Fraud Exam 4

Financial Statement Fraud Problems

The stock and bond markets are critical components of capitalist economies. The integrity of stock and bond markets depends on the ability of market participants to assess the financial performances of businesses.

Financial statements provide meaningful disclosure of a company’s financial health (based on GAAP).

Misleading financial statements reduce trust in the market, which can result on large investor losses.

Pressure in Financial Statement Fraud

Financial losses

Failure to meet Wall Street’s earning expectations

Inability to compete with other companies

Nature of executive stock option compensation

Opportunity in Financial Statement Fraud

Inadequate internal controls

Ability to hide fraud behind complex transactions or related-party structures 

Lack of independent auditing and independent board of directors 

Rationalization in Financial Statement Fraud

Need to protect shareholders by keeping stock prices high

Aggressive accounting practices are commonplace

Future positive results will offset any temporary problems 

Elements That Lead to Financial Statement Fraud

1. A booming economy

2. Decay of moral values

3. Misplaced incentives

4. High analyst’s expectations

5. High debt levels 

6. Focus on accounting rules rather than principles 

7. Lack of auditor independence 

8. Greed

9. Educator failings 

A Booming Economy

Allowed fraud perpetrators to conceal their activities for longer periods.

Decay of Moral Values

By most measures of integrity, moral values have been decaying over the past several decades.

Misplaced Incentives

The stock option model of executive compensation incentivized company leaders to keep stock prices rising.

High Analyst’s Expectations

Wall Street analysts had unachievable expectations of short-term company performance.

High Debt Levels

High corporate debt levels require high corporate earnings to avoid default on the debt.

Focus on Accounting Rules Rather Than Principles

Companies found loopholes not specifically prohibited by GAAP.

Lack of Auditor Independence

Since audit fees were much smaller than consulting fees, CPA firms had little motivation to function as independent auditors. 

Greed

Multiple groups benefitted from the impacts of continuously rising stock prices and quarterly earnings.

Educator Failings

Educators failed to provide sufficient ethics training to students. 

Nature of Financial Statement Fraud

Involves intentional deceit and attempted concealment — falsified documents; collusion among managers, employees, and third parties

Rarely seen and difficult to detect. Financial statement fraud symptoms appear to be symptoms caused by legitimate factors. Significance of red flags varies widely. 

Center for Audit Quality Study

The SEC’s Accounting and Auditing Enforcement Releases (AAER’s) provide a measure of financial statement fraud frequency

The CAQ conducted a study of financial statement fraud using AAERs issued from 1998-2010. Main deficiencies alleged by the SEC included:

• The audit failed to collect a sufficient level of competent audit evidence

• Due professional care was not exercised

• The auditors lacked a sufficient level of professional skepticism

• The auditor failed to obtain adequate evidence related to management representations

• Appropriate audit opinion was not expressed

Characteristics of a Skeptical Mindset

Characteristics necessary to help auditors detect fraud when management is attempting to conceal fraud in financial statements.

• Questioning mindset

• Suspension of judgment

• Search for knowledge 

• Interpersonal understanding 

• Autonomy 

• Self-esteem 

Strategic Reasoning

The mental process of anticipating a fraud perpetrator’s method of engaging in fraud and concealing fraud

Fraud is strategic in nature because management’s tendency to commit fraud is influenced by anticipated audits.

An auditor’s approach is also strategic because it is affected by management’s potential to commit fraud.

Effective thinking is based on game theory: predict an individual’s response given that individual’s motivations regarding their opponent

Several levels of strategic reasoning exist in audit settings:

• Zero-order: auditor and auditee consider only themselves

• First-order: the auditor considers conditions that directly affect the auditee

• Higher-order: the auditor considers how management may anticipate the auditor’s behavior

Effective audits require first-order and higher reasoning.

Put Financial Statements in Context

Financial statement fraud is more likely to be detected when financial information is compared to real-world quantities.

Consider the context in which management is operating and being motivated.

