Fraud Exam 1

Association of Certified Fraud Examiners (ACFE)

The world’s largest anti-fraud organization: more than 90,000 members.

Regularly conducts one of the most comprehensive fraud studies in the U.S.

Their study is the “Report to the Nations”

Based on actual fraud cases reported by certified fraud examiners. 

Seriousness of the Fraud Problem

Organizations lose 5% of annual revenues to fraud.

Fraud increases what we pay for goods and services.

Fraud losses reduce a firm’s income on a dollar-to-dollar basis.

Fraud strain adversely impacts national economies.

Fraud

Includes all ways one individual can gain advantage over another by false representation.

Typically includes surprise, trickery, cunning, and unfair ways another is cheated.

Different from unintentional error. 

Elements of Fraud

A representation about a material point that is false and intentionally or recklessly so that is believed and acted upon by the victim to the victim’s damage. 

Ponzi Scheme

A form of fraud in which belief in the success of a nonexistent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.

Confidence

The single most critical element for fraud to be successful. It is difficult to con anyone out of anything unless the deceived has confidence in the deceiver. 

Occupational Fraud

The use of one’s occupation for personal enrichment through the deliberate misuse or manipulation of the employing organization’s resources or assets. Done in secret, benefits the perpetrator, costs the victim organization. 

Employee Embezzlement

Most common type of occupational fraud. Employees steal company assets.

Direct Embezzlement

Employee directly steals company assets. Also occurs when employees create dummy companies and have their employers pay for goods not actually delivered.

Indirect Embezzlement

Employee takes kickbacks from vendors or customers in return for lower sales prices, higher purchase prices, or the delivery of inferior goods. Payment to employees is made by organizations that do business with the perpetrator’s employer. 

Vendor Fraud

Fraud perpetrated by vendors acting alone or fraud perpetrated through collusion between buyers and vendors. Usually results in overcharge for purchased goods, shipment of inferior goods, or non-shipment of goods even though payment is made.

Customer Fraud

Customers do not pay for goods, customers pay too little, customers get something for nothing, customers deceive organizations into giving them something they should not have.

Management Fraud

Also known as financial statement fraud. Top management deceptively misstates financial statements. 

Investment and Other Consumer Fraud

Fraudulent and usually worthless investments are sold to unsuspecting investors. Customers are sold worthless assets. Money is taken from unsuspecting individuals using a fictitious pretense.

Criminal and Civil Prosecution of Fraud

Successful prosecution requires that the perpetrators acted with intent to defraud the victim. Best accomplished by gathering evidential matter. Evidential matter consists of underlying data plus all corroborating information available. 

Certified Fraud Examiners (CFE)

Requirements to become one include being an associate member of the ACFE, meeting the specified academic and professional requirements, being of high moral character, passing the CFE examination, and agreeing to abide by ACFE Bylaws and Code of Professional Ethics.

Who Commits Fraud

Anyone can commit fraud. Most perpetrators have profiles similar to those of honest people. Psychological profiles of fraud perpetrators are more similar to those of college students than those of other property criminals. 

Predicting Individual Fraud Perpetrators

Characteristics of fraud perpetrators are similar to those that are attractive to most organizations. Most business associates and partners are capable of committing fraud. It is impossible to predict in advance which individuals will become dishonest.

When fraud is revealed, victims are often in denial. They find it difficult to believe that persons similar to themselves are capable of committing fraud. 

Fraud Triangle

Perceived pressure, perceived opportunity, rationalization.

Perceived Pressures

Different pressures motivate individuals to perpetuate fraud in order to benefit themselves, including financial pressures, vices, work-related pressures, and other pressures. 

Financial Pressure

Approximately 95% of all frauds involve financial or vice-related pressure due to personal greed, living beyond one’s means, high bills or personal debt, poor credit, personal financial losses, unexpected financial needs, inadequate income, medical bills, etc.

Personal Financial Pressure

Financial pressures can arise suddenly or can be long-term. Persons with longstanding reputations for honesty can commit fraud when they perceive severe financial pressure. The age range of the highest fraud incidence is 35-44 years — youthful aspirations frequently unrealized, debt accumulation, positions of trust and respect in their organizations. 

Management Financial Pressure

Poor cash position, receivables which are not collectible, loss of customers, obsolete inventory, declining market, violation of restrictive loan covenants.

Vices

Can create extreme financial pressure. Include gambling, drugs, alcohol, expensive extramarital relationships, and shopping. 

Work-Related Pressures

A need to “get even” for perceived mistreatment can motivate employees to commit fraud against their employers. Inadequate recognition for job performance, poor pay, denial of promotion opportunities. 

Other Pressures

Spouse or family member who insists on an unaffordable lifestyle, challenge to “beat the system,” social pressure to display wealth one has not yet accumulated, social or peer pressure to appear materially successful, general dissatisfaction with one’s financial situation or lifestyle. 

