Fraud and Other Investigative Techniques Chapter 10

Learning Objectives The definition of fraud The definition of fraud Different types of fraud Different types of fraud Components of the Fraud Triangle Components of the Fraud Triangle Utilization of ACL and i2 Analyst Notebook in fraud investigation Utilization of ACL and i2 Analyst Notebook in fraud investigation

Learning Objectives (contd.) Overview of fraud examination and business investigation Overview of fraud examination and business investigation Use of computer technology and fraud examination/investigations Use of computer technology and fraud examination/investigations

Types of value added services Risk assessment of fraud and illegal acts Risk assessment of fraud and illegal acts Legal counsel asks you to investigate embezzlement scheme involving hidden assets Legal counsel asks you to investigate embezzlement scheme involving hidden assets Vendor kickback determination Vendor kickback determination Fact-finding for alleged frauds involving bribery, wire fraud, securities fraud……. Fact-finding for alleged frauds involving bribery, wire fraud, securities fraud……. All of these involve forensic accounting or litigation support All of these involve forensic accounting or litigation support

Fraud defined Intentional deception, simply lying, cheating, or stealing Intentional deception, simply lying, cheating, or stealing A generic term, embracing all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get advantage over another by false suggestions or by suppression of truth. It includes surprise, trickery, cunning, dissembling, and any unfair way by which another is cheated. A generic term, embracing all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get advantage over another by false suggestions or by suppression of truth. It includes surprise, trickery, cunning, dissembling, and any unfair way by which another is cheated.

Fraud defined (contd.) Fraud includes the following elements: Fraud includes the following elements: A misrepresentation of a material fact A misrepresentation of a material fact Known to be false Known to be false Justifiably relied upon Justifiably relied upon Resulting in a loss Resulting in a loss

Types of frauds Fraudulent financial reporting (management fraud) Fraudulent financial reporting (management fraud) Actions whereby management attempts to inflate reported earnings or other assets in order to deceive outsiders Actions whereby management attempts to inflate reported earnings or other assets in order to deceive outsiders Overstating assets/revenues, price fixing, contract bidding fraud, understating expenses/liabilities Overstating assets/revenues, price fixing, contract bidding fraud, understating expenses/liabilities

Types of frauds (contd.) Misappropriation of assets (employee fraud) Misappropriation of assets (employee fraud) Actions of individuals whereby they misappropriate (steal) money or other property from their employers Actions of individuals whereby they misappropriate (steal) money or other property from their employers Embezzlement, theft of company property, kickbacks Embezzlement, theft of company property, kickbacks

Types of fraud (contd.) Employee embezzlement – fraud in which employees steal company assets either directly – stealing cash or inventory –or indirectly – taking bribes or kickbacks Employee embezzlement – fraud in which employees steal company assets either directly – stealing cash or inventory –or indirectly – taking bribes or kickbacks Management fraud – deception by top management of an entity primarily through the manipulation of the financial statements in order to mislead users of those statements Management fraud – deception by top management of an entity primarily through the manipulation of the financial statements in order to mislead users of those statements Investment scams – the sale of fraudulent and often worthless investments (telemarketing and Ponzi scheme type frauds) Investment scams – the sale of fraudulent and often worthless investments (telemarketing and Ponzi scheme type frauds)

Types of fraud (contd.) Vendor fraud – fraud resulting from overcharging for goods purchased, shipment of inferior goods, or non-shipment of inventory even when payment has been received Vendor fraud – fraud resulting from overcharging for goods purchased, shipment of inferior goods, or non-shipment of inventory even when payment has been received Customer fraud – fraud committed by a customer by not paying for goods received or deceiving the organization in various ways to get something for nothing Customer fraud – fraud committed by a customer by not paying for goods received or deceiving the organization in various ways to get something for nothing Miscellaneous fraud – all others – altering birth records or grade reports, etc. Miscellaneous fraud – all others – altering birth records or grade reports, etc.

Examples of fraud activities Misappropriation of assets Misappropriation of assets Skimming Skimming Forgery Forgery Kiting Kiting Phony refunds Phony refunds Larceny Larceny Fraudulent disbursements Fraudulent disbursements Lapping Lapping Fictitious write-offs Fictitious write-offs Duplicate payments Duplicate payments Nonexistent vendor Nonexistent vendor Kickbacks Kickbacks Misdirected shipments Misdirected shipments Theft Theft Unauthorized personal use of assets Unauthorized personal use of assets Fictitious burglary Fictitious burglary Phantom employees Phantom employees Falsified time cards Falsified time cards Fraudulent financial reporting Fraudulent financial reporting Fictitious revenues Fictitious revenues Asset overstatement Asset overstatement Unrecorded liabilities Unrecorded liabilities Improper disclosure Improper disclosure Corruption Corruption Conflict of interest Conflict of interest Bribery Bribery Illegal gratuities Illegal gratuities Economic extortion Economic extortion

