Fraud Flashcards

Use these for the fraud quiz

Corruption

An act done with the intent to give some advantage inconsistent with official duty and the rights of others. The act of an official or fiduciary person who unlawfully and wrongfully uses his station or character to procure some benefit for himself or for another person, contrary to duty and the rights of others.

Commercial Bribery

Giving or receiving anything of value for the influence of a business decision, without the consent or knowledge of the owner.

Official Bribery

giving or receiving anything of value to induce a public official to commit a specific act

Illegal Gratuity

Not necessarily to influence but rather for or because of an act — to reward a decision —Lesser Offense

Randy Duke Cunningham

A former U.S. Congressman who was convicted of bribery and fraud related to defense contracts.

Had a bribe menu where he would list his prices for the bribes he would take that had the his official house of representatives stamp on it.

One Contractor bought Mr. Cunningham’s house for $1.675 Million and then sold it a couple of months later for $975K which was the true market price of the house

Received antiques, luxury cars, cash and a yacht that he named the dukester which was parked next to capital hill in Washington DC

Bribery

Something of value offered to inflence business decision or official act

Under-the-table payments for the exercise of influence over a business decision

Just offering a payment can constitute as a bribe

Kickback Schemes

Submission of invoices for goods and services that are either overpriced or fictitious
Involve collusion between employers and vendors
Almost always attack purchasing function of the victim company
More common when the purchasing decision is ultimately made by one person
The usual kickback suspect is the head of the purchasing department

The Bribe Tax

The result of overinflated prices results in what is commonly referred to as this

Diverting Business to vendors

Ensures a steady stream of business

Because these transactions do not require the direct payment of cash, they are particularly difficult to detect

Overbilling Schemes: For Employees who have Authority

Kickback schemes often begin as overbilling schemes

The ability to authorize purchases (and thus to authorize fraudulent purchases) is usually a key to kickback schemes

Vendor submits inflated invoices to victim company

Overstate cost of goods or services or reflect fictitious sales

If employees have approval authority, they can do this without needing approvals from supervisors

Overbilling schemes: Employees who don’t have the authority

In some cases, the lack of authority simply makes the
illegal activity more challenging for the fraudster

When an employee cannot approve fraudulent purchases themself, they can still orchestrate a kickback scheme if they can circumvent purchasing controls – create a phony PO

In less sophisticated schemes, a corrupt employee might simply take a fraudulent invoice from a vendor and slip it into a stack of prepared invoices

Kickback schemes can be very difficult to detect

Kickback Schemes

Sometimes, outsiders seek other fraudulent assistance from employees of the
victim company
In other cases, bribes come from potential purchasers who seek a lower price from the victim company

Slush Funds

A slush fund is a noncompany account from which bribes can be mad

Employees must first divert company money into a slush fund

The key to the crime from the briber’s perspective is the diversion of money into a slush fund

Bid Rigging

“Inside influence”

In the competitive bidding process, all bidders are legally supposed to be placed on a “level playing field”

Categorized based on the stage in which fraudster exerts his influence
• Pre-solicitation phase
• Solicitation phase
• Submission phase

The Pre solicitation phase

need recognition schemes: employee of buyer recognizes a need for a certain product/services. victim company purchases unnecessary goods/services

Specifications schemes: fraud tailor of specifications to a particular vendor. prequalification procedures. bid splitting. deliberate writing of vague specification

The Solicitation phase

restriction of the pool competitors: the corrupt vendor is able to improve his chances of winning the job

bid pooling: a process by which several bidders conspire to split up contracts and ensure that each gets a certain amount of work

fictitious suppliers: another way to eliminate competition in the solicitation phase of the selection process is to solicit bids from fictitious suppliers.

