Forensic Accounting – How To Uncover Fraud Jan 2012

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Forensic Accounting How to Uncover Fraud Richard C. Hermerding January 26, 2012

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Forensic Accounting for Non Accountants

Transcript of Forensic Accounting – How To Uncover Fraud Jan 2012

Page 1: Forensic Accounting – How To Uncover Fraud Jan 2012

Forensic Accounting – How to Uncover Fraud

Richard C. Hermerding

January 26, 2012

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Richard C. Hermerding, MBA, MAIA, MSIS, CMA, CFM, CFE, CFS

• Richard Hermerding serves as Senior Principal – OLIVO CPA in San Jose, CA. He has over 25 years of experience providing accounting and consulting services. He has a broad range of experience and education in many aspects of accounting, auditing and financial management. His accounting and consulting experience includes Audit, Controllership, Chief Financial Officer services, Fraud, Forensic Accounting, and Strategic Planning. Richard has served as a Expert Witness. Richard’s experience spans numerous industries, including manufacturing, government, healthcare, nonprofits, and financial services.

• Richard holds a Bachelor of Arts degree (German and Russian), a MBA (Accounting and Finance), a MA (International Affairs) from Ohio University, and a MS (Information Systems) from Golden Gate University. He is a Certified Management Accountant (CMA), a Certified Financial Manager (CFM), a Certified Fraud Examiner (CFE), a Certified Fraud Specialist (CFS) and a Certified Senior Advisor (CSA). Richard also holds National Association of Security Dealers - 6, 63, 65, and 7 licenses, Life and Health and Property and Casualty Insurance licenses, as well as being a California Real Estate Broker.

• Richard speaks regularly at meetings and seminars and is an Instructor for the University of California – Santa Cruz Extension for Strategic Management.

• Richard is the President of the Silicon Valley Chapter of the Institute of Management Accountants and Vice President of Education of the Golden West Council of the Institute of Management Accountants.

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Contributing Authors and/or Sources

• AICPA, Special Report, Forensic Procedures and Specialists: Useful Tools and Techniques

• Association of Certified Fraud Examiners, Fraud Examiners Manual

• Association of Certified Fraud Examiners, Fraud Magazine March/April, May/June, July/August 2009

• Association of Certified Fraud Examiners, Understanding the Basics of Mortgage Fraud

• Bruce Frey, Statistics Hacks

• CPA Mutual Insurance Company SAS 99 Friend of Foe . Gary D. Zeune, CPA

• G. Jack Bologna/Robert J. Lindquist-Fraud Auditing and Forensic Accounting, Second Edition

• Howard Silverstone/Howard R. Davia, Fraud 101, Techniques and Strategies for Fraud Detection,

• Joseph T. Wells-Corporate Fraud Handbook, Prevention and Detection, Second Edition

• Martin T. Biegelman/Joel T. Barton, Executive Roadmap to Fraud Prevention and Internal Control

• Paul E. Zikmund, CFE, CFD, CFFA, MBA, Forensic Accounting for VLAF Practitioners

• Ralph R. Roberts/Rachel Dollar, Protect Yourself from Real Estate and Mortgage Fraud

• Second Edition

• Rebekah J. Poston/David A. Saltzman/Christopher Richardson, Foreign Corrupt Practices Act in Review July 2009

• Tracy L. Coenen, Essentials of Corporate Fraud

• W. Steve Albrecht, Fraud Examination

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Summary

• One survey stated that more than four out of five companies surveyed (85 percent) have suffered from corporate fraud in the past three years. These findings also indicated that not only is fraud widespread, but it is growing, and it is Global.

• You have heard and read the statistics. So what do you do now? How can Forensic Accounting help? What is Forensic Accounting. What should be reviewed? What should you look for? What are some common fraud schemes? What are the warning signs? What are basic fraud prevention procedures? What is the best way for management to be involved? Do you need to hire an outside expert?

• Black’s Law Dictionary defines forensic as “used in or suitable to courts of law or public debate.”

• Forensic accounting is a specialty field within the broader arena of accounting.

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Forensic Investigation

• Disciplines commonly applicable include accounting, auditing, fraud examination, law, computer and other technologies.