Compare financial statements with non-financial performance indicators:

• Reported increases in revenues and assets concurrent with multiple business closures

• Reduction in workforce concurrent with reported revenue increase

Fraud Exposure Rectangle

1. Management and directors

2. Relationships with others

3. Organization and industry

4. Financial results and operating characteristics 

Management and the Board of Directors

Top management is typically involved when financial statement fraud occurs. Committed by an organization’s highest individuals on behalf of the organization.

Three aspects of management should be investigated:

1. Management’s background

2. Management’s motivations 

3. Management’s influence in making decisions for the organization

Management’s Influence

Fraud is easier in organizations where a few individuals have primary decision-making power compared to more democratic organizations.

The more people who must be simultaneously dishonest, the lower the probability that fraud will be committed.

An active board of directors and/or audit committee involved in major decision making deters management fraud.

NASDAQ and NYSE corporate governance standards require a majority of board members be independent and key committees be composed of independent directors.

Relationships

Relationships with others

Relationships with financial institutions 

Relationships with related organizations and individuals

Relationships with auditors

Relationships with lawyers

Relationships with investors

Relationships with regulatory bodies

Relationships with Others

Financial statement fraud is often perpetrated with the help of other real or fictitious organizations.

Special purpose and variable interest entities: business interests formed solely to accomplish specific tasks. Can be used to disguise financial fraud

Relationships with financial institutions and bondholders can reveal extent to which a company is leveraged. 

Relationships with Financial Institutions

Likelihood of financial fraud increases with extent of leverage.

Personal relationships between company executives and officers of financial institutions can be an indicator of management fraud.

Banks and other financial institutions can provide unauthorized loans to executives using company assets as collateral.

Officers of financial institutions are in a position to falsify documents and audit confirmations.

Relationships with Related Organizations and Individuals 

Related parties, including family members, should be examined. Transactions with related parties is one of the easiest ways to perpetrate financial fraud.

Identify fraudulent relationships by examining. Large transactions, unusual transactions, transactions occurring at strategic times that make financial statements look better.

Relationships with Auditors

Auditor changes usually happen for good reasons.

Termination of auditor-auditee relationships are often caused by:

• Failure of the client to pay

• An auditor-auditee disagreement

• Suspected fraud or other problems by the auditor

• Auditee believing that the auditor’s fees are too high

Publicly traded companies are required to publicly disclose changes in their audit firm, as well as reasons for the change, on SEC form 8-K.

Relationships with Lawyers

Relationships between corporate managers and lawyers pose a significant risk for fraud.

Lawyers are usually advocates for their clients. Lawyers provide client support until fraud is obvious.

Lawyers have client information potentially significant for fraud. Legal difficulties and regulatory problems.

A change in legal firm without obvious reason is a cause for concern.

There are no SEC reporting requirements for changing lawyers.

Relationships with Investors

Financial statement fraud is often motivated by a debt or equity offering to investors.

Knowledge of the number and kinds of investors provides a gage of pressure and public scrutiny.

In the case of publicly held organizations, investor groups follow the company closely and can provide indications that something is wrong. “Short” sales of company stock.

Because investor groups focus on different information than the auditor, some fraud symptoms may be more obvious to investor groups than to auditors.

Relationships with Regulatory Bodies

If you are examining a company that is publicly held, you need to know the following:

• Has the SEC ever issued an enforcement release against it?

• Has the SEC ever issued a Wells Notice against it?

• Have all annual, quarterly, and other reports been filed on a timely basis?

• Relationship with appropriate regulatory bodies, including any outstanding issues

• Does the organization owe federal, state, or local back taxes?

Organization and Industry

Financial statement fraud can be masked by creating an organizational structure that makes it easy to hide fraud.

Attributes conducive to fraud:

• Unduly complex organizational structure

• No internal audit department

• Board of directors with no or few outsiders or audit committee

• One person that controls related entities

• Offshore affiliates with no apparent business purpose

• Numerous acquisitions

Investors must understand who the owners of the organization are. Silent and hidden owners can use organizations for illegal activities.