Other methods: restricting time for submitting bids, solicit bids in obscure publications

The submission Phase

In the actual submission phase of the process, several schemes may be used to win a contract for a particular supplier

The principal offense tends to be abuse of the sealed-bid process

Vendors also bribe employees of the purchaser for information on how to prepare their bids

Other reasons to bribe employees of the purchaser: To ensure acceptance of a late bid, To falsify the bid log, To extend the bid opening date, To control bid openings

Preventing and detecting bid-rigging schemes

monitor price trends

change order or amendments

very large, unexplained price differences among bidders

patterns with bidding process

Foreign Corrupt Practices Act

“the Foreign Corrupt Practices Act” of 1977 was enacted for the purpose of making it unlawful for certain classes of persons and entities to make payments to foreign government officials to assist in obtaining or retaining business”

Purpose of the FCPA

Lack of transparency and accountability, especially in developing nations, Poor regulation of political contributions, Low public sector wages in many foreign countries, Weak enforcement of laws and regulations by international governments, Excessive discretionary authority of public officials

UK Bribery Act

Was passed in 2010

Similar to FCPA

No exception for facilitating payments

Risk Assessment and Detection Approaches

Interviewing employees
• Conducting computer forensics
• Searching public records
• Testing transactions with a focus on high-risk accounts—
marketing, training, legal, consulting
• Auditing transactions to ensure proper documentation for
disbursements
• Reviewing contracts, including compliance with FCPA

Economic Extortion

• An employee demands a payment from a vendor in order to
make a decision in that vendor’s favor
• Economic extortion is common in bank loans
• Opposite of bribery – consent was induced by threat or fear

Conflicts of interest

An individual that takes an interest in a transaction that could be adverse to the corporation without full and timely disclosure to and approval by the corporation.

Undisclosed economic or personal interest in a transaction that adversely affects the company

Employee must have employment interest in the vendor that submits the invoice

Any bribery scheme could potentially be considered a conflict of interest
• Majority of conflict schemes fit into two categories:
• Purchasing schemes
• Sales schemes

Purchasing Schemes

Mechanics of billing scheme, conflict or fraudulent disbursement, do not change

Fraudsters also engage in bid rigging on behalf of their own companies

If the bill originates from a real company in which the fraudster has an economic or personal interest, and if the fraudster’s interest in the company is undisclosed to the victim company, then the scheme is a conflict of interest

Not all conflict schemes occur in the traditional vendor–buyer relationship

Turnaround sales
• Employee purchases asset then resells it to employer at an inflated price

Turnaround sales

With a turnaround sales scheme, an employee knows his employer is seeking to purchase a certain asset and takes advantage of the situation by purchasing the asset themself (similar but not exact to Duke Cunningham)
The fraudster then turns around and resells the item to the employer at an inflated price

Sales schemes

1. Under billings
   o Sell goods or services below fair market value to vendor
   with a hidden interest
   o Diminished profit margin

2. Writing-off sales
   o Tamper with victim company’s books to write off amount
   owed by an employee’s business
   o Delay billing

Preventing and detecting conflicts of interests

Specifically address conflict of interest illegalities in company ethics
policy
• Annual financial disclosure statement
• Communication with employees regarding their other business
interests
• Establish anonymous reporting mechanism to receive tips and
complaints
• Periodically run comparisons between vendor and employee
addresses and phone numbers

The Impact of Controls

• Accountants and auditors expect controls to do too
much
• Many controls have nothing to do with fraud
• Some controls are only indirectly related
• Controls are only part of the answer to fraud
deterrence

Perception of Detection

Employees who perceive that they will be caught
engaging in occupational fraud and abuse are less
likely to commit it

Deal with occupational fraud and abuse in an open
forum

If not handled correctly, it can cause more problems
than it solves

Financial statement fraud

The deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission or disclosures in the financial statements to deceive financial statement users

Users of Financial Statements

• Company’s owners
• Lending organizations
• Vendors / Customers
• Investors

Uses of financial statements

• Increase the apparent prosperity of the organization
• Dispel negative perceptions
• Judge employee or management performance

SAS 99

Statement on Auditing Standards (SAS) No. 99 — “Consideration of Fraud in a Financial Statement Audit”
• Intentional misstatements arising from fraudulent financial
reporting
• Misstatements arising from misappropriation of assets – theft
of defalcation

who commits financial statements fraud

Senior management – most likely – CEO was 72% /CFO was 65%

Mid- and lower-level employees – usually falsifies fortheir level or department

Organized criminals – hype a stock, Ponzi schemes, falsify to obtain loans

Owners of privately held businesses

WHY?

