2014-11-04 Fraud Risk Assessment - The Human Element

Thrive. Grow. Achieve.

Fraud Risk Assessment : The Human Element

Lawrence J. Hoffman, MAcc, CPA, CGMA, CFF, CVA, CFE - Senior Partner November 4, 2014

TABLE OF CONTENTS

• Why do people commit white collar crimes?

• Who are these people?

• How do these people get in?

• What can you do to identify these people?

• How can you keep them out?

• Concluding remarks

• Questions

Fraud Risk Assessment : The Human Element /

WHY DO PEOPLE COMMIT WHITE COLLAR CRIMES?

Three basic reasons why people commit crimes

• Economics $$$$$

• Passion love, lust, a cause (religious beliefs)

• Mental instability nuts



White Collar Crime-Early Pioneers

• 1907-E.A. Ross, Sin and Society: An Analysis of Latter Day Iniquity. Houghton, Mifflin & Company

• 1949-Edwin H. Sutherland, White Collar Crime. New

York, Holt, Rinehart & Winston • 1953-Dr. Donald R. Cressey, Other People’s Money: A

Study in the Social Psychology of Embezzlement. Glencoe, Illinois, The Free Press

• 1973-Marshall Clinard & Richard Quinney, Criminal Behavior Systems: a typology. New York, Holt, Rinehart & Winston


https://www.google.com/url?q=http://en.wikipedia.org/wiki/Edward_Alsworth_Ross&sa=U&ei=L5heU9-GJ_G2sASxw4CICw&ved=0CC4Q9QEwAg&usg=AFQjCNFHN7-NTGvt1c14_x5myDg6eIv0Sw

https://www.google.com/url?q=http://www.asanet.org/about/presidents/Edwin_Sutherland.cfm&sa=U&ei=uZheU6u9C47JsQSE1YGQBw&ved=0CDoQ9QEwBg&usg=AFQjCNHLeq6OJc_ekYH621vFMPi8T7kByA


THE FRAUD TRIANGLE

The Fraud Triangle originated from Dr. Donald Cressey's hypothesis:

“Trusted persons become trust violators when they conceive of themselves as having a financial problem which is non-shareable, are aware this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds or property.”



The fraud triangle


Rationalization (frame of mind or ethical character) Opportunity

(lack of controls)

Pressure / Incentive (The “Unshareable” Need or “Greed”)


Pressure / Incentive


Source Financial Non-Financial

Personal

• Distressed finances (DEBT!) • Divorce or extramarital affair • College education • Investment losses • Vices (gambling, alcohol, sex, drugs, rock n’ roll) • High lifestyle

• Greed • Lack of discipline • Health issues

Job

• Compensation is “too low” • Need to justify high compensation • Stock options / incentives • Bonuses based on performance • Production goals

• “Unfair” treatment • Fear of job loss • Resentment • Challenge to beat system

External

• Threat of business failure • Market expectations

• Board of Directors • Boss • Analysts • Reputation • Image • Social expectations • Peer pressure • Relatives and friends



Opportunity (perceived) A High Fraud Environment!

• Tone at the Top - lack of oversight and supervision,

poor leadership, no anti-fraud policy, code of conduct, hotlines, awareness

• Communication - poor communications within organization, lack of expectations

• Internal controls - lack of controls, segregation of duties, no monitoring, surprise audits, too predictable

• Access - lack of safeguards, sufficient access to assets and information that enables the crime

• Trust - too much trust placed in person or position. (Remember: trust is not an internal control!)

• Discipline - lack of prosecution for previous frauds


Rationalization (a way to rationalize the behavior as acceptable)

• “I am just borrowing the money and will repay it” • “I’ll stop once I pay off my debts” • “The company won’t even realize this amount is

gone; it’s not that much” • They feel they deserve it: “I am getting underpaid

and am underappreciated” • “Management is ‘living high,’ while I am oppressed” • “Everyone’s doing it, I am no different” • “It is for a good purpose” • They need the money



The Fraud Diamond*

• Adds fourth element – Capability! • Capability includes the fraudster’s personality traits

(e.g. knowledge, creativity, and ego) • Capability to carry out fraud may be limited, even

when opportunity exists with position • Fraudster must be smart enough to understand and

exploit internal control weaknesses for personal advantage

• Must be able to handle the stress of fraud!


Capability includes: •Position/function •Intelligence •Confidence/ego •Coercion skill •Effective lying •Stress immunity

Image courtesy of the Ohio Society of CPAs *Wolfe & Hermanson (2004)

WHO ARE THESE PEOPLE?

