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Introduction

Given the unethical practice of some accountants in preparing financial reports which are no faithful representation of the entities they represent and the impact such misconducts have on theinvestment and critical other decisions of stakeholders[1]such as investors and potential investors, this report aims at evaluating the role of financial reporting in the capital market; how financial frauds arise and their impacts on the capital market. In addition, the report evaluates how financial reporting frameworks and changes in accounting regulations can help reduce fraud and misconduct in financial reporting.

Financial Reporting and the Capital Market

Financial Reporting

The process of preparing a written report for users of financial records is referred to as "financial reporting," and the word itself refers to that process.It's the practice of disclosing financial information to whoever might be interested in it (Kyere, 2021). (Depending on the information needs of the end-user, this can be accomplished in a variety of ways, one of which is, but is not limited to, the use of conventional financial statements such as a balance sheet, income statement, and statement of cash flows.(s).As part of the continuing process of financial reporting, periodic reports are distributed at various intervals throughout the course of the fiscal year. Reporting on a company's finances on an interim basis takes place prior to the conclusion of a company's fiscal year and covers intervals of time that are shorter than one year, most frequently months or quarters. (Rezaee, 2014)

Financial reports are vital to a wide range of stakeholders broadly classified as internal and external users. The internal users of a company include the management team and other employees of a company whilst other stakeholders such as investors, potential investors, lenders, and suppliers amongst others constitute the external users. Internal users such as management will largelydepend on the financial reporting to make critical decisions bothering on theanalysing the profitability at all levels, management of cash flow for mature companies or assess fund for start-up companies; build budgets, projections and forecasts and support decisions regarding business expansion or reductionwhilst external users such as potential investors, investors, bankers and suppliers depend on financial reporting to make investment decision bothering on the viability of investing in the shares or other financial instruments of a company, retaining their interest (shares) in a company,make lending and trade credit decisions respectively (Russo, 2022).

Apart from satisfying compliance and legal requirements, producing and announcing financial reports of high quality can help in recognizing performance trends, control entities cash flow, improve the management of working capital, determine the basis for depicting the budgets or forecasts, suffice the purpose of enhancing operations and improving business partners relationship.

Capital Market

The purchasing and selling of a wide variety of financial instruments, including stocks, bonds, and other types of securities, is what the capital market's primary objective is to accomplish. This encompasses both the stock markets and the credit markets as well. They make it simpler for individuals with ideas to start companies, and they assist in the expansion of businesses that have already been started. In addition to this, they make it possible for individuals to save money and increase their overall fortune. (Federal Reserve Bank of St Louis, (2022)).The capital market makes it possible for owners of businesses to gain access to financing in the form of debt capital or ordinary share capital in exchange for a stake or interest in the company. The procedure of issuing or selling equity to members of the general public is known as an initial public offering (IPO). The price of the stock is determined by the gap between the amount that buyers are willing to pay and the amount that sellers are expecting to earn from the transaction. The antonym of an obligation, which is something that needs to be paid back.When a business conducts an initial public offering (IPO), also known as "going public," investors from the outside world are given the opportunity to buy shares of the company. At any given time, the shareholder who holds the most of the company's stock is regarded as the company's largest shareholder. This status can change from moment to moment.(s). (Solomon J. , 2020)

The Role of Financial Reporting in the Capital Market

Financial report plays a significant role in the functioning of an effective capital market. Some the roles played by financial reports in the workings of a capital include but not limited to the following

  1. Provide basis for performance comparison among entities: A major source for comparing the performance of entities operating within the same industry, country or even globally is their published financial reports. This helps investors to make informed decision on which companies to invest in.
  2. Reduces information gap between management of firms and outside investors: Since financial reporting forms the basis on which outside investors get to know the state of entities’ financial wellbeing, producing and publishing financial reports on a regular interval, which aligns with universally acceptable standards keep the investors abreast of the happenings or activities within the organization(s3.studentvip.com, 2020)
  3. Facilitate decision making process for investors and Analyst: Investors and potential investors alike depends largely on published financial reports to make critical decisions bothering on new investment into a company, retention of existing shares in a company or disposal of shares in pursuit of a more rewarding venture(Beaver, 2022). This is because they are able to see how well a company they want to invest in or have invested in is fairing, in terms of their ability to make profit, remain liquid[2] and maintain a right balance of gearing[3] that optimizes the overall cost of capital[4]. Similarly, the starting point of determining what value to be placed on the shares of a company by investment analyst is the audited and published financial reports (Kothari, The role of financial reporting in reducing financial risk, 2019)..
  4. Helps in monitoring performance trends of companies: One major way by which external stakeholders such shareholders and other providers of capital monitors and track the performance of the entities they have invested their fund is by reviewing the published financial reports of such entities(Wixley).

