Chapter 5 Recognizing the Symptoms

of Fraud
(Fraud Examination 6e
by Albrecht, Arbrecht, Arbrecht, Zimbelman)

ACC 5375 -260 – Forensic Accounting

Source: Adapted from Cengage Learning
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 Learning Objectives
➢ Obj. 1: Understand how symptoms help in the detection of fraud
➢ Obj. 2: Identify and understand accounting symptoms of fraud.
➢ Obj. 3: Describe internal controls that help detect fraud.
➢ Obj. 4: Identify and understand analytical symptoms of fraud.
➢ Obj. 5: Explain how lifestyle changes help detect fraud.
➢Obj. 6: Discuss how behavioral symptoms help detect fraud.
➢Obj. 7: Recognize the importance of tips and complaints as fraud
symptoms.

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 Symptoms of Fraud
➢Fraud is a crime that is seldom observed.
✓ With fraud it is not usually obvious that a crime has been committed.
✓ Only fraud symptoms, red flags, or indicators are observed.
➢Can be separated into six groups:
1. Accounting anomalies
2. Internal control weaknesses
3. Analytical anomalies
4. Extravagant lifestyle
5. Unusual behavior
6. Tips and complaints

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 Accounting Anomalies

➢Common accounting anomaly fraud symptoms involve

problems with:
✓Source documents
✓Faulty journal entries
✓Inaccuracies in ledgers

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 Elgin Aircraft Case
➢ Accounting Anomaly
✓ result from unusual processes or procedures in the accounting system
➢ Example:
✓ the 22 phony doctors
✓ checks were sent to the same two common addresses
➢ Why?
✓ managers trusted the perpetrator completely
✓ auditors merely matched claim forms with canceled checks

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 Elgin Aircraft Case

➢Internal Control Weaknesses

✓ Example:
o Manager had not taken a vacation in 10 years
o Employees never received payment confirmations
o Payments to new doctors were never investigated or cleared

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 Elgin Aircraft Case
➢Analytical Anomalies
✓relationships in financial or
nonfinancial data that do not
make sense

✓$12 million be paid to only 22

doctors over a period of four
years
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 Elgin Aircraft Case
➢Lifestyle Symptoms
✓The manager…
o took the employees to lunch in a limousine
o lived in a very expensive house
o drove luxury cars
o wore expensive clothes and jewelry
o was “independently wealthy”
o inherited a large sum of money
o yet never took a vacation!

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 Elgin Aircraft Case

➢Behavioral Symptoms
✓ The manager had a “Dr. Jekyll and Mrs. Hyde” personality
✓ Her highs and lows had become more intense and more frequent in recent
months
The Eligin Aircraft fraud was discovered because an observant auditor noticed a
fraud symptom.

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 Accounting Anomalies

➢Common anomaly frauds involve:

✓Irregularities in source documents
✓Faulty journal entries
✓Inaccuracies in ledgers

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 Irregularities in Source Documents
➢Common fraud symptoms involving source documents
✓ Missing documents
✓ Stale items on bank reconciliations
✓ Excessive voids or credits
✓ Common names or addresses of payees or customers
✓ Increased past-due accounts
✓ Increased reconciling items
✓ Alterations on documents

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 Irregularities in Source Documents

➢Common fraud symptoms involving source documents (cont.):

✓ Duplicate payments
✓ Second endorsements on checks
✓ Document sequences that do not make sense
✓ Questionable handwriting on documents
✓ Photocopied documents

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 Faulty Journal Entries

➢Common journal entry fraud symptoms:

✓ Journal entries without documentary support
✓ Unexplained adjustments to receivables, payables, revenues, or expenses
✓ Journal entries that do not balance
✓ Journal entries made by individuals who would not normally make such
entries
✓ Journal entries made near the end of an accounting period
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 Faulty Journal Entries

Do embezzlers leave the accounting equation in

balance??????

Do embezzlers leave the accounting equation in

balance?????? 14
 Faulty Journal Entries
➢ Fraud is hidden by using accounting language
Legal Expense .....................5,000
Cash ...................……………5,000
➢ English:
• “An attorney was paid $5,000 in cash”
➢ Accounting:
• “Debit Legal Expense; Credit Cash”
❖Was the attorney really paid $5,000?
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 Faulty Journal Entries
➢An embezzler steals assets, such as cash or inventory
➢Embezzler must decrease either liabilities or equities
➢Decreasing liabilities is not a good concealment method
➢Reasons not to change dividends, stock accounts, or revenues
➢Embezzler usually increases expenses

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 Inaccuracies in Ledgers

➢Fraud symptoms relating to ledgers:

✓Ledger that does not balance
o the total of all debit balances does not equal the total of all
credit balances
✓Master (control) account balances do not equal the sum
of the individual customer or vendor balances
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 Internal Control Weaknesses
➢Internal control fraud symptoms include :
✓ Lack of segregation of duties
✓ Lack of physical safeguards
✓ Lack of independent checks
✓ Lack of proper authorization
✓ Lack of proper documents and records
✓ Overriding of existing controls (most common)
✓ Inadequate accounting system
➢Many studies have found that the element most common in
frauds is the overriding of existing internal controls.
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 Internal Control Weaknesses
➢Three simple procedures to prevent small business
fraud
1. Owners should open and reconcile bank statements
2. Pay everything by check so there is a record
3. Owners should sign every check themselves

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 Analytical Fraud Symptoms
➢Analytical fraud symptoms are procedures or relationships
that are unusual or too unrealistic to be believable.
➢Analytical Fraud symptoms include:
✓ Unexplained inventory shortages or adjustments
✓ Deviations from specifications
✓ Increased scrap
✓ Excess purchases
✓ Too many debit or credit memos
✓ Significant increases or decreases in account balances, ratios, or relationships