Industry organization should be examined. Some industries are inherently risky. Many new business models prove themselves ineffective.

Financial Results and Operating Characteristics

Fraud symptoms most often manifest through changes in financial statements. Large changes in account balances period to period are more likely to contain fraud than small, incremental changes. Accompanying notes to financial statements give insight to potential fraud but may not be understood by auditors.

Compare balances to similar organizations in the same industry.

Assessing fraud exposures using financial relationships requires:

• Knowledge of the nature of the client’s business

• Kinds of accounts that should be included

• Kinds of fraud possible in the organization

• Symptoms the fraud would generate

Include non-financial performance measures to detect unusual financial results. Management cannot easily manipulate most non-financial performance measures.

Asset Misappropriation

Cash → larceny, skimming, fraudulent disbursements

Inventory and other assets → misuse, larceny 

Larceny

Cash is stolen after the cash is recorded in the company’s accounting system. Successful when they involve small amounts over extended periods.

Easier to detect than skimming schemes. 

Skimming

Scheme in which cash is stolen from an organization before it is recorded on the organization’s books and records.

Fraudulent Disbursements

Check and payment tampering

Register disbursement schemes

Billing schemes

Expense reimbursement 

Payroll disbursement schemes

Check and Payment Tampering

Schemes in which an employee either prepares a fraudulent check for their benefit or intercepts a check intended for another person or entity and converts it to their benefit. 

Only disbursement fraud in which the perpetrator physically prepares the fraudulent check. 

Register Disbursement Schemes

The least costly of all disbursement schemes.

False refunds and false voids.

False Refunds

The perpetrator’s processes a merchandise return when no return was made. Perpetrator takes money from the cash register in the amount of the false return.

False Voids

The perpetrator keeps the customer’s receipt at the time of sale and then rings in a voided sale after the customer has left. Perpetrator takes money from the cash register in the amount of the voided sale. 

Billing Schemes

The perpetrator submits or alters an invoice, which causes their employer to willingly issue a payment.

The three most common types are:

• Setting up dummy (shell) companies to submit invoices to the victim organization

• Altering or double paying a non-accomplice vendor’s statement

• Making personal purchases with company funds

Expense Reimbursement

Perpetrators produce false timecards, sales orders, or expense reports that cause the victim company to make a fraudulent disbursement.

Four common types:

• Mischaracterizing expense

• Overstating expenses

• Submitting fictitious expenses

• Submitting the same expenses multiple times

Usually involves the creation of bogus support documents. Easy to create using computer graphics software. 

Payroll Disbursement Schemes

3 major categories:

• Ghost employees

• Falsified hours and salary

• Commission schemes

Ghost Employee Schemes

Generate the greatest losses in payroll disbursement schemes.

Four things needed for it to work:

1. Must be added to the payroll

2. Timekeeping and wage rate information must be collected

3. A paycheck must be issued to them

4. The check must be delivered to the perpetrator or an accomplice

Wage Overpayment

Includes falsification of pay rate or hours worked or both.

Commission Fraud

An employee on commission can fraudulently increase their pay by:

• Falsifying the number of sales made by creating fictitious sales, falsifying sales values, or claiming sales made by another employee or in another period

• Increasing the rate of commission

Worker’s Compensation Fraud

Persons fraudulently collect benefits entitling persons injured on the job to compensation while they recuperate.

Most common method is faking an injury and collect payments from the victim company’s insurance carrier. Often includes collusion with a doctor who processes bogus claims.

The primary victim is the employer’s insurance carrier, who pays fraudulent medical bills and for perpetrator absences. Costs passed onto employees who pay higher premiums. 

Non-Cash Frauds Against Organizations

Inventory, information, and securities

Inventory Fraud

Any scheme involving the theft or misappropriation of physical, non-cash assets such as inventory, equipment, or supplies.

Examples: employee steals inventory from the warehouse; employee uses company equipment for personal businesses.

Information Fraud

Any scheme in which an employee steals or otherwise misappropriates proprietary confidential information or trade secrets. 

Examples: employee s sells research to competing organization; employee provides trade secrets to competing organization.

