CCIA 2011 Fall Conference Occupational Fraud Schemes & Increasing Fraud Awareness Jenny Dominguez Sr. Manager, VLS Fraud Solutions October 6, 2011

Presenter Contact Information Jenny Dominguez, CPA/CFF, CFE Vicenti, Lloyd & Stutzman, LLP 2

Topics To Cover 3 I.The Fraud Triangle – factors that influence the commission of fraud II.The Fraud Tree – occupational fraud & abuse classification system III.Fraud Schemes – Case Studies

I. Three Factors of the Fraud Triangle 4

What 3 Factors Influence the Commission of Fraud? FRAUD TRIANGLE “Pressures” (Motive) “Opportunities”“Rationalization” (Developed by Donald R. Cressey) 5 Pressures Serious financial problem that requires immediate attention and cannot be resolved by ordinary financial resources Opportunities Become aware that financial problem can be solved by stealing from organization or falsifying organizations records Rationalization Mindset and thinking that what you are doing is justified

II. The Fraud Tree: Occupational Fraud & Abuse Classification System 6

Occupational Fraud 7 The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.

What is the Fraud Tree? 8 Corruption Asset Misappropriation Fraudulent Statements Three Major Types of Occupational Fraud (page 7 of ACFE 2010 Report to the Nations) Off-book frauds that occur in the form of kickbacks, gifts, or gratuities to employees from contractors / vendors Theft or misuse of organization’s cash or assets Deliberate misrepresentation of the financial condition of an organization through intentional misstatement or omission

III. Fraud Schemes Case Studies 9

Corruption – Interesting Facts % of the cases studied in the ACFE 2010 Report to the Nations involved some form of Corruption. The median loss suffered was $250,000. Of the 90 cases studied involving organizations in the “Education” industry, Corruption was the 2 nd most common type of occupational fraud committed, after billing schemes. (page 35 of ACFE 2010 Report to the Nations)

Corruption – Types of Frauds 11 Conflicts of Interest -Purchase Schemes -Sales Schemes -Other Bribery -Invoice Kickbacks -Bid Rigging -Other Illegal Gratuities Economic Extortion

Corruption – Case Study 12 Background / Summary Government agency Performed $100 - $400 million in construction activity annually Construction work was contracted out – internal project managers “Emergency” work was approximately $2 million per year 95% of “emergency” work went to the same vendor Several large construction projects had change orders that exceeded 50% of the original contract, one exceeded 100% Manager of construction management department moved up the ranks from field personnel Manager and CEO vacationed with one particular vendor Any of these stand out as red flags?

Corruption – Case Study 13 Internal Audit Revealed “Emergency” work being performed did not qualify as emergency under PCC:  Fixing potholes outside of Board member’s house  Painting & other general work due to project time constraints Documentation was not kept to support that all contractors on approved list for emergency work were solicited for quotes Change orders paid on some projects were not related to the original construction contract Project tracking system not reconciled to accounting system Construction contracts did not include “right to audit” clause What would next steps be?

Asset Misappropriation – Interesting Facts % of the cases studied in the ACFE 2010 Report to the Nations involved some form of Asset Misappropriation. The median loss suffered was $135,000. Of the 90 cases studied involving organizations in the “Education” industry, “Billing” schemes were the most common type of occupational fraud committed. (page 35 of ACFE 2010 Report to the Nations)

Asset Misappropriation – Types of Frauds 15 Cash -Larceny -Skimming -Fraudulent Disbursements Inventory & All Other Assets -Misuse -Larceny

Asset Misappropriation – Case Study 16 Background / Summary Small dental practice Office manager handled:  Entering patient services into patient billing system – creating A/R  Collecting patient payments  Entering patient payments into patient billing system  Billing patients  Creating deposits and taking to bank Over 2 years “skimmed” approximately $35,000  Unrecorded sales  Write-offs and write-downs  Modified historical payment amounts Patient billing system did not have the capability to lock older months

Asset Misappropriation – Case Study 17 Red Flags Lack of segregation of duties No reconciliations between accounting software and other systems Change in level of activity for certain collection type, particularly cash Refusal to take vacation or share duties Increase in Accounts Receivable Increase in Write-offs Working during “off” hours Write-offs / other adjustments don’t require approval Assets are not safeguarded Deposits done infrequently or irregularly