• Generally involves the application of special skills in accounting, auditing, finance, quantitative methods, certain areas of law and research, and investigative skills to collect analyze, evaluate evidential matter and to investigate and communicate findings.

• Has been defined as … the art & science of investigating people & money.

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Seven Forensic Investigative Techniques

1. Public Document Review and Background Investigation

2. Interviews of Knowledgeable Persons

3. Confidential Sources

4. Laboratory Analysis of Physical and Electronic Evidence

5. Physical and Electronic Surveillance

6. Undercover Operations

7. Analysis of Financial Transactions

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Forensic Accounting

Forensic Accounting

Tax

Audit/

Review/ Comp

Internal Audit

Fraud

Valuation

Performance Auditing

Economic Damages

PI

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Seriousness of Fraud

ACFE study in the mid 1990’s

• Over $400 Billion at that time

• That was before Enron, WorldCom, Tyco, Madoff, etc.

• $9 per day per employee

• 6% of companies Total Revenue

• FBI has labeled it the fastest growing crime

• Every $1 of Fraud reduces Net Income by $1

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What is Fraud?

• Fraud is a generic term, and embraces all the multifarious means which human ingenuity can devise, which are resorted to by one individual, to get an advantage over another by false representations. No definite and invariable rule can be laid down as a general proposition in defining fraud, as it includes, surprise, trickery, cunning, and unfair ways by which another is cheated. The only boundaries defining it are those which limit human knavery.

• (Webster’s New World Dictionary-College Edition 1964)

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Who Commits Fraud

• Almost anyone can commit Fraud

• Fraud perpetrators usually cannot be distinguished from other people by demographics or psychological characteristics

• Most Fraud perpetrators have profiles that look like honest people

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Sarbanes Oxley’s Impact On Fraud

• Audit Committee

• Code of Ethics

• Internal Controls

• Internal Audit

• Common Problem

Segregation of Duties

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Why People Commit Fraud The Fraud Triangle

Perceived Opportunity

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Why People Commit Fraud • To make the Company’s earnings look better

on paper

• To cover up embezzlement of company funds

• To encourage investment through the sale of stock

• To demonstrate increased earnings per share

• To cover the inability to generate cash flow

• To dispel negative market perceptions

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Why People Commit Fraud

• To obtain financing, or to obtain more favorable terms on existing financing

• To receive higher purchase prices for acquisitions

• To demonstrate compliance with financing covenants

• To meet company goals and objectives

• To receive performance based-related bonuses

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Why People Commit Fraud

• However; in government contracts, just the opposite may be true.

• Assets and revenues are understated

• Liabilities and expenses are overstated

Why?

• The entities may rely on understated revenues or overstated expenses to get more money for a project or contract

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Financial Statement Fraud

• Improper Revenue Recognition

Recording fictitious revenues

Recording revenues prematurely

• Overstatement of Assets

Overstating existing assets or recording fictitious assets

• Understatement of Expenses

Capitalizing assets that should have been expensed

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Financial Statement Fraud Assets most often misstated were:

• Accounts Receivable

• Inventory

• Property, plant and equipment

• Loans/notes receivable

• Cash

• Investments

• Patents

• Natural Resources

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Who was most often the perpetrator of the Fraud? • Chief Executive Officer (72%)

• Chief Financial Officer

• Controller

• Chief Operating Officer

• Vice Presidents

• Members of the Board of Directors

• Lower level personnel

• External auditor (29%)

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Today’s Objectives

• Provide some insight to “Red Flags”

• Highlight a few common methods to misstate financial statements and/or commit Fraud

• Demonstrate how forensic accounting can assist in uncovering Financial Transaction Fraud

• Provide basic methodologies for Financial Transaction Fraud Detection

• Provide basic tools for Financial Transaction Fraud Detection

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General - Red Flags

• Industry has a reputation for corruption

• Company culture

• Excessive Miscellaneous and/or unsupported expenses

• Incomplete invoices and/or supporting documentation

• Unusual cash disbursements or excessive use of petty cash

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General –Red Flags

• Offshore bank accounts

• Customer Complaints

• Vendor Complaints

• “Special arrangements”

• Override of internal controls, (SOX 404 issues)

• Advance payments, excessive commissions

• Pressure to “make the numbers”

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General –Red Flags

• Manual Journal Entries and/or those lacking support

• Financial estimates that require significant subjective judgment

• Generic and/or un-descriptive account names and activity.