Securities Fraud

Any scheme involving the theft or misappropriation of stocks, bonds, or other securities.

Examples: employee fraudulently steals company bonds; employee fraudulently steals stock options from the organization. 

Corruption

Four main types:

• Bribery schemes

• Conflict of interest schemes

• Economic extortion schemes

• Illegal gratuity schemes

Bribery

Involves offering, giving, receiving, or soliciting anything of value to influence an official act. 

Commercial bribery, kickbacks, bid-rigging.

Commercial Bribery

Offering something of value to an employee to influence a business decision. Employee’s employer does not consent to the payment.

Kickbacks

Undisclosed payments made by vendors to employees of purchasing companies.

Bid-Rigging

An employee fraudulently assists a vendor in winning a contract through the competitive bidding process. 

Conflict of Interest

An employee, manager, or executive has an undisclosed economic or personal interest in transactions that adversely affect the company.

Requires that the employee’s interest in the transaction be undisclosed.

Two categories are purchase schemes and sales schemes.

Economic Extortion

An employee demands payment from a vendor to make a decision in that vendor’s favor. Involves the use of actual or threatened force and is a criminal offense.

Illegal Gratuities

Similar to bribery schemes except that the intent is to reward someone for making a favorable decision rather than simply to influence them.

Consumer Fraud

The use of deceptive business practices that cause financial or other losses for consumers; targets individuals as victims.

Identity Theft

Circumstances in which someone uses another person’s personal information to commit fraud or other crimes.

Victims suffer loss of credit rating and reputation as well as money.

Prevention is the best way to fight it.

Frequently involves betrayal of the victim’s trust by close friends or family.

Identity Theft Cycle

State 1: Discovery — gain information, verify information

Stage 2: Action — accumulating documentation

Stage 3: Trial — 1st, 2nd, and 3rd dimensional

Converting Personal Informtaion to Financial Gain

Purchase expensive goods and services.

Engage in fraudulent financial transactions. Open new checking account from which they write checks for which there are insufficient funds.

Commit crimes or reduce the consequences of crimes. Fraudsters with criminal records may use a victim’s identity to purchase firearms.

Stealing a Victim’s Identity

Gather information from entities with whom the victim does business

Steal wallets or purses

Break into victim’s homes and steal information

Steal mail, including bank, tax, or credit card information

Complete a “change of address form” at a local post office

Watch customers and steal credit card and other information (shoulder surfing)

Pose as a legitimate employee, government official, or representative of an organization with which the victim conducts business

Rummage through a consumer’s trash (dumpster diving)

Skim victims’ credit card information when they pay their bills

Use the internet to steal important information. Phishers send emails and pop-up messages claiming to be from legitimate organizations. Messages ask victims to “update” or “validate” their accounts to encourage them to divulge personal information.

Minimizing Risk of Identity Theft

Guard your mail from theft

Opt out of pre-approved credit cards

Check personal credit information at least annually

Protect social security numbers (SSNs)

Safeguard personal information from housemates or domestic service providers

Guard trash from theft

Protect wallets and other valuables

Use strong passwords

Protect your home from fraudsters

Opt out of information sharing. Under the Gramm-Leach Bliley Act: Financial institutions have the right to share personal information for a profit. Individuals have the right to opt out of having their information sold

Protect your computer. Do not respond to requests for personal information. Do not open unknown attachments. Send information using secure websites. Websites should begin with “https:” where the “s” indicates a secure website. Frequently review bank and credit card information. Use antivirus software.

Prosecution of Identity Theft

Identity theft can now be prosecuted criminally and/or civilly. Every state and the federal government has statutes prohibiting identity theft.

Must show that the perpetrator acted with intent to defraud the victim.

Intent to defraud is best shown using: appropriate evidential matter and proof that loans or large purchases were made using the fake identity.

Foreign or Diplomatic Money Offer

Fraudsters from an economically disadvantaged country contact victims by email or phone and offer millions of dollars. Victims must provide names and bank account and routing numbers. Fraudsters use information to drain victim’s bank accounts.