The One Common Element in Every Fraud!



THE FACES OF FRAUD



Three Potential Fraud Perpetrators*


1. Those who are totally honest

2. Those who are situationally honest

3. Those who are totally dishonest

*Giles, S. (2012)


Is Everyone a Potential Criminal?



The Dilemma • Everyone has to a degree a propensity to commit a

crime!

• 90-99% of the population may commit a crime!

• 1-5% are hard-core white collar criminals – psychopaths!

• We are interested in the severity of the propensity of the 90-99% and definitely don’t want the 1-5% working for us!



A Few Definitions* • Character – the distinct aspects of personality that

reflect the presence and strength of a person’s virtues, personal ethics, social conscientiousness, and depth of commitment to respect-worthy and meritorious social conduct.

• Personality – a stable set of traits, preferred thinking and behavior patterns that define our unique style of interaction over a wide variety of situations, and for most of our lifetime.


*Simon, G. (2011)


A Few Definitions • Conscience (superego) – the aspect of personality

that represents the internalization of a society’s values, standards, and morals*

• Psychopathy – a personality disorder; psychopaths are without conscience and incapable of empathy, guilt, or loyalty to anyone but themselves.**


*The American Psychological Association’s Glossary of Terms **Babiak & Hare (2006)


Personality Disorders

Per the DSM-V (2013)

Percentages represent

incidence in general population


*DSM-V (2013)

Cluster A (Odd) Cluster B (Dramatic) Cluster C (Anxious)

Paranoid PD (.5-2.5%) – pervasive distrust and suspiciousness

Antisocial PD (5% men, 2.5-5% women, 40% prison) – disregard for rights of other people, deceitful and hostile

Avoidant PD (.1-.5%) – social inhibition, feeling of inadequacy

Schizoid PD (1%) – pattern of social detachment, restricted range of emotional expression

Borderline PD (3%) – intense and unstable emotions and moods

Dependent PD (.5%) – strong need to be taken care of

Schizotypal PD (3%) – pervasive pattern of social and interpersonal limitations

Histrionic PD (2-3%) – excessive emotionality and attention seeking

Obsessive-Compulsive PD (1%) – preoccupied with rules, regulations, and orderliness

Narcissistic PD (1-2%) – powerful sense of entitlement, excessive self-worth


White Collar Crime Continuum


80% 9% 9% 1% 1% Neurotic Psychopathic

Situational Honesty Total

Honesty Total

Dishonesty

Frauds: Smaller Larger Impact: Not individually materially Very destructive, can significant but can be completely destroy the costly over time organization

If a person is making themselves miserable, they are probably neurotic. If a person is making everyone else miserable, they are character-disordered.



*Simon (2010)

Neurotic Psychopathic Well-developed, overactive superego; “suffer from too much conscience”*

Significantly underdeveloped conscience, or no conscience at all

Excessive capacity for guilt and shame

Diminished capacity for share of guilt or remorse

Suffer unreasonable and excessive anxiety

Limited or no feeling of anxiety; impulsive; risk-taker

Submissive Possessive; insensitive to the needs/wants of others; manipulative

Hypersensitive to adverse consequences and social rejection

Self-focused/self-centered; egomaniacal; narcissistic

Ego-dystonic Ego-syntonic


Domains and Traits of the Psychopath*


*Psychopathy Checklist: Short Version (PCL:SV); Hare, Hart, & Cox

• 1 - Superficial • 2 - Grandiose • 3 - Deceitful

Interpersonal

• 4 - Lacks remorse • 5 - Lacks empathy • 6 - Doesn’t accept responsibility

Affective

• 7 - Impulsive • 8 - Lacks goals • 9 - Irresponsible

Lifestyle

• 10 - Poor behavior controls • 11 - Adolescent antisocial behavior • 12 - Adult antisocial behavior

Antisocial

Scoring: 2 points per trait; score of 18+ is generally diagnosed psychopathy


Who did the FBI profile with these symptoms and signs?

• Anger and arrogance • Capable of acting witty and charming • Good at flattery and manipulating other people’s

emotions • Disregards the safety of self and others • Does not show any guilt • Lies, steals, and fights often • Breaks the law repeatedly • Substance abuse and/or legal problems




Selected Quotes from Bernie Madoff • “I’m not the kind of person I’m being portrayed as.”