Financial Reporting Frauds and their Impacts on the Capital Market

Fraud

Using dishonest means to obtain something of value is fraudulent. When someone "knowingly misrepresents the truth or conceals a material fact in order to induce another to act to his or her detriment," they have committed the crime of fraud.”. (Association of Certified Fraud Examiners, 2023)

The diagram below summarises the rationale for committing fraud.

Source: https://www.rlb.ca/fraud-awarenes 1

Classification of Fraud

Fraud can be categorized in a number of ways. The diagram below summarizes the major ways by which frauds can be classified;

Source: https://www.acfe.com/-/media/fil 1.

However, for the purpose of this report, the focus will be on financial statement fraud withemphasis on those emanating from preparation and presentation of financial reports.

Financial Reporting Fraud and its Types

Financial reporting fraud as a ‘deliberate attempt by corporations to deceive or mislead users of published financial statements, especially investors and creditors, by preparing and disseminating materially misstated financial statements (Rezaee, 2014).

Themain types of fraud resulting from the preparation and presentation of financial statement include but not limited to;

If a business falsely claims it has gotten payment before all promised goods and services have been provided, it is committing fraud. Prematurely recording anticipated or speculative future purchases can accomplish this. Overstating sales can give investors and potential buyers a distorted image of the company's financial health and drive up the stock price (Beaver, 2022).

Double counting sales, making up fictional customers, inflating or falsifying genuine bills for real purchasers, and other such practices can all contribute to the creation of fraudulent "fictitious revenue."

 When a company exaggerates the value of its assets by failing to take into consideration the effects of depreciation or to set aside a valuation reserve, such as inventory reserves, the company has committed fraud. The increase in retained earnings and net sales will cause a corresponding increase in the wealth of the shareholders. (Celina, 2022)

 The intentional omission of responsibilities or commitments in order to artificially inflate equity, assets, and/or net earnings is an example of the fraudulent practice known as "concealment," which is a subtype of the more general category of fraud. Loans, sales warranties, and unreported salaries, benefits, and vacation time are some examples of expenditures that could fall under the category of "hidden costs." (Beaver, 2022)

It is possible to prevent users from being deceived by providing accurate and uncomplicated summaries of financial information. If it is anticipated that complying with the new accounting standards will have a significant effect on the financial records, then the change should be acknowledged. What constitutes deception in financial statements is the concealment or omission of material facts or information that is material. Coverage includes every material occurrence, transaction involving connected parties, contingent obligation, and accounting adjustment.

The recording of expenditures in a manner that is either inaccurate or incomplete is an additional type of financial statement fraud. Because of inflated net revenue and understated expenditures, the true condition of the company's finances has been given an inaccurate impression.

How Financial Reporting Fraud Arise and their Impact on Capital Market.

Causes of Financial Reporting Fraud

Financial reporting fraud can be attributable to the factors identified and explained below;

  1. Lack of adequate controls or failing control mechanism: The opportunity to commit fraud arises when control mechanisms are absent or the available control within an organization are failing. In situation, it will be easy to carry fraud out since the manager will be free and without control within the company. Further still, it is possible for senior managers to circumvent or override existing controls, especially if the external governance mechanisms such as the regulators, or internal ones such as the board of directors, are insufficient or less effective. When they commit fraud, the managers of a company know very well the operations within the company and have access to data and systems. The effect of such misconduct can be alarming and almost uncontrollable when the executives involved get the buy-in or support of major shareholders, this will make them in a position of strength, while reducing the role of the board of directors to which they belong. Managers can therefore exercise absolute control over the company(Chenguel, 2022).
  2. Pressure to meet certain targets: Another opportunity that favours fraud is the pressuretowards meeting high performance target; this usually happen during stock market bubbles[5]. Over time, rapid deflations of stock market bubbles are very often accompanied by the manifestation of fraud committed by business managers. Usually, the stock quotes of several companies always reflect expectations of optimistic profits, which implies very high growth rates. Any profit announcement that does not meet stock market expectations will result in a sharp drop in the stock price. In this context, if the performance of the company begins to decline, the management of the company will be forced to manipulate the accounting results to ensure that the earnings per share announced meet or even exceed market expectations. Investors then imposed a stock market valuation, at an increasing, unrealistic rate, which forces managers to fraud, by favouring accounting manipulations(Harris, 2007).