Opportunity

The ability to commit or conceal fraud without punishment. Six major factors that increase fraud opportunities:

1. Insufficient controls to prevent and/or detect fraud

2. Inability to judge the quality of performance

3. Failure to discipline fraud perpetrators

4. Lack of access to information

5. Ignorance, apathy, and incapacity

6. Lack of an audit trail

Controls That Prevent/Detect Fraudulent Behavior

The control environment, the accounting system, and the control activities and procedures

The Control Environment

Management philosophy and operating style, modeling

Effective hiring procedures

Clear organizational structure of proper modeling and labeling

Effective internal audit department

The Accounting System

Valid transactions, properly authorized, completeness, proper classification, proper timing, proper valuation, correct summarization

The Control Activities and Prodecures

Segregation of duties (important when cash is involved)

Proper procedures for authorization

Physical control over assets and records

Independent checks on performance

Adequate documents and records

Non-Control Factors of Increasing Opportunity

Inability to judge the quality of performance

Failure to discipline fraud perpetrators

Lack of access to information

Ignorance, apathy, and incapacity

Lack of an audit trail

Inability to Judge the Quality of Performance

It is often difficult to know whether or not you are paying an excessive amount or receiving inferior service or products. Professionals and companies can overcharge, perform work not needed, provide inferior service, and charge for work not performed. Customers may not have the expertise to detect the fraud. 

Failure to Discipline Fraud Perpetrators

Fraud perpetrators who are not prosecuted or disciplined have a high rate of recidivism. Fraud perpetrators who are terminated but not prosecuted are likely to repeat fraudulent behavior in their new jobs.

Fraud perpetrators are usually well-respected in their families, communities, and jobs. The humiliation of fraud discipline or prosecution is a potent deterrent. 

Lack of Access to Information

Many frauds are possible because victims do not have access to information possessed by the perpetrators. Prevalent in large management frauds perpetrated against stockholders, investors, and debt holder.s

Ignorance, Apathy, and Incapacity

At-risk citizens are easy fraud targets because they may not have the capacity or knowledge to detect illegal acts. Older people adn people with language difficulties are often targets.

Lack of an Audit Trail

An audit trail refers to the detailed, chronological record of financial transactions and other accounting events. This trail allows auditors to trace the financial data back to its source documents and original journal entries.

Fraud perpetrators usually manipulate income statements because their audit trails disappear quickly (debit: expense, credit: cash)

Rationalization

Most fraud perpetrators are first-time offenders who would not commit other crimes and must think of a way to justify the dishonesty of their fraudulent acts.

Include philosophies like, the organization owes it to me, I am only borrowing the money and will pay it back, nobody will get hurt, I deserve more, it’s for a good purpose, we’ll fix the books as soon as we overcome this financial difficulty, something has to be sacrificed. 

Fraud Prevention

Most cost-effective way to reduce losses from fraud. Avoids embarrassment to both the victim and perpetrator, eliminates the need for legal action and stolen proceeds repayment, less expensive than fraud investigation.

Fraud cannot be completely prevented, but its frequency can be reduced. Companies should create and maintain a culture of honesty and high ethics and assess fraud risks and develop concrete responses to reduce fraud risk and opportunity. 

5 Elements of a Culture of Honesty and High Ethics

1. Making sure that top management models appropriate behavior

2. Hiring the right kind of employees

3. Communicating the right expectations throughout the organization and requiring periodic written confirmation of expectation acceptance

4. Creating a positive work environment

5. Developing and maintaining an effective policy for fraud when it occurs

Management Behavior

Management cannot act one way and expect subordinates to behave differently. Managers must demonstrate through their own actions that dishonest, questionable, and unethical behavior is not tolerated. Employees rationalize that if fraud is okay for the leaders, it is okay for them.

Hiring the Right Employees

Effective hiring practices must distinguish between marginally ethical and highly ethical individuals, especially for high-risk positions. Proactive hiring practices for hiring ethical individuals include conducting background checks, checking references, properly interpreting responses to inquiries regarding candidates, and testing for honesty and other attributes. 

Ethical Maturity Model (EMM)

1. Ethical leadership → helping others to be ethical

2. Ethical courage → willingness to pay the price for ethics

3. Application of ethics to business situations → fraudulent practices, misleading advertising, unfairness

4. Personal ethical understanding → right/wrong, fairness, honesty, personal integrity, respect for others

Distribution of Employee Honesty

Honest employees will always be honest; dishonest employees will not be receptive to policies; the swing group could go either way.

The swing group represents the majority of employees: they are highly influenced by organizational structure and culture and are likely to be honest when companies have strong ethical leadership.