• Suspense account activity or large un-reconciled balances.

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General – Red Flags

• False or incomplete invoice or mischaracterization of invoices

• Falsified or “mislabeled” records

• Unrecorded “off the books” payments

• Payment to different suppliers with the same address

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ABC Historical Balance Sheets

2000 2001 2002 2003 2004 2005 2006

ASSETS

Cash 7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235 9,506,321

Accounts Receivable 3,037,713 3,531,609 3,450,584 4,066,189 5,354,956 4,681,143 4,572,910

Inventory 20,707,347 21,186,365 22,272,693 23,672,161 25,709,465 27,993,935 30,665,649

Other Current Assets 1,999,511 2,208,786 2,132,999 2,160,575 2,680,688 2,599,862 3,713,573

Total Current Assets 33,085,424 35,926,901 38,103,313 40,511,430 43,536,387 44,346,175 48,458,453

Fixed Assets 78,479,188 82,986,383 79,502,294 69,918,680 70,554,241 79,566,514 83,028,658

Net Intangible 8,641,354 8,274,062 8,007,702 13,192,621 19,238,106 24,625,266 30,806,473

Other Non Current Assets 9,604,551 8,448,813 8,920,030 12,707,889 15,107,652 15,732,002 16,053,086

Non-Operating Assets - - - 7,252,562 7,252,562 7,252,562 7,252,562

Total Assets 129,810,517 135,636,159 134,533,339 143,583,182 155,688,948 171,522,519 185,599,232

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ABC Historical Balance Sheets

LIABILITIES & EQUITY 2000 2001 2002 2003 2004 2005 2006

Accounts Payable 11,814,573 10,301,276 11,934,461 13,292,947 11,859,356 14,958,034 17,604,006

Short Term Notes Payable

5,500,000 4,000,000 2,000,000 3,000,000 7,000,000 10,000,000 12,200,000

Current Portion of LT Debt

6,721,928 9,503,629 11,767,006 6,037,797 6,220,074 8,049,385 7,791,760

Other Current Liabilities

9,017,676 13,135,508 15,012,197 12,996,169 16,201,172 17,138,682 18,000,661

Total Current Liabilities

33,054,177 36,940,413 40,713,664 35,326,913 41,280,602 50,146,101 55,596,427

Long Term Debt 67,002,033 66,935,421 55,527,283 70,863,356 72,528,541 75,292,777 91,310,219

Other Non-Current Liabilities

6,715,823 7,268,366 7,919,523 8,294,939 8,770,469 8,546,452 8,776,146

Non-Operating Liabilities

- - - -

Total Liabilities 106,772,033 111,144,200 104,160,470 114,485,208 122,579,612 133,985,330 155,682,792

Total Equity 23,038,484 24,491,959 30,372,869 29,097,974 33,109,336 37,537,189 29,916,440

Total Liabilities & Equity

129,810,517 135,636,159 134,533,339 143,583,182 155,688,948 171,522,519 185,599,232

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ABC Historical Income Statement

2000 2001 2002 2003 2004 2005 2006

Revenue 282,684,058 316,134,725 323,807,201 341,198,318 361,434,956 375,711,489 423,455,160

Cost of Goods Sold 200,052,646 222,411,651 223,585,996 236,708,393 246,858,110 252,374,610 285,797,507

Gross Profit 82,631,412 93,723,074 100,221,205 104,489,925 114,576,846 123,336,879 137,657,653

Operating Expenses 66,358,848 76,006,290 78,403,789 84,387,118 92,285,289 96,952,085 112,592,318

Officer's Compensation

804,848 881,452 938,124 839,878 830,235 795,465 521,241

Depreciation/Amortization 5,227,725 5,922,793 5,492,676 5,751,120 5,516,684 6,052,032 7,010,348