Impact of Financial Reporting Fraud on the Capital Market

There is no gainsaying that shareholders depend largely on published financial statement of entities to make investment decision, preparing and reporting financial statement that does not reflect a fair view of the financial state of an organization have dire consequences on these unsuspecting investors. These impacts can be summarised as follows;

If investors place their trust in fraudulently generated financial reports, they run the risk of suffering financial losses. Because of this, investor confidence in the effectiveness and efficiency of the capital market is likely to continue to decline, if not completely disappear. (Celina, 2022)

If a business has been found to have committed fraudulent financial reporting, the price at which its stock and other financial instruments are sold will be lower than the price at which they are sold for businesses in a comparable situation that have not been found to have committed such an infraction. This implies that the return on investment for those who have money invested in the company will be lower.

When a business has a history of presenting financial statements that do not accurately represent its financial health, investors and lenders may demand higher returns on their money. This is because the company is not being honest with them. If the business needs to borrow money or acquire funds at a higher rate, it will be less able to make investments in promising prospects or pay dividends to shareholders. When a company's trustworthiness is damaged as a result of the publication of false or misleading financial statements, the company might be required to pay a higher cost for the financing it requires. (Apoorva A, 2023) 

Financial Reporting Framework and Regulation and Reduction of Fraud and Misconduct

Financial Reporting Framework

(Okoye, (2014)) posit the underlisted as the basic reasons for the adoption of financial framework. An organization is required to adhere to a set of fundamental accounting assumptions, principles, and methods known as a "financial reporting framework" in order to prepare, present, and report financial statements for a wide variety of entities, including publicly listed companies and privately - held companies, non-profit organizations, and the public sector-government. These entities include publicly traded companies and privately held companies. (Olakunori, 2009). The laws, regulations, rules, and standards governing accounting are decided upon by regulatory authorities in each nation, as well as by the International Accounting Standards Board (IASB) and the International Financial Reporting Standards Board. These bodies are responsible for establishing the foundation for financial reporting. (IFRSB). The presumptions, guiding principles, and limiting circumstances that form the basis of the norms that have been established are as follows. The accounting framework that is commonly known as Generally Accepted Accounting Principles (GAAP) should not be treated as gospel by those who are responsible for the preparation of financial statements.

Changes in Accounting Regulation and Reduction of Fraud and is Conduct in Financial Reporting

Over the years, variousbodies responsible for regulating the practice of preparing and presenting financial statements have continuously see need to update or modify the underlying principles or assumptions guiding the preparation and presentation of financial statements.One of the basic reasons for this constant review bothers on addressing the inadequacies observed with existing standards, as preparers of financial statement uses them. Another reason why such changes are necessary is that for financial statements to maintain its value of faithful representation of an entity financial state and relevance in making economic decision, it must take cognizance of the current trend and changes in the economy and give consideration to these changes when setting basis on which financial reports will be prepared (Puni & Anlesinya, 2020).

The place of changes in accounting regulations in addressing the concerns around fraudulent financial reporting cannot be overemphasised because of the reasons noted below;

  1. Changes in accounting regulations will usually lead to a set of high-quality and transparent global standards that are intended to achieve consistency and comparability across the world. This to a large extent limit the potential for creative accounting by those who make practice of it. 
  2. Changes in accounting regulations is usuallya thought through consultative process among internationally renowned standard setters, with the aspiration of achieving consensus and global convergenceand thus have the tendencies to reduce the practice of fraudulent financial reporting.
  3. Only companies that complies with updated changes in accounting regulations and have their financial statements audited in accordance with International Standards on Auditing (ISA) will have an enhanced status and reputation. The guidance or restrictions which these changes will normally bring reduces the likelihood of preparing and presenting financial statements that are no true or faithful representation of the state of financial affairs of the company. 
  4. Complying with changes in accounting regulations is a core requirement for a set of financial statement to be certified ‘true and fair’ by the auditing team of an entity. Where there is a contrary opinion by the auditors, the entity is a t a risk of jeopardizing its reputation in the public. This forces companies to comply with these changes which has the objective of ensuring that financial statements are produced with outmost integrity and objectivity thus reducing the potential for misstatement, errors or deliberate fraudulent reporting.

