INABILITY TO JUDGE THE QUALITY OF PERFORMANCE

❑ Judging quality of performance

- Situations where it is easy—fence example

Case of a California dermatologist – - Situations where it is difficult—hiring lawyer, a doctor, a dentist,

accused of saving skin samples from
patients with skin cancer and then using
these cancerous tissues to diagnose
healthy patient with skin cancer.
Reason: To increase his pay
an accountant, an engineer, or an auto mechanic
- Often difficult to know whether you are paying an excessive
amount or receiving inferior service or products

- Easy for service provider to overcharge, perform work not needed,

Case of Sears Tire and Auto Centers in
California provide inferior service, or charge for work not performed
- Additional work was necessary
Reason: Quota system
FAILURE TO DISCIPLINE FRAUD PERPETRATORS

❑ Recidivism (Repeat offenses)

➢ Study: Rapist highest rate; 2nd – Fraud perpetrators who are not
prosecuted or disciplined
➢ Suffers no penalty or embarrassment

❑ Termination only – (to get rid of the problem)

➢ Rarely inform their families and others of the real reason for their
termination

❑ Prosecution – suffer significant embarrassment and shame

➢ Expensive and tedious litigation

❑ Worker mobility
 TABLE 2.2 JOHN DOE’S EMPLOYMENT AND FRAUD HISTORY
(Termination not Punished for Fraud)

OCCUPATION JOB LENGTH AMOUNT EMBEZZLED

Insurance sales 10 months $ 200
Victims:
Office manager 2 years 1,000
- Felt sorry for him;
Bookkeeper 1 year 30,000
- Prosecution is time-
consuming and too Accountant 2 years 20,000
expensive
Accountant 2 years 30,000
- Merely chose to pass
the problem on to others Controller & CFO 6 years 1,363,700

Manager Still employed ?

 LACK OF ACCESS TO INFORMATION OR ASYMMETRICAL INFORMATION

❑ Many frauds are allowed to be perpetrated because victims don’t

have access to information possessed by the perpetrators. (only
offenders have access)

❑ These are cases of asymmetrical information: that is, one party has
information about products or situations and the other party does
not.

ESM Fraud Case – selling same - This is especially prevalent in many of the large management frauds that
securities several times to investors; have been perpetrated against stockholders, investors, and debt holders.
investment records were only in ESM’s
management possession
- Certain employee frauds are also allowed to be perpetrated because
(Ronnie Ewton, Robert Seneca and only offenders have access to information.
George Mead)
❑ How to protect? Insist on Full Disclosure; Demand Transparency
Note of: Lincoln Savings and Loan case
 IGNORANCE, APATHY, OR INCAPACITY
Apathy - lack of
interest, enthusiasm, or concern

❑ Older people, individuals with language difficulty, and other “vulnerable”

people are often fraud victims since perpetrators know that such individuals
may not have the capacity or the knowledge to detect their illegal acts.
➢ The Nurse Case (embezzling money from patients’ rooms); purple
- Pigeon drops – kind substance/dye-covered bills
of fraud specially ➢ Influence of sedating drugs
designed to take
advantage of elderly
victims ❑ Various consumer frauds such as prime bank fraud, pyramid scams, Internet
fraud, phone scams, chain letters, modeling agencies, telemarketing fraud,
- Usually getting
and Nigerian scams are all crimes of persuasion that try to get victims to
elderly to withdraw
money from their unknowingly invest money.
bank accounts
FIGURE 2.5 NIGERIAN SCAM LETTER
 ❑ Organizations go to great lengths to create documents
that will provide an audit trail so that transactions can be
reconstructed and understood.

❑ Many frauds, however, involve cash payments or

LACK OF AN AUDIT TRAIL manipulation of records that cannot be followed.

- Smart fraud perpetrators understand that their frauds must

be concealed.

- They also know that such concealment must usually involve

manipulation of financial records.

- When faced with a decision about which financial record to

manipulate, perpetrators almost always manipulate the
income statement because they understand that the audit
trail will quickly be erased.
 ❑ Most fraud perpetrators are first-time offenders who would not commit other
crimes.
❑ In some way, they must rationalize away the dishonesty of their acts.
❑ Common rationalizations used by fraud perpetrators include the following:
THE ELEMENT OF - The organization owes me.
RATIONALIZATION
- I am only borrowing the money and will pay it back.

