Certified Forensic Accountant

Module 2: Topic 5
Uncovering Corporate Fraud
 PREVENTION AND DETECTION AWARENESS
FOR THE FRAUD AUDITOR

Preventing fraud is what this program is all about.

• Our primary goal is to reduce incidents of accounting-
type frauds.
 To reduce the amount of losses attributable to such
frauds.

With those goals in mind, we offer the following

“invitations to fraud” for whatever instructive value
that list contains.
INVITATIONS TO CORPORATE FRAUD, THEFT,
AND EMBEZZLEMENT
1. Make profit the only corporate objective and the only criterion for
performance appraisal.
2. Create a corporate culture in which everyone knows the cost of everything
but not the value of integrity.
3. Create a corporate culture in which profit or economic incentives are the
only motivators.
4. Fail to establish and to communicate an effective code for corporate
conduct.
5. Create strong and authoritarian management controls but do not monitor
them to compliance.
6. Ignore complaints from customers, stockholders, or employees.
7. Fail to monitor management override of internal controls.
8. Make internal communications a one-way process – top down.
9. Fail to enforce to monitor non-arm’s-length transactions.
10. Ignore the importance of effective personnel policies.
HIGH-FRAUD/LOW-FRAUD ENVIRONMENTS
Employee fraud, theft, and embezzlement are more
prevalent in some organizations than in others.

The most vulnerable to fraud are the ones with the

weakest management, accounting, and security controls.
Audit and Security community propose the following
solutions:

1.Tight accounting and auditing controls

2.Thorough screening of applicants for employment
3.Close supervision and monitoring of employee
performance and behavior
4.Explicit rules against theft, fraud, embezzlement,
sabotage, and information piracy, and strict sanctions for
their breach
 Definition of Employee Fraud
 White collar crime is fraud perpetrated by people who work in offices
and steal with a pencil or a computer terminal. The contrast is violent
street crime.
 Employee fraud is the use of fraudulent means to take money or other
property from an employer. It consists of three phases: (1) the
fraudulent act, (2) the conversion of the money or property to the
fraudster's use and (3) the cover-up.
 Embezzlement is a type of fraud involving employees' or
nonemployees' wrongfully taking money or property entrusted to their
care, custody, and control, often accompanied by false accounting
entries and other forms of lying and cover-up.
 Larceny is simple theft of an employers property that is not entrusted
to an employee's care, custody or control.
 Defalcation is another name for employee fraud and embezzlement.

Source: McGraw-Hill/Irwin 2007

6
 3 Major Types of Fraud
• Asset misappropriations.

• Corruption - bribery, extortion and a conflict

of interest.

• Financial statement fraud.

Source: Association of CFEs (ACFE)

7
 Misappropriation Methods

• Billing (fake vendors)

• Skimming (cash is taken before recorded)

• Expense reimbursements (inflated)

• Check tampering

• Cash on hand

• Others

Source: ACFE 2012 Report to the Nation

8
The Corporate Fraud Environment

Potential for Fraud

High Fraud Potential Low Fraud Potential
Management Style Management Style
Autocratic Participative
Management Orientation Management Orientation
Low trust High trust
X Theory Y Theory
Power driven Achievement driven
Distribution of Authority Distribution of Authority
Centralized, reserved by Decentralized, delegated to
top management all levels
Planning Planning
Centralized Decentralized
Short range Long range
Performance Performance
Measure quantitatively and Measure both qualitatively and
on a short-term basis quantitatively and on a long-term

basis
Potential for Fraud
High Fraud Potential
Profit Focused
Management by Crisis
Reporting by Routine
Rigid Rules Strongly Policed
Primary Management Concerns
Preservation of capital
Profit maximization
Reward System
Punitive
Penurious
Politically administered
Feedback on Performance
Critical
Negative
Interaction Mode
Issues and personal differences
are skirted or repressed
Low Fraud Potential
Customer Focused
Management by Objectives
Reporting by Exception
Reasonable Rules Fairly Enforced
Primary Management Concerns
Profit optimization
Human, then capital and
technological assets utilization
Reward System
Reinforcing
Generous
Fairly administered
Feedback on Performance
Positive
Supportive
Interaction Mode
Issues and personal differences
are confronted and addressed
openly
Potential for Fraud
High Fraud Potential
Payoffs for Good Behavior
Mainly monetary
Business Ethics
Ambivalent, rides and tides
International Relationships
Highly competitive, hostile
Values and Beliefs
Economic, political,
group-centered
Success Formula
Works harder
Biggest Human Resource Problems
High turn-over
Burn-out
Grievance
Absenteeism
Low Fraud Potential
Payoffs for Good Behavior
Recognition, promotion, added
responsibilities, choice
assignments,
plus money
Business Ethics
Clearly defined and regularly
followed
International Relationships
Friendly, competitive,
supportive
Values and Beliefs
Social, spiritual, group-centered
 
