Fraud Examination Midterm

Fraud (definition)

Intentional deception that causes its victim to suffer an economic loss: "theft by deception"

Forensic accounting (definition)

The intersection of accounting and the law

Four basic elements of fraud

1) Material false representation

2) Intent (scienter)

3) Reliance

4) Damages

Element 1: Material

A false representation of material nature; if something isn't material, it doesn't affect the decision

Element 2: Intent (scienter)

Knowledge that the representation is false, or reckless disregard for the truth (negligence/recklessness, e.g. "didn't mean to send that document")

Element 3: Reliance

The person receiving the representation reasonably and justifiably relied on it

Element 4: Damages

Financial damages resulting from the false representation, intent, and reliance

Average % of revenue companies lose to fraud each year

5% (understated because many cases aren't reported to authorities)

Three main types of fraud

1) Employee fraud/asset misappropriation

2) Financial statement fraud

3) Bribery & corruption

Misappropriation of Assets (employee theft)

Theft or misuse of an organization's assets;

INWARD (employee theft); the MOST COMMON type

Financial statement fraud

Intentional misrepresentation of financial or nonfinancial information to mislead those relying on it for economic decisions;

OUTWARD (info going to third parties);

LEAST detected but GREATEST loss

Bribery & corruption

Unlawful or wrongful misuse of influence in a business transaction to procure personal benefit; involves BOTH inward and outward (e.g. paying a foreign official to misreport the numbers)

Most common fraud type vs greatest loss

Most common = asset misappropriation

greatest loss (and least detected) = financial statement fraud

Four categories under corruption

Conflicts of interest

bribery

illegal gratuities

economic extortion

Asset misappropriation: two main branches

Cash

Inventory and all other assets

Cash misappropriation: three types

1) Theft of cash on hand

2) Theft of cash receipts (skimming, cash larceny)

3) Fraudulent disbursements

Fraudulent disbursements include

Billing schemes, payroll schemes, expense reimbursement schemes, check tampering, register disbursements

Financial statement fraud: two directions

Net worth/net income OVERSTATEMENTS and UNDERSTATEMENTS

Net income overstatement methods (5)

Fictitious revenue; improper timing of revenue/expense recognition; concealed liabilities and expenses; improper asset valuation (incl. inappropriate capitalization of expenses); improper disclosures

Net income understatement methods (5)

Understated revenue; improper timing of revenue/expense recognition; overstated liabilities and expenses; improper asset valuation (incl. inappropriate asset write-offs); improper disclosures

Two ways to think of frauds (perpetrator view)

1) Frauds by people within the org that harm the org itself

2) Frauds by those responsible for financial reporting who use info they know is false to defraud investors/creditors/third parties, benefiting the org and often themselves

What fraud is now understood to be driven by (5)

Corporate performance (trying to look better);

financing pressures/access to financing;

competition to enter and dominate markets;

legal requirements and exposure;

personal needs and agenda

what is the number one way to catch fraud

Whistleblowing / tips

Corporate governance: first line of defense

Properly constructed systems of corporate governance, risk management, and internal controls; board and executive management are responsible

Who oversees management on behalf of shareholders

The board and audit committee

Three lines of defense

First line = board/management (governance, risk mgmt, internal controls)

second line = auditors

third line = fraud investigators

Audit vs forensic investigator: response to fraud

An audit considers the RISK of fraud; the forensic accounting investigator typically RESPONDS to suspicions, allegations, or evidence of fraud

Fraud deterrence cycle: four elements

1) Appropriate corporate governance (tone at the top)

2) Transaction- and entity-level controls

3) Retrospective examination through audits

4) Investigation and remediation of suspected problems

Transaction-level controls (definition)

Controls designed to ensure only valid, authorized, legitimate transactions occur and to safeguard assets from theft or fraud

Retrospective procedures (auditors)

Key link in communicating intolerance for fraud and discovering problems before they grow large enough to threaten the organization

Investigation and remediation: purpose

Findings form the basis for internal and external actions AND for remediating control procedures

Audits purpose for fraud

Auditors seek to detect errors or improprieties absent any specific information that they exist