- Nobody will get hurt.

- I deserve more.

- It’s for a good purpose.

- We’ll fix the books as soon as we get over this financial difficulty.

- Something has to be sacrificed—my integrity or my reputation.

RATIONALIZATIONS
ON TAX EVASION:
- I pay more than my fair share of taxes.

- The rich don’t pay enough taxes.

- The government wastes our tax money.

- I “work” for my money.

- The government spends taxes collected on things I don’t support.

FRAUD RECRUITMENT

❑ The majority of frauds—especially financial statement

frauds—are collusive, meaning that the act involves
more than one perpetrator.

❑ In some cases one person, after he or she has become

involved in fraud as a result of the fraud triangle,
influences another individual to participate in the fraud.

❑ Power is used in different ways to recruit people to

participate in fraud.
 FIGURE 2.6 FIVE TYPES OF POWER
1947 – Max Weber

Power – a person can

carry out his or her
will despite resistance
 ❑ Reward power
- The ability of a fraud perpetrator to convince a potential victim that he or
she will receive a certain benefit through participation in the fraud scheme.
- Sharing of the proceeds; large bonus; job promotions

POWER ❑ Coercive power

- The ability of the fraud perpetrator to make an individual perceive
punishment if he or she does not participate in the fraud.
- Punishment is based on fear – losing job; receiving public humiliation

❑ Perceived expert power

- The ability of the fraud perpetrator to influence another person because of
expertise or knowledge.
- Enron Case – management claimed to have expert knowledge
- Enron executives used fraudulent accounting practices to inflate company's
revenues and hide debt in its subsidiaries
 ❑ Legitimate power
- The ability of the fraud perpetrator to convince a potential
POWER perpetrator that he or she truly has power over him or her.
- CEO may claim, to have legitimate power to make decisions and
direct the organization – even if the direction is unethical

❑ Referent power
- The ability of the perpetrator to relate to the potential co-
conspirator.
- Individuals persuaded by a trusted friend to participate in fraud
FIGURE 2.7 HOW POWER IS USED TO RECRUIT OTHERS INTO FRAUDS
FIGURE 2.8 HOW OTHERS ARE RECRUITED INTO FRAUD SCHEMES
 ❑ Cite one instance where you’ve done something simply because a
EXERCISE person(s) has legitimate authority (such as boss or teacher) over you?
Who was him/her? What did you do? Was there fraud involved? How
(15 Points) did you feel? (5 Points)

❑ Cite one instance where you did something because a person offered
you a reward or benefit for your actions? Who offered the reward?
What did you do? What was the reward? Was there fraud involved?
How did you feel? (5 Points)

❑ Cite one instance where you were influenced to participate in

something simply because you were asked by a close friend or
colleague? Who was him/her? What did you do? Was there fraud
involved? What was it and how did you feel?
 CHAPTER 3

Fighting Fraud: An Overview

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

❑ Become familiar with the different ways in which

organizations fight fraud.
❑ Understand the importance of fraud prevention.
❑ Understand how to create a culture of honesty and
high ethics.
❑ Understand why hiring the right kind of employees
can greatly reduce the risk of fraud.
❑ Understand how to assess and mitigate the risk of
fraud.
❑ Understand the importance of early fraud detection.
❑ Understand different approaches to fraud
investigation.
❑ Be familiar with the different options for legal action
that can be taken once fraud has occurred.
DIFFERENT WAYS ORGANIZATIONS FIGHT FRAUD

❑ Fraud prevention

❑ Early fraud detection

❑ Fraud investigation

❑ Follow-up legal action and/or resolution

 FRAUD PREVENTION
Cost-effective - producing good results
without costing a lot of money. ❑ Preventing fraud is generally the most cost-
effective way to reduce losses from fraud.

