Fraud Examination and Abuse

Introduction to Fraud Examination

• Fraud accounting and fraud investigation in financial reports will be examined

Learning Objectives

• Define fraud examination and how it is different from auditing
• Understand the fraud theory approach
• Define occupational fraud, fraud and 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

Legal Jargons Applied to Judiciary System

• Tort
• Litigation
• Plaintiff
• Defendant
• Evidence
• Common/Statute Law
• Allegation

Fraud Types

• Asset Misappropriation
• Corruption
• Fraudulent Statements

Need for a Code of Ethics and Internal Controls

• Several companies, including Global Crossing, WorldCom, Enron, Xerox, and Adelphia, were named regarding fraudulent financial reporting during 2001 and 2002

Corporate Collapses and Reform

• Enron filed bankruptcy in 2001 and had a $35 million loss, a $1.2 billion asset reduction, and a $586 million income overstatement
• Enron used debt-hiding schemes and bribes
• Arthur Anderson breached independence as an internal auditor and destroyed Enron documents
• This was the largest bankruptcy case in the US, and the CEO was sentenced to 24 years imprisonment
• Key lessons from the Enron case: there is a need for integrity and honesty, auditors should be open, and there is a need for independent non-executive directors
• Xerox (USA) falsified its accounts through misleading accounting schemes
• Global Crossing (USA) filed bankruptcy in 2002 and was the 4th largest bankruptcy in US history
• There was a loss of 9000 jobs due to manipulation of accounting books
• AA served as accountants and management consultant.
• Worldcom (USA) overstated cash flow, and AA was the auditor
• HIH Insurance debacle, one of Australia's largest insurance companies compromised independence in 2001 with Auditor AA
• There was an overstatement of profits & understatement of liabilities, resulting in a debt of $5b
• Lessons Learnt: inherent & business risk
• Parmalat Saga (Italy) involved fraud & forgery, specifically false paperwork and a forged letter from Bank of America confirming a cash balance of 4 billion euros, leading to a 10-year sentence for the owner
• Key lessons involved family-owned businesses
• Akai Holdings (Hongkong) had an Ernst & Young settlement of HK$7.8 billion which was Hongkongs biggest ever corporate collapse involving false accounting
• Lehman Brothers (US) had balance sheet manipulation, and Ernst & Young was negligent
• Satyam (India) was India's 4th largest IT group in 2009, and had overstatement of profits & inclusion of non-existent assets understatement of liabilities
• Key lessons involved a powerful chairman
• NBF (Fiji) failed to comply with accounting standards and hid massive losses, risks & debts in 1996, bankrupt with debt of NZ$10m
• Key lessons involve proper disclosure & risk management

Need for a Code of Ethics and Internal Controls

• Fraud is more likely when management is unethical
• Management obligations include stewardship, providing accurate reports, maintaining internal controls, and enforcing a code of ethics

Accounting Irregularities

• Includes fraud, illegal acts, intentional/illegal misstatements, and errors/unintentional mistakes

Accounting Related Fraud

• Fraud includes theft, concealment, and conversion to personal gain of another's money, physical assets, or information
• Misappropriation of Assets is defalcation or internal theft
• Misstatement of Financial Records involves earnings management or fraudulent financial reporting

Distinction Between Fraud & Errors

• A fraudulent/illegal act is premeditated, while an error is accidental
• Fraud may involve manipulation, falsification or alteration of records, omission of transactions, recording transactions without substance, and intentional misapplication of accounting policies
• Errors may involve mathematical or clerical mistakes, oversight or misinterpretation of facts, and misapplication of accounting policies

Categories of Accounting-Related Fraud

• Management fraud involves misstating financial statements and is usually not preventable by internal control because of management override
• Employee fraud involves inflating hours worked on time cards, is preventable with supervisor verification and signed time cards
• Customer fraud involves returning stolen merchandise for cash and is preventable with refund policies
• Vendor fraud involves requesting duplicate payment for one invoice and is preventable with invoice matching

The Nature of Management Fraud

• Management Fraud is typically fraudulent financial reporting
• Financial statements are misstated in order to increase stock price, improve financial statements, increase chances of promotion, increase incentive-based compensation, and delay cash flow problems or bankruptcy
• Management Fraud may involve overstating revenues and assets, understating expenses and liabilities, and misapplying accounting principles
• Enron hid debt and losses using special purpose entities (SPEs)
• Xerox approved and encouraged accounting practices that violated GAAP and accelerated revenue recognition

The Nature of Employee Fraud

• Employee Fraud is an employee steals cash or assets for personal gain and can include kickbacks, collusion, larceny, skimming, payroll fraud, and expense account fraud

The Nature of Customer Fraud

• Customer Fraud is when a customer improperly obtains cash or property from a company, or avoids a liability through deception and can include credit card fraud, check fraud, and refund fraud

The Nature of Vendor Fraud

• Vendor Fraud occurs when vendors obtain payments to which they are not entitled
• Vendors may submit duplicate or incorrect invoices, send shipments with short quantities, or send lower-quality goods than ordered

The Nature of Computer Fraud

• Computer Fraud may include industrial espionage which is when gaining access to the information an organization is trying to protect and software piracy, which is unauthorized copying of software
• Cyber theft is computer crime involving the theft of money

Occupational Fraud & Abuse

• It is when one's occupation is used for personal enrichment through the deliberate misuse or misapplication of the employing organization's resources or assets

