Fraud Examination CH 1-6 - Exam 1 2.13.23

- can not be applied generically to all businesses - tour the area - become familiar with the competitor processes - interview key personnel (ask where fraud may be found) - analyze financial statements and other accounting information - review and process documentation - work with auditors and security personnel - observe employees preforming their duties

1. Understand the business

- begins by conceptually dividing the business unit into its functions or cycles - should brainstorm potential frauds by type and player

2. Identify possible frauds that could exist

- begin to carefully consider what symptoms could be present in the potential frauds identified

3. Catalog possible fraud symptoms

- searching and analysis - data analysis applications - custom structured query language queries and scripts - deliverable = a set of data that matches the symptoms identified in the previous step

4. Use technology to gather data about symptoms

- having good internal controls - discouraging collusion between employees and customers or vendors and clearly informing vendors and other outside contacts of the company's policies against fraud - monitoring employees and providing a hotline for anonymous tips - creating an expectation of punishment - conducting proactive auditing

5 methods of eliminating fraud opportunities

- once errors are determined. by the examiners to be likely indications of fraud, they are analyzed using either traditional or technology based methods - screening results using computer algorithms - real time analysis and detection fo fraud - advantage = potential reuse

5. Analyze results

- most promising indicators - can highlight frauds while small - do not need to wait for a tip - - primary set back is the price and time taken than the traditional approach

6. Investigate symptoms

- asset misappropriations - corruption - fraudulent financial statements

ACFE's categories of Occupational Fraud

- source documents - faulty journal entries - inaccuracies in ledgers

Accounting anomalies

- 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 - physical abnormalities - cash shortages or overages - excessive late charges - unreasonable expenses or reimbursements - excessive turnover of executives - strange financial statement relationships

Analytical fraud

- to detect fraud investigators focus on unexplained changes - balance sheets and income statements are converted from position to period statements to change statements in four ways 1. comparing acct balances to the one previous or to the next 2. calculating key ratios and comparing them from period to period 3. preforming vertical analysis 4. preforming horizontal analysis - statement of cash flows Is already a change statement and doesn't need to be converted

Analyzing financial statements

- these vary based on investigator - many rely heavy on interviews, computer records and emails, and examination of accounting records and internal controls - can be classified into the following: types of evidence produced elements of fraud

Approaches to fraud investigations

- accurately identifying sources and measuring risks - implementing appropriate preventive and detective controls to mitigate those risks - creating widespread monitoring by employees - having internal and external auditors who provide independent checks on performance

Assessing and mitigating the risk of fraud

one party has information about products or situations and the other party does not

Asymmetrical Information

- statistical sampling has become a standard procedure - effective analysis procedure for finding routine errors spread throughout a data set - poor analysis when looking for a needle in a haystack - often examiners will strive to complete a full population analysis to ensure needles are found - full population analysis is preferred

Audit sampling and fraud

having a system of proper authorizations so that only authorized or designated individuals have permissions to complete certain tasks

Authorizations

- analytical skills - communication skills - technological skills

Basic skills of fraud - fighting

4 sections - fraud detection and deterrence - financial transactions and fraud schemes - investigation law

CFE Examination

- 2 years of professional experience in a field related to fraud - accounting and auditing - criminology and sociology - fraud investigation - loss prevention - law

CFE professional requirements

body of law that provides remedies for violations of private rights deals with rights of individuals begins when one party files a complaint against another, usually for the purpose of gaining financial restitution

Civil Law

purpose is to recover money or other assets from the fraud perps and others associated with the fraud

Civil action

- facilitates early detection - deters frauds because potential perps realize that others are watching

Close monitoring

the ability of the fraud perp to make an individual perceive punishment if they do not participate

Coercive power

- good control environment - risk assessment process - set of control activities - information and communication system (including the accounting system) - process of monitoring compliance with the controls

Committee of Sponsoring Organizations' (COSO) definition of internal control framework includes the following elements:

- undertaken to only "establish the truth of the matter under question" - investigators must be experienced and objective - hypothesis about whether or not some one committed fraud should be closely guarded when discussing an investigation with others - investigators must ensure that only those who have a need to know are kept apprised of investigation activities - information is independently corroborated - exercise care to avoid questionable investigation techniques - report all facts fairly and objectively

