Introduction to Fraud Examination Chapter 1 Introduction to Fraud Examination

Learning Objectives Define fraud examination and differentiate it from auditing. Understand the fraud theory approach. Define occupational fraud. Define fraud. Define abuse. Know the difference between fraud and abuse. Describe the criminological contributions of Edwin H. Sutherland. Understand Donald Cressey’s hypothesis. Give examples of non-shareable problems that contribute to fraud. Understand how perceived opportunity and rationalization contribute to fraud. Explain W. Steve Albrecht’s “fraud scale.” Summarize the conclusions of the Hollinger-Clark study. Summarize the results of the 2010 Report to the Nations on Occupational Fraud and Abuse.

Discipline of Fraud Examination Resolving allegations of fraud from tips, complaints, or accounting clues Documentary evidence Interviewing witnesses Writing investigative reports Testifying Assisting in the detection and prevention of fraud Forensic accounting vs. fraud examination

Auditing vs. Fraud Examination Issue Auditing Fraud Examination Timing Recurring Nonrecurring Scope General Specific Objective Opinion Affix blame Relationship Nonadversarial Adversarial Methodology Audit techniques Fraud examination techniques Presumption Professional Proof skepticism

Fraud Examination Methodology Predication Totality of circumstances that would lead a reasonable, professionally trained, and prudent individual to believe a fraud has occurred, is occurring, and/or will occur Fraud examinations must be based on predication.

Fraud Theory Approach Analyze available data Create a hypothesis Test the hypothesis Refine and amend the hypothesis

Tools Used in Fraud Examination Document Analysis Neutral Third-Party Witnesses Corroborative Witnesses Co-Conspirators T Target Observation

Defining Occupational Fraud and Abuse The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets

Elements of Fraud A material false statement Knowledge that the statement was false when it was uttered Reliance on the false statement by the victim Damages resulting from the victim’s reliance on the false statement

Occupational Fraud and Abuse Research Edward Sutherland Donald Cressey Cressey’s Hypothesis

Opportunity Fraud Triangle Pressure Rationalization

2010 Report to the Nations on Occupational Fraud & Abuse Global survey Measuring the costs of occupational fraud 5 percent lost to fraud $2.9 trillion worldwide

Position of Perpetrator

Median Loss by Position

Gender of Perpetrator

Median Loss by Gender

Department of Perpetrator

Median Loss by Department

Criminal History of Perpetrator

Median Loss per Number of Employees

Initial Detection of Frauds

Occupational Fraud and Abuse Corruption Asset Misappropriations Fraudulent Statements Conflicts of Interest Cash Financial Bribery Inventory & All Other Assets Nonfinancial Illegal Gratuities Economic Extortion

Frequency of Types of Occupational Fraud and Abuse

Median Loss of Types of Occupational Fraud and Abuse

Chapter 2 Skimming

Chapter Objectives Define skimming. List and understand the two principal categories of skimming schemes. Understand how sales skimming is committed and concealed. Understand schemes involving understated sales. Understand how cash register manipulations are used to skim currency. Be familiar with how sales are skimmed during non-business hours. Understand the techniques discussed for preventing and detecting sales skimming.

Chapter Objectives List and be able to explain the six methods typically used by fraudsters to conceal receivables skimming. Understand what “lapping” is and how it is used to hide skimming schemes. Be familiar with how fraudsters use fraudulent write-offs or discounts to conceal skimming. Understand the techniques discussed for preventing and detecting receivables skimming. Be familiar with proactive audit tests that can be used to detect skimming.

Skimming Schemes Skimming Sales Receivables Refunds & Other Write-off Unrecorded Write-off Schemes Understated Lapping Schemes Unconcealed

Skimming Theft of cash from a victim entity prior to its entry in an accounting system “Off-book” No direct audit trail Its principal advantage is its difficulty of detection.

Asset Misappropriations 2009 Global Fraud Survey Scheme Type % of Asset Misappropriation Cases Median Loss Cash Misappropriations 85.6% $120,000 Non-Cash Misappropriations 20.3% $90,000

Frequency of Cash Misappropriations

Median Loss of Cash Misappropriations

Sales Skimming Employee makes a sale of goods or services, collects the payment, and makes no record of the transaction. Employee pockets the proceeds of the sale. Without a record of the sale, there is no audit trail.

Sales Skimming After hours sales Skimming by off-site employees Cash register manipulation “No sale” or other non-cash transaction is recorded. Cash registers are rigged so that sales are not recorded on the register tapes. No receipt is issued. After hours sales Sales are conducted during non-business hours without the knowledge of the owners. Skimming by off-site employees Independent salespeople Employees at remote locations – branches or satellite offices away from the primary business site

Sales Skimming Poor collection procedures Understated sales Sale is recorded for a lower amount than was collected. Price of sales item is reduced. Quantity of items sold is reduced. Theft in the mail room – incoming checks Incoming checks are stolen and cashed. Customer’s account is not posted.

Preventing and Detecting Sales Skimming Maintain a viable oversight presence at any point. Create a perception of detection. Install video cameras. Utilize customers to detect and prevent fraud. All cash registers should record the log-in and log-out time of each user. Off-site sales personnel should also be required to maintain activity logs. Eliminate potential hiding places for stolen money. Incoming mail should be opened in a clear, open area free from blind spots and with supervisory presence.

Receivables Skimming More difficult than skimming sales There is a record of the sale. Collection is expected. Customers are notified when payment is not received and will most likely complain. Lapping Force balancing Stolen statements Fraudulent write-offs or discounts Debiting the wrong account Document destruction

Receivables Skimming Lapping Force balancing Stolen statements Crediting one customer’s account with payment received from another customer Keeping track of payments becomes complicated. Second set of books is sometimes kept. Force balancing Posting to the customer’s account without depositing the check creates an imbalance condition. Cash account is overstated so the amount skimmed must be forced in order to balance the account. Stolen statements Employee steals or alters the account statement or produces counterfeit statements. May change the customer’s address in order to intercept the statement

Receivables Skimming Fraudulent write-offs or discounts Write off the account as bad debt. Post entries to a contra revenue account – “discounts and allowances.” Debiting the wrong account Debit an existing or fictitious A/R. Wait for the A/R to age and be written off. Destroying or altering records of the transaction Often a last ditch effort to conceal the fraud Makes it more difficult to prove the fraud

Preventing and Detecting Receivables Skimming Succeed when there is a breakdown in an organization’s controls Mandate vacations. Mandate supervisory approval. Train audit staff. Proactively search for accounting clues. Perform trend analysis on aging of customer accounts. Conduct audit tests.

Chapter 3 Cash Larceny

Pop Quiz What is the difference between larceny and skimming?  

Learning Objectives Define cash larceny. Understand how cash receipts schemes differ from fraudulent disbursements. Recognize the difference between cash larceny and skimming. Understand the relative frequency and cost of cash larceny schemes as opposed to other forms of cash misappropriations. Identify weaknesses in internal controls as inducing factors to cash larceny schemes. Understand how cash larceny is committed at the point of sale.

Learning Objectives Discuss measures that can be used to prevent and detect cash larceny at the point of sale. Understand and identify various methods used by fraudsters to conceal cash larceny of receivables. Understand schemes involving cash larceny from deposits including lapping and deposits in transit. Understand controls and procedures that can be used to prevent and detect cash larceny from bank deposits. Be familiar with proactive audit tests that can be used to detect cash larceny schemes.