• “I made a lot of money for my clients.”

• “My notoriety impresses [fellow inmates]. It shouldn’t, but it does.”

• “Does anybody want to hear that I had a successful business and did all these wonderful things for the industry? And got all these awards? And so did my family? I did all of this during the legitimate years. No. You don’t read any of that.

• “I realized from a very early stage that the [financial & investment] market is a whole rigged job. There’s no chance that investors have in this market.”

• “I was very proud of my sons, and they were very proud of me, what I accomplished. They liked being a Madoff. There was a lot of recognition in that, you know.

• “Everyone was greedy. I just went along. It's not an excuse. Look, there was complicity, in my view. It’s unbelievable. Goldman…no one has any criminal convictions – the whole new regulatory reform is a joke. The whole government is a Ponzi scheme.”

*Ghosh, P. (2011)



The Sociopath: Nature or Nurture ANSWER: Both are involved!

• Behavior genetics play at least as important a role in the development of the core features of psychopathy, as do environmental factors and forces…

See Clekley (1941); Hare – Psychopathy Checklist (PCL) (1980); Blonigen, Carlso, Kruger & Patrick (2003); Viding, Blair, Moffitt & Plomin (2005); Larrson, Andershed & Lichstenstein (2006)

Amygdala



A Character Crisis “After a detour through the hedonism of the 1960’s, the narcissism of the 1970’s, the materialism of the 1980’s and the apathy of the 1990’s, most everyone today seems to believe that character is important after all and that the United States is facing a character crisis on many fronts, from the playground, to the classroom, to the sports arena, to the Hollywood screen, to business corporations to politics.” Peterson, C., Seligman, M. (2004), Character Strengths and Values: A Handbook and Classification.

HOW DO THESE PEOPLE GET IN?


The Business Environment Evolution Problem*

• The old “bureaucratic” industrial business model has given way to a more free-form, faster-paced organizational style

• The more lean and efficient companies are who can compete and survive in the new environment

• Fewer organizational “layers” mean simple systems and controls, and more autonomous decision making

• Technology changes – speed and innovation is more important

*Adapted from Babiak & Hare (2006)



The Business Environment Evolution Problem* • What new management styles strive in this environment – people

who get things done quickly, “shake the trees” and “rattle cages”

• Valued traits overlap with psychopaths, leading to their hiring in positions of power

• Psychopathic individuals – known for ignoring rules and regulations and having talent for confidence tricks and manipulation – find these new, flexible organizational structures very inviting…




How Psychopaths Infiltrate Companies • Some companies “innocently” recruit individuals with psychopathic

tendencies…



Practical Application Problems* • Poor hiring and selection process – the first line of defense!

• Screening resumes • Interviewing • Verifying resumes • Reference checks

• Ineffective (or absent) background checks/investigations • Executive/management hiring and promotion procedures

• Internal vs. external candidates • Reliance on executive recruiters

• Poor succession planning • Poor evaluation process • Poor definitions of key competencies for job


WHAT CAN YOU DO TO IDENTIFY THESE PEOPLE?


Red Flags • Inability for form a workable team • Inability to share • Disparate treatment of subordinates • Inability to tell the truth • Inability to be modest • Inability to accept blame • Inability to act predictably • Inability to react calmly • Inability to act without aggression

HOW CAN YOU KEEP THEM OUT?

THE BEST PREVENTIVE MEASURE!

HIRE ONLY HONEST, ETHICAL AND MORAL PEOPLE!


HOW CAN YOU KEEP THEM OUT?

Fraud is a people problem! • Environment - Does your organization have a

reputation for questionably ethical behavior? • Hiring – What traits do you seek in job applicants? • Incentives – Does your organization’s compensation

system encourage risky or fraudulent behavior? • Promotions – Does your organization focus on

promoting individuals with proven track records for ethical behavior?

• Opportunity – Does your organization emphasize the importance of obeying internal controls?

• Detection – Does your organization have reporting mechanisms for possible fraud and abuse?

• Tolerance – Have you publicly displayed a zero tolerance policy for fraud?


CONCLUDING REMARKS


The total destruction caused by

ONE psychopath

QUESTIONS AND ANSWERS


BIBLIOGRAPHY


• American Psychiatric Association (APA). (2013, 5th ed.). Diagnostic and Statistical

Manual of Mental Disorders.

• Association of Certified Fraud Examiners (ACFE), (2012). Report to the Nations on Occupational Fraud and Abuse, 2012 Global Fraud Study.