Discipline of Fraud Examination

• Resolving allegations of fraud from tips, complaints, or accounting clues through documentary evidence, interviewing witnesses, writing investigative reports, testifying findings, and assisting in the detection and prevention of fraud
• Auditing, forensic accounting, and fraud examination are all considered

Forensic vs Fraud vs Auditing

• Forensic accounting is accounting knowledge or skill for courtroom purposes and involves fraud, bankruptcy, business valuations, disputes, and divorce
• Fraud examinations are performed by accountants and can include lawyers or private investigators
• Auditing is involved in fraud examination due to most occupational frauds are financial crimes

Auditing vs. Fraud Examination

• Auditing is recurring, general, is an opinion, non-adversarial, auditing techniques and it involves professional skepticism
• Fraud Examination is nonrecurring, specific, affixing blame, adversarial, fraud examination techniques and it involves proof

Auditing vs. Financial Forensics

• Auditing is recurring, general, is an opinion, non-adversarial, and audit techniques with Professional skepticism
• Financial Forensics is nonrecurring, specific with financial impact determined ,independent, financial forensics techniques and it involves proof

Fraud Examination Methodology

• Based on predication which is the totality of circumstances that would lead a reasonable, professionally trained, and prudent individual to believe a fraud has occurred
• Fraud examinations must be and examiner begins based on predication
• Fraud theory approach is often used in occupational fraud cases where there is no direct evidence

Fraud Theory Approach

• Analyze available data
• Create a hypothesis
• Test the hypothesis
• Refine and amend the hypothesis

Tools Used in Fraud Examination

• Legal ramifications of evidence, interviewing, observation and surveillance are used
• Internal fraud is offenses by employees
• External fraud is individuals against the organization or vice versa

Tools Used in Fraud Examination

• Includes document analysis, corroborative witnesses, neutral third-party witnesses, co-conspirators, and targeting suspects

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 are needed for fraud to exist under common law

Defining Abuse

• Defined as misconduct, or improper or excessive use. Such as surfing the net or personal business at work, long lunch breaks, lateness, sick leave when not sick, slow work, and working under the influence of alcohol

Occupational Fraud and Abuse Research

• Edward Sutherland: white-collar crime
• Donald Cressey: fraud triangle, embezzlers (trust violators) and Cressey's Hypothesis
• Dr. W. Steve Albrecht: fraud scale
• Richard Hollinger: employee theft
• Uniform Occupational Fraud Classification System: fraud tree

Fraud Triangle

Includes Pressure, Opportunity and Rationalization.

Fraud triangle

• Pressure/Incentive: targets, bonuses, promotions, internal control weaknesses, greediness, gambling
• Opportunity: access to assets, cash, inadequate controls, management override, computer logs
• Rationalization: feelings, job dissatisfaction, low pay, grudges
• Additional motivations of fraud include money (greed), ideology, coercion, ego (power), Enron, Worldcom.

2010 Report to the Nations on Occupational Fraud & Abuse

• Global survey measuring the costs of occupational fraud
• Results revealed approximately 5% loss due to fraud, equaling $2.9 trillion worldwide

2010 Report to the Nations on Occupational Fraud & Abuse

• Position of Perpetrator, Employee: 42.1%, Manager: 41.0%, Owner/Executive: 16.9%
• Median Loss by Position, Employee: $80,000, Manager: $200,000, Owner/Executive: $723,000
• Gender of Perpetrator, Male: 66.7%, Female: 33.3%
• Median Loss by Gender, Male: $232,000, Female: $100,000
• Department of Perpetrator: Accounting, Operations, Sales, Executive/Upper Management, Customer Service, Purchasing, Warehousing/Inventory, Finance, Information Technology, Marketing/PR, Manufacturing & Production, Board of Directors, Human Resources, Research and Development, Legal, Internal Audit
• Median Loss by Department, Executive/Upper Management, Board of Directors Legal Purchasing Finance, Marketing/PR, Warehousing/Inventory, Human Resources, Accounting, Manufacturing & Production, Operations, Research and Development, Sales Information Technology, Customer Service, Internal Audit
• Criminal History of Perpetrator: Never Charged or Convicted 85.7%,Prior Convictions 6.7%, Charged but not Convicted 7.7%
• Median Loss per Number of Employees: <100 $155,000, 100-999 $200,000, 1,000-9,999 $139,000, 10,000+ $164,000
• Initial Detection of Frauds: Tip: 40.2%, Management Review 15.4%, Internal Audit 13.9%, Accident 8.3%

Occupational Fraud and Abuse

• Includes Corruption, Asset Misappropriations, and Fraudulent Statements

Occupational Fraud and Abuse

• Corruption includes conflict of interest, bribery, illegal gratiuties and economic extortion
• Asset Misappropriations includes cash, inventory & all other assets
• Fraudulent Statements include financial and non financial

Frequency of Types of Occupational Fraud and Abuse

• Financial Statement Fraud: 4.8%
• Corruption: 32.8%
• Asset Misappropriation: 86.3%

Median Loss of Types of Occupational Fraud and Abuse

• Financial Statement Fraud: $4,100,000
• Corruption: $250,000
• Asset Misappropriation: $135,000

Explore fraud examination, occupational fraud, and abuse. Understand the elements of fraud under common law. Learn about employee fraud categories and the fraud theory approach.