for schemes to inflate revenue, take advantage of timing differences, conceal liabilities and expenses, improperly value assets and make incomplete or improper disclosures. These have always been risks in the financial reporting process, but IFRS will likely increase these risks substantially.
The world is moving rapidly toward IFRS and U.S. companies can best prepare for the change with adequate staffing, planning and training now. By removing uncertainty from the process, a company is more likely to produce reliable financial data.
Users of financial statements should learn more about IFRS in order to increase their understanding of the new financial statements and to help them compare statements between companies and countries. As always, they should be skeptical of the data, whether or not they believe management to be honest.
No matter what accounting system exists, companies with good corporate governance and ethical cultures will by-and-large do the right thing.
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Tracy L. Coenen, CPA, CFF, is a forensic accountant and fraud investigator with Sequence Inc. in Milwaukee and Chicago. She has conducted hundreds of high-stakes investigations involving corporate embezzlement, financial-statement fraud, securities fraud, investment fraud, tax fraud, and criminal defense. Coenen is the author of Expert Fraud Investigation: A Step-by-Step Guide and Essentials of Corporate Fraud, and has been qualified as an expert witness in both state and federal courts.