An auditor for Bailey Books Corporation received a tip about potential illegal activity involving Linda Reed Collins, the purchasing manager.
The caller, a long-term supplier of paper products, claimed Collins had systematically squeezed him out of doing business with the company.
Introduction to Fraud Examination
Organizations incur various costs (labor, taxes, etc.) but fraud and abuse are fundamentally different as their true expense is hidden.
Fraud can manifest as multi-billion dollar accounting misstatements or asset misappropriations/corruption.
Resolving fraud allegations involves:
Obtaining documentary evidence.
Interviewing witnesses and suspects.
Writing investigative reports.
Testifying to findings.
Assisting in fraud detection and prevention.
Fraud Examination vs. Forensic Accounting
Fraud examination and forensic accounting are related but not precisely equivalent.
Forensic accounting is the use of accounting knowledge for courtroom purposes, including fraud, bankruptcy, business valuations, divorce, etc.
Fraud examinations can be conducted by various professionals (law enforcement, security specialists, private investigators), not just accountants.
Fraud Examination vs. Auditing
Fraud examination and auditing are related, but not identical.
Occupational frauds are financial crimes, but fraud examination involves more than just reviewing financial data.
Fraud examination encompasses interviews, statement analyses, public record searches, and forensic document examination.
Key Differences:
Timing:
Audits are recurring.
Fraud examinations are non-recurring, based on predication.
Scope:
Audits are general examinations of financial data.
Fraud examinations resolve specific allegations.
Objective:
Audits express an opinion on financial statements.
Fraud examinations determine if fraud occurred and who is responsible.
Relationship:
Audits are non-adversarial.
Fraud examinations are adversarial (seek to affix blame).
Methodology:
Audits use audit techniques (examining financial data).
Fraud examinations use document examination, review of outside data, and interviews.
Presumption:
Auditors use professional skepticism.
Fraud examiners seek sufficient proof to support or refute allegations.
Fraud Examination Methodology
Fraud allegations must be handled uniformly and legally, resolved in a timely manner.
Steps involve narrowing focus from general to specific, leading to a final conclusion.
Start with a hypothesis about how the fraud occurred and by whom, refined as evidence emerges.
Predication
Predication is the totality of circumstances that would lead a reasonable professional to believe that a fraud has occurred, is occurring, or will occur.
All fraud examinations must be based on proper predication. Suspicion alone is insufficient.
An anonymous tip can be a starting point but requires underlying circumstantial evidence.
Fraud Theory Approach
Direct evidence of fraud is rare; circumstantial evidence is assembled into a coherent structure.
The fraud examiner makes assumptions and tests them, similar to a scientist postulating a theory.
Steps:
Analyze available data.
Create a hypothesis.
Test the hypothesis.
Refine and amend the hypothesis.
Example: Linda Reed Collins Scenario
Analyze data:
Examine contracts and their distribution among Bailey Books suppliers.
Create a hypothesis:
Purchasing manager accepting kickbacks.
Test the hypothesis:
Look for a personal relationship between Collins and a vendor.
Check for ability to steer business.
Investigate higher prices or lower quality.
Assess excessive personal spending.
Refine/Amend hypothesis as needed
Tools Used in Fraud Examinations
Three primary tools:
Examination of financial statements, books, records, and supporting documents.
Must know legal ramifications of evidence and how to maintain chain of custody.
Interviews: Obtain relevant information from those with knowledge.
Evidence gathered from general to specific:
Neutral third-party witnesses.
Corroborative witnesses.
Suspected co-conspirators (least to most culpable).
Prime suspect.
Observation: Observe behavior, displays of wealth, and specific offenses.
Example: Video surveillance of meetings.
Types of Fraud
Internal Frauds: Committed by people who work for organizations (occupational fraud and abuse).
External Frauds: Committed by individuals against other individuals or organizations (insurance fraud, consumer fraud).
Defining Occupational Fraud and Abuse
Occupational fraud and abuse is defined as the use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization's resources or assets.
Involves a wide variety of conduct by executives, employees, managers, and principals, including:
Asset misappropriation.
Fraudulent statements.
Corruption.
Pilferage and petty theft.
False overtime.
Use of company property for personal benefit.
Payroll and sick time abuses.
Four Common Elements:
Clandestine.
Violates fiduciary duties to the organization.
Committed for direct or indirect financial benefit to the employee.
Costs the employing organization assets, revenues, or reserves.
Employee: Any person receiving regular compensation from an organization.
Defining Fraud
Fraud is any crime for gain that uses deception as its principal modus operandi.
Three ways to illegally relieve a victim of money: force, trickery, or larceny. Fraud employs trickery.
Synonyms: Deceive, mislead, delude, beguile.
Common Law Elements:
A material false statement.
Knowledge that the statement was false when it was uttered.
Reliance of the victim on the false statement.
Damages resulting from reliance on the false statement.
Legal definition is the same for criminal or civil cases; criminal cases require a higher burden of proof.
Legal Ramifications of Theft
Larceny: Felonious stealing, taking and carrying away another's property with intent to convert or deprive the owner.
Elements:
Taking or carrying away.
Of the money or property of another.
Without the consent of the owner.
With the intent to deprive the owner of its use or possession.
Conversion: Unauthorized assumption and exercise of the right of ownership over goods belonging to another, to the alteration of their condition or the exclusion of the owner's rights.
Embezzlement: Willfully take, or convert to one's own use, another's money, or property of which the wrongdoer acquired possession lawfully.
Keywords: Acquired possession lawfully.
Fiduciary: A person holding a character analogous to a trustee, acting for the benefit of another.
Breach of Fiduciary Duty: Violation of a duty to act in the best interests of the person he represents.