Interest Expense 7,275,085 7,282,709 6,117,280 5,445,046 8,450,906 9,096,521 12,157,828

Total Operating Expenses 79,666,506 90,093,244 90,951,869 96,423,162 107,083,114 112,896,103 132,281,735

Operating Profit 2,964,906 3,629,830 9,269,336 8,066,763 7,493,732 10,440,776 5,375,918

Other Income/(Expense)

(1,146,303) (914,014) 187,403 435,827 178,091 (27,316) (1,498,016)

Income Before Taxes 1,818,603 2,715,816 9,456,739 8,502,590 7,671,823 10,413,460 3,877,902

Income Taxes

563,764 1,020,347 3,281,760 4,390,591 2,251,513 4,133,187 1,120,966

Net Income 1,254,839 1,695,469 6,174,979 4,111,999 5,420,310 6,280,273 2,756,936

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ABC Historical Cash Flow Statements

2000 2001 2002 2003 2004 2005 2006

Increase/(Decrease in Cash)

Cash Provided by (Used for) Operations

Net Income/(Loss)

1,254,839

1,695,469 6,174,979 4,111,999 5,420,310 6,280,273 2,756,936

Total Cash Provided by (Used for) Operations

5,371,528

9,248,889 12,427,953 (2,502,077) 10,937,989 16,990,295 11,706,653

Cash Provided by (Used for) Investing Activities

Total Cash Provided by (Used for) Investing Activities

(15,263,142)

(10,062,696) (1,742,227) (1,352,425) (12,197,730) (20,451,465) (16,653,699)

Cash Provided by (Used for) Financing Activities

Total Cash Provided by (Used for) Financing Activities

8,135,899

2,473,095 (9,438,830) 4,219,970 438,514 2,741,127 5,382,132

Total Increase/(Decrease) in Cash

(1,755,715)

1,659,288 1,246,896 365,468 (821,227) (720,043) 435,086

Cash Balance at Beginning of Year

9,096,568

7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235

Cash Balance at End of Year

7,340,853

9,000,141 10,247,037 10,612,505 9,791,278 9,071,235 9,506,321

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A Few Ratios

• Current Ratio = Current Assets/Current Liabilities

• Quick (Acid-Test) Ratio = Cash + Securities + Receivables/ Current Liabilities

• Receivable Turnover = Net Sales On Account/Average Net Receivables

• Revenue-Accounts Receivable=Revenue/Accounts Receivable

• Collection Ratio=365/Receivable Turnover

• Inventory Turnover= Cost of Goods Sold/Average Inventory

• Average Number of Days Inventory in Stock=365/Inventory Turnover

• Debt to Equity=Total Liabilities/Total Equity

• Profit Margin=Net Income/Net Sales

• Asset Turnover=Net Sales/Average Assets

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ABC Ratios

Name 2000 2001 2002 2003 2004 2005 2006

Current Ratio 1.00 0.97 0.94 1.15 1.05 0.88 0.87

Quick Ratio 0.31 0.34 0.34 0.42 0.37 0.27 0.25

Revenue/AR 93.06 89.52 93.84 83.91 67.50 80.26 92.60

Debt to Equity 4.63 4.54 3.43 3.93 3.70 3.57 5.20

Revenue/ Working Capital 9046 -311 -124 66 160 -65 -59

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Example of Fictitious Revenues

In one case, a foreign subsidiary of a U.S. company recorded sales to a series of companies. They invoiced the sales but did not collect any of the accounts receivable, which became severely past due.

The manager of the foreign subsidiary arranged for false confirmations of the AR for audit purposes and even hired actors to pretend to be the customers during a visit from US management. Background checks on the customers would have revealed that some of the companies were fictitious while others were either undisclosed related parties or operated in industries that would have no need for the goods supposedly supplied.

An investigation revealed that the manager of the foreign subsidiary directed the scheme to record fictitious revenues to met unrealistic

revenue goals set by the U.S. Management.

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Red Flags - Revenue

• Fake Journal Entries to record Goods or Services sales that did not occur

• Sales to Fake or Phantom Customers

• Fake sales to Legitimate Customers

• Altered (higher) invoices to Legitimate Customers

• Sales with Conditions (do not qualify as revenue)

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Red Flags - Revenue

• Rapid growth or unusual profitability.