Limitations of Financial Reporting Framework in Reducing Financial Reporting Fraud and Misconduct

As much as setting financial reporting framework has lot benefits some of which have been discussed in a portion of the previous section, it is not without some limitations.

  1. Limitation in scope: The range of issues that can be addressed under the conceptual framework is limited to those within its scope. This still give professionals who have make a practice of manipulating financial statement to carry out their acts of deception and misleading(Celina, 2022).
  2. Limitation in jurisdiction:Financial reporting framework and changes to them will sometimes not consider all the possible situations across different jurisdictions and locations of the world. For perpetrators of financial reporting fraud who report for multinational organizations, this loophole will allow them the opportunity to present an unfair view of their entity financial state particularly for locations where such loopholes have been identified(Celina, 2022).
  3. Difficulty in understanding: Arguably, a significant number of conceptual frameworks that have been developed and modified over the years are not understood by some participants of the capital market. This gives scrupulous professionals, who have mastered the act of manipulation to hide under such lack of understanding to present statements that are not true reflection of the financial statement(Bhagat, 2019).
  4. Connivance between top managers and major shareholders: Again, there is little financial reporting framework or changes to them can do when top executives and major shareholders have joined forces to deceive and manipulate the result coming out of an entity. Again, where a fraudulent CEO doubles as a major shareholder, the framework or changes to them might no be able to address the potentials for producing and presenting an untrue state of financial affairs.

Conclusion

The damage financial reporting fraud and misconduct has done to the capital markets across the globe cannot be underestimated. Many investors have been distressed by these unprofessional acts whilst so many companies have lost their reputation and others gone bankrupt and eventually liquidated. This is as a result of some professionals making a practice of reporting financial affairs of the entities, they represent in manners that does not reflect the true state of the financial well being of the organization.

Accounting framework and constant changes in regulations have played a significant role in restricting the likelihood of the occurrence of these acts whilst also addressing the concerns that these acts create over time.Notable improvements have been witnessed from many of the capital markets across the world. However, the truth still is that the framework and the changes in accounting regulations cannot completely eradicate these practices but might reduce it to the barest minimum. A major reason for this conclusion is that when frameworks and regulations are developed or modified, they will not usually capture all realities in different jurisdiction and this create a loophole for fraudulent reporters to carry out their mischievous acts. 

In addition to the constant review of accounting regulations and development of framework guiding the preparation and presentation to help prevent financial reporting fraud and misconducts, the steps identified and explained can be of value in preventing and addressing the concern around the unprofessional conduct of fraudulent reporting.

Segregation of Duties

The concept of "segregation of duties" states that no one employee in the accounting department should be responsible for multiple tasks that could open the door to fraud. various workers should be responsible for various tasks, such as recordkeeping, authorizing, and reviewing. Errors and other improper actions that could lead to fraud are less likely when duties are separated.

Organizations should at least divide up tasks like checking accounts, composing checks, and making financial statements. (Russo, 2022)

Set up a System of Conciliation

Important key accounts must be reconciled in a formal, methodical manner as part of an internal control. For instance, you should compare your payments to the records of all checks that came in. Verify that payments are not being sent out of order by frequently reviewing bank statements and canceled checks. (which can indicate the presence of missing reviews and fraudulent activities).

In accordance with the segregation of tasks, reconciliation should be handled by a separate party who is not responsible for bookkeeping or signing checks. This authorized individual should sign and date the reconciliation report to attest to the fact that the reconciliation was carried out, when it was carried out, and by whom.

Employees should be made aware that their accounts will be reviewed and reconciled on a regular basis, and that any discrepancies will be fully investigated. Having this knowledge may make it less appealing to falsify financial records.

Employ a Third Party Auditor

Management deception against financial statements is common. Financial statements should be reviewed yearly by a qualified auditor to avoid this. (For publicly traded companies in the United States, for example, annual external audits are required by law.)

