AF405 Trimester 1 - 2025: Introduction to Fraud Examination PDF

AF405: TRIMESTER I - 2025 FRAUD ACCOUNTING & FRAUD INVESTIGATION IN FINANCIAL REPORTS WEEK 1 LECTURE # 1 - CHAPTER 1 INTRODUCTION TO FRAUD EXAMINATION  Learning Objectives Define fraud examination and differentiate it from auditing. Understand the f...

AF405: TRIMESTER I - 2025 FRAUD ACCOUNTING & FRAUD INVESTIGATION IN FINANCIAL REPORTS WEEK 1 LECTURE # 1 - 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. 2 Legal Jargons applied to Judiciary System Tort Tort Litigation Litigation Plaintiff Plaintiff Defendant Defendant Evidence Evidence Common/Statute Common/StatuteLaw Law Allegation Allegation  ASSET MISSAPPROPRIATION FRAUD FRAUDULENT CORRUPTION STATEMENTS Need Need for for aa Code Code of of Ethics Ethics and and Internal Internal Controls Controls During 2001 and 2002, several companies were named in regards to fraudulent financial reporting. WorldCom (Audit firm) SO 1 An introduction to the need for a code of ethics and good internal controls  Corporate collapses and reform Enron – filed bankruptcy in 2001, $35m loss, 1.2b reduction in asset, overstatement of income 586m, complex debt-hiding schemes, bribes, Arthur Anderson breached independence (also internal auditor), AA destroyed Enron documents. USs largest bankruptcy case. CEO sentenced to 24 yrs imprisonment. – Lessons learnt: Enron case highlights overriding need for integrity & honesty. Auditors to be open. Need for independent non-executive directors. Xerox (USA): Xerox falsified its accounts through misleading accounting schemes. Global Crossing (USA): telecom giant filed bankruptcy in 2002. it was 4th largest bankruptcy in US history resulting loss of 9000 jobs – manipulation of accounting books. AA as accountants and management consultant. Worldcom (USA) – overstated cash flow. Also AA was auditor.  Corporate collapses and reform HIH Insurance debacle: one of Australias largest insurance companies. 2001. Auditor AA compromise independence. Overstatement of profits & understatement of liabilities. Debt of $5b Lessons learnt: inherent & business risk Parmalat Saga (Italy): fraud & forgery – false paperwork. This scandal involved a forged letter from Bank of America confirming cash bal of 4billion euros. Owner sentenced for 10 yrs. Lessons learnt: domination of family owned business which affects board. Akai Holdings (Hongkong): Ernst & Young-settlement of HK$7.8billion. Hongkongs biggest ever corporate collapse – false accounting. Lehman Brothers: (US) balance sheet manipulation. Ernst & Young negligent.  Corporate collapses and reform Satyam (India): 2009. India’s 4th largest IT group. Overstatement of profits & inclusion of non-existent assets understatement of liabilities. – Lessons learnt: powerfull chairman NBF (Fiji): 1996. failure to comply with accounting standards. Hiding massive losses, risks & debts. Bankrupt with debt of NZ$10m Lessons learnt: proper disclosure & risk management Need Need for for aa Code Code of of Ethics Ethics and and Internal Internal Controls Controls When management is unethical, fraud is likely to occur. Management obligations:  Stewardship.  Provide accurate reports.  Maintain internal controls.  Enforce a code of ethics. SO 1 An introduction to the need for a code of ethics and good internal controls Accounting Irregularities Irregularities include: Fraud Illegal acts Intentional/illegal misstatements Errors/unintentional mistakes Accounting Accounting Related Related Fraud Fraud Fraud - theft, concealment, and conversion to personal gain of another’s money, physical assets, or information. Misappropriation of Assets - defalcation or internal theft. Misstatement of Financial Records - earnings management or fraudulent financial reporting. SO 2 The accounting related fraud that can occur when ethics codes and internal controls are weak or not correctly applied Distinction between fraud & errors A fraudulent/illegal act is premeditated. An error is accidental. Fraud may involve: Manipulation, falsification or alteration of records. Omission of effects of transactions from records. Recording transactions without substance. Intentional misapplication of accounting policies. Errors may involve: Mathematical or clerical mistakes. Oversight or misinterpretation of facts. Misapplication of accounting policies. Accounting Accounting Related Related Fraud Fraud Exhibit 3-2 Categories of Accounting Related Fraud Categories of Accounting-Related Fraud SO 2 The accounting related fraud that can occur when ethics codes and internal controls are weak or not correctly applied The The Nature Nature of of Management Management Fraud Fraud Management Fraud is usually in the form of fraudulent financial reporting. Managers misstate financial statements in order to: 1. Increased stock price. 2. Improved financial statements. 3. Enhanced chances of promotion, or avoidance of firing or demotion. 4. Increased incentive-based compensation. 5. Delayed cash flow problems or bankruptcy. SO 3 The nature of management fraud The The Nature Nature of of Management Management Fraud Fraud Management Fraud may involve:  Overstating revenues and assets.  Understating expenses and liabilities.  