Larceny Of Cash on Hand From the Deposit Other

Cash Larceny Intentional taking away of an employer’s cash without the consent and against the will of the employer Fraudulent disbursements Cash receipt schemes

Frequency – Cash Misappropriations

Median Loss – Cash Misappropriations

Cash Larceny Schemes Can occur under any circumstance in which an employee has access to cash At the point of sale From incoming receivables From the victim organization’s bank deposits

Larceny at The Point of Sale It’s where the money is Most common point of access to ready cash Results in an imbalance between the register tape and cash drawer

Larceny Schemes Theft from other registers Death by a thousand cuts Using another cashier’s register or access code Death by a thousand cuts Stealing small amounts over an extended period of time Reversing transactions Using false voids or refunds Causes the cash register tape to balance to the cash drawer Altering cash counts or cash register tapes Destroying register tapes

Preventing and Detecting Cash Larceny at the Point of Sale Enforce separation of duties Independent checks over the receipting and recording of incoming cash Upon reconciliation of cash and register tape, cash should go directly to the cashier’s office Discrepancies should be checked, especially if a pattern is identified Periodically run reports showing discounts, returns, adjustments, and write-offs by employee, department, and location to identify unusual patterns

Larceny of Receivables Theft occurs after the payment has been recorded Force balancing Having total control of the accounting system can overcome the problem of out-of-balance accounts Can make unsupported entries in the books to produce a fictitious balance between receipts and ledgers Reversing entries Post the payment and then reverse the entry through “discounts” Destruction of records Destroying the records can conceal the identity of the perpetrator even though the fraud has been discovered

Cash Larceny From The Deposit Whoever takes the deposit to the bank has an opportunity to steal a portion of it Having controls—such as matching the receipted deposit slip to the originally prepared slip—does not always prevent theft Failure to reconcile the slips can foster an environment leading to theft Lack of security over the deposit before it goes to the bank can also lead to theft

Cash Larceny From The Deposit Deposit lapping Day one’s deposit is stolen and is replaced by day two’s deposit . . . . Deposits in transit The missing money is carried as a deposit in transit but it never clears the bank statement

Preventing and Detecting Cash Larceny From The Deposit Separation of duties is the most important factor All incoming revenues should be delivered to a centralized department Compare the authenticated deposit slip with the company’s copy of the deposit slip, the remittance list, and the general ledger posting of the day’s receipts Two copies of the bank statement should be delivered to different persons in the organization Require that deposits be made at a night drop at the bank

Chapter 4 Billing Schemes

Pop Quiz What is a pass-through billing scheme?

Learning Objectives List the five major categories of fraudulent disbursements. Define the term “billing schemes.” List the three categories of billing schemes. Understand what a shell company is and how it is formed. List and understand the four ways false invoices are approved for payment. Understand why most shell company schemes involve the purchase of services rather than goods. Understand how a pass-through scheme differs from the usual shell company schemes. Be familiar with the methods identified in this chapter for preventing and detecting shell company schemes.

Learning Objectives Understand how pay-and-return schemes work. Understand how non-accomplice vendor schemes work. Be familiar with the methods identified in this chapter for preventing and detecting non-accomplice vendor schemes. Understand how personal purchases schemes work. Be familiar with the methods identified in this chapter for preventing and detecting personal purchases schemes. Be familiar with proactive audit tests that can be used to detect billing schemes.

Billing Schemes Shell Company Non-Accomplice Vendor Personal Purchases

Frequency of Fraudulent Disbursements

Median Loss of Fraudulent Disbursements

Billing Schemes The perpetrator uses false documentation to cause a payment to be issued for a fraudulent purpose Fraudulent disbursement is issued in same manner as a legitimate disbursement Schemes Shell company schemes Non-accomplice vendor schemes Personal purchases schemes

Shell Company Schemes Fictitious entities created for the sole purpose of committing fraud Bank account is usually set up in the company’s name Forming a shell company Certificate of incorporation or assumed-name certificate set up Shell company may be formed in someone else’s name Best way is to set up company under a fictitious name Set up entity’s address – home address, post office box, or friend/relative’s address

Shell Company Submitting false invoices Invoice is manufactured using a professional printer, personal computer, or typewriter Self-approval of fraudulent invoices Most fraudsters are in a position to approve payment Approvals may be forged “Rubber stamp” supervisors Don’t check the documentation Approve whatever is submitted Reliance on false documents Without approval authority, fraudster submits false documents – purchase order, invoice, and receiving report

Shell Company Collusion Purchases of services rather than goods Two or more employees conspire to steal More difficult to detect Circumvents controls implemented to prevent fraud Purchases of services rather than goods Purchases of service are preferable to purchases of goods Services are intangible and fraud is more difficult to detect Pass-through schemes Goods or services are purchased by the employee and resold to the victim company at an inflated price

Preventing and Detecting Shell Company Schemes Maintain and regularly update an approved vendor list Independently verify all vendors before payment Identifying shell company invoices Lack of detail on the fraudulent invoice Invoice that lacks detailed descriptions of the items billed Mailing address may be an indicator of fraud Consecutively numbered invoices over a period of time Reviewing payables and sorting payments by vendor and invoice number

Preventing and Detecting Shell Company Schemes Testing for shell company schemes Investigate budget overruns and departments that regularly exceed their budget Conduct horizontal analysis of expenses Investigate unexplained increases in “soft” accounts Investigate unexplained increases in quantity of items purchased

Preventing and Detecting Shell Company Schemes Testing for shell company schemes Monitor trends in average unit price Investigate goods and services that would not normally be purchased Compare vendor addresses to employee addresses Run reports of average turnaround time for invoices to look for unusual payment patterns

Preventing and Detecting Shell Company Schemes Verifying whether a shell company exists Use the phone book to verify the vendor Contact others in the industry Verify vendor’s address through a site visit or by using satellite imaging software Identifying the employee behind a shell company Conduct a public records search of the company’s registration Be alert for related names, addresses, phone numbers, Social Security numbers, and other identities Match vendor payments with payroll checks Conduct surveillance of mail drops to see who picks up the checks

Billing Schemes – Non-Accomplice Vendors Vendor is not a part of the scheme Pay-and-return schemes Payments owed to legitimate vendors intentionally mishandled Double pay an invoice Pay the wrong the vendor Overpay the invoice amount Purchase excess merchandise Overbilling with a non-accomplice vendor’s invoices Fake invoice is created for a vendor that regularly does business with victim organization Rerun an invoice already paid

Preventing and Detecting Non-Accomplice Vendor Fraud Incoming checks should be photocopied and attached to the remittance advice Regarding overpayments, banks should be instructed not to cash checks payable to an organization Spot check past accounts payable files when a pay-and-return scheme is suspected

Personal Purchases With Company Funds Employees make personal purchases for themselves, their businesses, their family, or their friends using company money Perpetrator causes the victim company to order and pay for an unneeded asset

Personal Purchases Through False Invoices The fraudster is authorizer of invoices Falsifying documents such as purchase orders to obtain authorization Altering existing purchase orders False purchase requisitions Misrepresent the nature of the purchase Change the delivery address of the purchase

Company cards may be stolen or “borrowed” from authorized users Personal Purchases on Credit Cards, Purchasing Cards, or Other Company Accounts Employees make purchases using their company credit cards, purchasing cards, or running accounts with vendors Company cards may be stolen or “borrowed” from authorized users Charge accounts Employees order items using an existing account with the vendor Returning merchandise for cash/credit Employee purchases a good or service, receives reimbursement, and then returns the item for a credit

Preventing and Detecting Personal Purchases Conduct a thorough review of each credit card or purchasing card statement independent of the signature authority Only original support for the reimbursement should be allowed Card issuer should send two copies of the statement to two different individuals within the organization Card statements should be compared with employee expense vouchers for duplications, and monitored for unexplained increases in purchasing levels

Chapter 5 Check Tampering

Learning Objectives Define check tampering. Understand the five principal categories of check tampering. Detail the means by which employees fraudulently obtain company checks. Understand how forged signatures are created on blank check stock. Be familiar with the methods identified in this chapter for preventing and detecting forged maker schemes. Differentiate between forged maker and forged endorsement schemes. Detail the methods employees use to intercept outgoing checks before they are delivered to the intended payee.

Learning Objectives Be able to discuss methods that can be used to prevent and detect the theft and/or alteration of outgoing company checks. Understand how authorized maker schemes work and why they are especially difficult to prevent. Understand how check tampering is hidden in a company’s accounting records. Describe measures companies can take to prevent and detect fraudulent electronic payments. Be familiar with proactive audit tests that can be used to detect check tampering.