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 Analytical Fraud Symptoms
➢ Analytical Fraud symptoms include: (Continued)
✓ Physical abnormalities

✓ Cash shortages or overages

✓ Excessive late charges

✓ Unreasonable expenses or reimbursements

✓ Excessive turnover of executives

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 Analytical Fraud Symptoms
➢Strange financial statement relationships, such as
✓ Increased revenues with decreased inventory
✓ Increased revenues with decreased receivables
✓ Increased revenues with decreased cash flows
✓ Increased inventory with decreased payables
✓ Increased volume with increased cost per unit
✓ Increased volume with decreased scrap
✓ Increased inventory with decreased warehousing costs

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 Extravagant Lifestyles
➢ Most people who commit fraud are under financial pressure—real or perceived.
➢ Once perpetrators meet their financial needs, they usually continue to steal, using the embezzled
funds to improve their lifestyles.
➢ Examples of lifestyle improvements
✓ Buy new cars
✓ Buy expensive toys such as boats or recreation vehicles
✓ Take vacations
✓ Remodel homes
✓ Move into more expensive houses
✓ Buy expensive jewelry or clothes
✓ Spend more money on food and other day-to-day living expenses
➢ Very few save the money they steal.
✓ As they become more and more confident in their fraud schemes, they steal and spend larger amounts.
✓ Soon they are living lifestyles far beyond what they can afford.

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 Unusual Behaviors
➢Research in psychology reveals that when a person (especially a first-
time fraud perpetrator) commits a crime, he or she becomes engulfed
by emotions of fear and guilt.
➢These emotions express themselves as stress.
➢The individual often exhibits unusual and recognizable behavior
patterns to cope with the stress
➢No particular behavior signals fraud; rather, changes in behavior are
signals.
✓ People who are normally nice may become intimidating and belligerent.
✓ People who are normally belligerent may suddenly become nice.
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Figure 5.2 Behavior Signals of Fraud
Perpetrators

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 Tips and Complaints
➢Why are tips and complaints just symptoms?
✓ Many tips and complaints turn out to be unjustified
✓ Difficult to know what motivates a person to complain or provide a tip
o Customers may feel taken advantage of
o Employee may have malice, personal problems, or jealousy
o Spouses and friends may be motivated by anger, divorce, or blackmail
✓ Individuals should always be considered innocent until proved guilt

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 Tips and Complaints
➢Why people are hesitant to come forward:
✓ Impossible to know for sure that a fraud is taking place
✓ Fear of being the whistle-blower
✓ Intimidation by the perpetrator
✓ Feel that squealing on someone is wrong
✓ Not easy to come forward
Three frauds that were detected by tips and complaints or that involved whistle-blowers
are the GE fraud, the Revere Amored Car Company fraud, and the fraud at Enron.

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 Tips and Complaints
➢Auditors are often criticized for not detecting more frauds.
➢Yet because of the nature of fraud, auditors are often in the worst
position to detect its occurrence.
➢As we covered previously, the factors that lead to fraud are depicted in
the fraud triangle.
➢These factors consist of perceived pressure, perceived opportunity,
and rationalization.

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 Figure 5.3 Elements of Fraud
➢ Elements of fraud
✓ Theft act
o involves the actual taking of cash, inventory, information, or
other assets.
✓ Concealment
o involves the steps taken by the perpetrator to hide the fraud
from others.
✓ Conversion
o involves selling stolen assets or transferring them into cash and
then spending the cash.

➢ Company employees are in the best position to detect fraud

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 Fraud Detection
➢Fraud can be detected in all three elements.
✓ First, in the theft act, someone can witness the
perpetrator taking cash or other assets.
✓ Second, in concealment, altered records or miscounts of
cash or inventory can be recognized.
✓ Third, in conversion, the lifestyle changes that
perpetrators almost inevitably make when they convert
their embezzled funds are visible.

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 Company Employees Are in the Best
Position to Detect Fraud
➢Although co-workers and managers are in the best position to detect
fraud, they are usually the least trained to recognize fraud or even be
aware that it can exist.
➢Even so, many frauds are detected when an employee, a friend, a
manager, a customer, or another person untrained in fraud provides a
tip or complaint that something is wrong.

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Tips and Complaints Are Fraud Symptoms
➢ Complaints and tips are categorized as fraud symptoms because many tips
and complaints turn out to be unjustified.
✓ Examples of motivations behind complaints and tips:
o Customers may complain because they feel they are being taken advantage of
o Vendors may provide a false tip because they are disgruntled because of a lost contract
o Employee tips may be motivated by malice, personal problems, or jealousy
o Tips from spouses and friends may be motivated by anger, divorce, or blackmail
➢ Whenever tips or complaints are received, they must be treated with care and
considered only as fraud symptoms.

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Unreported Knowledge or Suspicions of Fraud
➢In some situations, people are hesitant to come forward with
knowledge or suspicions of fraud.
➢Reasons include:
✓ Some uncertainty that a fraud is taking place
✓ Fear reprisal for being a whistle-blower
✓ Intimidation by the perpetrator
✓ Belief that squealing on someone is wrong
✓ Not easy to come forward within many organizations

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 New Laws Protect Whistle-Blowers and
Promote Fraud Detection
➢Sarbanes-Oxley Act (2002)
✓ Mandated that every public company have a whistle-blower system in place and
that it be promoted among employees and others
➢Dodd-Frank Act (2010)
✓ Authorized the payment of financial rewards to whistle-blowers

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 Figure 5.4 Watkins’ Whistle-blower Letter
to Enron Chairman
• Refer to Figure 5.4 in textbook

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