The Fraud Triangle Three factors in the triangle (usually all 3 exist in a fraud) Three factors in the triangle (usually all 3 exist in a fraud) Motivation (perceived pressure or incentive) Motivation (perceived pressure or incentive) Perceived opportunity Perceived opportunity Rationalization Rationalization Effective internal controls limit fraud Effective internal controls limit fraud If an organization can contain any one of the three elements, fraud will most likely not occur If an organization can contain any one of the three elements, fraud will most likely not occur

Overview of financial fraud examination Two basic categories of fraud an auditor investigates when examining material misstatement risk assessment Two basic categories of fraud an auditor investigates when examining material misstatement risk assessment Fraudulent financial reporting Fraudulent financial reporting Misappropriation of assets Misappropriation of assets

Overview of financial fraud examination (contd.) Financial reporting fraud red flags Financial reporting fraud red flags Incentive/pressures Incentive/pressures High degree of competition or market competition in conjunction with declining profit margins High degree of competition or market competition in conjunction with declining profit margins Perceived or real adverse effects of reporting poor financial results Perceived or real adverse effects of reporting poor financial results Personal guarantees by management or board members of entity debt Personal guarantees by management or board members of entity debt

Overview of financial fraud (contd.) Financial reporting fraud (contd.) Financial reporting fraud (contd.) Opportunities – flags Opportunities – flags Highly complex transactions Highly complex transactions Major international operations Major international operations Deficiencies in internal controls Deficiencies in internal controls

Overview of financial fraud (contd.) Financial reporting fraud (contd.) Financial reporting fraud (contd.) Attitudes/rationalization flags Attitudes/rationalization flags Ineffective communication or enforcement of ethical standards Ineffective communication or enforcement of ethical standards Excessive interest by management in maintaining or increasing the entity’s earnings trend Excessive interest by management in maintaining or increasing the entity’s earnings trend

Overview of financial fraud (contd.) Misappropriation of asset risk factors Misappropriation of asset risk factors Susceptibility of assets to misappropriation Susceptibility of assets to misappropriation Large amounts of cash on hand Large amounts of cash on hand Easily convertible assets (bonds, diamonds) Easily convertible assets (bonds, diamonds) Controls (lack of) Controls (lack of)

Overview of financial fraud (contd.) Steps of the fraud examination Steps of the fraud examination Indentify issue/plan the investigation Indentify issue/plan the investigation Gather the evidence/the investigation phase Gather the evidence/the investigation phase Evaluate the evidence Evaluate the evidence Report he findings to management?/legal counsel Report he findings to management?/legal counsel

Computer technology in fraud investigation (contd.) Data mining software Data mining software Software tool that models a database for the purpose of determining patterns and relationships among the data Software tool that models a database for the purpose of determining patterns and relationships among the data Wizrule – used for data cleaning (searching for clerical errors) or anomaly detection. Wizrule – used for data cleaning (searching for clerical errors) or anomaly detection. Financial Crime Investigator – systematic approach for investigating, detecting, and preventing contract and procurement fraud Financial Crime Investigator – systematic approach for investigating, detecting, and preventing contract and procurement fraud

Computer technology in fraud investigation (contd.) Data mining software (contd.) Data mining software (contd.) IDEA (Audimation Services, inc) – allows user to display, analyze, manipulate, sample or extract data IDEA (Audimation Services, inc) – allows user to display, analyze, manipulate, sample or extract data Monarch – allows investigator to convert electronic editions of reports into text files Monarch – allows investigator to convert electronic editions of reports into text files ACL for windows – data inquiry, analysis, and reporting software ACL for windows – data inquiry, analysis, and reporting software Analyst’s notebook – assists investigators by uncovering, interpreting, and displaying complex information in easily understood charts. Analyst’s notebook – assists investigators by uncovering, interpreting, and displaying complex information in easily understood charts.

Public records – see figure 10-7 Courthouse records – lawsuits, judgments, property filings, bankruptcy filings Courthouse records – lawsuits, judgments, property filings, bankruptcy filings Company records – SEC filings, Dun and Bradstreet has private company data, D/B/A filings with state or county, real estate filings Company records – SEC filings, Dun and Bradstreet has private company data, D/B/A filings with state or county, real estate filings Online databases – lexis nexis, dow jones, etc Online databases – lexis nexis, dow jones, etc The internet – knowX – fraud searches, switchboard – white and yellow page listing, The internet – knowX – fraud searches, switchboard – white and yellow page listing,