Check Tampering Forged Maker Forged Endorsement Altered Payee Concealed Checks Authorized Maker

Frequency of Fraudulent Disbursements

Median Loss of Fraudulent Disbursements

Check Tampering Schemes Perpetrator physically prepares the fraudulent check Depend on: Access to check stock Access to bank statements Access to cash disbursements journal Ability to forge signatures or alter other information on the check

Forged Maker Schemes An employee misappropriates a check and fraudulently affixes the signature of an authorized maker Must have: Access to a blank check Convincing forgery of an authorized signature Ability to conceal the crime

Obtaining the Check Employees having access to company checks A/P clerks, office managers, bookkeepers Employees lacking access to company checks Checks poorly guarded Producing counterfeit checks

Safeguarding the Check Stock Maintained under lock and key Access limited to those with check preparation duties Boxes of blank checks should be sealed with security tape Periodically check the security of unused checks Voided check should be promptly destroyed Checks should be printed on watermark paper with security threads and distinctly marked paper Out-of-sequence canceled checks and duplicate check numbers should be investigated Each day the first check of the day should be reconciled to the last check written the previous day

To Whom Is The Check Made Payable? Perpetrator Accomplice “Cash” Vendors

Forging the Signature Free-hand forgery Photocopied forgeries May not need to be particularly accurate Photocopied forgeries Photocopies are made of legitimate signatures and affixed to the check Automatic check-signing mechanisms Produce perfect forgeries

Forged Maker Schemes Concealing the fraud Converting the check Miscode the check Converting the check Fake identification may be needed Checks made payable to “cash” require the endorsement of the person converting the check thus leaving a clue as to the identity of the forger

Preventing and Detecting Forged Maker Schemes Safeguard blank check stock Establish rules for custody of checks that have been prepared but not signed Separate duties of check preparer and check signers Rotate authorized check signers when possible and keep track of authorized signers Strictly limit access to signature stamps

Forged Endorsement Schemes Employee intercepts a company check intended for a third party Signs the third party’s name on the endorsement line of the check

Intercepting Checks Before Delivery Employee involved in delivery of checks Poor controls of signed checks Theft of returned checks Rerouting the delivery of checks Converting the stolen check

Preventing and Detecting the Theft of Outgoing Company Checks Separate the functions of cutting checks, check signing, and delivery of checks Employees should be trained to look for schemes involving check theft Investigate vendor and customer complaints Accounting system should identify duplicate payments

Preventing and Detecting the Theft of Outgoing Company Checks Authority to make changes to vendor records should be restricted Periodic report listing all changes to vendor records should be generated to determine if there is an unusual number of changes made Investigate canceled checks with dual endorsements and non-payroll checks signed by an employee Chart the date of mailing for every outgoing check so that if a check is stolen, you can determine who worked in the mailroom on the date it was stolen

Altered Payee Schemes Employee intercepts a company check intended for a third party Payee designation is altered so the check can be converted Less chance of discovery unless canceled checks are reviewed during reconciliation

Altering Checks Prepared by Others Inserting a new payee A false payee’s name is inserted in place of the true payee’s name Accounts payable system is manipulated and the payee’s name is changed “Tacking on” Letters or words are added to the end of the real payee designation

Altering Checks Prepared by the Fraudster Erasable ink Erasing typewriters Erasable pens Pencils Blank checks Authorized signer signs a check left blank to be filled in by the fraudster

Preventing and Detecting Altered Company Checks Separation of duties in the check writing process Check preparation, signing, and delivery Separation of duties of the check reconciliation process Check preparation and check reconciliation Check the canceled check against the entry in the books Consider using carbon copy checks to check against canceled checks for discrepancies

Concealed Check Schemes Employee prepares a fraudulent check and submits it along with legitimate checks Check is payable to the employee, an accomplice, a fictitious person, or a fictitious business Occurs when checks are signed without proper review or reviewer is busy In many cases, only the signature line is exposed and the payee is concealed

Authorized Maker Schemes Employee with signatory authority writes a fraudulent check Overriding controls through intimidation High-level managers can make employees afraid to question suspicious transactions Can happen when ownership is absent or inattentive Poor controls Failure to closely monitor accounts Lack of separation of duties

Preventing and Detecting Check Tampering by Authorized Makers Difficult to detect because check signer is relied on to serve as a control Separate the duties of the check writing function Check preparer and check signer Check signers should not have access to blank checks Require dual signatures for disbursements over a certain amount Maintain up-to-date vendor lists and confirm all disbursements to the lists, scrutinizing checks to unknown vendors

Concealing Check Tampering Forged endorsement schemes and altered payee schemes create a problem for the fraudster because the checks are intended for a legitimate recipient who will complain if a payment isn’t received An investigation could be triggered and the fraud discovered

Concealing Check Tampering Fraudster reconciling the bank statement Remove fraudulent check Doctor the bank statement Code check as “void” or don’t include it in the disbursements journal Re-alteration of checks Check is changed back to the rightful payee when returned from the bank Re-altered checks will match the names of the legitimate payees listed in the disbursements journal

Concealing Check Tampering Falsifying the disbursements journal Check made payable to the perpetrator but a different person is listed as the payee in the books Amount of the check can also be falsified in the disbursements journal Existing accounts that are rarely reviewed or are very active are preferred

Concealing Check Tampering Reissuing intercepted checks New checks are issued to replace the ones that the vendor did not receive The original invoice is changed in a manner that avoids a duplicate check for new check New check is issued and a stop payment is supposed to have been made Bogus supporting documents Fake documentation is needed to support the check False payment vouchers, invoices, purchase orders, receiving reports are submitted

Electronic Payment Tampering Electronic payments Alternative to paper checks Enable payer to transmit funds electronically over Internet or other medium Include ACH payments, online bill payments, and wire transfers

Electronic Payment Tampering Methods used to manipulate electronic payments include Abusing legitimate access to employer’s payment system Gaining access through social engineering or password theft Exploiting weaknesses in internal control or payment system

Prevention and Detection of Electronic Payment Tampering Internal controls Separation of duties; e.g., segregate duties for creating, approving, and releasing wires Segregating bank accounts; e.g., separate accounts for paper and electronic transactions Daily account monitoring and reconciliation Management and protection of user access and account information

Prevention and Detection of Electronic Payment Tampering Bank security services Set up ACH blocks/ACH filters Use positive pay for ACH Restrict banking software access to specific banking activities to enhance separation of duties; e.g., viewing bank statements or initiating electronic payments Customize banking software to incorporate dual authorization and daily or individual transaction limits Use bank’s multi-factor authentication tools; e.g., tokens, digital certificates, and smart cards

Chapter 6 Payroll Schemes

Learning Objectives List and understand the three main categories of payroll fraud. Understand the relative cost and frequency of payroll frauds. Define a ghost employee. List and understand the four steps to making a ghost employee scheme work. Understand how separation of duties in payroll and human resources functions can reduce the threat of payroll fraud. Be familiar with methods identified in this chapter for preventing and detecting ghost employee schemes.

Learning Objectives List and understand the four ways that employees can obtain authorization for a falsified timecard in a manual system. Understand the role that payroll controls play in preventing falsified hours and salary schemes. Discuss the methods identified in this chapter for preventing and detecting falsified hours and salary schemes. Understand how employees commit commission schemes. Identify red flags that are typically associated with commission schemes. Be familiar with proactive audit tests that can be used to detect various forms of payroll fraud.

Payroll Schemes Ghost Employees Commission Schemes Workers Compensation Falsified Wages

Frequency of Fraudulent Disbursements

Median Loss of Fraudulent Disbursements

Payroll Schemes Occupational frauds in which a person who works for an organization causes that organization to issue a payment by making a false claim for compensation Ghost employee schemes Falsified hours and salary schemes Commission schemes

Ghost Employees Someone on the payroll who does not actually work for the victim company Fictitious person Friend or relative Accomplice Other

Ghost Employee Schemes Adding the ghost to the payroll Through the personnel department Through the hiring department Through the payroll department Using names similar to real employees Failing to remove terminated employees from the payroll

Ghost Employee Schemes Collecting timekeeping information Fake timecards Approval of timecards Computerized timekeeping systems Salaried workers vs. hourly workers

Ghost Employee Schemes Issuing the ghost’s paycheck Delivery of the paycheck Hand delivered Mailed to the employees address Direct deposited

Preventing and Detecting Ghost Employee Schemes Separate the hiring function from the payroll function Personnel records should be independently maintained from payroll and timekeeping functions Personnel department should verify any changes to payroll Background and reference checks should be made in advance of hire

Preventing and Detecting Ghost Employee Schemes Periodically check the payroll records against personnel records for terminated employees and unauthorized wage or deduction adjustments Periodically run computer reports for employees Without SSNs With no deductions - withholding taxes or insurance With no physical address or telephone number Compare payroll expenses to production schedules Keep signed checks in a secure location Verify proper distribution and require employee identification