❑ Effective fraud prevention involves two (2)

fundamental activities:

1. Taking steps to create and maintain a culture of

honesty and high ethics; and

2. Assessing the risks for fraud and developing

concrete responses to mitigate the risks and
eliminate the opportunities for fraud.
 CREATING A CULTURE OF HONESTY AND HIGH ETHICS

Five (5) Most Critical and

Common Elements:
❑ 1. Tone at the top (proper modeling)

➢ Honesty can be best reinforced when a proper

example is set.
➢ Management must reinforce to its employees
through its actions that dishonest, questionable, or
unethical behavior will not be tolerated.

➢ Problem: Bad modeling is everywhere today

(websites, social media, etc.), and more accessible
than before.
CREATING A CULTURE OF HONESTY AND HIGH ETHICS

❑ 2. Hiring the right kind of employees

➢ Not all people are equally honest or have equally well-

developed personal codes of conduct

➢ Study: Many people, when faced with significant pressure

and opportunity, will behave dishonestly rather than face the
perceived “negative consequences” of honest behavior
(losing reputation or esteem, feeling to meet expectations,
inability to pay debts)
 FIGURE 3.1 ETHICS DEVELOPMENT MODEL

Instilling in others a desire to develop ethical

awareness and courage; inspire others through
word, example, persuasions and good management

Strength and conviction to act

appropriately in difficult situation

Translate One’s Ethical Understanding

to the business world

Foundation of Ethics

FIGURE 3.2 HONESTY OF EMPLOYEES
Have well-defined
personal codes of
conduct; translate
ethical values to
business settings; have
courage to do what is
right
Largest group; have situational ethics;
have traits of honest employees but,
because of inconsistent modeling and
labeling, their ethics depend upon the
situation they are placed in
This group follow their leaders
Lack strong personal
codes of conduct; will
be dishonest anytime
if it benefits them
 RESEARCH ON HONESTY:

Individuals fall into three (3) groups:

1. Those who will almost always be honest (appr. 30% of the population);

2. Those who are situationally honest – who will be honest when it pays to be
honest, but dishonest when pays to be dishonest (appr.40% of the
population); and

3. Those who will always be dishonest (appr. 30% of the population);

CREATING A CULTURE OF HONESTY AND HIGH ETHICS

❑ 3. Communicating expectations of honesty and integrity

➢ Includes:
1. Identifying and codifying appropriate values and ethics (codes of
conduct – be in writing; posters; videos);

2. Fraud awareness training that helps employees understand

potential fraud problems they may encounter and how to resolve or
report them; and

3. Communicating consistent expectations about punishment of

violators. (“dishonest actions will not be tolerated and that violators
will be terminated an prosecuted to the fullest extent of the law”)
CREATING A CULTURE OF HONESTY AND HIGH ETHICS

❑ 4. Creating a positive work environment

➢ Research: Fraud occurs less frequently when employees

have positive feelings about an organization and have a
feeling of ownership in that organization;

➢ Dishonesty likely to occur: Employees feel abused,

threatened or ignored.
CREATING A CULTURE OF HONESTY AND HIGH ETHICS

❑ Factors on work environment associated with high levels of fraud:

1. Management does not care about or pay attention to the behavior of

employees;
2. Negative feedback or lack of recognition of job performance;
3. Perceived inequities in an organization;
4. Autocratic rather than participative management;
5. Low organizational loyalty;
6. Unreasonable budget expectations;
7. Unrealistically low pau;
8. Poor training and promotion opportunities;
9. High turn-over (quit the organization over a certain period of time) and/or
absenteeism;
10. Lack of clear organizational responsibilities; and
11. Poor communication with the organization.
CREATING A CULTURE OF HONESTY AND HIGH ETHICS

❑ 5. Proper handling of fraud and fraud perpetrators when

fraud occurs

➢ Having appropriate policies on place for handling fraud if it

occurs;

➢ How the organization reacts to fraud signals the number of

future incidents (precedent)
➢ Facts are investigated thoroughly; firm and consistent action
against perpetrators;
START
ASSESSING AND MITIGATING THE RISK OF FRAUD

❑ Organizations can proactively eliminate most fraud opportunities

(eliminating opportunities for fraud to occur).

❑ Ways to assess and mitigate the risk of fraud:

- Accurately identifying sources and measuring risks;

(organization should have a process in place)

- Implementing appropriate preventive and detective controls to

mitigate those risks;
- Creating widespread monitoring by employees;
- Having internal and external auditors who provide independent
checks on performance.
 FRAUD PREVENTION

❑ Detection of fraud usually begins by identifying

symptoms, indicators, or red flags that tend to be
associated with fraud.