3 Steps to Communicate Expectations of Honesty and Integrity

1. Identify and codify appropriate values and ethics

2. Institute fraud awareness training that helps employees understand potential fraud problems and how to report or resolve them

3. Communicate consistent expectations about punishment of violators

Ethics Communication Tools

Published codes of conduct, posters, and videos presented at hiring and regular training intervals.

Periodic, written employee confirmation that they understand ethics expectations

Clear statements from management regarding consequences of dishonesty, including termination and prosecution

Codes of conduct conveying expectations of appropriate behavior are required by law under the Sarbanes-Oxley Act of 2002

Creating a Positive Work Environment

Fraud occurs less frequently when employees have positive feelings about their organization.

Factors that detract from a positive work environment include: 

• Top management that does not care or pay attention to employee behavior

• Negative feedback and lack of recognition for job performance

• Perceived inequities in an organization

• Autocratic rather than participative management 

• Low organizational loyalty

• Unrealistically low pay

• Poor training and promotion opportunities

• High turnover and/or absenteeism 

Assessing and Mitigating Fraud Risk

How organizations proactively eliminate fraud opportunities:

• Accurately identifying sources and measure risks

• Implement appropriate preventative and detective controls to mitigate those risks

• Create widespread monitoring by employees

• Retain both internal and external auditors who provide independent checks on performance

Sarbanes-Oxley Act of 2002

Requires every public company to have a whistleblower system and prohibit retaliation against an employee who uses it.

Fraud Detection

Primary ways fraud can be identified: chance, providing ways for people to report fraud suspicions, proactively examining transaction records and documents.

Proactive Fraud Detection

Install a fraud-reporting hotline (whistleblower systems). Employees can report fraud anonymously without fear of retribution.

Fraud reporting services can be provided in-house or outsources to independent organizations.

Fraud-reporting hotlines are subject to abuse → reporting hoaxes, grudge or anger-motivated reporting.

Analyze data and look for indicators of fraud → “red flags” like suspicious trends, frequent occurrences, unexpected numbers, fraud analysis algorithms can be implemented to databases to proactively look for fraud symptoms.

Fraud Investigation

Expensive, sensitive, and complex. Predication is the circumstances that would lead a reasonable professional to believe that fraud has occurred, is occurring, or will occur. Predication is a prerequisite for fraud investigation.

Once predication is present, fraud investigation is used to determine whether fraud actually occurred and the who-what-when-where elements of the fraud.

Approaches to Fraud Investigation

Investigation must be done with approval from the organization’s management. The fraud investigation must not be detectable to perpetrators as they might hide or destroy evidence or commit suicide to avoid humiliation. 

Most fraud perpetrators are first-time offenders and the thought of being caught is traumatic. 

Evidence Square 

1. Testimonial evidence

2. Documentary evidence

3. Physical evidence

4. Personal observation

Testimonial Evidence

Gathered from individuals via interviews and honesty tests.

Documentary Evidence

Gather from paper, computers, or other written sources. Effective tools include data mining, public records searches, audits, net worth calculations, and financial statement analysis. Most effective form of evidence.

Physical Evidence

Fingerprints, tire marks, weapons, stolen property, identification numbers, other tangible evidence. Usually gathered via forensic analysis by experts.

Personal Observation

Acquired by the investigators themselves by invigilation, surveillance, and covert operations.

Fraud Element Triangle

Theft act, concealment, conversion

Steps for Conducting a Fraud Investigation

1. Actions must be taken only to “establish the truth of the matter under question”

2. Individuals conducting the investigation must be experienced, objective, and avoid jumping to conclusions

3. Hypotheses of investigators regarding culpability must be closely guarded when discussing the progress of the investigation

4. Ensure that only those who have a need to know are kept apprised of investigation activities and techniques

5. Ensure that all information gathered during the investigation is independently corroborated and factually correct

6. Investigators should restrict investigation techniques to those that are scientifically and legally sound and fair

7. Investigators should report all facts fairly and objectively

Follow-Up Legal Action

Most organizations and fraud victims make one of three choices regarding legal action against the perpetrator:

• Pursue no legal action

• Pursue civil remedies

• Pursue criminal action

Victim organizations pursue legal action against perpetrators in less than half of fraud cases.

Civil Action

Unless fraud perpetrators have considerable assets, civil action is rare in employee fraud. Civil actions are more common with fraud against individuals or when perpetrators are perceived as having “deep pockets.” Vendors who provide kickbacks are often the target of civil action by victim companies. Stockholders who are creditors victims of financial statement fraud usually sue perpetrators, and anyone associated with the company perceived to have “deep pockets” (frequently result in class-action lawsuits).

Criminal Action

Can only be brought by law enforcement or statutory agencies. Victim organizations wishing to pursue criminal action must work with local, state, and federal agencies to prosecute fraud perpetrators. Criminal penalties may include restitution to victim organizations as well as fines and prison terms. A criminal conviction is more difficult to obtain than a civil judgment, as you must have proof “beyond a reasonable doubt.”