Success Formula
Works smarter
Biggest Human Resource Problem
Not enough promotional
opportunities
 
Potential for Fraud
High Fraud Potential
Company Loyalty
Low
Major Financial Concern
Cash flow shortage
Growth Patterns
Sporadic
Relationship with Competitors
Hostile
Innovativeness
Copycat, reactive
CEO Characteristics
Swinger, braggart
self-interested, driver
insensitive to people,
feared, insecure, gambler,
impulsive, tight-fisted,
number and thing-oriented,
profit-seeker, vain,
bombastic, highly emotional,
partial, pretends to be more
than he is
Low Fraud Potential
Company Loyalty
High
Major Financial Concern
Opportunities for new investment
Growth Patterns
Consistent
Relationship with Competitors
Professional
Innovativeness
Leader, proactive
CEO Characteristics
Professional, decisive,
fast-paced, friendly,
respected by peers, secure,
risk-taker, thoughtful,
generous with personal time
and money, products-and
markets-oriented, builder,
helper, self-confident,
composed, calm, deliberate,
even disposition, fair, knows
who he is, what he is, and
where he is
Potential for Fraud
High Fraud Potential
Management Structure, Systems and
Controls
Bureaucratic
Regimented
Inflexible
Imposed controls
Mainly-tiered structure, vertical
Everything documented; a rule of
everything
Internal Communication
Formal, written, stiff, pompous,
ambiguous, CYA
Peer Relationships
Hostile, aggressive, rivalrous
Low Fraud Potential
Management Structure, Systems and
Controls
Collegial
Systematic
Open to change
Self-controlled
Flat structure, horizontal
Documentation adequate but not
burdensome;
some discretion afforded
Internal Communication
Informal, oral, clear, friendly, open,
candid
Peer Relationships
Cooperative, friendly, trusting
 Other Environmental Red Flags (1/2)

1. Do employees have an economic reason to cheat?

2. Does the company suffer from a “we – they” syndrome.
Management versus non-management personnel or middle
management versus top management?
3. Do conflicts bound among the top-management group over
issues that involve corporate philosophy, purpose, direction, or
ethics?
4. Is there evidence of spite, hate, hostility, or jealous among the
firm’s top-management group?
 Other Environmental Red Flags (2/2)

5. Do employees feel oppressed, abused, exploited, or neglected

by top management?
6. What is the company’s past history with respect to:
-What is the past history of the firm and the industry regarding
regulatory compliance?
7. What is past, current, and future profitability of the firm?
8. Are there litigation and complaints pending against the firm by
regulatory authorities, vendors, customers, creditors, and
competitors?
HOW CAN MANAGEMENT AND CORPORATE
FRAUD BE DETECTED?
Detecting fraud is a matter of acknowledging:
1. That fraud exists
2. That any organization can become either a victim of
fraud or perpetrator of fraud
3. That certain weakness is internal controls and human
character can be conducive to fraud
4. That certain tests of internal controls and tests of
organization’s motivational environment can provide
some insight on the possibility of fraud in the
environment.
A few exceptions fraud auditors should look for:
 
Transactions that are odds as to:
– Internal controls that are not enforced or too often
compromised by higher authorities
– Employee motivation, morale, and job satisfaction levels that
are chronologically low
– A corporate culture and rewards system that supports the
unethical behavior toward employees, customers
competitors, lenders, and shareholders

Fraud abounds in environments in which there is low regard for

truth, justice, and fair dealing and high regard for money rewards
and personal vanity.
 TELLTALE SIGNS OF MANAGEMENT AND
CORPORATE FRAUD
In every case of management and corporate fraud there are telltale
signs of the fraud in existence for some period of time before the
fraud itself is detected or disclosed by third party. These signs may be
as follows:
 
• Significant observed changes from the past behavior pattern of the
defrauder
• Knowledge that the defrauder was undergoing emotional trauma in
his or her home life or work life
• Knowledge that the defrauder was betting heavily, drinking heavily,
had a very expensive social life, or was sexually promiscuous
• Knowledge that the defrauder was heavily in debt
 TELLTALE SIGNS OF MANAGEMENT AND
CORPORATE FRAUD
• Audit findings deemed to be errors and irregularities that
were considered immaterial at the time
• Knowledge that the company was having financial
difficulties such as frequent cash flow shortages, declining
sales and/or net profits, and loss of market share
• Knowledge that the management was showing increasing
signs of incompetence (i.e., poor planning, organization,
communication, controls, motivation, and delegation;
management indecision and confusion about corporate
mission, goals, and strategies; and management ignorance
of conditions in the industry and in the general economy)
• Substantial growth beyond the industry norm in regulated
industries
 Badges of Top-Management Fraud (1/2)