❑ Three primary ways to detect fraud:

- By chance;
- By providing ways for people to report suspicions of
fraud;
- By proactively examining transaction records and
documents to determine if there are anomalies that
could represent fraud.
 PREDICATION

❑ Predication refers to the circumstances, taken as a whole, that

would lead a reasonable, prudent professional to believe a
fraud has occurred, is occurring, or will occur.

- Fraud investigations should not be conducted without predication.

- A specific allegation of fraud against another party is not

necessary, but there must be some reasonable basis for concern
that fraud may be occurring.
 ❑ Once predication is present, an investigation is usually
undertaken to determine whether or not fraud is actually
occurring.

FRAUD INVESTIGATION - The purpose of an investigation is to find the truth.

- Do the symptoms observed actually represent fraud or do they
represent unintentional errors or other factors?

❑ If investigations are not properly conducted, any or all of the

following might occur:

- Reputations of innocent individuals can be irreparably injured.

- Guilty parties can go undetected and be free to repeat the act.
- Offended entity may not have information to use in preventing
and detecting similar incidents or in recovering damages.
APPROACHES TO FRAUD INVESTIGATION

❑ The approaches to fraud investigation vary,

although most investigators rely heavily on
interviews, computer searches of e-mails and
records, and examination of accounting records
and internal controls.

❑ Fraud investigation methods can be classified

according to:

- Types of evidence produced

- Elements of fraud
FIGURE 3.3 EVIDENCE SQUARE

Types of Evidence Produced

❑ Testimonial evidence
- Evidence gathered from individuals.
❑ Documentary evidence
- Evidence gathered from paper, computers,
and other written or printed sources.
❑ Physical evidence includes
- Tangible evidence that can be associated
with dishonest acts.
❑ Personal observation
- Evidence that is sensed (seen, heard, felt,
etc.) by investigators themselves.
FIGURE 3.4 ELEMENTS OF FRAUD
 CONDUCTING A FRAUD INVESTIGATION

❑ Investigations must be undertaken only to “establish the

truth of the matter under question.”
❑ Investigators must be experienced and objective.
❑ Hypothesis about whether or not someone committed fraud
should be closely guarded when discussing an investigation
with others.
❑ Investigators must ensure that only those who have a need
to know are kept apprised of investigation activities.
❑ Investigators must ensure that all information collected
during an inquiry is independently corroborated.
❑ Investigators must exercise care to avoid questionable
investigative techniques.
ADMINISTRATIVE LEVEL ❑ Investigators must report all facts fairly and objectively.
 FOLLOW-UP LEGAL ACTION

❑ When fraud is discovered, victims (including

organizations and individuals) must make
decisions about legal action.

Choices:

- Pursue no legal action;

- Pursue civil remedies, and/or;

- Pursue criminal action against the perpetrators.

 ❑ Civil action

- Purpose is to recover money or other

assets from the fraud perpetrators and
others associated with the fraud

CIVIL ACTION AND ❑ Criminal action

CRIMINAL ACTION
- Law enforcement or statutory agencies

- Fines, prison terms, or both

- Restitution agreements
 CHAPTER 14

Fraud Against Organizations

 LEARNING OBJECTIVES

After studying this chapter, you should be able to:

❑ Understand the extent to which employees and

others commit occupational fraud.

❑ Describe the nature and various types of asset

misappropriations.

❑ Discuss the nature and various types of

corruption.
FRAUD STATISTICS RELATED TO LOSS*

❑ Occupational fraud and abuse impose enormous costs

on an organization.
➢ The median loss caused by occupational frauds in the
study was $150,000.
➢ Nearly one-quarter of the cases caused at least $1
million or more in losses.
❑ Participants in the study estimated that organizations
lose 5 percent of their annual revenues to fraud.

*These statistics about occupational fraud are based on 2,410

fraud cases reported in the ACFE’s 2016 study by Certified Fraud
Examiners (CFEs).
FRAUD STATISTICS RELATED TO DETECTION*

❑ Occupational fraud schemes can be very difficult to detect.

