Unformatted text preview: Forensic and Investigative Accounting Forensic Chapter 3 Fraudulent Financial Reporting © 2009 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com An International Problem
Fraud is an international phenomenon touching all Fraud countries. Transparency International (TI) is a global network including more than 90 locally established national chapters and chapters-in-formation, whose goal is to fight corruption in the national arena. TI produces a Transparency International Corruption Perception Index (CPI), which ranks more than 150 countries by their perceived levels of corruption, as determined by expert assessments and opinion surveys.
Chapter 3 Forensic and Investigative Accounting 2 Michael Comer’s Types of Fraud
Corruptions (e.g., kickbacks). 2. Conflicts of interest (e.g., drug/alcohol abuse, part-time Conflicts work). work). 3. Theft of assets. 4. False reporting or falsifying performance (e.g., false False accounts, manipulating financial results). accounts, 5. Technological abuse (e.g., computer related fraud, Technological unauthorized Internet browsing). unauthorized Comer’s Rule: Fraud can happen to anyone at anytime.
Source: M.J. Comer, Investigating Corporate Fraud, Burlington, Vt.: Gower Source: Investigating Burlington, Publishing Co., 2003, pp. 4-5. Publishing
Chapter 3 Forensic and Investigative Accounting 3 The Cost of Fraud Organizations lose 7 percent of annual revenue Organizations percent to fraud and abuse. to Fraud and abuse costs U.S. organizations more Fraud than $994* billion annually (about $6,860 per billion employee). employee). The average organization loses more than $18.30 The a day per employee due to fraud and abuse. day
* $652 billion in 2006. $660 billion in 2004. $652
Source: 2008 Wells Report
Chapter 3 Forensic and Investigative Accounting 4 Advantage of Compliance Spending
General Counsel Roundtable says that General each $1 of compliance spending saves $1 saves organizations, on the average, $5.21 in $5.21 heightened avoidance of legal liabilities, harm to the organization’s reputation, and lost productivity. productivity.
Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April 2004, p. 47. Source: Internal Chapter 3 Forensic and Investigative Accounting 5 Some Research on Fraud
Primary motivation to commit fraud [Dechow et al.] 1. Desire to obtain low-cost loans. 2. Weaker governance system. 3. Experience higher cost of capital after fraud discovered. Summers and Sweeney : In the presence of fraud, insiders reduce their holdings of company stock through high levels of selling activity. Also, growth, inventory, and ROA differ significantly.
Chapter 3 Forensic and Investigative Accounting 6 The Methods - Frequency Asset misappropriation accounted for more Asset than four out of five offenses or 88.7% in 2008 (91.5% in 2006) (92.7% in 2004). $150,000 in $150,000 Bribery and corruption constituted about Bribery 27.4% (30.8% in 2006) (30.1% in 2004) of 27.4% 30.8% offenses. $375,000 ($538,000) offenses. Fraudulent statements were the smallest Fraudulent category of offense 10.3% in 2008 (10.6% in category 10.6% 2006) (7.9% in 2004) (most costly). $2 million 2006) ). per scheme. per
Chapter 3 Forensic and Investigative Accounting 7 Source: 2008 Wells Report, ACFE. Transparency International Corruption Perceptions Index 2008 Chapter 3 Forensic and Investigative Accounting 8 One Small Clue
A former Scotland Yard scientist tried to create the world’s former biggest fraud by authenticating $2.5 trillion worth of fake trillion U.S. Treasury bonds. U.S. When two men tried to pass off $25 million worth of the When bonds in Toronto in 2001, a Mountie noticed the bonds bore the word “dollar” rather “dollars.” “dollar” “dollars.” Police later raided a London bank vault and discovered that Police the bonds had been printed with an ink jet printer that had not been invented when the bonds were allegedly produced. been Zip codes were used even though they were not introduced Zip until 1963. until
Sue Clough, “Bungling Scientist Is Jailed for Plotting World's Biggest Fraud,” Sue News.telegraph.co.uk, January 11, 2003. News.telegraph.co.uk,
Chapter 3 Forensic and Investigative Accounting 9 Numbers Don’t Lie. Criminals are another story. Catch Me If You Can Money talks. But more often it whispers. When shady characters are up to no good, they often leave a trail of questionable financial transactions. Use your skills and smarts to trace the money trail back to the crooks in the all-new version of Catch Me If You Can. Now more interactive and exciting than ever. You could win up to $2,000 in cash or other prizes. And have a lot fun doing it. Register to play at www.CatchMeGame.com/college