Pressure – on either the company or management

Opportunity – perceived minimal likelihood they will get caught
• Lack of adequate oversight
• Lack of internal controls

Rationalization – ability to justify the crime

• To meet or exceed the earnings or revenue growth expectations of stock analysts
• To comply with loan covenants
• To increase the amount of financing available from asset-based loans
• To meet a lender’s criteria for granting/extending loans
• To meet corporate performance criteria set by the parent company
• To meet personal performance criteria

types of F/S Fraud

Asset / Revenue Overstatements
Understated liabilities and expenses
• Timing differences
• Fictitious revenues
• Concealed liabilities and expenses
• Improper asset valuations
• Improper disclosures

Results of overstated assets

• Reflects a stronger company
• Results in increased net income and equity
• Results in increased earnings per share

Fictitious revenues

• Recording sales or services that did not occur
• Can use fake customers or an existing ones with fictitious
or inflated invoices
• The other side of the transaction is usually cash or
accounts receivable
• Sales with Conditions – ownership has not passed to
the purchaser

Timing differences

• Recording of revenues and/or expenses in improper
periods
• Shift revenues or expenses between one period and
the next – income smoothing
• Increase or decrease earnings as desired

Matching revenues with expenses

Revenues and corresponding expenses should be matched in the same accounting period

Failure to do so violates GAAP’s matching principle:
• Step 1—using revenue recognition principles, record revenues in
the appropriate period
• Step 2—match expenses associated with those revenues in the same
period

Incorrect Method: Record revenue in December and
expense in January to overstate net income at year end

Proper Revenue Recognitions

Revenues should be recorded when realized or
realizable and they have been earned
• Persuasive evidence of an arrangement exists
• Delivery has occurred or services have been rendered
• Seller’s price is fixed
• Collectability is reasonably assured

Long term contracts

1. Completed contract method
   • Does not record revenue until completion of the project is 100% complete
   • Construction costs are held in an inventory account until completion of the project

2. Percentage of completion method
   • Recognizes revenues and expenses as measurable progress on a project is made
   • Vulnerable to manipulation
   • Used to prematurely recognize revenues and conceal contract overruns

Channel Stuffing

“Trade loading”
Sale of unusually large quantity of a product to distributors
• Encouraged to overbuy through the use of deep discounts and/or extended payment terms
Attractive in industries with high gross margins
Steals from next period’s sales
Raises questions about collectability of accountsreceivable

Returns and Allowances and Warranties

1. What should happen:
   • Expense associated with sales returns and customer
   allowances
   • Record expense as contra-sales account
   • Reduce amount of net sales
   • Estimated warranty expense should be accrued as liability
   Fraud occurs when there has been a failure to properly
   accrue for warranty and product-return liabilities

Liability Omissions

• Failure to disclose loan covenants
• Agreements that borrower has promised to keep as long as
financing is in place
• Ratio limits or restrictions on other financial agreements
• Failure to disclose contingent liabilities
• Potential liabilities that will materialize only if certain events occur
in the future

Contingent Liabilities

A contingent liability has to be recorded if the contingency is likely
and the amount of the liability can be reasonably estimated. GAAP
recognizes three categories of contingent liabilities: probable, possible,
and remote.
• Probable contingent liabilities can be reasonably estimated (and
must be reflected within financial statements).
• Possible contingent liabilities are as likely to occur as not (and need
only be disclosed in the financial statement footnotes).
• Remote contingent liabilities are extremely unlikely to occur (and
do not need to be included in financial statements at all)