➢ The median length of the schemes in the study was 18
months from the time the fraud began until it was detected.
➢ Occupational frauds are more likely to be detected by a tip
than by other means such as internal audits, external audits,
or internal controls.
❑ Whistle-blowers were most likely to report fraud to their
direct supervisors or company executives.

*These statistics about occupational fraud are based on 2,410 fraud cases
reported in the ACFE’s 2016 study by Certified Fraud Examiners (CFEs).
FRAUD STATISTICS RELATED TO PREVENTION*

❑ Certain anti-fraud controls have a significant impact on an

organization’s exposure to fraud.
➢ Anti-fraud controls include internal audit departments,
surprise audits, and anti-fraud training for employees and
managers.
➢ Victim organizations that had such anti-fraud controls in
place had lower losses compared to organizations without
antifraud controls in place.

*These statistics about occupational fraud are based on 2,410 fraud cases
reported in the ACFE’s 2016 study by Certified Fraud Examiners (CFEs).
FRAUD STATISTICS RELATED TO ORGANIZATION SIZE*

❑ The median loss suffered by small organizations (those with

fewer than 100 employees) was the same as that incurred by
the largest organizations.
➢ However, this type of loss is likely to have a much greater
impact on smaller organizations.
❑ The size of the loss caused by occupational fraud is strongly
related to the position of the perpetrator.
➢ For example, frauds committed by owners/executives were
more costly when compared to frauds committed by
managers.
*These statistics about occupational fraud are based on 2,410 fraud cases
reported in the ACFE’s 2016 study by Certified Fraud Examiners (CFEs).
ASSET MISAPPROPRIATIONS

❑ Employees, vendors, and customers of organizations have

three opportunities to steal assets:
➢ Steal receipts of cash and other assets as they are coming
into an organization.
➢ Steal cash, inventory, and other assets that are on hand.
➢ Commit disbursement fraud by having the organization
pay for something it shouldn’t pay for or pay too much for
something it purchases.

❑ With each of these three types of fraud, the perpetrators

can act alone or work in collusion with others.
❑ Figure 14.1 outlines the misappropriation possibilities.
Assets − Liabilities = Net Worth
FIGURE 14.1 TYPES OF ASSET MISAPPROPRIATIONS
ASSET MISAPPROPRIATIONS—WELLS’S CLASSIFICATION SCHEME

❑ Thefts of cash
➢ Larceny (intentionally taking away an employer’s cash
without the consent and against the will of the employer)
➢ Skimming (the removal of cash from a victim entity prior
to its entry in an accounting system)
➢ Fraudulent disbursements

❑ Thefts of inventory and other assets

➢ Misuse
➢ Larceny

❑ Figure 14.2 illustrates the main elements of Wells’s

classification scheme.
FIGURE 14.2 OCCUPATIONAL FRAUD CLASSIFICATION SCHEME
THEFT OF CASH THROUGH LARCENY

❑ When larceny occurs, cash is stolen by employees or others after

the cash is recorded in the company’s accounting system.
➢ As a result, larceny schemes are easier to detect than skimming
schemes and are far less common.
❑ Cash larcenies can take place in any circumstance in which an
employee has access to cash.
➢ Common larceny schemes involve the theft of cash or currency
on hand (in a cash register or petty cash box, for example) or
from bank deposits.
➢ Cash larcenies are most successful when they involve relatively
small amounts over extended periods of time.
➢ With such thefts, businesses often write the small missing
amounts off as “shorts” or “miscounts,” rather than as thefts.
 THEFT OF CASH THROUGH SKIMMING

❑ Skimming is any scheme in which cash is stolen from an organization

before it is recorded on the organization’s books and records.

❑ Basic skimming scheme

➢ Taking money from the sale of goods or services but making no
record of the sale
THEFT OF CASH THROUGH SKIMMING

❑ More complicated skimming schemes occur when employees

➢ Understate sales and collections by recording false or larger-
than-reality sales discounts.
➢ Misappropriate customer payments and write off the
receivable as “uncollectible”.
➢ Embezzle a first customer’s payment and then credit that
customer’s account when a second customer pays (a delayed
recognition of payment, called lapping).
➢ Work together with customers to allow them to pay later than
required or less than required.
CASH THEFT THROUGH FRAUDULENT DISBURSEMENTS

❑ The ACFE found that fraudulent disbursements comprised

by far the highest percentage of asset misappropriations.
❑ It identified six cash schemes involving outgoing
disbursements of cash:
➢ Billing schemes
➢ Check tampering
➢ Expense reimbursements schemes
➢ Payroll disbursement schemes
➢ Wire transfer schemes
➢ Register disbursement schemes

❑ Table 14.1 summarizes these six disbursement schemes.