• Recurring negative cash flows from operations or inability to generate cash flows while reporting profits.

• Significant transactions with related parties or special purpose entities not in the ordinary course of business.

• Significant, unusual, or highly complex transactions, especially close to period end that pose difficult “substance over form” questions.

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Red Flags – Revenue

• Unusual growth in days sales in receivables.

• A significant volume of sales to entities whose substance and ownership is not known.

• An unusual surge in sales by a minority of the units within a company, or of sales recorded by corporate headquarters.

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Red Flags – Asset Valuation

• Inventory Valuation

• Accounts Receivable

• Business Combinations

• Fixed Assets

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Asset Valuation

Inventory • Not stated at the Lower of Cost or Market

• Fictitious Physical Inventory counts

• Inflating of Unit costs used to price out inventory

• Failure to release Inventory to Cost of Goods Sold

• Creation of Fake documents

• Capitalizing non-asset costs

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Misrepresenting Fixed Asset Costs

Enron

In October 2002, the SEC filed a civil enforcement action against former

Enron CFO Andrew S. Fastow, who also faced criminal charges relating to an alleged self enriching scheme to defraud Enron’s security holders through the use of off-balance sheet entities. One of the six transactions is the SEC’s complaint against Andrew Fastow involved Raptor I and Avici. According to the complaint, Enron and the Fastow controlled partnership LJM2 engaged in complex transactions with an entity called Raptor I. Raptor I was used to manipulate Enron’s balance sheet and income statement and to generate profits for LJM2 and Fastow at Enron’s expense. In September 2000, Fastow and others used Raptor I to effectuate a fraudulent hedging transaction and thus avoid a decrease in the value of Enron’s investment in the stock of a public company called Avici Systems, Inc. Specially, Fastow and others back dated documents to make it appear that Enron locked in the value of its investment in Avici in August 2002. when Avici’s stock was trading at its all time high price.

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Reds Flags – Improper Asset Valuation

• Assets, liabilities, revenues, or expense based on significant estimates that involve subjective judgments or uncertainties

• On-financial management’s excessive participation in or preoccupation with the selection of accounting principals or determination of significant estimates

• Unusual increase in gross margins or margin in excess of industry peers

• Unusual growth in the number of days sales in receivables

• Unusual growth in the number of days of purchases in inventory.

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Reds Flags – Improper Asset Valuation

• Allowances for bad debts, excess or obsolete inventory, etc. that is shrinking in percentage terms or are other wise out of line with industry peers

• Unusual change in the relationship between fixed assets and depreciation

• Adding to assets while competitors are reducing capital tied up in assets

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Red Flags – Concealed Liabilities and Expenses

Three common methods

• Liability/Expense Omissions

• Capitalized Expenses

• Failure to Disclose Warranty Costs and Liabilities

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Omission of Liabilities

In July 2002, the SEC filed suit in the US District Court for the Southern

District of New York, charging major cable television producer Adelphia Communications; its founder John J. Rigas, his three sons, Timothy J. Rigas, Michael J. Rigas, and James P. Rigas, and two senior executives at Adelphia, James R. Brown and Michaels C. Mulcahey, in one of the most extensive financial frauds ever to take place at a public company. The SEC charged that Adelphia, at the direction of the individual defendants (1) fraudulently excluded over $2.3 billion in liabilities from its consolidated financial statements by hiding them in off-balance sheet affiliates; (2) falsified operations statistics and inflated Adelphia’s earnings to meet Wall Street expectations; and (3) concealed rampant self dealing by the Rigas family, including the undisclosed use of corporate funds for Rigas stock purchase and the acquisition of luxury condominiums in New York and elsewhere.

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Three Elementary Fraud Types

• Duplicate Payment Fraud

• Multiple Payment Fraud

• Shell Fraud

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Duplicate Payment Fraud

• The issue of two more identical checks to pay the same debt

• Employee of the paying entity initiates procedure to issue a second check and intercepts the second check

• Payee’s name is usually no problem

• Unless the Auditor’s are specifically looking for it, it is difficult to uncover

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Duplicate Payment Fraud

If the Auditor’s are specifically looking for it, it is relatively easy to discover.