Falsified Hours and Salary Overpayment of wages is the most common form of misappropriating payroll funds Increase number of hours or rate of pay Time clocks Computer tracking of employee time Manually prepared timecards

Manually Prepared Timecards Forging a supervisor’s signature Collusion with a supervisor Rubber stamp supervisors Poor custody procedures

Other Schemes Time clocks and other automated timekeeping systems Employee has someone else clock in for him/her when absent Rates of pay

Preventing and Detecting Falsified Hours and Salary Schemes Preparation, authorization, distribution, and reconciliation should be segregated Transfers of funds from general accounts to payroll accounts should be handled independently No overtime should be paid unless authorized in advance Sick leave and vacation time should not be granted without supervisory review and should be monitored for excessive time taken

Preventing and Detecting Falsified Hours and Salary Schemes A designated official should verify all wage rate changes Timecards should be taken directly to the payroll department after approval Time cards should be secured and monitored Run programs to actively seek out fraudulent payroll activity

Tests for Fraudulent Payroll Activity Review employees who have significantly more overtime than similar employees Trend analysis of budgeted vs. actual expenses Run exception reports for employees who have had disproportionately large increases in wages Verify payroll taxes equal federal return tax forms Compare net payroll to payroll checks issued

Commission Schemes Pay is based on an employee’s output rather than hours worked or a set salary Falsify the amount of sales made Create fraudulent sales orders, customer purchase orders, credit authorizations, packing slips, invoices, etc. Ring up a false sale on the cash register Overstate legitimate sales Fraudulently increase the rate of commission

Detecting Commission Schemes Run periodic reports to show an unusual relationship between sales figures and commission figures Run reports that compare commissions earned among salespersons Track uncollected sales generated by each salesperson Conduct random samples of customers to verify that the customer exists

Expense Reimbursement Schemes Chapter 7 Expense Reimbursement Schemes

Learning Objectives Explain what constitutes expense reimbursement fraud. Discuss the data on expense reimbursement fraud from the 2009 Global Fraud Survey. Understand how mischaracterized expense reimbursement schemes are committed. Be familiar with the controls identified in this chapter for preventing and detecting mischaracterized expense schemes. Identify the methods employees use to overstate otherwise legitimate expenses on their expense reports. Understand controls that can be used to prevent and detect overstated expense schemes.

Learning Objectives Explain what a fictitious expense reimbursement scheme is and differentiate it from other forms of expense reimbursement fraud. Identify red flags that are commonly associated with fictitious expense schemes. Discuss what a multiple reimbursement scheme is and how this kind of fraud is committed. Discuss the controls identified in this chapter for preventing and detecting multiple reimbursement schemes. Be familiar with proactive audit tests that can be used to detect various forms of expense reimbursement fraud.

Expense Reimbursement Schemes Mischaracterized Expenses Overstated Fictitious Expenses Multiple Reimbursements

Frequency of Fraudulent Disbursements

Median Loss Fraudulent Disbursements

Expense Reimbursement Schemes Employees are reimbursed for expenses paid on behalf of their employer Airfare, hotel bills, business meals, mileage, etc. Business purpose explained and receipts attached per the organization’s guidelines

Mischaracterized Expense Reimbursements Purpose of reimbursement request is misstated Fraudster seeks reimbursement for personal expenses Personal trips listed as a business trips Non-allowable meals with friends and family Perpetrators are usually high-level employees, owners, or officers Common element – lack of detailed expense reports

Preventing and Detecting Mischaracterized Expenses Establish and adhere to a system of controls Require detailed expense reports with original support documentation Require direct supervisory review of all travel and entertainment expenses Establish a policy that clearly states what will and will not be reimbursed

Preventing and Detecting Mischaracterized Expenses Scrutinize any expense report that is approved outside the requestor’s department Compare dates of claimed expenses to work schedules Compare prior year expenses to current year expenses and to budgeted expenses

Overstated Expense Reimbursements Altered receipts Overpurchasing Overstating another employee’s expenses Orders to overstate expenses

Preventing and Detecting Overstated Expense Reimbursements Require original receipts for all expense reimbursements If photocopied receipts are submitted, independently verify the expense Book travel through company travel agent using designated company credit card Compare employee’s expense reports with co-workers to identify inconsistencies Spot check expense reports with customers

Fictitious Expenses Producing fictitious receipts Personal computers Calculators Cut and paste Obtaining blank receipts from vendors Claiming the expenses of others

Preventing and Detecting Fictitious Expense Reimbursements Look for: High dollar items that were paid in cash Expenses that are consistently rounded off, ending with “0” or “5” Expenses that are consistently for the same amount Reimbursement requests that consistently fall at or just below the reimbursement limit Receipts that are submitted over an extended time that are consecutively numbered Receipts that do not look professional or that lack information about the vendor

Multiple Reimbursement Schemes A single expense item is submitted several times to receive multiple reimbursements Example: Airline ticket receipt and travel agency invoice Submit the credit card receipt for items charged to the company’s credit card account Submitting the same expenses to different budgets

Preventing and Detecting Multiple Reimbursement Schemes Enforce a policy against accepting photocopies Establish clearly what types of support documentation are acceptable Scrutinize expense reports that are approved by supervisors outside the requestor’s department Require that expense reimbursements be approved by the employee’s direct supervisor Establish a policy that expenses must be submitted within a certain time limit

Mid-term Exam Practice Questions

1. In a ______________ scheme, the perpetrator uses false documentation to cause a payment to be issued for a fraudulent purpose. Purchasing Skimming Larceny Billing

1. In a ______________ scheme, the perpetrator uses false documentation to cause a payment to be issued for a fraudulent purpose. Purchasing Skimming Larceny Billing

2. Mel Turner, the runner for a small bookstore, had a bad habit of helping himself to cash from the deposit on the way to the bank. He covered his tracks by substituting a check from the next day’s deposit for the amount he stole from the previous day. This is an example of what type of concealment? Deposit in transit Deposit lapping Force balance depositing None of the above

2. Mel Turner, the runner for a small bookstore, had a bad habit of helping himself to cash from the deposit on the way to the bank. He covered his tracks by substituting a check from the next day’s deposit for the amount he stole from the previous day. This is an example of what type of concealment? Deposit in transit Deposit lapping Force balance depositing None of the above

3. Which of the following is not considered to be a red flag for fictitious expenses? An employee repeatedly uses the company credit card for business travel expenses. An employee’s reimbursement requests are always for round-dollar amounts. An employee submits reimbursement requests that consistently fall just below the reimbursement limit. An employee frequently requests reimbursement for high-dollar items that he claims were paid for in cash.

3. Which of the following is not considered to be a red flag for fictitious expenses? An employee repeatedly uses the company credit card for business travel expenses. An employee’s reimbursement requests are always for round-dollar amounts. An employee submits reimbursement requests that consistently fall just below the reimbursement limit. An employee frequently requests reimbursement for high-dollar items that he claims were paid for in cash.

4. In order to prove that fraud occurred, four general elements must be present. Which of the following is not a general element of fraud? A material false statement Knowledge that the statement was false Reliance on the false statement by the victim Intent to cause the victim damages

4. In order to prove that fraud occurred, four general elements must be present. Which of the following is not a general element of fraud? A material false statement Knowledge that the statement was false Reliance on the false statement by the victim Intent to cause the victim damages

5. Check tampering includes both fraudulently preparing a company check for one’s own benefit and intercepting a company check that is intended for a third party and converting it for one’s own benefit. True False

5. Check tampering includes both fraudulently preparing a company check for one’s own benefit and intercepting a company check that is intended for a third party and converting it for one’s own benefit. True False

6. Which of the following procedures would not be useful in preventing and detecting sales skimming schemes? Comparing register tapes to the cash drawer and investigating discrepancies Summarizing the net sales by employee and extracting the top employees with low sales Installing video cameras at cash entry points Offering discounts to customers who do not get receipts for their purchases

6. Which of the following procedures would not be useful in preventing and detecting sales skimming schemes? Comparing register tapes to the cash drawer and investigating discrepancies Summarizing the net sales by employee and extracting the top employees with low sales Installing video cameras at cash entry points Offering discounts to customers who do not get receipts for their purchases

7. In the 2010 Report to the Nations on Occupational Fraud and Abuse, fraudulent financial statements schemes had a higher median loss than asset misappropriation and corruption schemes. True False

7. In the 2010 Report to the Nations on Occupational Fraud and Abuse, fraudulent financial statements schemes had a higher median loss than asset misappropriation and corruption schemes. True False

8. In one of the case studies in the textbook, Albert Miano, the facilities supervisor for a popular magazine, submitted phony invoices. When Miano received the checks for the phony invoices, he forged the contractor’s signature. He then endorsed the check in his own name. How was the fraud caught? The auditors found a discrepancy in the invoices that were submitted. The new chief of internal audit found it by accident. A vendor received a check by mistake and called the accounts payable department. The external audit found it in an audit sample of canceled checks.