Fraud investigations purpose for fraud

seek to discover the full methods and extent of improprieties that are suspected or known

Litigation advisory services

Recognize the role of the forensic accountant as an expert or consultant (support)

Investigative services

Use the forensic accountant's skills; may or may not lead to courtroom testimony; fraud examination is a SUBSET of forensic accounting

Non-fraud forensic accounting engagements (examples)

Damage claims (plaintiffs/countersuits), workplace issues, divorce/matrimonial issues, antitrust actions, insurance claims, tax disputes, environmental issues

Commonalities between auditors & forensic investigators (4)

1. Knowledge of the industry/company and its processes

2. knowledge of the GAAP of the jurisdiction/industry

3. interpretation of business documents and records

4. independence, objectivity and skepticism

Roles of the auditor (4)

Fair, Detection, Corrections, Alerts

Auditor role: FAIR

Financial statements are fairly stated in all material respects

Auditor role: DETECTION

Make appropriate and reasonable measures to detect material misstatements

Auditor role: CORRECTIONS

Management corrects material misstatements before the FS are shared with users

Auditor role: ALERTS

Alert users not to rely on the statements through qualifications of the professional opinion

Roles of a forensic investigator (4)

Consensus, Scope, Losses, Evidence

Forensic investigator role: CONSENSUS

Not concerned with reaching a general opinion on the FS (or internal controls) as a whole

Forensic investigator role: SCOPE

Not concerned with a general opinion on sampling and materiality when determining scope of procedures

Forensic investigator role: LOSSES

Assess and measure losses to the organization; recommend corrective and preventative actions

Forensic investigator role: EVIDENCE

Concerned with evidence (documentary, physical, testimonial) about the who, what, when, where, how, and why of a suspected or known impropriety

Patrolman vs Detective analogy

Patrolman = auditor (broad scope, looks at the whole); Detective = fraud examiner (called in when necessary, very specific duty)

Management judgment: estimates

Concern the final amounts of cash that will be received or paid once assets/liabilities are converted to cash

Management judgment: challenge for accountants

Reflect objectively the impact of management's decisions without regard to the underlying motivation

Management override

Top management can directly or indirectly override established controls and enlist others to do so; unique position to perpetrate fraud

Fraudsters by nature are

Trust violators; they achieved a position of trust and chose to violate it

Typical fraudster profile

Looks like an average person with no criminal background; usually with the organization 1+ years

Fraud perpetrator profile (details)

Male, well-educated, middle-aged to retired, accountant/upper management/executive; with company 5+ years; never charged or convicted; usually acts alone (but increasingly collusive due to segregation of duties)

Cressey's hypothesis

The Fraud Triangle

Three sides of the fraud triangle

Perceived pressure (motivation), perceived opportunity, rationalization

Fraud triangle: perceived pressure

Motivation, e.g. meeting analysts' expectations, deadlines, cutoffs, qualifying for bonuses; includes the nonshareable financial problem

Fraud triangle: perceived opportunity

Poor internal controls; the employee must believe they can commit the crime without being caught

Fraud triangle: rationalization

Lets the perpetrator make illegal behavior intelligible and maintain self-concept as a trusted person; often abandoned after the act

Fraud triangle: how many elements are required

ALL THREE must be present; if any is missing, the trust violation does not occur

Fraud triangle in court: three hints

1) Don't call it a theory 2) Can't use it to show someone has (or lacks) the propensity to commit fraud 3) Expert witness can't use it to speculate about the accused's mental state

Nonshareable financial pressure: six categories

Violation of ascribed obligations; problems from personal failure; business reversals; physical isolation; status gaining; employer-employee relations

Why is secrecy needed in embezzlement?