Fraudsters try to make the victim feel sorry for them. Present the scam as a “once in a lifetime opportunity.”

Clearinghouse Scam

Fraudster poses as a foreign banker acting as a clearinghouse for venture capital companies seeking investors. 

Real Estate Purchase Scam

Fraudsters convince victims to pay “up-front fees” on a land purchase by a foreign concern.

Crude Oil Sale at Below Market Price

Fraudsters offer below-market prices for crude oil in return of registration and licensing fees.

Disbursement of Money From Wills

Fraudsters pose as “benefactors” interested in bequeathing large sums of money, but to the get the money, victims must pay inheritance taxes and fees.

Multilevel Marketing Overview

When structured correctly, multilevel (network) marketing is a legitimate form of business. Distributors make money on their own sales and on the sales of their recruited subordinates.

Many work-at-home schemes are fraudulent versions of network marketing that function as pyramid or Ponzi schemes.

• Products are illusionary and the focus is on recruitment

• Founders and those at the top make large amounts of money

• Those at the bottom always lose their investment

Indicators of Fraudulent MLMs

Focus on recruitment rather than sales is a fraud indicator. Headhunter fees for signing additional recruiters. Requirement for minimum depth or width of subordinate distributors in order to receive compensation.

Requirement that representatives purchase large, expensive amounts of inventory – “front loading.”

Pressure to sign contracts in high-pressure situations such as “opportunity meetings.”

Business deals that generally seem “too good to be true.”

International Multilevel Marketing Schemes

Some countries have outlawed all types of MLM organizations, including those with valid products.

Countries new to capitalism, such as Albania in the early 1990s, are vulnerable to fraudulent MLMs on a national scale. Excessive investment in MLMs and similar fraudulent schemes destroyed the Albanian economy. Negative effects from MLMs and pyramid schemes lasted for years.

Chain Letters

Victims receive letters telling them to send money in return for mailing lists with vague promises of lucrative returns.

Mail Stuffing

Victims answer ads promising lucrative work stuffing envelopes, but only receive promotional material and requests for cash.

Product Testing

Victims pay an enrollment fee to enter a product testing program but receive no response after sending the fee.

Craft Assembly

Victims are offered pay in exchange for assembling craft products but are consistently denied payment with the excuse that assembled products “don’t meet standards.”

Bogus Mystery Shopper Scams

Perpetrators promise victims a job strolling through stores and filing reports on their experience. Typical victims are teenagers or college students.

Victims pay an enrollment fee, but only receive a list of companies that hire mystery shoppers.

Very few of the advertisements are legitimate.

Legitimate employers of mystery shoppers usually hire experienced merchandise managers and other retail professionals. Most mystery shoppers have years of industry experience.

Telemarketing Fraud

Fraudsters assemble large telemarketing centers where specially trained salespeople find and defraud victims.

Fraudster moves locations frequently in order to hinder local law enforcement.

Victims are typically offered fraudulent investment opportunities.

More effective than similar mail or internet-based schemes because the fraudsters can speak to victims directly.

Scamming Older Adults

Older adults are more susceptible to telemarketing fraud than any other type of fraud. Many older adults are lonely and willing to speak with fraudulent telemarketers.

Older adults are afraid to admit when they were conned out of money. Concerned with being considered unfit to care for themselves.

Many older adults are very trusting and unlikely to believe that someone is deliberately trying to take advantage of them.

Safeguards Against Telemarketing Fraud

Never give a social security number, credit card, or other personal information over the phone unless you initiate the call.

Do not pay up-front fees in return for promised prizes or rewards.

When conducting transactions by phone, be sure that you know to whom you are speaking.

Register with the national “do not call” registry. Free service from the federal government.

Mortgage Fraud

Falsifying or omitting information on a mortgage application in order to qualify for a higher mortgage loan.

During the 2007-2010 subprime mortgage crisis, banks and mortgage brokers encouraged applicants to falsify information.

Consumers played the role of perpetrator and victim.