• Albrecht, W. Steve., Albrecht, Chad. O., Albrecht, Conan C., & Zimbelman, Mark F., (2012). Fraud Examination (4th ed.). Mason, OH; South-Western.

• Babiak, Ph.D., Paul, Hare, Ph.D., Robert D. (2006). Snakes In Suits, When Psychopaths Go To Work. New York, New York. HaperCollins Publishers Inc.

• Cressey, D. (1973). Other People’s Money: A Study in the Social Psychology of Embezzlement. Glencoe, Illinois, The Free Press.

• Giles, S. (2012). Managing Fraud Risk: A Practical Guide for Directors and Managers. United Kingdom. John Wiley & Son Ltd.

• Ghosh,P. (2011). Select quotes from Bernard Madoff in magazine interview. International Business Times, February 28, 2011. Retrieved from: http://www.ibtimes.com/select-quotes-bernard-madoff-magazine-interview-271615

BIBLIOGRAPHY

• Hopwood, William S., Leiner, Jay J., Young, George R. (2012). Forensic Accounting and Fraud Examination. (Second Edition.) New York, New York. McGraw-Hill.

• Hussain, M. (2014). Corporate Fraud, The Human Factor. London. United Kingdom. Bloomsbury

• Keys, D. (2012) Narcissists Exposed. Light’s House Publishing

• KPMG. (2013). Global profiles of the fraudster. www.kpmg.com/fraudster

• Peck, M. (1978). The Road Less Traveled. New York, New York. Touchstone, Simon & Schuster, Inc.

• Simon, G. (2011). Character Disturbance, The Phenomenon of Our Age. Chicago, Illinois. Parkhurst Brokers, Inc.

• Wolfe, D.T. and Hermanson, D. (2004). The Fraud Diamond: Considering the four elements of fraud, The CPA Journal, December, p.4.


http://www.kpmg.com/fraudster

HOW CAN RAFFA ASSIST YOU IN PREVENTING AND DETECTING FRAUD?

A resource for the nonprofit community to help organizations effectively manage risk and better ensure

the prevention and detection of fraud.

Visit US AT www.raffa.com/fraud

38 Fraud Risk Assessment : The Human Element / Page


OUR WEEKLY NEWSLETTER

OU



Are you threatened by fraud, litigation or insolvency? Are you selling your business, transferring assets or structuring a new venture? Raffa forensic accounting experts will do more to assist you in these challenging circumstances.

Forensic Accounting Services Group

Our Team’s Services: • Fraud Investigations & Prevention • Litigation Support & Expert Testimony • Business Valuation & Due Diligence • Insolvency & Reorganization



How We Empower You • We identify and mitigate fraud risk by performing a fraud

risk assessment • We provide fraud investigations if you are, or suspect you

are, a victim of fraud • We provide litigation support, expert testimony and forensic

accounting services in business disputes, financial investigations, bankruptcies, arbitrations and mediations

• We analyze, investigate and interpret complex transactions to provide an understandable, well-researched and unbiased valuation of your business or organization

• We have expertise in restructuring and turnaround management for underperforming organizations




Fraud Investigations & Prevention

• Fraud examinations and internal investigations

• Fraud risk assessments • Review of internal controls and

management practices • Financial statement

misrepresentations • Background and workplace

investigations • Computer forensic analysis,

imaging, data mining and recovery

• Reconstruction of accounting records

• Continuous audit services • Anti-fraud consulting and training



Litigation Support & Expert Testimony

• Lost earnings and profits • Lost value • Breach of contract • Breach of fiduciary duty • Business interruption • Contract costs and claims • Tortious interference • Patent infringement • Professional malpractice • Shareholder disputes • Theft of intellectual property • Wrongful termination • Wrongful death


Business Valuation & Due Diligence

• Mergers, acquisitions and divestitures

• Marital dissolution • Partner/shareholder disputes • Estate and gift tax planning • Financial reporting • Compensation related • Employee stock ownership plans

• Benchmark studies • Financial modeling



Insolvency & Reorganization

• Viability analysis and survival assessment

• Strategic restructuring • Cash flow analysis and forecasting • Liquidation analysis • Evaluating creditor and debtor

positions • Restructuring debt • Interim management services,

including Chief Restructuring Officer

• Preparing plans of reorganization and disclosure statements

• Pre-bankruptcy planning and post-filing compliance

• Bankruptcy litigation consulting to trustees

BIOGRAPHY


• 35 years of consulting, audit, accounting and tax experience in the public and private sectors.