Conducting a fraud investigation

- prime bank fraud - pyramid schemes - internet fraud - phone scams - chain letters - modeling agencies - telemarketing fraud - Nigerian scams

Consumer fraud types that get victims to unknowingly invest money

- segregation of duties - authorizations - physical controls - independent checks - documentation

Control activities

- tone at the top - hiring the right kind of employees - communicating expectations of honesty and integrity - creating a positive work space - proper handling of fraud and fraud perps when fraud occurs

Creating a culture of honesty and high ethics

- three major factors >hiring honest people and providing fraud awareness training creating a positive work >environment which means having a well-defined code of conduct, having an open-door policy, not operating on a crisis basis, and having a low-fraud atmosphere >providing an employee assistance program (EAP) that helps employees deal with personal pressures

Creating a culture of honesty, openness, and assistance

- create expectations about honesty through having a good corporate code of conduct and conveying those expectations through the organization - having open door access policies - positive personnel and operating procedures

Creating a positive work environment

- fear of punishment > termination (not always a real punishment), having to disclose dishonest behavior to family and friends, prosecution - expectation of punishment can be conveyed by > having a policy that states employees who engage in fraud will be prosecuted to the fullest extent of the law > applying the policy

Creating an expectation of punishment

branch of law that deals with offenses of a public nature - generally deal with offenses against society as a whole - prosecuted either federally or by a state for violating a statute that prohibits some type of activity

Criminal Law

- law enforcement or statutory agencies - fines, prison, or both - restitution agreements

Criminal action

Types - they do not pay - pay too little - get something for nothing - deceive organizations into giving them something they should not have fraud involving bank in chi-town

Customer Fraud

- most important and often most difficult step is the gathering the right data in the right format during the right time period - methods include = open database connectivity, text import, hosting a data warehouse

Data access

- high level view of which contracts have indicator hits that need to be investigated - allows the investigator to mentally combine different indicators to different schemes EXAMPLE - one record per contract for which vendors bid - each column in the table represents an indicator run by the system - one matrix may include 50-100 indicator columns

Data analysis matosas matrix

1. understand business 2. identify possible frauds that could exist 3. catalog possible fraud symptoms 4. use technology to gather data about symptoms 5. analyze results 6. investigate symptoms

Data analysis process

- acl audit analytics = powerful program, most widely used - caseware IDEA = recent versions include an increasing number of fraud techniques - acl's primary competitor - microsoft office and active data = this is a plug in, provides data analysis procedures, based in excel and access, less expensive alternative - other = SAS and SPSS statistical analysis platforms with fraud modules available, traditional programing languages used

Data analysis software

- once data is retrieved and stored in a warehouse, analysis application, or text file they need to be analyzed to identify transactions that match the indicators identified earlier in the process > techniques used: - data preparation - benford's law - digital analysis - outlier analysis - stratification and summarization - time trend analysis - fuzzy matching - real-time analysis

Data analysis techniques

- one of the most important and difficult tasks areas of concern = 1. type conversion and consistency of value 2. descriptives about columns of data 3. time standardization

Data preparation

- art of analyzing the digits that make up number sets like invoice amounts, reported hours, and costs - Benford's Law accurately predicts for many kinds of financial data that the first digits of each group of numbers in a set of random numbers will conform to the predicted distribution pattern - using this law to detect fraud has the major advantage of being very inexpensive to implement and use - disadvantage is that it is tantamount to hunting fraud with a shotgun

Digital analysis

gathered from paper, computers, and other written or printed sources

Documentary evidence

having a system of documents and records that provide an audit trail that can be forwarded to check on suspicious activity and to document transactions

Documentation

- wellness - team building - coaching - conflict resolution - critical incident response - assessment - counseling - referral

EAP program examples

- a perceived opportunity to commit fraud, conceal it, or avoid being punished is the second element of the fraud triangle - 6 major factors increase perceived or real opportunities for individuals to commit fraud 1. lack of internal controls that prevent or detect fraud 2. inability to judge quality of performance 3. failure to discipline fraud perps 4. lack of access to information or asymmetrical information 5. ignorance, apathy or incapacity 6. lack of audit trial