Chapter 3 Forensic and Investigative Accounting 10 SAS No. 2
Statement of Financial Accounting Concepts No. 2 Statement provides these nine qualities and characteristics that make financial information useful for investors, creditors, analysts, and other users of financial information: analysts, Relevance Timeliness Reliability Verifiability Representational Representational faithfulness faithfulness Chapter 3 Neutrality Comparability and Comparability consistency consistency Materiality Feasibility or costs and Feasibility benefits benefits 11 Forensic and Investigative Accounting Three M’s of Financial Reporting Fraud Manipulation, falsification, or alteration of falsification, accounting records or supporting documents from which financial statements are prepared. from Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information. transactions, Intentional misapplication of accounting Intentional misapplication principles relating to amounts, classification, manner of presentation, or disclosure. manner Source: D.S. Hilzenrath, “Forensic Auditors Find What Some Companies Try to Hide,” The Washington Post, November 23, 2002, p.19.
Chapter 3 Forensic and Investigative Accounting 12 Fraud Schemes Based on Fraud SEC Releases SEC
1. 2. 3. 4. 5. Fictitious and/or overstated revenues and Fictitious assets. assets. Fictitious reductions of expenses and liabilities. Premature revenue recognition. Misclassified revenues and assets. Overvalued assets or undervalued expenses and Overvalued liabilities. liabilities.
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Chapter 3 Forensic and Investigative Accounting 13 Fraud Schemes Based on Fraud SEC Releases SEC
1. 2. 3. 4. 5. 6. Omitted liabilities. Omitted or improper disclosures. Equity fraud. Related-party transactions. Alter ego. Minimizing income or inflating expenses to Minimizing reduce tax liabilities. reduce
Forensic and Investigative Accounting 14 Chapter 3 Shenanigans to Boost Earnings Recording revenue before it is earned. Creating fictitious revenue. Boosting profits with nonrecurring Boosting transactions. transactions. Shifting current expenses to a later period. Failing to record or disclose liabilities. Shifting current income to a later period. Shifting future expenses to an earlier period.
Forensic and Investigative Accounting 15 Chapter 3 Reframing
Behavioral psychologists call this rationalization Behavioral “reframing,” where someone who is about to cheat will adjust the definition of cheating to exclude his or her actions. Dan Ariely says “people who would never take $5 from petty cash have no problem paying for a drink for a stranger and putting it on a company tab.” company Source: S.L. Mintz, “The Gauge of Innocence,” Source: CFO, April 2009, p. 56. CFO
Chapter 3 Forensic and Investigative Accounting 16 Rationalization Sherron Watkins provides an excellent Sherron comment about rationalization with respect to rationalization Enron’s Jeff Skilling and Andy Fastow. At what point did they turn crooked? “But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a slow erosion of values over time.” slow
Source: Pamela Colloff, “The Whistle-Blower,” Texas Monthly, Texas April 2003, p. 141. April
Chapter 3 Forensic and Investigative Accounting 17 Internal vs. External Fraud
Internal Employee Management Stock theft Lapping Misappropriation Expense accounts Misappropriation of cash assets of Lapping False financial False statements statements Check forgery Misappropriation Misappropriation of cash/assets of Expense accounts Unnecessary Unnecessary purchases purchases
Chapter 3 Forensic and Investigative Accounting External Check forgery False insurance False claims claims Credit card fraud False invoices Product Product substitution substitution
18 Internal vs. External Fraud (contd.)
Internal Employee Management Petty cash Check forgery Kickbacks Loans/ investments Ghost Ghost employees employees
Chapter 3 External Bribes/secret Bribes/secret commission commission Bid rigging/price Bid fixing fixing False representation False of funds of Kickbacks Ghost vendors Diversion of sales Source: KPMG, Fraud Awareness Survey, Dublin: KPMG, 1995, pp. 10-12.
