CH-12 Fraudulent Financial Statement Schemes – Principles of Fraud Examination : Chapter Notes

Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 12 – Fraudulent Financial Statement Schemes Defining Financial Statement Fraud – deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors Costs of financial statement fraud 1. Undermines the reliability, quality, transparency, and integrity of the financial reporting process; 2. Jeopardizes the integrity and objectivity of the auditing profession; 3. Diminishes the confidence of the capital markets in the reliability of financial information; 4. Makes the capital market less efficient; 5. Adversely affects the nation’s economic growth and prosperity; 6. Results in huge litigation costs; 7. Destroys careers of individuals involved in financial statement fraud; 8. Causes bankruptcy or substantial economic losses; 9. Encourages regulatory intervention; 10. Causes devastation in the normal operations and performance of alleged companies; 11. Raises serious doubt about the efficacy of financial statement audits; and 12. Erodes public confidence and trust in the accounting and auditing profession Fictitious revenues 1. Fictitious revenues – a scheme that involves the recording of sales or services that did not occur Sales with conditions – a sale is recorded even though some terms have not been fulfilled Pressures to boost revenues External pressures – bankers, stockholders, families, and communities Internal pressures – departmental budget requirements Red flags associated with fictitious revenues Rapid growth or unusual profitability Recurring negative cash flows from operations Significant transactions with related parties Significant, unusual, or highly complex transactions Unusual growth in the number of days' sales in receivables Significant sales to entities with unknown ownership Large number of sales by a small number of company units 2. Timing differences – recording revenues and/or expenses in improper accounting periods Matching revenues with expenses – according to generally accepted accounting principles (GAAP) Premature revenue recognition – recognizing revenue before the actual transfer of ownership occurs. SEC Staff Accounting Bulletin Topic 13, “Revenue Recognition,” establishes that the following criteria must be satisfied to recognize revenue: Persuasive evidence of an arrangement exists Delivery has occurred or services have been rendered The seller’s price to the buyer is fixed or determinable Collectibility is reasonably assured Long-term contracts Completed contract method – records revenue when contract is complete Percentage of completion method – recognizes revenue and expenses as project progresses. This method is subject to manipulation. Channel stuffing ("trade loading") – customers are encouraged to overbuy merchandise through offers of large discounts Recording expenses in the wrong period Due to pressures to meet budget projections Lack of proper accounting controls Red flags associated with timing differences Rapid growth or unusual profitability Recurring negative cash flows from operations Significant, unusual, or highly complex transactions Unusually high, or unusual increase in, gross margin Unusual growth in the number of days' sales in receivables Unusual decline in the number of days' purchases in accounts payable 3. Concealed liabilities and expenses Liability/expense omissions – one of the most difficult schemes to detect because there is no audit trail Capitalized expenses – improper capitalization of expenses causes income to be overstated in the current period. Subsequently, as assets are depreciated, income will be understated. Expensing capital expenditures – improper expensing of capital assets causes income to be understated and, therefore, reduces tax liability Returns and allowances and warranties - failure to disclose and accrue appropriate expenses and liabilities for potential product returns or warranty repairs Red flags associated with concealed liabilities and expenses Recurring negative cash flows from operations Significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate Nonfinancial management’s excessive participation in the selection of accounting principles or the determination of significant estimates Unusually high, or unusual increase in, gross margin Allowances for accounting estimates that are out of line with industry peers Unusual decline in the number of days' purchases in accounts payable Unusual reduction in accounts payable 4. Improper disclosures Liability omissions – generally include the failure to disclose loan covenants or contingent liabilities Subsequent events – events occurring after the close of the period may have a significant impact on the financial statements and should be disclosed Management fraud – disclosure is required of significant fraud committed by officers, executives, and others in positions of trust Related-party transactions – a company doing business with entities that can be controlled or significantly influenced by that company must disclose the relationship Accounting changes – FASB ASC 250, “Accounting Changes and Error Corrections,” requires disclosure of changes in: Accounting principles Accounting estimates Reporting entities Red flags associated with improper disclosures Dominating manager Ineffective board of directors or audit committee oversight Ineffective communication or enforcement of ethical values and standards Rapid growth or unusual profitability Significant, unusual, or highly complex transactions Significant related-party transactions Significant bank accounts or branch operations in tax-haven jurisdictions Overly complex organizational structure Known history of violations of securities laws or other regulations Inappropriate accounting policy justified on the basis of materiality Limiting auditor access to information during an audit 5. Improper asset valuations – Generally, assets should be recorded at their historical (acquisition) cost. a. Inventory valuation Lower of cost or market Overstating inventory through fictitious (phantom) inventory b. Accounts receivable Fictitious accounts receivable Failure to write down Business combinations – Fraud-related issues include: Temptation to over-allocate the purchase price to in-process research and development assets, to write them off immediately Establish excessive reserves with the intention to release them into earnings at a future date d. Fixed assets Booking