Element of Opportunity

- most are first time offenders who would NOT commit other crimes - they are able to some how rationalize away the dishonesty of what they are doing i.e.: - organization owes me mindset - I am only borrowing the money and I will give it back - nobody will get hurt - I deserve more mindset - it is for a good purpose - we'll fix the books as soon as we are over the financial difficulty - something has to be sacrificed (my integrity or my reputation)

Element of rationalization

- anonymity - independence - accessibility - follow - up

Elements of an effective whistle blowing system

1. positive tone at the top 2. education and training for employees and others about the seriousness of fraud and informing them what to do if fraud is suspected 3. integrity risk assessment and having a good internal control system 4. reporting and monitoring system 5. proactive fraud detection methods in place 6. effective investigation and follow-up when fraud occurs

Elements of fraud-fighting model

- financial - vice - work-related - other

Elements of pressure

- occupational fraud (most common) - employees steal company assets - direct or indirect direct - employee directly steals company cash, inventory, tools, supplies, or other assets indirect - employee takes bribes or kickbacks from other vendors, customers, or other for lower sale prices, higher purchase prices, nondelivery. of goods, or the delivery of inferior goods

Employee Embezzlement

ethical leadership - ethical courage - application of ethics to business situations - personal ethical understanding

Ethics development model

- Carlo "Charles" Ponzi - scheme involving postal coupons and currency exchange - bragging about the success - promise to investors - double their money in 90 days - people questioned the legitimacy - paid returns to original investors - unable to pay returns without new investments - legal action against Ponzi

Explain the Ponzi Scheme

- most people are under financial pressure - real or perceived - once perps meet their financial needs they continue to steal in order to improve their lifestyles - lifestyle improvements - new cars, expensive toys, vacations, home remodel, expensive houses, jewelry, clothing, more day-to-day living expenses - very few save the money they steal

Extravagant lifestyles

- 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

Faulty journal entries

- common real or perceived financial pressures associated with fraud that benefits perpetrators - greed - living beyond ones means - inability to pay bills or personal debt - poor credit - personal financial losses - unexpected financial needs

Financial Pressures - Individual Perpetrators

- when management fraud occurs - companies overstate assets on the balance sheet and net income on the income statement - some causes - poor cash position - receivables that are not collectible - a loss of customers, obsolete Inventory - declining market - restrictive loan covenants that are being violated

Financial Pressures - Organizations

- when fraud is discovered victims (organizations or individuals) must make decisions about legal actions - choices include pursue no legal action pursue civil remedies pursue criminal action against perps

Follow-up legal action

- identify fraud risk exposures - identify the fraud symptoms of each exposure - build audit programs to proactively look for symptoms and exposures - investigate fraud systems identified

Four steps of good fraud auditing

- once predication is present an investigation is undertaken to determine whether or not fraud is present - purpose is to find the truth - do the symptoms presented represent fraud or do the represent unintentional errors or other factors

Fraud Investigation

- perceived pressure - perceived opportunity - some way to rationalize fraud as acceptable

Fraud Triangle elements

- begins by identifying symptoms, indicators, or red flags that tend to be associated with fraud - 3 primary ways by chance by providing ways for people to report suspicions of fraud by proactively examining transaction records and documents to determine if there are anomalies that could represent fraud

Fraud detection

- 1st someone can witness the perp taking cash or assets (theft act) - 2nd altered records or miscounts of cash or inventory can be recognized (concealment) - 3rd lifestyle changes that perps almost inevitably make when they convert their embezzled funds are visible (conversion)

Fraud detection using the three elements

1. a representation 2. about a material point 3. which is false 4. and intentionally or recklessly so 5. which is believed 6. and acted upon by the victim 7. to the victims damage FRAUD IS DIFFERENT FROM UNINTENTIONAL ERRORS

Fraud is deception that includes what

- most cost effective - taking steps to maintain a culture of honesty and high ethics - assessing risk for fraud and developing concrete responses to mitigate risks and eliminate opportunities