8. In one of the case studies in the textbook, Albert Miano, the facilities supervisor for a popular magazine, submitted phony invoices. When Miano received the checks for the phony invoices, he forged the contractor’s signature. He then endorsed the check in his own name. How was the fraud caught? The auditors found a discrepancy in the invoices that were submitted. The new chief of internal audit found it by accident. A vendor received a check by mistake and called the accounts payable department. The external audit found it in an audit sample of canceled checks.

9. Which of the following is not a type of payroll scheme? Ghost employee schemes False deduction schemes Falsified hours and salary schemes Commission schemes

9. Which of the following is not a type of payroll scheme? Ghost employee schemes False deduction schemes Falsified hours and salary schemes Commission schemes

Multiple reimbursement scheme Shell company scheme 10. Mary Duncan is an internal auditor for the Western Realty Group. Recently, she ran a program that extracted checks that were out of sequence. She found that four or five checks were written every month that fit this category. Based on the information given, which of the following schemes is likely occurring? Multiple reimbursement scheme Shell company scheme Personal purchases scheme Forged maker scheme

Multiple reimbursement scheme Shell company scheme 10. Mary Duncan is an internal auditor for the Western Realty Group. Recently, she ran a program that extracted checks that were out of sequence. She found that four or five checks were written every month that fit this category. Based on the information given, which of the following schemes is likely occurring? Multiple reimbursement scheme Shell company scheme Personal purchases scheme Forged maker scheme

Register Disbursement Schemes Chapter 8 Register Disbursement Schemes

Pop Quiz According to the 2006 National Fraud Survey, register disbursement schemes have a higher median loss than payroll schemes. True or false?

Learning Objectives Explain what constitutes a register disbursement scheme. Differentiate register disbursements from skimming and cash larceny schemes. List the two basic categories of register disbursements. Explain how false refund schemes are committed. Explain how false void schemes are committed.

Learning Objectives Understand how register disbursement schemes cause shrinkage. Discuss the methods by which fraudulent register disbursements are concealed. Understand the methods identified in this chapter for preventing and detecting register disbursement schemes. Be familiar with proactive audit tests that can be used to detect register disbursement schemes.

Register Disbursements False Voids False Refunds

Frequency of Fraudulent Disbursements

Median Loss of Fraudulent Disbursements

Register Disbursement Schemes False refunds False voids

False Refunds A refund is processed when a customer returns an item of merchandise purchased from the store Merchandise is placed back into inventory Purchase price is returned to the customer

False Refunds Fictitious refunds Fraudster takes cash from the register in the amount of the false return Debit is made to the inventory system showing that the merchandise has been returned to the inventory

False Refunds Overstated refunds Fraudster overstates the amount of a legitimate refund and skims the excess money Customer is paid the actual amount owed for the returned merchandise and the excess is kept by the fraudster

False Refunds Credit card refunds Refunds appear as credits to the customer’s credit card rather than as cash disbursements Perpetrator does not have to physically take cash from the register Refunded to the perpetrator’s credit card

False Voids Also generate a disbursement from the register Copy of customer’s receipt is attached to the void slip Managers must generally approve voided sales Rubber stamp approvals allow the fraud to succeed Management and the employee may conspire

Concealing Register Disbursements Fraudsters typically do not make any effort to conceal the shrinkage Register disbursement schemes leave the victim organization’s books in balance Fraudster often takes no further action

Concealing Register Disbursements Small disbursements Keep the size of the disbursements low to where management review is not required Destroying records Employee has conceded that management will discover the theft Goal is to prevent management from discovering who the thief is

Preventing and Detecting Register Disbursement Schemes Maintain appropriate separation of duties Management approval should be required for all refunds and voided sales Closely guard access to the control key or management code Prohibit cashiers from reversing their own sales

Preventing and Detecting Register Disbursement Schemes Require proper documentation for voided transactions such as the original receipt Require cashiers to maintain a distinct login code Periodically generate reports of all reversing transactions

Preventing and Detecting Register Disbursement Schemes Look for large numbers of transactions just below the approval amount Institute store policies encouraging customers to ask for and examine their receipts Randomly call customers who have returned merchandise or voided sales

Chapter 9 Non-Cash Assets

Learning Objectives List the five categories of tangible non-cash misappropriations discussed in this chapter. Discuss the data on non-cash misappropriations from the 2009 Global Fraud Survey. Explain how misuse of non-cash assets can negatively affect organizations. Understand how and why unconcealed larceny of non-cash assets occurs. Be familiar with internal controls and tests that can be used to prevent and detect non-cash larceny. Understand how weaknesses in internal asset requisition and transfer procedures can lead to the misappropriation of non-cash assets.

Learning Objectives Explain how purchasing and receiving schemes are used to misappropriate non-cash assets. Understand how the theft of non-cash assets through the use of fraudulent shipments is accomplished. Define the term “shrinkage.” Describe how fraudsters conceal the theft of non-cash assets on the victim organization’s books. Understand how fraudsters misappropriate intangible assets and how companies can protect themselves. Be familiar with proactive audit tests that can be used to detect misappropriations of non-cash assets.

Inventory and All Other Assets Misuse Larceny Asset Req. & Transfers False Sales & Shipping Purchasing & Receiving Unconcealed Larceny

Cash vs. Non-Cash Schemes 2009 Global Fraud Survey Scheme Type % of Asset Misappropriation Cases Median Loss Cash Misappropriations 85.6% $120,000 Non-Cash Misappropriations 20.3% $90,000

Non-Cash Cases by Type of Asset Misappropriated

Median Loss by Type of Asset in Non-Cash Schemes

Non-Cash Tangible Asset Misappropriations Misuse Unconcealed larceny Asset requisitions and transfers Purchasing and receiving schemes Fraudulent shipments

Misuse of Non-Cash Tangible Assets Typical misuse Company vehicles Company supplies Computers Other office equipment Doing personal work on company time Running side businesses

The Costs of Inventory Misuse Loss of productivity Need to hire additional employees to compensate Lost business if employee’s business competes Unauthorized use of equipment can mean additional wear and tear sooner or more often

Unconcealed Larceny Schemes Greater concern than misuse of assets Most schemes are not complex Some employees know their co-workers are stealing but refrain from reporting it Many of the employees who steal company property are highly trusted Assets misappropriated after-hours or mailed to perpetrator

The Fake Sale Needs an accomplice Sale is not rung up but the accomplice takes the merchandise Accomplice may return merchandise for cash

Preventing and Detecting Unconcealed Larceny of Non-Cash Tangible Assets Segregate the duties of requisitioning, purchasing, and receiving Segregate the duties of payables, purchasing, and receiving Maintain physical security of merchandise Track those who enter secure areas through access logs Install security cameras and let their presence be known

Preventing and Detecting Unconcealed Larceny of Non-Cash Tangible Assets Conduct inventory counts on a periodic basis by someone independent of the purchasing and warehousing functions Suspend shipping and receiving activities during physical counts Investigate significant discrepancies Independently follow-up on customer complaints

Asset Requisitions and Transfers Documentation enables non-cash assets to be moved from one location to another Internal documents can be used to fraudulently gain access to merchandise Basic scheme is to requisition materials to complete a work-related project, then steal the materials Inventory stored in multiple locations creates opportunities

Purchasing and Receiving Schemes Assets were intentionally purchased by the company but misappropriated Falsifying incoming shipments May also reject portion of the shipment as being substandard Perpetrator keeps the “substandard” merchandise