Asset Misappropriation – Case Study 18 How Can This Be Prevented / Detected Earlier? Prevention:  Better segregation of duties  Secondary / separate approval or log-in required for write-offs  Lock patient tracking system to prevent modification  Perform background checks of new employees  Issue pre-numbered receipts for all payments (perform independent check daily) Detection:  Analytical procedures – compare sales / collections over time  Review of historical write-offs  Perform regular reconciliations between the patient tracking system (which reports total collections) to QuickBooks  Have aggressive collection department / personnel

Fraudulent Statements – Interesting Facts % of the cases studied in the ACFE 2010 Report to the Nations involved some form of Financial Statement Fraud. The median loss suffered was $4.1 million. Of the 90 cases studied involving organizations in the “Education” industry, “Financial Statement Fraud” was the least common type of occupational fraud committed. (page 35 of ACFE 2010 Report to the Nations)

Fraudulent Statements – Types of Frauds 20 Financial -Timing Differences -Fictitious Revenue -Concealed Liabilities & Expenses -Improper Disclosures -Improper Asset Valuations Non-Financial -Employment Credentials -Internal Documents -External Documents

Fraudulent Statements – Case Study (Improper Disclosures) 21 Background / Summary City government - defined benefit pension plan Beginning in 1982 adopted use of “surplus earnings” to alleviate financial obligations of City:  “13 th Check” – extra check to retirees  $10 million, one-time reduction in City’s contribution to pension  Paid 100% of post-retirement healthcare benefits 1996: Passed “MP-1” which set City contribution rates at negotiated rates lower than the actuarially calculated rate 2002: Pass “MP-2” which reduced trigger in MP-1 and slowly ramped up contribution rates Manipulated actuarial valuations:  Changed valuation methods based on what favored City  Excluded certain liabilities as “contingent” – legally required to pay  Reset amortization period of unfunded liability

Fraudulent Statements – Case Study (Improper Disclosures) 22 Background / Summary Investigated financial statement disclosures over 7 years Primary issue: Disclosures related to pension plan funding  City claimed it was funding the pension system at actuarially determined rates, when it was not  City failed to disclose that surplus earnings were used to pay for retiree healthcare benefits Secondary issue: Conflict of interest  Pension board members voted on changes to the pension system that eroded assets and increased their individual benefits

Fraudulent Statements – Case Study (Improper Disclosures) 23 Motivation? City issued $3.1 billion in public bonds from City sought credit ratings from the various Rating Agencies  Better rating provided for better interest rate communication discovered during investigation:  “…when we book the NPO [Net Pension Obligation] the rating agencies won’t like it. It will be a negative for the City. As we market a large amount of bonds it might cost us a lot of money…”  “…my biggest suggestion to her is to eliminate any reference to fitch and rating agencies…this letter will be seen by press and the city does not need to telegraph its pension problems to the rating agencies…”

Fraudulent Statements – Case Study (Improper Disclosures) 24 Cost to City $$$$$  $24 million in fees for investigation  Increased auditor fees  Additional costs to comply with SEC & DA investigations  Higher interest rate on bonds Decreased credit rating Delayed / rejected bond approvals by tax payers Delayed audits (FY2003 completed in 2007) Employees fired and under investigation Significant reduction in public services Reduction in benefits for incoming employees

Fraudulent Statements – Case Study (Improper Disclosures) 25 Red Flags Ineffective Board of Directors or Audit Committee Significant, unusual, or highly complex transactions Recurring attempts by management to justify marginal or inappropriate accounting Formal or informal restrictions on the auditor that limit access to people or information Non-financial management’s excessive involvement in determination of significant estimates Insufficient training of accounting staff Lack of “ownership” of financial statements

Fraudulent Statements – Case Study (Improper Disclosures) 26 How Can This Be Prevented / Detected Earlier? Implement full internal audit department Implement use of independent fraud hotline Ownership for financial statements is clearly assigned – establish accountability Adequate and continuous technical training for employees (accounting department) Training for all employees on what constitutes dishonest behavior Implement Audit Committee

27 THANK YOU!