Fraud prevention

- majority of fraud is not done alone it is collusive between multiple people - some people after becoming involved in fraud bring others in (the fraud triangle) to participate - power can be an influence in getting people to join in

Fraud recruitment

- accounting professionals - corporate security officers - expert witness - govt inspectors - independent consultant - internal auditor - investigator - law enforcement - lawyers

Fraud related careers

- employee embezzlement - vendor fraud - customer fraud

Fraud where the organization is the victim

- another common technique with textual values - this technique allows for searches to be preformed that will find matches between some text and entries in a data base that are less than 100 percent identical - first and most common usage is Soundex algorithm - a more powerful technique for fuzzy matching uses n-grams. this compares runs of letters in two values to get a match score from 0-100 percent

Fuzzy matching

- many investigators simply import data directly into their analysis application = creating a simplified data warehouse - while most programs are capable of storing millions of records in multiple tables, most applications are relatively poor data repositories - databases are optimal methods of storing data - accounting applications like CAL and IDEA provide options for server based storage of data

Hosting a data warehouse

- because many tips and complaints turn out to be unjustified - customers may complain that they are being taken advantage of - vendors may provide a false tip because they are disgruntled because of a lost contract - employee tips may be motivated by malice, personal problems, or jealousy - tips from spouses and friends may be motivated by anger, divorce, or blackmail - all tips and complaints must be treated with care and only considered a symptom

How are tips and complaints fraud symptoms

Affects how much we pay for goods and services - we pay a fraud bill and detection and investigation for fraud with every purchase

How are we affected by fraud

- most perps will conceal their fraud - may include a manipulation of financial records -> mainly resorting to the income statement as this will erase it completely - they ensure all transactions are done in cash - all of the above results in items that can not be traced or followed

How do perps get around an audit trail for records?

reduces on a dollar to dollar basis for every $1 of fraud net income is reduced by $1 it takes more revenue to recover from from fraud since fraud reduces net income

How does fraud impact a firm's income

3 specific ways - divide fraud into those that are committed against organizations and those that are committed on behalf of organizations - use the ACFE's definition of "occupational fraud" - divide fraud according to victims

How is fraud classified

5% or $3.5 trillion in losses (2015 Gross World Product)

How much revenue do US organizations loose to fraud

- require all applicants to certify that all information is accurate - train those involved in the hiring process to conduct thorough and skillful interviews - use industry specific or other approaches as deemed necessary (credit check, fingerprinting, drug tests, public records search, honesty tests)

How to verify an applicants resume or application

- a ledger that does not balance; that is, the total debit does not equal the credit - master (control) account balances that do not equal the sum of the individual customer or vendor balances

Inaccuracies in ledgers

implementing a system of independent checks such as job rotations, mandatory vacations, audits, and so on

Independent checks

- 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

Internal control weaknesses

- control environment - mgmts role and example - mgmt communication - clear organizational structure - effective internal audit department - information and communication - control activities (procedures) segregation of duties system of authorizations independent check physical safeguards documents and records

Internal controls to prevent or detect fraudulent behavior

victims are unwary individuals

Investment Scams or Other Consumer Frauds

fraudulent and usually worthless investments are sold to unsuspecting investors - ponzi scheme - telemarketing fraud - nigerian letter/money scam - identity theft - advance fee scam - redemption/strawman/bond fraud - letter of credit fraud - internet fraud

Investment and Other Consumer Fraud

- missing documents - stale items on bank reconciliations - excessive voids or credits - common names or addresses of payees or customers - increased past-due amounts - increased reconciling items - alterations on documents - duplicate payments - second endorsements on checks - document sequences that do not make sense - questionable handwriting on documents - photocopied documents

Irregularities in source documents

- Sarbanes-Oxley Act - mandated that every public company have a whistle blower system in place and that it be promoted among employees and others - Dodd-Frank Act - authorized the payment of financial rewards to whistle blowers

Laws to protect whistle blowers

the ability of a fraud perp to convince a potential perp that he or she has power over them

Legitimate power

known as financial statement fraud top management deceptively misstates financial statements enron worldcom sunbeam