Forensic and Investigative Accounting 19 Four Factors Contributing to Four Business Fraud Business
1. 2. 3. 4. Motive Opportunity Lack of integrity (or rationalization) Capacity—the person must have the Capacity—the necessary traits, abilities, or positional authority to commit the crime authority Chapter 3 Forensic and Investigative Accounting 20 Components of Internal Controls
Control environment Risk assessment Control activities or control procedures Information and communication systems Information support support Monitoring Source: SAS No. 94, The Effect of Information Technology on the Auditor’s Consideration of Internal Control in a Financial Statement Audit, New York: AICPA.
Chapter 3 Forensic and Investigative Accounting 21 Types of Controls
Preventive Controls Segregation of duties Required approvals Securing assets Passwords Using document control numbers Drug testing Job rotation Computer backup
Forensic and Investigative Accounting 22 Chapter 3 Types of Controls
Detective Controls Reconciliations Reviews Event notifications Surprise cash count Counting inventory Chapter 3 Forensic and Investigative Accounting 23 Types of Controls
Corrective Controls Training Process redesign Additional technology Quality circle teams Budget variance reports Chapter 3 Forensic and Investigative Accounting 24 Earnings Management
Earnings management may be defined as the Earnings “purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.” obtaining
– Katherine Schipper, “Commentary on Earnings Management,” Accounting Horizon, December 1989, p. 92. Management,” Chapter 3 Forensic and Investigative Accounting 25 Difficult to Measure Integrity
Richard Davis says there is no psychometric way to Richard measure integrity, so forget about personality tests to pick the fraudsters. They are easily faked. He is more hopeful about new methods involving microexpressions, or those brief facial expressions that may reveal a person’s predisposition to fraud. that
Source: S.L. Mintz, “The Gauge of Innocence,” CFO, April 2009, p. 57. Source: CFO
Chapter 3 Forensic and Investigative Accounting 26 Psychology of Fraud Fraud can be explained by three factors:
• Supply of motivated offenders. • Availability of suitable targets. • Absence of capable guardians (e.g., internal controls). The three B’s -- babes, booze, and bets. Some fraudsters wish to make fools of their victims. They Some take delight in the act itself. take Risk of fraud is a product of both personality and Risk environmental (or situational) variables. environmental Grace Duffield and Peter Grabosky, “The Psychology of Fraud,” Australian Institute of Criminology, Grace No. 19. No.
Chapter 3 Forensic and Investigative Accounting 27 Parallel Universe: Two Opinions
External auditors must do a regular audit of a company External regular audit (e.g., financial statements are fairly stated) and must also also audit the internal controls that are to ensure that the audit financial statements are accurate (e.g., issue two opinions). financial Prior to the external auditors’ arrival, the company itself Prior must review its internal controls and issue a report on the must issue effectiveness of these controls. effectiveness There will be two external opinions: on management’s There two on assessment of the internal controls over financial reporting and another one on the effectiveness of the internal controls themselves (e.g., statements are fairly stated). themselves
PCAOB Release 2004-001.
Chapter 3 Forensic and Investigative Accounting 28 Anti-Fraud Program
An auditor must perform “company-wide anti-fraud An programs and controls and work related to other controls that have a pervasive effect on the company, such as general controls over the company’s electronic data processing.” Further, the auditor must “obtain directly the ‘principal Further, principal evidence’ about the effectiveness of internal controls.” evidence PCAOB endorses the COSO Cube [pp. 24-26 and A-25 and A[pp. PCAOB
Source: PCAOB Release 2004-001.
Chapter 3 Forensic and Investigative Accounting 29 Source: 2008 Wells Report, ACFE.
Chapter 3 Forensic and Investigative Accounting 30 Fraud’s Fatal Failings 85% of fraud victims never get their money never or property back. or Most investigations flounder, leaving the Most victims to defend for themselves against counter-attacks by hostile parties. counter-attacks 30% of companies that fail do so because of fraud. fraud Source: Michael J. Comer, Investigating Corporate Fraud, Source: Investigating Burlington, VT: Gower Publishing, 2003, p. 9. Burlington,
Chapter 3 Forensic and Investigative Accounting 31 ...
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