Management Fraud

Must disclose fraud committed by officers, executives, and others in position of trust
Withholding such information likely involves lying to auditors, an illegal act

Related Party Transactions

Business with entity that is significantly influenced by company

“Self-dealing”

Legal as long as they are fully disclosed

Arm’s length transaction

Accounting Changes

Statement of Financial Accounting Standards No. 154 (SFAS 154) “Accounting Changes and Error Corrections” – 3 types of changes that must be disclosed:
• Accounting principles
• Estimates
• Reporting entities

Fraudster may not restate if change causes financial
statements to appear weaker

Improper Asset Valuation

Misclassification of long-term assets as current assets
• “Window dressing”
Improper asset valuation categories
• Inventory valuation
• Accounts receivable
• Business combinations
• Long-term assets

• “Lower of cost or market value”
• Failure to write off or down inventory value
• Manipulation of physical inventory count
• Inflation of unit costs used to price out inventory
• Failing to relieve inventory for costs of goods sold
• Phantom inventory

A/R

Should be reported as net realizable value
Fictitious accounts receivable
• Common at end of accounting period
• False confirmations of balances to auditors
Failure to write down
• Required to accrue losses on uncollectable receivables
• Record impairment of long-lived assets and goodwill

Business Combinations

Required to allocate purchase price to tangible and intangible assets

Changes in goodwill accounting – have reduced the incentive to minimize the amount recorded

Companies still may be tempted to
• Over-allocate purchase price to in-process R&D assets
• Establish excessive reserves for various expenses to release
at a future date

Long Term Assets

Booking fictitious assets
• One of the easiest methods of asset misrepresentation is the
recording of fictitious assets
• Because company assets are often physically found in many different
locations, this fraud can sometimes be easily overlooked
• Can book assets actually being leased as assets
Misrepresenting asset value
• Long-lived assets should be recorded at cost
• Many financial statement frauds have involved the reporting of long-
lived assets at market values instead
• Also fail to record impairment in values

Understating assets
• In some cases, it may be advantageous to understate assets
• Can be done directly or through improper depreciation
Capitalizing non-asset costs
• Excluded from the cost of a purchased asset are interest and finance charges
• Should be charged to interest expense
Misclassifying assets
• Assets are sometimes misclassified into general ledger accounts in which they
do not belong
• Manipulation can skew financial ratios and help in complying with loan
covenants or other borrowing requirements

Detection of Fraudulent Financial Statement Schemes

• Vertical analysis
• Horizontal analysis
• Ratio analysis
• Analysis of cash flows
• Analysis of nonfinancial numbers

Vertical analysis

Vertical analysis is a technique for analyzing the relationships
between the items on an income statement, balance sheet, or statement
of cash flows by expressing components as percentages
• Often referred to as common sizing

Horizontal Analysis

Horizontal analysis is a technique for analyzing the percentage
change in individual financial statement items from one year to the
next
• First year is the base
• If more than two periods are presented, each period’s changes are computed
as a percentage of the preceding period
These techniques will not work for small, immaterial frauds

Ratio Analysis

Ratio analysis is a means of measuring the relationshipbetween different financial statement amounts

Traditionally, financial statement ratios are used in comparison to an entity’s industry average

When the financial ratios highlight a significant change in key areas of an organization from one year to the next, or over a period of years, it indicates that there may be a problem

Ratio analysis is limited by its inability to detect fraud on a small, immaterial scale

Cash Flow Analysis

• Financial statement fraud often creates an unexpected and irreconcilable difference between income and cash flows, especially cash flows from operations
• Cash flows should be examined in relation to a company’s reported income over time and in comparison to competitors in the industry and industry averages

Analysis of Non-Financial Numbers

• Nonfinancial measures (NFMs), including production facilities, retail outlets, production capacity, weather data, and the number of employees, may be less vulnerable to manipulation, as they are often independently verifiable
• NFMs must correlate with the performance to serve as an effective benchmark for evaluating financial statement data