A review of behaviors of corporate defrauders leads one to suggest

the following profile for top-management defrauders:
1. They tend to have highly material personal values. Success to
them means financial success, not professional recognition.
2. They tend to treat people as objects, and often as object for
exploitation.
3. They are highly self-centered.
4. They are often eccentric in the way they display their wealth or
spend their money. They tend to be conspicuous consumers and
often boast of things they have acquired, the friends they have in
office, and all the fine places they have visited.
5. They boast about their cunning achievements and winnings more
than their losses.
 Badges of Top-Management Fraud (2/3)
6. They appear to be reckless or careless with facts and often
enlarge on them.
7. They appear to be hardworking, almost compulsive, but most of
their time at work is spent in scheming and designing shortcuts to
get ahead or beat the competition.
8. They may gamble or drink a great deal.
9. They buy expensive gifts for their families, usually to compensate
for spending so little time with them.
10. They show great hostility toward people who oppose their views.
They feel exempt from accountability and controls because of
their station or position.
11. They create a great deal of turnover among their subordinates
and often set off one subordinate against another.
 Badges of Top-Management Fraud (3/3)
12. They play favorites among their subordinates, but the
relationship can cool very quickly because a subordinate
often falls from grace after one mistake, even an
insignificant mistake.
13. They more often mange by crisis than by objectives. They
tend to drift with the times and have no long-range plans.
14. They tend to override internal controls with impunity and
argue forcefully for less formality in controls.
15. They demand absolute loyalty from subordinates but they
themselves are loyal only to their own self-interest.
16. They have few real friends within their own industry or
company. Their competitors and colleagues often dislike
them.
 Badges of Lower-Level Fraud (1/2)
Here are some of the conditions found in their environment:

1. Their superiors to achieve high performance exert great pressure-

higher sales, lower costs, more profits. Top management for less
than expected or demanded sales, cost, and profit targets
tolerates no justification or excuse.
2. Bonuses are tied to short-term performance levels and do not
take economic or competitive realities into consideration.
3. Internal controls are absent or loosely enforced.
4. Management controls consist mainly of pressures for
performance: “Make your numbers come out right or we’ll get
somebody else.”
 Badges of Lower-Level Fraud (2/2)

5. Business ethics are subordinated to economic self-interests.

6. Vendors and suppliers are squeezed for the last once of
profitability in their goods, wares, and services.
7. There is a great deal of confusion about duties and
responsibilities among subordinates.
8. A high level of hostility exists among subordinates and
between lower level managers and their line and staff
superiors.
9. They believe the present level of responsibility exceeds the
original job description.
 EMBEZZLEMENT
WOULD YOU KNOW ONE IF YOU SAW ONE?
1. Detection of embezzlement is possible
2. Through the traditional control concepts of separation of duties
and audit trails
3. Through periodic financial and operational audits
4. Through the gathering of intelligence on the life-styles and
personal habits of employees
5. Through the allegations and complaints of fellow employees
6. Through the logging and the exceptions to prescribe controls and
procedures
7. Through the review of variances in operating performance
expectations (standards, goals, objectives, budgets, and plans)
8. Through the intuition of the embezzler’s superior
9. Through generalized suspicion (neurotic paranoia).
 Proactive approaches include:

1. adequate internal controls

2. financial and operational audits
3. intelligence gathering
4. logging for exceptions
5. review of variances

Reactive approaches include

1. allegations and complaints

2. Intuition
3. suspicion.
 IS CORPORATE FRAUD CYCLICAL?
• Every aspect of economic life seems to have a
reason, a cycle, or a wave.
• These variations in movement over time
facilitate business planning and government
economic policy.
• Although the highs and lows of such economic
trends cannot be predicted with the precision
on the short-term basis, they can be predicted
from long-term perspective.
 CAN MANAGEMENT CONTROLS BECOME
TOO MUCH OF A GOOD THING?
• Establishing effective and efficient management
controls tends to be a matter of balancing costs
against benefits.
• Tipping the balance to either extreme of over
control or under control is inefficient and
ineffective.
• But the cost of implementing controls is far easier to
calculate than the intended benefits of such controls
because costs tend to be quantitative whereas
benefits tend to be qualitative