• Small business – scan Accounts Payable manually

• Larger business – use a automated computer search program using data mining software to display identical payment amounts to same payee

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Multiple Payee Fraud

Involves two or more payments to different payees for the

same item or service

• One of the payments will be to a legitimate payee, the other will be fraudulent

• The underlying documentation is switched to support the bogus transaction

• A bogus vendor name, PO Box can be used to control the payment receipt

• More difficult to uncover than Duplicate Payment fraud.

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Shell Fraud

Probably got the name from the old carnival game

• Shell frauds are like the object under the shells, the item that was purchased and paid for did not exist and never existed

• Perpetrator conceives of a fictional purchase and prepares paperwork and accounting entries, forging whatever signatures are needed

• Perpetrator submits a bogus invoice at the proper time

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Statement on Auditing Standards 99

• 1. All frauds are material because they

signal that management lacks integrity.

Further, materiality isn’t just an amount

• 2. Malpractice cases are litigated with

20/20 hindsight, with all the facts out for

the world to see.

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SAS 99 • 3. SAS 99 requires that you significantly

change your relationship with clients. You no longer can assume that your clients are honest just because they have been in the past.

• 4. The cost of audits is on the rise. Clients may attempt to save money by either terminating their current accountants or asking for a compilation or review rather than an audit. You should consider adding, in large, bold print, the wording,

“NOT AN AUDIT OPINION” at the top of compilation and review opinions.

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SAS 99

• 5. SAS 99 is an admission that risk-based auditing doesn’t work.

This is because no matter how good the controls are,

management can always override them.

• 6. Don’t wait until you have identified a risk of material fraud to perform appropriate procedures. That’s backwards. Perform the procedures to identify the risk.

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How a Company Can Reduce Fraud

The risk of fraud can be reduced through a combination of prevention, deterrence and detection measures.

However, fraud often is difficult to detect because it often involves concealment through falsification of documents or collusion. Therefore, it is important to place a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals that they should not commit fraud because of the likelihood of detection and punishment. Moreover, prevention and deterrence measures are much less costly than the time and expense required for fraud detection and investigation.

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Create and maintain a culture of honesty and high ethics.

The ethical culture needs to be set by management through their daily words, but more importantly, their actions.

Therefore, the organizations value system requires not so much a written code of conduct (which is important as well) but a daily, consistent adherence to these values.

Companies should also clearly communicate their ethical values, decision-making processes and codes of conduct to all employees so they may be empowered to make appropriate ethical decisions even when they are far from headquarters or confronted with a new dilemma.

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Evaluate the risks of fraud, and implement risk mitigation

Fraud risk assessment should be part of a more enterprise-wide risk monitoring process but can also be done separately.

A collection of fraud risk factors are included in SAS 99 and are segregated into the areas of fraudulent financial reporting and asset misappropriation. Based on the assessed risks, a response is developed which may include preventative controls (reducing the opportunity to commit fraud), mitigation controls (reducing the impact of the potential fraud), or transference (selecting appropriate fraud insurance such as a fidelity insurance policy).

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Develop an appropriate oversight process.

Internal and external parties need to oversee the risk of and responses to fraudulent financial reporting.

Although the entire management team shares the responsibility for implementing and monitoring these activities, the entity’s CEO should initiate and support such measures.

In addition, the entire organization should adopt a level of fraud awareness similar to a neighborhood watch program. Employees should have a means to communicate wrongdoing without fear of retribution as tips from employees are still the number one way fraud is uncovered.

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Develop an appropriate oversight process.

Further, independent verifications by internal and external auditors help to ensure controls are operating effectively. Such reviews should be reported directly to the audit committee.

Coupled with follow-up work to suspected wrongdoing, these reviews send a strong deterrent message throughout the organization.

Oversight needs to take a tiered approach so that override at any given layer, including the CEO, may be identified and properly handled. The top layer of this oversight process is reserved for the audit committee who must ensure top management upholds its responsibilities to the organization.

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Questions??