Set a Strong Tone at the Top

Only when there is firm leadership can internal accounting rules thrive. Management should act ethically, make a commitment to honesty and integrity, and set a good model for their employees. It would be beneficial to have written policies in place to disseminate the company's ethics, beliefs, and procedures company-wide.

The repercussions for failing to adhere to these processes should also be clearly laid out in writing. All policies need the stamp of approval from the board.

References

Apoorva A. (2023). cleartax.in. Retrieved March 09, 2023, from https://cleartax.in/g/terms/financial-fraud

Association of Certified Fraud Examiners. (2023). https://www.acfe.com/. Retrieved March 09, 2023, from https://www.acfe.com/fraud-resources/fraud-101-what-is-fraud#:~:text=%E2%80%9CFraud%E2%80%9D%20is%20any%20activity%20that,%E2%80%9D%20(Black's%20Law%20Dictionary).

Beaver, S. (2022). netsuite.com. Retrieved March 18, 2023, from https://www.netsuite.com/portal/resource/articles/accounting/financial-statement-fraud.shtml

Bhagat, S. &. (2019). Corporate governance and firm performance:. The sequel. Journal of Corporate Finance, , 58, 142-168.

Celina. (2022). myassignmentservices.com. Retrieved March 18, 2023, from https://www.myassignmentservices.com/blog/conceptual-framework-in-accounting#:~:text=It%20also%20has%20limitations%20as,between%20one%20company%20and%20another.

Chenguel, M. B. (2022). Corporate Social Responsibility (1st ed., Vol. 32). London: IntechOpen Limited.

Federal Reserve Bank of St Louis. ((2022)). www.stlouisfed.org. Retrieved March 03, 2023, from https://www.stlouisfed.org/education/tools-for-enhancing-the-stock-market-game-invest-it-forward/episode-1-understanding-capital-markets#:~:text=Capital%20markets%20are%20financial%20markets,businesses%20grow%20into%20big%20companies.

Harris, J. a. (2007). Incentives to cheat: The influence of executive compensation and firm performance. Organiozation Science , 2 (18), 350-367.

Isa, T. (2011). Impacts and Losses Caused By the Fraudulent and Manipulated Financial Information on Economic Decisions . CORE , 12 (5), 929-939.

Kothari, S. ((2019), June 08). The role of financial reporting in reducing financial risk. Retrieved March 08, 2023, from https://core.ac.uk/download/pdf/6706729.pdf

Kothari, S. (2019, June 08). The role of financial reporting in reducing financial risk. Retrieved March 08, 2023, from https://core.ac.uk/download/pdf/6706729.pdf

Kyere, M. &. (2021). Corporate governance and firms financial performance in the United Kingdom., . International Journal of Finance & Economics , 26(2), 1871-1885.

Ndofor, .. e. (2013). Providing CEOs With Opportunities to Cheat:The Effects of Complexity-Based Information Asymmetries on Financial Reporting Fraud. Journal of Management , 41 (6), 1774-1797.

Okoye, P. ((2014), March). Financial reporting framework in Nigeria and the adoption of the international financial reporting standards. International Journal of Business and Economic Development , pp. 52-63.

Olakunori, D. (2009, June). Financial reporting framework. American Economic Review , pp. 114-119.

Puni, A., & Anlesinya, A. (2020). Corporate governance mechanisms and firm performance in a developing country. International Journal of Law and Management, , 62(2), 147-169.

Reciprocity. (2022). reciprocity.com/. Retrieved March 20, 2023, from https://reciprocity.com/blog/internal-controls-to-prevent-financial-statement-fraud/

Rezaee, Z. (2014). Causes, consequences, and deterence of financial statement fraud. ELSEVIER , 16 (3), 277-298.

Russo, K. (2022). Oracle NetSuite. Retrieved March 02, 2023, from https://www.netsuite.com/portal/resource/articles/accounting/financial-reporting.shtml#:~:text=Financial%20reporting%20%E2%80%94%20the%20communication%20of,information%20needs%20of%20the%20reader.

s3.studentvip.com. (2020). s3.studentvip.com. Retrieved March 22, 2023, from https://s3.studentvip.com.au/notes/19385-sample.pdf

Solomon, J. (. (n.d.). Corporate governance and accountability. . John Wiley & Sons.

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Wixley. Corporate Governance 5ed. . 2018: Siber Ink.

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