False Shipments of Inventory and Other Assets False shipping and sales documents are created to make it appear that the inventory was sold False packing slips can allow the inventory to be delivered to fraudster or accomplice To hide the theft a false sale is created Receivable is aged and written off Legitimate sale is understated

Other Schemes Assets are written off in order to make them available for theft Assets are declared as scrap and given to the employee New equipment is ordered for the company to replace old – new equipment is sent to employee’s home leaving old equipment in place

Concealing Inventory Theft Key concealment issue is shrinkage Inventory shrinkage is the unaccounted-for reduction in the company’s inventory due to theft Since shrinkage signals fraud, the fraudster must prevent anyone from looking for the missing assets Physical count of inventory detects shrinkage

Concealing Inventory Theft Altered inventory records Forced reconciliation Deleting or covering up the correct totals and entering new totals Fictitious sales and accounts receivable Charge sale to existing account Write-off to discounts and allowances or bad debt expense

Concealing Inventory Theft Write off inventory and other assets Eliminates the problem of shrinkage Physical padding Make it appear that there are more assets present that there actually are

Preventing and Detecting Thefts of Non-Cash Tangible Assets Separate the duties of: Ordering goods Receiving goods Maintaining perpetual inventory records Issuing payments Match the invoices to receiving reports before payments are issued Match the packing slip to an approved purchase order

Preventing and Detecting Thefts of Non-Cash Tangible Assets Match outgoing shipments to sales orders before merchandise goes out Periodically match inventory shipments to sales records Investigate shipments that cannot be traced to a sale Check out unexplained increases in bad debt expense

Preventing and Detecting Thefts of Non-Cash Tangible Assets Compare shipping addresses to employee addresses Review unexplained entries in perpetual inventory records Reconcile materials ordered for specific projects with actual work done Perform trend analysis on scrap inventory Check to make sure that inventory removed from inventory is properly approved

Misappropriation of Intangible Assets Misappropriation of information Includes theft of competitively sensitive information, (e.g., trade secrets, customer lists, marketing strategies) Can undermine value, reputation, and competitive advantage Can result in legal liabilities Identify most valuable information and take steps to protect it Misappropriation of securities Proper internal controls over investment portfolio

Chapter 10 Corruption

Pop Quiz What are the two principle schemes involving bribery?  

Learning Objectives Define corruption. Identify the four categories of corruption. Define bribery. Compare and contrast bribery, extortion, and illegal gratuities. Identify the two categories of bribery schemes. Understand kickback schemes and how they are committed. Understand bid-rigging schemes and explain how they are categorized.

Learning Objectives Describe the types of abuses that are committed at each stage of the competitive bidding process. Be familiar with the controls and techniques that can be used to prevent and detect bribery. Define conflicts of interest. Differentiate conflicts of interest from bribery schemes and billing schemes. List and understand the two major categories of conflicts of interest. Be familiar with proactive audit tests that can be used to detect corruption schemes.

Corruption Conflicts of Interest Bribery Illegal Gratuities Economic Extortion Purchase Schemes Invoice Kickbacks Sales Schemes Bid Rigging Other Other

Frequency of Types of Occupational Fraud and Abuse

Median Loss of Types of Occupational Fraud and Abuse

Frequency of Corruption Schemes

Bribery Offering, giving, receiving, or soliciting any thing of value to influence an official act Buys influence of the recipient Commercial bribery Kickbacks Bid-rigging schemes

Kickback Schemes Involve submission of invoices for goods and services that are either overpriced or completely fictitious Involve collusion between employees and vendors Almost always attack the purchasing function of the victim company

Kickback Schemes Diverting business to vendors Vendor pays the kickbacks to ensure a steady stream of business from the purchasing company No incentive to provide quality merchandise or low price Almost always leads to overpaying for goods or services

Overbilling Schemes Employees with approval authority Vendor submits inflated invoices to the victim company Overstates the cost of actual goods or services or reflects fictitious sales Ability to authorize purchases is key to the scheme

Overbilling Schemes Employees lacking approval authority Circumvent purchasing controls May prepare false vouchers to make it appear that the invoice is legitimate May forge an approval signature or have access to a restricted password in a computerized system Difficult to detect since the victim company is being attacked from two directions

Other Kickback Schemes Discounts are given in exchange for bribes Slush funds Other side of the transaction Funds can be paid from other accounts or paid as “consulting fees”

Detecting Kickbacks Normal controls may not detect kickback schemes Look for price inflation Monitor trends in cost of goods sold and services purchased Often start small but increase over time

Detecting Kickbacks Look for excessive quantities purchased Investigate inventory shortages Look for inferior goods purchased Compare actual amounts to budgeted amounts

Preventing Kickbacks Assign an employee independent of the purchasing department to routinely review buying patterns Make sure that all contracts have a “right to audit” clause Establish written policies prohibiting employees from soliciting or accepting any gift or favor from a customer or supplier Expressly forbid any employee from engaging in any transaction, on behalf of the company, in which he or she has an undisclosed personal interest Implement an ethics policy that clearly explains what improper behavior is and provides grounds for termination if an employee accepts a bribe or kickback

Bid-Rigging Schemes All bidders are expected to be on an even playing field – bidding on the same specifications The more power a person has over the bidding process, the more influence he or she can exert over the selection of the winning bid Potential targets include: Buyers Contracting officials Engineers and technical representatives Quality or produce assurance representatives Subcontractor liaison employees

Pre-Solicitation Phase Need recognition schemes Employee of the purchasing company convinces the company that a particular project is necessary Has the specifications tailored to the strengths of a particular supplier Trends indicating a need recognition scheme is occurring Higher requirements for stock and inventory levels Writing off large numbers of surplus items to scrap Defining a need that can only be met by a certain supplier Failure to develop a satisfactory list of backup suppliers

Specification Schemes Specifications include a list of the elements, materials, dimensions, and other relevant requirements Set the specifications to a particular vendor’s capabilities Use“prequalification” procedures to eliminate certain vendors Sole-source or noncompetitive procurement justifications Deliberately writes vague specifications requiring amendments at a later date Bid splitting Gives a vendor the right to see the specifications before his competitors get the specs

The Solicitation Phase Restricting the pool of vendors from which to choose Bid pooling Fictitious suppliers Restricting the time for submitting bids Soliciting bids in obscure publications Publicizing the bid during holiday periods

The Submission Phase Fraud in the sealed bid process Last bid submitted is the one that is awarded the contract Winning bidder finds out what the other competitors are bidding Winning bidder may see the other competitors’ bids before submitting his bid Gets help on preparing the bid

Detecting Bid-Rigging Schemes Look for: Unusual bidding patterns Low bids followed by change orders A very large unexplained price difference among bidders Contractors who bid last and repeatedly receive the contract A predictable rotation of bidders Losing bidders who become subcontractors Vendors with the same address and phone number Fewer bidders than expected for the project Projects that have been split into smaller ones

Something of Value Cash Promises of future employment Promise of ownership in the supplier’s firm Gifts Liquor and meals Free travel and accommodations Cars and other merchandise Payment of credit card bills Loans on very favorable terms Transfers of property

Other Corruption Schemes Illegal gratuities Given to reward a decision rather than influence it Decision made to benefit a person or company but is not influenced by any sort of payment May influence future decisions Economic extortion “Pay up or else” Employee demands payment from a vendor in order to make a decision in the vendor’s favor

Conflicts of Interest Employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the company Victim organization is unaware of the employee’s divided loyalties Distinguished from bribery–in conflicts of interest, the fraudster approves the invoice because of his own hidden interest in the vendor Purchasing schemes Sales schemes

Purchasing Schemes Overbilling schemes Turnaround sales Bill originates from a real company in which the fraudster has an undisclosed economic or personal interest Fraudster uses influence to ensure the victim company does business with this particular vendor Does not negotiate in good faith or attempt to get the best price for the employer Turnaround sales The employee knows that the company is seeking to purchase a particular asset and purchases it himself Turns around and sells it to the company at an inflated price

Sales Schemes Underbillings Writing off sales Goods are sold below fair market value to a customer in which the perpetrator has a hidden interest Writing off sales Purchases are made from the victim company and credit memos are later issued

Other Conflict of Interest Schemes Business diversions Siphoning off clients of the victim company to the employee’s own business Resource diversions Diverting funds and other resources for the development of the employee’s own company Financial disclosures Inadequate disclosures of related-party transactions to the company

Preventing and Detecting Conflicts of Interest Implement, communicate, and enforce an ethics policy that addresses conflicts of interest offenses Require employees to complete an annual disclosure statement Establish an anonymous reporting mechanism to receive tips and complaints Compare vendor address and telephone files to employee address and telephone files for matches

Fraudulent Financial Statement Schemes Chapter 12 Fraudulent Financial Statement Schemes

Pop Quiz Name at least three of the five principal financial statement fraud schemes.  

