It is important to understand the motivations for committing FSF as they help in implementing corrective and preventive measures within a company. Donald Cressey, in his book ‘Other People’s Money,’ developed the fraud triangle that identifies the presence of three factors i.e., pressure, opportunity and rationalization that motivate a person to commit fraud.
Table of Contents
Motivations to Commit Financial Statement Frauds
‘pressure’ – when management is under internal and/or external pressure to manipulate financial statements to achieve unrealistic earnings targets, and consequences of not achieving these targets may be detrimental to them.
‘opportunity’ – when an individual believes that there lies an opportunity to use the presence of a loophole in the firm.
‘rationalization’ – the ability of individuals to rationalize the act of fraud.
In light of these motivations, following are the motivations that may drive management to manoeuvre financial statements.
Compensation Gains
Internal pressures are exerted on the managers through the design of executive compensation tied to stock options, remuneration, bonuses, promotion, and job security, which pressurizes the managers to commit FSF to secure compensation gains. Managers display their loyalty towards the company by misrepresenting FS under the pressures of top-level management to ensure job security.
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Sustaining Financial Health Internally
In order to conceal the poor fi nancial health of the business from external stakeholders, managers indulge in false reporting of high earnings to evade debt covenant constraints, meet unrealistic internal financial commitments related to sales, profitability, and rapid growth and offset high interest costs for as long as possible.
The threatened profitability conditions (financial distress or bankruptcy) may propel managers to manipulate or conceal the deteriorating financial performance and health of the business. Managers are motivated to commit FSF to make a new strategy succeed to showcase their leadership qualities and to avoid adverse consequences (layoffs, retrenchment, demotions) resulting from poor financial reporting.
Protecting Market Confidence
Managers are under external pressure to protect market confidence in the business and therefore report inaccurate earnings that are in line with external earnings forecasts. The introduction of national and international regulations that are adverse to the business, cut-throat competition, and rapid changes in industrial and technological environment act as external pressures to motivate managers to indulge in FSF to maintain the financial credibility of the company and to avoid getting delisted from stock exchanges or having to sell their own holdings in the company at a higher price.
Optimizing Capital Structure and Tax Strategy
Under constant external pressure from external stakeholders (investors, lenders) to optimize the capital structure and to minimize tax liabilities, managers may be propelled to manipulate earnings. In order to raise external financing at low cost or to avoid debt covenant restrictions, managers are motivated to indulge in earnings management and also to obtain tax incentives.
While internal users are more interested in knowing about the motivations to falsify financial statements in order to maintain control or reduce motivations, external users are more inclined towards gaining knowledge of red flags to protect their self-interests.
