Fraud Examination, 3E Chapter 5: Recognizing Symptoms of Fraud COPYRIGHT © 2009 South-Western, a part of Cengage Learning

Learning Objectives Understand how symptoms help in the detection of fraud. Identify and understand accounting symptoms of fraud. Describe internal controls that help detect fraud. Identify and understand analytical symptoms of fraud. 2

Learning Objectives Explain how lifestyle changes help detect fraud. Discuss how behavioral symptoms help detect fraud. Recognize the importance of tips and complaints as fraud symptoms. 3

Symptoms of Fraud Can be separated into six groups: 1.Accounting anomalies 2.Internal control weaknesses 3.Analytical anomalies 4.Extravagant lifestyle 5.Unusual behavior 6.Tips and complaints 4

Elgin Aircraft Case Accounting Anomalies – result from unusual processes or procedures in the accounting system Example: – the 22 phony doctors – checks were sent to the same two common addresses Why? – managers trusted the perpetrator completely – auditors merely matched claim forms with canceled checks 5

Elgin Aircraft Case Internal Control Weaknesses Example: – Manager had not taken a vacation in 10 years – Employees never received payment confirmations – Payments to new doctors were never investigated or cleared 6

Elgin Aircraft Case Analytical Anomalies – relationships in financial or nonfinancial data that do not make sense 12 million be paid to only 22 doctors over a period of four years 7

Elgin Aircraft Case Lifestyle Symptoms The manager… – took the employees to lunch in a limousine, – lived in a very expensive house, – drove luxury cars, – wore expensive clothes and jewelry, – was “independently wealthy,” – inherited a large sum of money, – yet never took a vacation! 8

Elgin Aircraft Case Behavioral Symptoms – The manager had a “Dr. Jekyll and Mrs. Hyde” personality – Her highs and lows had become more intense and more frequent in recent months 9

Accounting Anomalies Common anomaly frauds involve: Irregularities in source documents Faulty journal entries Inaccuracies in ledgers 10

Accounting Anomalies Irregularities in Source Documents Include the following: – Missing documents – Stale items on bank reconciliations – Excessive voids or credits – Common names or addresses of payees or customers – Increased past-due accounts – Increased reconciling items – Alterations on documents 11

Accounting Anomalies Irregularities in Source Documents Include the following (cont.): – Duplicate payments – Second endorsements on checks – Document sequences that do not make sense – Questionable handwriting on documents – Photocopied documents 12

Faulty Journal Entries Fraud is hidden by using accounting language Legal Expense ,000 Cash ……………5,000 English: “An attorney was paid $5,000 in cash” Accounting: “Debit Legal Expense; Credit Cash” Was the attorney really paid $5,000? 13

Faulty Journal Entries Fraud is hidden by increasing the expense account 14 Assets=Liabilities +Owner’s Equity Stock Dividends Revenues Retained Earnings Net Income Expenses

Faulty Journal Entries Common journal entry fraud symptoms: Journal entries without documentary support Unexplained adjustments to receivables, payables, revenues, or expenses Journal entries that do not balance Journal entries made by individuals who would not normally make such entries Journal entries made near the end of an accounting period 15

Inaccuracies in Ledgers Fraud symptoms relating to ledgers: Ledger that does not balance – the total of all debit balances does not equal the total of all credit balances Master (control) account balances do not equal the sum of the individual customer or vendor balances 16

Internal Control Weaknesses Internal control fraud symptoms include : Lack of segregation of duties Lack of physical safeguards Lack of independent checks Lack of proper authorization Lack of proper documents and records Overriding of existing controls Inadequate accounting system 17

Analytical Fraud Symptoms Analytical Fraud symptoms include: Unexplained inventory shortages or adjustments Deviations from specifications Increased scrap Excess purchases Too many debit or credit memos Significant increases or decreases in account balances, ratios, or relationships 18

Analytical Fraud Symptoms Physical abnormalities Cash shortages or overages Excessive late charges Unreasonable expenses or reimbursements Excessive turnover of executives Strange financial statement relationships, such as: – Increased revenues with decreased inventory – Increased revenues with decreased receivables 19

Analytical Fraud Symptoms Strange financial statement relationships, such as (cont.): – Increased revenues with decreased cash flows – Increased inventory with decreased payables – Increased volume with increased cost per unit – Increased volume with decreased scrap – Increased inventory with decreased warehousing costs 20

Extravagant Lifestyles Example Kay… Embezzled $3 million from her employer Bought a $500,000 or more home Bought five luxury cars Filled home with artwork and glass Bought a boat Paid cash to have yard landscaped Served lobster flown in from the east coast 21

Unusual Behaviors 22 Guilt Fear Stress Behavior Changes Insomnia Increased drinking Taking drugs Unusual irritability and suspiciousness Inability to relax Lack of pleasure in things usually enjoyed Fear of getting caught Inability to look people in the eyes Showing embarrassment around friends, co-workers, and family Defensiveness or argumentativeness Unusual belligerence in stating opinions Confessing (either to a religious leader, psychologist, or other professional) Obsessively contemplating possible consequences Working standing up Sweating Increased smoking Insomnia Increased drinking Taking drugs Unusual irritability and suspiciousness Inability to relax Lack of pleasure in things usually enjoyed Fear of getting caught Inability to look people in the eyes Showing embarrassment around friends, co-workers, and family Defensiveness or argumentativeness Unusual belligerence in stating opinions Confessing (either to a religious leader, psychologist, or other professional) Obsessively contemplating possible consequences Working standing up Sweating Increased smoking

Tips and Complaints 23 Theft Act Concealment Conversion The Fraud Element Triangle Who is in the best position to recognize fraud in each of these elements—Auditors or Company Employees? Company Employees

Tips and Complaints Why are tips and complaints just symptoms? – Many tips and complaints turn out to be unjustified – Difficult to know what motivates a person to complain or provide a tip Customers may feel taken advantage of Employee may have malice, personal problems, or jealousy Spouses and friends may be motivated by anger, divorce, or blackmail – Individuals should always be considered innocent until proved guilt 24

Tips and Complaints Why people are hesitant to come forward: – Impossible to know for sure that a fraud is taking place – Fear of being the whistle-blower – Intimidation by the perpetrator – Feel that squealing on someone is wrong – Not easy to come forward 25