Learning Objectives Define financial statement fraud and related schemes. Understand and identify the five classifications of financial statement fraud. Explain how fictitious revenues schemes are committed, as well as the motivation for, and result of, committing this fraud. Explain how timing difference schemes are committed, as well as the motivation for, and result of, committing this fraud. Describe the methods by which concealed liabilities and expenses are used to fraudulently improve a company’s balance sheet.

Learning Objectives Understand how improper disclosures may be used to mislead potential investors, creditors, or any other users of financial statements. Recognize how improper asset valuation may inflate the current ratio. Identify detection and deterrence procedures that may be instrumental in dealing with fraudulent financial statement schemes. Understand financial statement analysis for detecting fraud. Identify and characterize current professional and legislative actions that have sought to improve corporate governance, enhance the reliability and quality of financial reports, and foster the credibility and effectiveness of audit functions.

Financial Statement Fraud Defined Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors.

Defining Financial Statement Fraud Falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions Material intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared Deliberate misapplication of accounting principles, policies, and procedures used to measure, recognize, report, and disclose economic events and business transactions Intentional omissions of disclosures, or presentation of inadequate disclosures, regarding accounting principles and policies and related financial amounts (Rezaee 2002)

Costs of Financial Statement Fraud In addition to the direct economic losses of fraud are Legal costs; increased insurance costs; loss of productivity; adverse impacts on employees’ morale, customers’ goodwill, and suppliers’ trust; and negative stock market reactions These costs are impossible to measure

Costs of Financial Statement Fraud Undermines the reliability, quality, transparency, and integrity of the financial reporting process Jeopardizes the integrity and objectivity of the auditing profession, especially of auditors and auditing firms Diminishes the confidence of the capital markets, as well as of market participants, in the reliability of financial information Makes the capital markets less efficient

Costs of Financial Statement Fraud Adversely affects the nation’s economic growth and prosperity Results in huge litigation costs Destroys careers of individuals involved Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud

Costs of Financial Statement Fraud Encourages regulatory intervention Causes devastation in the normal operations and performance of alleged companies Raises serious doubt about the efficacy of financial statement audits Erodes public confidence and trust in the accounting and auditing profession

Methods of Financial Statement Fraud Fictitious revenues Timing differences Improper asset valuations Concealed liabilities and expenses Improper disclosures

Fictitious Revenues Recording of goods or services that did not occur Fake or phantom customers Legitimate customers Sales with conditions Pressures to boost revenues

Red Flags – Fictitious Revenues Rapid growth or unusual profitability, especially compared to that of other companies in the same industry Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities are not audited or are audited by another firm

Red Flags – Fictitious Revenues Significant, unusual, or highly complex transactions, especially those close to period-end that pose difficult “substance over form” questions Unusual growth in the number of days’ sales in receivables A significant volume of sales to entities whose substance and ownership are not known An unusual surge in sales by a minority of units within a company, or of sales recorded by corporate headquarters

Timing Differences Recording revenue and/or expenses in improper periods Shifting revenues or expenses between one period and the next, increasing or decreasing earnings as desired

Timing Differences Matching revenues with expenses Premature revenue recognition Long-term contracts Channel stuffing Recording expenses in the wrong period

Red Flags – Timing Differences Rapid growth or unusual profitability, especially compared to that of other companies in the same industry Recurring negative cash flows from operations, or an inability to generate cash flows from operations, while reporting earnings and earnings growth Significant, unusual, or highly complex transactions, especially those close to period-end that pose difficult “substance over form” questions Unusual increase in gross margin or margin in excess of industry peers Unusual growth in the number of days’ sales in receivables Unusual decline in the number of days’ purchases in accounts payable

Concealed Liabilities Liability/expense omissions Capitalized expenses Failure to disclose warranty costs and liabilities

Red Flags – Concealed Liabilities Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates

Red Flags – Concealed Liabilities Unusual increase in gross margin or margin in excess of industry peers Allowances for sales returns, warranty claims, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers Unusual reduction in the number of days’ purchases in accounts payable Reducing accounts payable while competitors are stretching out payments to vendors

Improper Disclosures Liability omissions Subsequent events Management fraud Related-party transactions Accounting changes

Red Flags – Improper Disclosures Domination of management by a single person or small group (in a non-owner managed business) without compensating controls Ineffective board of directors or audit committee oversight over the financial reporting process and internal control Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management, or the communication of inappropriate values or ethical standards Rapid growth or unusual profitability, especially compared to that of other companies in the same industry

Red Flags – Improper Disclosures Significant, unusual, or highly complex transactions, especially those close to period-end that pose difficult “substance over form” questions Significant related-party transactions not in the ordinary course of business, or with related entities not audited or audited by another firm Significant bank accounts, or subsidiary or branch operations, in tax haven jurisdictions for which there appears to be no clear business justification Overly complex organizational structure involving unusual legal entities or managerial lines of authority

Red Flags – Improper Disclosures Known history of violations of securities laws or other laws and regulations; or claims against the entity, its senior management, or board members, alleging fraud or violations of laws and regulations Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee

Improper Asset Valuation Inventory valuation Accounts receivable Business combinations Fixed assets

Red Flags – Improper Asset Valuation Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth Significant declines in customer demand and increasing business failures in either the industry or overall economy Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates Unusual increase in gross margin or margin in excess of industry peers

Red Flags – Improper Asset Valuation Unusual growth in the number of days’ sales in receivables Unusual growth in the number of days’ purchases in inventory Allowances for bad debts, excess and obsolete inventory, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers Unusual change in the relationship between fixed assets and depreciation Adding to assets while competitors are reducing capital tied up in assets

Detection of Fraudulent Financial Statement Schemes SAS 99 (AU 316) – Consideration of Fraud in a Financial Statement Audit “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

SAS 99 (AU 316) Description and characteristics of fraud Misstatements arising from fraudulent financial reporting Misstatements arising from misappropriation of assets Importance of exercising professional skepticism Discussion among engagement personnel regarding risk of material misstatement due to fraud Brainstorming Internal and external pressures

SAS 99 (AU 316) Obtaining information needed to identify risks of material misstatement due to fraud Make inquiries of management about the risks of fraud and how they are addressed Consider any unusual or unexpected relationships that have been identified in performing analytical procedures in planning the audit Consider whether one or more fraud risk factors exist Consider other information that may be helpful in the identification of risks of material misstatement due to fraud

SAS 99 (AU 316) The type of risk that may exist Identifying risks that may result in material misstatement due to fraud The type of risk that may exist The significance of the risk The likelihood of the risk The pervasiveness of the risk Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls Specific controls designed to mitigate specific risks of fraud Broader programs designed to deter and detect fraud

SAS 99 (AU 316) Responding to the results of the assessment Overall responses to the risk of material misstatement Responses involving the nature, timing, and extent of procedures to be performed to address the identified risks Responses to further address risk of management override of controls Examining journal entries and other adjustments for evidence of possible material misstatement due to fraud Reviewing accounting estimates for biases that could result in material misstatement due to fraud Evaluating the business rationale for significant unusual transactions

SAS 99 (AU 316) Evaluating audit evidence Assessing risks of material misstatement due to fraud throughout the audit Evaluating whether analytical procedures indicate a previously unrecognized risk of fraud Evaluating risks of material misstatement at or near the completion of fieldwork Responding to misstatements that may be the result of fraud

SAS 99 (AU 316) Communicating about fraud to management, the audit committee, and others If fraud may exist, the matter should be brought to the attention of an appropriate level of management even the matter is considered inconsequential Fraud involving senior management should be reported directly to the audit committee If risks that have been identified have continuing control implications, consider communicating these risks to senior management Disclosing possible fraud to outside parties Documenting the auditor’s consideration of fraud