 CHECK TAMPERING

❑ Employee prepares a fraudulent check for his or her

own benefit.

❑ Employee intercepts a check intended for another

person or entity and converts the check to his or
her own benefit.
REGISTER DISBURSEMENT SCHEMES

❑ False refunds

❑ False voids
BILLING SCHEMES

❑ Setting up dummy companies (shell companies) to

submit invoices to the victim organization.

❑ Altering or double-paying a nonaccomplice vendor’s

statements.

❑ Making personal purchases with company funds.

 PAYROLL DISBURSEMENT SCHEMES

❑ Ghost employees

❑ Falsified hours and salary

❑ Commission schemes

❑ False workers’ compensation claims

 EXECUTIVE CASH FRAUDS

❑ Examples
➢ Tyco scandal

➢ Adelphia scandal
MISUSE OF COMPANY ASSETS

❑ A person can misappropriate company assets

other than cash in one of two ways.
➢ The asset can be misused (or “borrowed”), or it
can be stolen.
❑ Simple misuse is obviously the less egregious of
the two types of fraud.
➢ Assets that are misused but not stolen typically
include company vehicles, company supplies,
computers, and office equipment.
➢ These assets are also used by some employees to
conduct personal work on company time.
 THEFT OF INVENTORY AND OTHER ASSETS

❑ Noncash types of frauds against organizations:

➢ Inventory
➢ Information
➢ Securities

❑ Table 14.2 describes the most common noncash

types of frauds against organizations.
CORRUPTION

❑ The tradition of “paying off” public officials or

company insiders for preferential treatment is
rooted in the crudest business systems
developed.
❑ Corruption can be broken down into the following
four scheme types:
➢ Bribery schemes
➢ Conflict of interest schemes
➢ Economic extortion schemes
➢ Illegal gratuity schemes
❑ Table 14.3 from the 2012 ACFE report
summarizes these types of frauds.
 BRIBERY

❑ Bribery involves the offering, giving, receiving, or soliciting

of anything of value to influence an official act.
➢ The term “official act” means that traditional bribery
statutes only proscribe payments made to influence the
decisions of government agents or employees.
❑ Many occupational fraud schemes involve commercial
bribery—something of value is offered to influence a
business decision rather than an official act of government.
❑ Bribery schemes generally fall into two broad categories:
➢ Kickbacks
➢ Bid-rigging schemes
CONFLICTS OF INTEREST

❑ A conflict of interest occurs when an employee, a manager,

or an executive has an undisclosed economic or personal
interest in a transaction that adversely affects the company.
➢ Conflicts usually involve self-dealing by an employee.
➢ In some cases, the employee’s act benefits a friend or
relative, even though the employee receives no financial
benefit from the transaction.
❑ To be classified as a conflict of interest scheme, the
employee’s interest in a transaction must be undisclosed.
❑ Most conflict schemes fall into one of two categories:
➢ Purchase schemes
➢ Sales schemes
 MUTUAL FUND FRAUDS

❑ Market timing

❑ Late trading
ECONOMIC EXTORTION

❑ Economic extortion is basically the flip side of a bribery

scheme.
➢ Instead of a vendor offering a payment to an employee to
influence a decision, the employee demands a payment
from a vendor in order to make a decision in that vendor’s
favor.
➢ In any situation where an employee might accept bribes
to favor a particular company or person, the situation
could be reversed to a point where the employee extorts
money from a potential purchaser or supplier.
 ILLEGAL GRATUITIES

❑ Illegal gratuities are similar to bribery schemes,

except that there is not necessarily an intent to
influence a particular business decision but
rather to reward someone for making a
favorable decision.

❑ Illegal gratuities are made after deals are

approved.