• Started career with a Big-Four international accounting firm in Washington, DC. • Founded a regional certified public accounting and consulting firm in 1982 and grew it to on

of the Washington, DC’s largest firms in seven years. Merged his practice with Raffa P.C. in 2008.

• Managed and conducted audit and accounting engagements ranging from small privately held to large publicly held businesses in various industries, including multi-national businesses, nonprofit organizations, and governmental entities and agencies.

• Performed economic and financial analysis, including projections and forecasts, in support of litigation and claims for lost earnings and profits, business interruption, shareholder disputes, patent and trademark infringements, bankruptcy and restructuring, and structural settlements; assistance with interrogatories, document requests and depositions; and serving as an expert and consulting witness.

• Performed and supervised business valuations for both public and closely held companies in a variety of industries, individuals and estates, family limited partnerships and limited liability companies, including valuations for business combinations (SFAS 141R), mergers, acquisitions, and divestitures, estate and gift taxes, marital dissolution proceedings, buy-sell agreements, intangible assets and intellectual property, purchase price allocations, goodwill (SFAS 142) and long-lived asset (SFAS 144) impairment, fair value accounting (SFAS 157), cheap stock (IRC 409A), stock-based compensation (SFAS 123R), phantom stock and employee stock ownership plans.

• Conducted and led teams of forensic accountants on fraud audits and investigations, including fraudulent financial statements, misappropriations of assets and embezzlements; money laundering, kickbacks, bribery and conflicts of interest; insurance claims; bankruptcy; financial institutions and loan fraud. Also has conducted fraud risk assessments, anti-fraud programs, and fraud training and education.

LAWRENCE J. HOFFMAN, CPA/CFF, CVA, CFE

SENIOR PARTNER RAFFA, P.C. 1899 L STREET, NW WASHINGTON, DC 20036 TEL. 202-822-5408 FAX 202-822-0669 [email protected]

BIOGRAPHY


• Assisted companies and nonprofits with restructuring and turnaround situations, including recapitalizations, reorganizations and liquidations. Advised entities on Chapters 11 and 7, bankruptcy filings and proceedings and non-judicial workouts. Developed and administered crisis management plans, cash flows, liquidation and turnaround analysis, debt restructuring and creditor negotiations, and turnaround plans.

• Formulated strategic short- and long-term business and financial planning for various business organizations and served as interim “C” level positions, including for a major North American sports league, European and U.S. aircraft manufacturer, aviation charter airline and travel company, and a multi-chain quick service food chain.

• Formulated syndication strategies and prepared business plans and private placement offerings, including financial forecasts, market research and analysis, due diligence, securities pricing and structuring for various public and private securities offerings, including SEC filing.

• Founded and developed a regional NASD licensed broker dealer investment banking firm. Placed over $150 million in debt and equity and represented over $200 million in merger and acquisition transactions.

• Founded and developed two private equity funds in excess of $10 million, including investments in early stage and mature emerging companies in the form of debt and equity. Portfolio investments included aviation, food and hospitality, software and technology, telecommunications, sports and entertainment, banking and financial institutions, healthcare, and wholesale and retail.

• Co-founded and managed various real estate acquisition, ownership, and operating entities, including commercial office buildings, shopping centers, flex warehouses, residential housing and developed land.

• Performed tax and financial consulting services for individuals and closely held businesses. • Instructor in audit, accounting, finance, and forensic accounting.



BIOGRAPHY


EDUCATION & CERTIFICATIONS • Bachelor of Science, Accounting – Mount St. Mary’s University • Certified Public Accountant (CPA) • Certified Fraud Examiner (CFE) • Certified in Financial Forensics (CFF) • Certified Valuation Analyst (CVA) • Private Investigator (PI), Virginia • Series 7 General Securities Representative (not active) • Series 24 General Securities Principal (not active) • Series 63 Uniform Securities Agent (not active)

PROFESSIONAL ASSOCIATIONS & AFFILIATIONS

• American Institute of Certified Public Accountants, Member • Virginia Society of Certified Public Accountants • Association of Certified Fraud Examiners • National Association of Certified Valuation Analysts • Institute of Business Appraisers

PERSONAL INTERESTS

• Private pilot with instrument, multi-engine, high performance complex and aircraft ratings • Golf and fishing • Reading and politics



2014-11-04 Fraud Risk Assessment - The Human Element

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