Elements:
A fiduciary relationship between the plaintiff and the defendant.
Breach of the defendant's duty to the plaintiff.
Harm to the plaintiff resulting from the breach.
Officers and directors usually have a fiduciary duty, while ordinary employees usually do not.
Fraud: Always involves some form of deceit/false statement upon which the victim relies.
Defining Abuse
Abuse: A corrupt practice or custom; improper or excessive use or treatment; a deceitful act.
Examples:
Using equipment belonging to the organization.
Surf the Internet while at work.
Attend to personal business during working hours.
Take a long lunch or break without approval to work late or leave early.
Use sick leave when not sick.
Do slow or sloppy work.
Use employee discounts to purchase goods for friends and relatives.
Work under the influence of alcohol or drugs.
Abuse describes misconduct that does not fall into a clearly defined category of wrongdoing.
Research in Occupational Fraud and Abuse (Sutherland)
Edwin H. Sutherland (1883-1950):
Coined the term "white-collar crime" in 1939 to mean criminal acts of corporations and individuals acting in their corporate capacity.
Developed the theory of differential association: crime is learned through communication with others, usually within intimate personal groups.
Learning involves techniques for committing crimes and the attitudes/rationalizations of the criminal mind.
The problem that drives the fraudster is a financial issue that can be solved by stealing assets. Example is large debt.
Some nonfinancial problems can be solved by misappropriation such as getting revenge on employer.
Cressy found that the problems fall into six basic categories:
Violation of ascribed obligations.
Problems resulting from personal failure.
Business reversals.
Physical isolation.
Status gaining.
Employer-employee relations.
Importance of Solving the Problem in Secret
Crucial that the employee resolve the financial problem in secret.
Problems deal with status; violators fear losing approval and cannot share their issues.
The non-sharable financial problems create the motive.
Opportunity
Two components of perceived opportunity:
General information: knowledge that the position of trust could be violated.
Technical skill: abilities needed to commit the violation.
Perpetrator's job defines the fraud they commit.
Trusted persons apply their understanding of trust violation to specific crises.
Rationalizations
The rationalization is a necessary component of the crime before it takes place.
The embezzler does not view himself as a criminal, so he must justify the misdeeds before he ever commits them.
Cressy found that embezzlers generally view their crimes:
As essentially noncriminal.
As justified.
As part of a general irresponsibility for which they are not completely accountable.
Independent Businessmen
Persons in business for themselves who converted deposits.
Use one of two excuses:
They were borrowing the money they converted.
The funds entrusted to them were really theirs and you can't steal from yourself.
Long Term Violators
Individuals who converted their employers' funds by taking relatively small amounts over time.
Preferred the borrowing rationalization.
Other rationalizations:
They were embezzling to keep their families from shame, disgrace, or poverty.
It was a case of necessity or their employers were cheating them financially.
Eventually, most of the long term violators finally realized they were in too deep.
Those who wanted to readopt the attitudes of law abiding citizens reported their behavior, quit taking funds, or specualted wildly in order to regain the amounts taken
Those who adopted the attitudes of criminals become reckless in their defalcations, taking larger amounts than formally.
Absconders
People who take the money and run.
Problems resulted from physical isolation.
They rationalized their conduct by noting that their attempts to live honest lives had been futile.
The absconders tended to have lower occupational and socioeconomic status than the members of the other two categories.
Conjucture of Events
The Cressi study revealed that it took all three elements opportunity, ability to rationalize for the trust violation to to occur.
If any of the three elements were missing, trust violation did non occur.
Research in Occupational Fraud and Abuse (Albrecht)
Dr. W. Steve Albrecht:
Conducted an analysis of 212 frauds.
Developed a list of 50 possible red flags or indicators of occupational fraud and abuse.
Variables fell into two principal categories: perpetrator characteristics and organizational environment.
Albrecht's Red Flags
Personal Characteristics
Unusually high personal debts
Severe personal financial losses
Living beyond one's means
Extensive involvement in speculative investments
Excessive gambling habits
Alcohol problem
Drug problems
Undue family or peer pressure to succeed
Feeling of being underpaid
Disatisfaction or frustration with job
Feeling of insufficient recognition for job performance
Continuous threats to quit
Overwhelming desire for personal gain
Belief that job is in jeopardy
Close associations with suppliers
Close associations with customers
Poor credit rating
Consistent rationalization of poor performance
Wheeler dealer attitude
Lack of personal stability, such as frequent job changes, changes in residence, etcetera.
Intellectual challenge to beat the system
Unreliable communications and reports
Criminal Record
Defendant in a civil suit, other than divorce
Not taking vacations of more than two or three days
Organizational Environment
A department that lacks competent personnel
A department that does not enforce clear lines of authority and responsibility
A department that does not enforce proper procedures for authorization of transactions
A department that lacks adequate documents and records
A department that is not frequently reviewed by internal auditors
Lack of independent checks, other than
No separation of custody of assets from the accounting for those assets
No separation of authorization of transactions from the custody of related assets
No separation of duties between accounting functions
Inadequate physical security in the employees' department such as locks, safes, fences, gates, guards, etc.
No explicit and uniform personnel policies.
Failure to maintain accurate personnel records of disciplinary actions.
Inadequate disclosures of personal investments and incomes.
Operating on a crisis basis.
Equip attention to details.
Not operating under a budget.
Lack of budget. Or justification.
Placing too much trust in key employees
Unrealistic productivity expectations
Pay levels not commensurate with the level of responsibility assigned
Inadequate Staffing
Failure to discipline violators of company policy
Not adequately informing employees about rules of discipline or codes of conduct within the firm
Not requiring employees to complete conflict of interest questionnaires
Not adequately checking background before employment.