Misapplying accounting principles. Enron’s top management had been hiding debt Two Examples: and losses by using special purpose entities (SPEs). Managers at Xerox approved and encouraged accounting practices that violated GAAP and accelerated revenue recognition. SO 3 The nature of management fraud The The Nature Nature of of Employee Employee Fraud Fraud Employee Fraud usually means that an employee steals cash or assets for personal gain. Kinds of Employee Fraud: Kickback 1. Inventory theft. 2. Cash receipts theft. Collusion 3. Accounts payable fraud. Larceny 4. Payroll fraud. 5. Expense account fraud. Skimming SO 4 The nature of employee fraud The The Nature Nature of of Customer Customer Fraud Fraud Customer Fraud occurs when a customer improperly obtains cash or property from a company, or avoids a liability through deception. Kinds of Customer Fraud: 1. Credit card fraud. 2. Check fraud. 3. Refund fraud. SO 5 The nature of customer fraud The The Nature Nature of of Vendor Vendor Fraud Fraud Vendor Fraud occurs when vendors obtain payments to which they are not entitled. Vendors may: 1. Submit duplicate or incorrect invoices. 2. Send shipments in which the quantities are short. 3. Send lower-quality goods than ordered. SO 6 The nature of vendor fraud The The Nature Nature of of Computer Computer Fraud Fraud Computer Fraud may include: 1. Industrial espionage - the act of gaining access to the information an organization is trying to protect by an unauthorized individual. 2. Software piracy – unauthorized copying of software. Cyber theft - computer crime involving the theft of money. SO 7 The nature of computer fraud  Occupational Occupational Fraud Fraud & & Abuse Abuse 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 20 SO 5 The nature of customer fraud Discipline of Fraud Examination Resolving allegations of fraud from tips, complaints, or accounting clues – Documentary evidence – Interviewing witnesses – Writing investigative reports – Testifying findings – Assisting in the detection and prevention of fraud Auditing vs. Forensic accounting vs. fraud examination 21  Forensic vs Fraud vs Auditing Forensic accounting-is the use of any accounting knowledge or skill for courtroom purposes and involves not only fraud but also bankruptcy, business valuations & disputes, divorce etc… Fraud examinations - thou typically performed by accountants but can also include lawyers or private investigators. Auditing – auditing is involved in fraud examination as most occupational frauds are financial crimes.  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 23  Auditing vs. Financial Forensics Issue Auditing Fraud Examination Timing Recurring Nonrecurring Scope General Specific Objective Opinion Determine financial impact Relationship Nonadversarial Independent Methodology Audit techniques Financial forensics techniques Presumption Professional Proof skepticism 24 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 examiner begins by developing hypothesis to explain how alleged fraud was committed and by whom? – In most occupational fraud cases, there are no direct evidences or rarely eye witnesses and perpetrator will not confess right away, thus to solve such incomplete fraud cases we use fraud theory approach…… 25  Fraud Theory Approach 4 Steps: Analyze available data Create a hypothesis Test the hypothesis Refine and amend the hypothesis 26  Tools used in fraud examination 1. Skills – legal ramifications of evidence 2. Interview – obtaining relevant information, taking witness statements, 3rd party witness, corroborating witnesses, suspect co- conspirators, confront suspect 3. Observation – surveillance Internal vs External fraud Internal – offenses by employees External – individuals against org or vice versa. Tools Used in Fraud Examination T Observation 28  Elements of Fraud 4 elements for fraud to exist under common law: 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 29  Defining Abuse Misconduct, improper or excessive use Surfing net while at work Personal business during work hours Long lunch break Going late to work Taking sick leave when not sick Do work slowly Work under influence of alcohol….  Occupational Fraud and Abuse Research Edward Sutherland – “white-collar crime” Donald Cressey – fraud triangle, embezzlers (trust violators) – Cressey’s Hypothesis Dr. W. Steve Albrecht – “fraud scale” Richard Hollinger – employee theft Uniform Occupational Fraud Classification System – fraud tree 31  Opportunity Fraud Triangle Pressure Rationalization 32  Fraud triangle Incentive/pressure – targets, bonuses, promotions, internal control weaknesses, greediness, gambling etc… Opportunity – access to assets, cash, inadequate controls, mgt. overrride, computer logs etc… Rationalization – feelings, job dissatisfaction, low $, grudges etc… Other motivations of fraud perpetrators may be: money (greed), ideology, coercion, ego (power). Eg. Enron, Worldcom etc…  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 34 Position of Perpetrator 35 Median Loss by Position 36 Gender of Perpetrator 37 Median Loss by Gender 38 Department of Perpetrator 39 Median Loss by Department 40 Criminal History of Perpetrator 41 Median Loss per Number of Employees 42 Initial Detection of Frauds 43 Occupational Fraud and Abuse Asset Fraudulent Corruption Misappropriations Statements Conflicts of Interest Cash Financial Bribery Inventory & All Other Assets Nonfinancial Illegal Gratuities Economic Extortion 44  Frequency of Types of Occupational Fraud and Abuse 45  Median Loss of Types of Occupational Fraud and Abuse 46  End of Lecture! Chapter 1