Financial Statement Analysis Vertical analysis Analyzes relationships between items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages Horizontal analysis Analyzes the percentage change in individual financial statement items Ratio analysis Measures the relationship between two different financial statement amounts

Deterrence of Financial Statement Fraud Reduce pressures to commit financial statement fraud Reduce the opportunity to commit financial statement fraud Reduce rationalization of financial statement fraud

Reduce Pressures to Commit Financial Statement Fraud Establish effective board oversight of the “tone at the top” created by management Avoid setting unachievable financial goals Avoid applying excessive pressure on employees to achieve goals Change goals if changed market conditions require it Ensure compensation systems are fair and do not create incentive to commit fraud Discourage excessive external expectations of future corporate performance Remove operational obstacles blocking effective performance

Reduce the Opportunity to Commit Financial Statement Fraud Maintain accurate and complete internal accounting records Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who participate in the transactions between financial units Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items Maintain accurate personnel records, including background checks on new employee. Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures Establish clear and uniform accounting procedures with no exception clauses

Reduce Rationalization of Financial Statement Fraud Promote strong values, based on integrity, throughout the organization Have policies that clearly define prohibited behavior with respect to accounting and financial statement fraud Provide regular training to all employees, communicating prohibited behavior

Reduce Rationalization of Financial Statement Fraud Have confidential advice and reporting mechanisms to communicate inappropriate behavior Have senior executives communicate to employees that integrity takes priority and that goals must never be achieved through fraud Ensure management practices what it preaches and sets an example by promoting honesty in the accounting area Clearly communicate the consequences of violating the rules and the punishment for violators

Interviewing Witnesses Chapter 15 Interviewing Witnesses

Learning Objectives List the five types of interview questions. Understand how to ask introductory questions. Explain how to construct informational questions. Understand the differences between open, closed, and leading questions. Explain how to close an interview.

Learning Objectives Define and explain the purpose of assessment questions. List some nonverbal clues to deception. List some verbal clues to deception. Discuss the methodology of admission-seeking questions. List the elements of a signed statement.

Interviewing Questions Introductory Informational Assessment Closing Admission-seeking

Introductory Questions Provides an introduction Establishes rapport Establishes the theme of the interviews Observes the person’s reactions

General Rules for Introductory Questions Don’t interview more than one person at a time Conduct interviews under conditions of privacy Ask nonsensitive questions Instead of: Use: Investigation Inquiry Audit Review Interview Ask a few questions Embezzlement Shortage or paperwork problems

General Rules for Introductory Questions Get a commitment for assistance Make a transitional statement Seek continuous agreement Do not promise confidentiality Negotiations Discussing the source of allegations

Informational Questions Open questions Closed questions Leading questions Question sequences

Informational Question Techniques Begin by asking questions that are not likely to cause the respondent to become defensive or hostile. Ask the questions in a manner that will develop the facts in the order of their occurrence, or in some other systematic order. Ask only one question at a time, and frame the question so that only one answer is required. Ask straightforward and frank questions; generally avoid shrewd approaches. Keep interruptions to a minimum, and do not stop the subject’s narrative without good reason.

Informational Question Techniques Give the respondent ample time to answer; do not rush the respondent. Try to help the respondent remember, but do not suggest answers; be careful not to imply any particular answer by facial expressions, gestures, methods of asking questions, or types of questions asked. Repeat or rephrase questions, if necessary, to get the desired facts. Be sure you understand the answers, and if they are not perfectly clear, have the subject interpret them at that time instead of saving this for later. Give the subject an opportunity to qualify his/her answers.

Informational Question Techniques Separate facts from inferences. Have the subject give comparisons by percentages, fractions, estimates of time and distance, and other such methods to ensure accuracy. After the respondent has given a narrative account, ask follow-up questions about every key issue that has been discussed. Upon conclusion of the direct questioning, ask the respondent to summarize the information given; then summarize the facts, and have the respondent verify that these conclusions are correct.

Methodology Informational Phase Begin with background questions Observe verbal and nonverbal behavior Ask nonleading (open) questions Approach sensitive questions carefully

Dealing with Difficult People Do not react Disarm the person Change tactics

Volatile Interviews An interview that has the potential to bring about strong emotional reactions in the respondent There should be two interviewers Should be conducted on a surprise basis The order of questions should be out of sequence Use hypothetical questions

Closing Questions Reconfirming facts Gathering additional facts Concluding the interview

Assessment Questions Establishes the credibility of the respondent Norming or calibrating Process of observing behavior before critical questions are asked Physiology of deception People lie for one of two reasons: to receive rewards or to avoid punishment The human body will attempt to relieve stress through verbal and nonverbal clues

Verbal Clues to Deception Changes in speech patterns Repetition of the question Comments regarding the interview Selective memory Making excuses Oaths Character testimony Answering with a question

Verbal Clues to Deception Overuse of respect Increasingly weaker denials Failure to deny Avoidance of emotive words Refusal to implicate other suspects Tolerant attitudes Reluctance to terminate interview Feigned unconcern

Nonverbal Clues Full-body motions Anatomical physical responses Illustrators Hands over the mouth Manipulators Fleeing positions Crossing the arms Reaction to evidence Fake smiles

Methodology Interviewer: “Most of them aren’t criminals at all. A lot of times, they’re just trying to save their jobs or just trying to get by because the company is so cheap that they won’t pay people what they are worth. Do you know what I mean?” Interviewer: “Why do you think someone around here might be justified in making a secret arrangement with one of the company’s vendors?” Interviewer: “How do you think we should deal with someone who got in a bind and did something wrong in the eyes of the company?” Interviewer: “Do you think someone in your department might have done something wrong because they thought they were justified?”

Methodology Interviewer: “Have you ever felt justified—even though you didn’t go through with it—in taking advantage of your position?” Interviewer: “Who in your department do you think would feel justified in doing something against the company?” Interviewer: “Do you believe that most people will tell their manager if they believed a colleague was doing something wrong, like committing fraud against the company?” Interviewer: “Is there any reason why someone who works with you would say they thought you might feel justified in doing something wrong?” Interviewer: “What would concern you most if you did something wrong and it was discovered?”

Admission-Seeking Questions Distinguish the innocent from the culpable Obtain a valid confession Obtain from the confessor a written statement acknowledging the facts

Admission-Seeking Questions Presence of outsiders Miranda warnings Theme development People will confess if they perceive that the benefits outweigh the penalties. Offer a morally acceptable reason for the confessor’s behavior. Convey absolute confidence in the premise of the admission you seek from the subject.

Accusing an Innocent Person The accuser has reasonable suspicion or predication to believe the accused has committed an offense. The accusation is made under conditions of privacy. The accuser does not take any action likely to make an innocent person confess. The accusation is conducted under reasonable conditions.

Steps in the Admission-Seeking Interview Direct accusation Observe reaction Repeat accusation Interrupt denials Delays Interruptions Reasoning

Steps in the Admission-Seeking Interview Establish rationalization Unfair treatment Inadequate recognition Financial problems Aberration of conduct Family problems Accuser’s actions Stress, drugs, alcohol Revenge Depersonalizing the victim Minor moral infraction Altruism Genuine need

Steps in the Admission-Seeking Interview Diffuse alibis Display physical evidence Discuss witnesses Discuss deceptions Present alternative Benchmark admission Reinforce rationalization

Steps in the Admission-Seeking Interview Verbal confession That the accused knew the conduct was wrong Facts known only to the perpetrator An estimate of the number of instances or amounts A motive for the offense When the misconduct began

Steps In The Admission-Seeking Interview Verbal confession When/if the misconduct was terminated Others involved Physical evidence Disposition of proceeds Location of assets Specifics of each offense

Taking a Signed Statement Voluntary confessions Intent Instead of: Use: Lied I knew the statement/action was untrue. Stole I wrongfully took the property of ______ for my own benefit. Embezzled I wrongfully took ______’s property, which had been entrusted to me, and used it for my own benefit. Defrauded I knowingly told ______ an untrue statement and he/she/they relied on it.

Taking a Signed Statement Approximate dates of the offense Approximate amounts of losses Approximate number of instances Willingness to cooperate Excuse clause Have the confessor read the statement Truthfulness of statement Preparing the statement