Management Fraud

victims are shareholders or debt-holders of the organization

Management Fraud

- standard method of querying data from corporate relational databases - connector between the front end analysis and the back end corporate database - usually the best way to retrieve data for analysis - retrieve in real time - powerful SQL language for searching and filtering - repeated pulls for iterative analysis retrieves metadata link column types and relationships directly

Open database connectivity (ODBC)

- family pressure - challenge to beat the system - envy - desire for success

Other Pressures

- another common analysis that fraud investigators perform is identification of outliers - by focusing on outliers investigators can easily identify cases that do not match the norm

Outlier investigation

the ability of a fraud perp to influence another person because of their expertise or knowledge

Perceived expert power

evidence that is sensed (seen, heard, or felt etc.) by the investigator themselves

Personal observation

implementing physical safeguards such as locks, keys, safes, fences, and so on to prohibit access to assets and records

Physical controls

tangible evidence that can be associated with dishonest acts

Physical evidence

circumstances taken as a whole that would lead to a reasonable prudent professional to believe a fraud has occurred is occurring or will

Predication

- data driven investigation is one of the most powerful methods of discovering fraud - usually preformed during investigations or periodic audits, but it can be integrated directly Into existing systems to preform real time analysis on transactions - although this is similar to traditional accounting controls because it works at transaction time, it is a distinct technique because it specifically analyses each transaction for fraud - rather than for accuracy or another attribute

Realtime analysis

the ability of a perp to relate to the co-conspirator

Referent power

- associate member of ACFE in good standing - meet the specified academic and professional requirements - be of high moral character - pass the CFE exam - agree to abide by the ACFE Bylaws and Code of Professional Ethics - no specific field of study is needed

Requirements to become a CFE (Certified Fraud Examiner)

the ability of a fraud perp to convince a potential victim that he or she will receive a certain benefit through their participation

Reward Power

having two people do a task together to splitting the task into parts so that no one person handles the complete assignment

Segregation of duties

- some understanding of accounting and business - a knowledge of civil and criminal laws, criminology, privacy issues, employee rights, fraud statutes, and other legal fraud-related issues - the ability to speak and write in a foreign language - a knowledge of human behavior, including why and how people rationalize dishonesty, how they react when caught, and what is the most effective way to deter individuals from committing fraud

Specific skills of fraud - fighting

- splitting of complex data sets into groupings - data set must be placed into "subtables" before analysis can be done - for many data sets this can result in thousands of subtables - while basic programs (spreadsheets) make working with this many tables difficult and time consuming analysis applications like ACL and IDEA make it easier

Stratification

- extension of stratification - runs one or more calculations on the subtables to produce a single record representing each subtable - basic summarization usually produces a single result table with one record per case value - pivot tables are two dimensional views with cases in one dimension and calculation in the detail cells (cross tables)

Summarization

- accounting anomalies - internal control weakness - analytical anomalies - extravagant lifestyle - unusual behavior - tips and complaints

Symptoms of fraud

gathered from individuals

Testimonial evidence

- several text formats exist for copying data from one application to another - delimited text = comma separated values (CSV), tab separated values (TSV - fixed width format - extensible markup language (XML) - EBCDIC = used mainly on IBM mainframes

Text import

- summarization technique that produces a single number that summarizes each graph - by sorting the results table appropriately the investigator quickly knows which graphs need further manual investigation

Time trend analysis

- often criticized for not detecting more frauds - auditors are often in the worst position to detect occurrence

Tips and complaints of auditors

1. Testimonial evidence - evidence gather from individuals 2. Documentary evidence - evidence gathered from paper, computers, and other written or printed sources 3. physical evidence - tangible evidence that can be associated with dishonest acts 4. Personal observation- evidence that is sense (seen, heard, felt) by investigators

Types of evidence produced - Evidence Square

- company or organization is victim - management fraud -investment scams and other consumer fraud - misc fraud

Types of fraud according to victims

- reward power - coercive power - expert power - legitimate power - referent power

Types of power

- some people are hesitant to come forward with knowledge or suspicions of fraud - some uncertainly that a fraud is taking place - fear reprisal for being a whistle-blower - intimidation by the perp - belief that squealing on someone is wrong - not easy to come forward within many organizations

