LOS E requires us to:
describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports
Merely the motive for low-quality reporting is not sufficient to have poor financial reports, it should be accompanied by the existence of conditions that could conducive to such unfair reporting. There should be the existence of the three factors, typically referred to as ‘fraud triangle’ which instigates low-quality reporting, they are:
a. Motivation. As discussed, there should be a motivation, either for personal or corporate reasons to produce low-quality reports.
b. Opportunity. Motivation alone cannot be a driving force unless there exists an opportunity that can be explored for producing low-quality reports. They may exist in form of poor internal controls, management overriding internal controls, or ineffective board of directors.
c. Rationalization. The management must find rationales for poor quality reporting to justify their actions. These rationales may range from the need to overcome a tough time that a company is facing, that could be reversed at a later stage, or the protect stock price at the time of hostile takeovers, etc.
Thus, generally, when there is the existence of poor quality reports, it is due to the presence of motivation coupled with the existence of opportunities, backed by the rationalization of behavior by the management.