It's not the embezzlement itself that creates the need for secrecy; it's the circumstances that led to it. The employee must be able to resolve the financial problem in secret

Fraud deterrence: key factor

Perception of detection ("How likely am I to get caught?"); increasing it may be the best way to deter employee theft

Common behavioral red flags

Living beyond means; financial difficulties; unusually close association with a vendor/customer; control issues or unwillingness to share duties; (no red flags at all can itself be suspicious: "(too clean")

Situational fraudster

Law-abiding person who normally would never consider fraud; most closely aligns with the fraud triangle

Predatory fraudster

Seeks out organizations where they can start scheming almost immediately after being hired; more highly skilled; complex frauds, corruption, financial crimes

Why collusion increases losses

Many antifraud controls rely on segregation of duties, so perpetrators work together to defeat them

Four ways to combat fraud

Hire well, train well, monitor well, punish and publish

SAS 99: key attitude needed

Professional skepticism ("trust but verify"); guards against overreliance on client representations

SAS 99: brainstorming phase

Discuss how fraud might be perpetrated; set a proper "tone at the top"

SAS 99 eight steps: Step 1-4

1. Staff discussion about fraud risks at the outset of the audit

2. Gather the information needed to identify fraud risks

3. Identify risks that may result in fraud

4. Assess fraud risk after considering programs and controls meant to prevent fraudulent fin reporting

SAS 99 eight steps: Step 5-8

5. Develop specific responses to the fraud risks

6. Consider audit evidence and continually assess fraud risk throughout the audit

7. Communicate the findings

8. Ensure the auditor documented each step

Two forces that deter fraud

(1) Fear of getting caught

(2) fear of punishment

two ways fraud can be prosecuted

Criminally or civilly

Employee obligation to employer

Must cooperate with their employer or be subject to dismissal

Whistleblower protection

Federal and many state laws protect employees who report improper or illegal acts by their employer

Do constitutional rights apply in private employer interviews?

No, but common law still limits how an interview is conducted

Seven common-law limits on employee interviews

1) Minimize invasion of privacy 2) Limit content to job duties 3) Limit public disclosure of private facts 4) Limit intentional infliction of emotional distress 5) Limit defamation 6) Deal fairly and in good faith 7) No false imprisonment

Confession

Valid only if voluntary

• Confessions can’t be obtained through coercion or threats of violence.

• Promises of leniency can nullify a confession.

• Small deceptions are generally permitted and won’t invalidate it.

Fourth Amendment

Protects against unreasonable searches and seizures

Workplace searches by public employers

No search warrant needed when investigating misconduct

A workplace search is reasonable if

It is likely to reveal evidence of work-related misconduct AND necessary to further the investigation

Search limitations

"Exclusive control" and "fruit from the forbidden tree"

Attorney-client privilege (definition)

Right not to disclose confidential communications relating to the professional relationship

Attorney-client privilege: who holds it

The client has the right to compel nondisclosure

Attorney-client privilege: limits

Applies only to communications intended to be confidential; doesn't let the attorney conceal physical evidence; doesn't apply to future acts of crime or fraud

Attorney work-product privilege

Protects all materials prepared by an attorney in anticipation of litigation; shields materials that disclose the attorney's theory of the case; covers written materials directed toward preparing a case

Probable cause is required to

Make an arrest, conduct a search, obtain a warrant, and by grand juries

Culpability scale: three levels

Witness, Subject, Target

Rules of evidence: basic requirements

Evidence must be relevant, trustworthy, and admissible; it relates to the "facts at issue"

Five types of evidence

Testimonial, real, demonstrative, circumstantial, direct

Demonstrative evidence

Educates, summarizes, or amplifies real evidence; tells a story or complements other evidence; must not create prejudice; the heart of most fraud/forensic accounting investigations

Best evidence rule

Allows copies to be presented at trial under certain circumstances

Chain of custody

The individuals who had possession of physical evidence and what they did with it

Independence: why it matters

If stakeholders don't believe the auditor is independent, they lack confidence in management's information

Unlawful for an accountant to

Provide expert opinions or other services to an audit client to advocate the client's interests in litigation or regulatory/administrative proceedings

What an audit firm CAN do with its own forensic investigators

Extend audit procedures; shadow the client's independent legal counsel and outside forensic accountants; or a combination of both

Auditors investigating illegal acts

May do so at the request of the audit committee when no litigation or regulatory proceedings are involved

Integrity and objectivity: five requirements

Maintain 1) objectivity and 2) integrity; be 3) free of conflicts of interest; 4) not knowingly misrepresent facts; 5) not subordinate judgment to others