Unreported knowledge or suspicions of fraud

- research in psychology reveals that when a person (especially if it is a first time offense) commits a crime they will be engulfed by emotions of fear and guilt - the emotions express themselves as stress - usually exhibits unusual and recognizable behavior patterns to cope - no particular behavior signals fraud - rather behavior changes are signals -> will be a complete 180 change mean to nice and vise versa

Unusual behaviors

2 common forms -vendors acting alone - collusion between buyers and vendors Typically results in: - overcharge - shipment of inferior goods - non-shipment even though payment is made

Vendor Fraud

- gambling - drugs - alcohol - expensive extramarital relationships

Vice Pressures

- fraud prevention - early fraud detection - fraud investigation - follow-up legal action and/or resolution

Ways organizations fight fraud

- use periodic letters to explain policies to vendors - include a right to audit clause on all purchase invoices - approximately 29% of frauds involve collusion

Ways to discourage fraud involving collusion

- understanding of fraud - involved: greed by the perpetrator and greed by investors, deception, confidence

What did the Ponzi Scheme teach

- substance abuse - gambling - money management - health, family, and personal problems

What do EAPs help employees deal with

Government agencies, Researchers, Insurance Companies, and Victims of Fraud

What do fraud statistics, whether it increases or decreases and how much the average fraud costs, come from

Separation of duties Authorizations Physical controls Independent checks Documents and records - first three are most expensive to implement - last two don't prevent fraud but are instead detective controls that help catch or detect fraud before it gets too large

What is SAPID

Single most critical element for fraud to be successful - by paying early "returns" Ponzi gained investors confidence and created the illusion he had a legitimate business it is difficult to con anyone out of anything unless the deceived have confidence in the deceiver

What is confidence

Control environment - est an atmosphere where proper behavior is modeled and labeled Accounting system - provides records that make it difficult for perps to gain access to assets to conceal frauds and convert stolen assets without being discovered - Many variations of the 5 control activities or procedures (SAPID)

What three components work together to eliminate/reduce opportunity for fraud

- reputations of individuals involved can be irreparably injured - guilty parties can go on to be free, undetected, and repeat the act - offended entity may not have information to use in preventing and detecting similar incidents or in recovering damages

What will happen is a fraud investigation is not properly conducted

- approximately 33% of all fraud is detected through tips - section 806 of the sarbanes-oxley act of 2002 requires all public companies to have a whistle-blower system - government agencies and some foreign companies have wb systems

Whistle-blowing programs - against fraud

older people, when a language barrier is present, and other non-knowing individuals

Who are the vulnerable individuals in the fraud equation

- anyone can commit fraud - fraud perpetrators usually can no be distinguished from other people on the basis of demographic or psychological characteristics - most employees, customers, vendors, business associates and partners fit the profile of fraud perps and are capable of committing fraud - it is impossible to predict in advance which employees, vendors, customers, and others will become dishonest

Who commits fraud

- co-workers and managers are in the best positions but they are also the least trained

Who is in the best position to detect fraud

- difficult to know whether or not you are paying an excessive amount or receiving inferior services or products from an individual - easy for a service provider to overcharge, preforming work that is not needed (over charging for services not needed = loss in profits), provide inferior services compared to competition if no research was done or if you are not paying attention they can charge you for work that was not completed

Why is the judgement of character hard - why should it be important

- victims often do not have access to the information possessed by the perps - mainly seen in large management frauds that have taken place against stockholders, investors, and debt holders

Why is the lack of access to information or asymmetrical information detrimental?

- some people commit fraud to get even with their employer or others - motivating factors getting little recognition for work job dissatisfaction fearing loss of job being overlooked for a promotion feeling underpaid

Work - Related Pressures

- must be prepared to learn new methods, software tools, and analysis techniques to take advantage of data methods - proactive in nature - investigator does not need to wait for a tip - investigator brainstorms the schemes and symptoms that might be found and then looks for them - data driven detection is essentially a hypothesis testing approach - tests to see what is supported by the data

data analysis process