fictitious assets – by creating false documents or recording equipment that is leased as owned Misrepresenting asset value – fixed assets should be recorded at their historical (acquisition) cost Improperly capitalizing inventory and start-up costs Capitalizing non-asset costs – interest and finance charges should be excluded from the cost of an asset Misclassifying assets – can skew financial ratios to comply with loan requirements Red flags associated with improper asset valuation Recurring negative cash flows from operations Significant declines in customer demand Significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate Nonfinancial management’s excessive participation in the selection of accounting principles or the determination of significant estimates Unusually high, or unusual increase in, gross margin Unusual growth in the number of days' sales in receivables Unusual growth in the number of days' purchases in inventory Allowances for accounting estimates that are out of line with industry peers Unusual change in the relationship between fixed assets and depreciation Unusual increase in assets Detection of Fraudulent Financial Statement Schemes A. SAS No. 99 (AU 316) – “Consideration of Fraud in a Financial Statement Audit” Description and characteristics of fraud a. Misstatements arising from fraudulent financial reporting Manipulation or alteration of accounting records Misrepresentations or intentional omissions Intentional misapplication of accounting principles Misstatements arising from misappropriation of assets – theft or defalcation Importance of exercising professional skepticism – SAS No. 1 (AU 110), “Responsibilities and Functions of the Independent Auditor,” includes exercising professional skepticism as part of due professional care. Discussion among engagement personnel regarding risk of material misstatement due to fraud Obtaining information needed to identify risks of material misstatement due to fraud a. Making inquiries of management and others within the entity b. Considering the results of analytical procedures c. Considering fraud risk factors d. Considering other information Identifying risks that may result in material misstatement due to fraud Type Significance Likelihood Pervasiveness Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls Responding to the results of the assessment Overall responses to the risk of material misstatement Assignment of personnel and supervision Consider selection and application of accounting principles Incorporate an element of unpredictability in auditing procedures Responses involving the nature, timing, and extent of procedures to be performed to address the identified risks Substantive tests Tests of the operating effectiveness of the entity's programs and controls Responses to further address risk of management override of controls Examining journal entries and other adjustments for evidence of possible material misstatement due to fraud Reviewing accounting estimates for biases that could result in material misstatement due to fraud f. Evaluating the business rationale for significant, unusual transactions Evaluating audit evidence Assessing risks of material misstatement due to fraud throughout the audit Discrepancies in the accounting records Conflicting or missing evidential matter Problems experienced by the auditors during the audit Evaluating whether analytical procedures indicate a previously unrecognized risk of fraud – unusual or unexpected relationships should be considered Evaluating risks of material misstatement at or near the completion of fieldwork – to assess whether further audit procedures are needed Responding to misstatements that may be the result of fraud Attempt to obtain additional evidence Consider the implications for other aspects of the audit Discuss the matter with an appropriate level of management If appropriate, recommend the client consult with legal counsel Communicating about possible fraud to management, the audit committee, and others Documenting the auditor’s consideration of fraud Percentage analysis – vertical and horizontal 1. Vertical analysis – analyzes the relationships between the items on each of the financial statements by expressing the components as percentages of a specific base item 2. Horizontal analysis – analyzes the percentage change in individual financial statement items from one year to the next 3. Financial ratios – measures the relationship between two different financial statement amounts Current ratio = Quick ratio = Receivable turnover = Collection ratio = Inventory turnover = Average days inventory in stock = Debt to equity = Profit margin = Asset turnover = Deterrence of financial statement fraud incorporates the principles of the fraud triangle. Reduce pressures to commit financial statement fraud Reduce the opportunity to commit financial statement fraud Reduce rationalization of financial statement fraud Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 13—Fraud Risk Assessment Overview What is fraud risk? 1. The vulnerability an organization has to overcoming the interrelated elements that enable someone to commit fraud. a. Non-sharable financial need Opportunity Ability to rationalize 2. Sources of fraud risk Internal External Why should an organization be concerned about fraud risk? 1. No organization is immune to fraud risk. 2. One key to reducing vulnerability to fraud risk is being aware and realistic about the organization’s weaknesses. Factors that influence fraud risk 1. Nature of the business 2. Operating environment 3. Effectiveness of internal controls 4. Ethics and values of the company and the people within it What is a fraud risk assessment? Definition—A process aimed at proactively identifying and addressing an organization’s vulnerabilities to internal and external fraud Objective—To help an organization recognize what makes it most vulnerable to fraud so that it can take proactive measures to reduce its exposure Why should organizations conduct fraud risk assessments? Improve communication about and awareness of fraud Identify what activities are the most vulnerable to fraud Know who puts the organization at the greatest risk of fraud Develop plans to mitigate fraud risk Develop techniques to determine if fraud has occurred in high-risk areas Assess internal controls 1. Controls eliminated during restructuring 2. Controls eroded over time 3. Lack of controls in a vulnerable area 4. Nonperformance of control procedures 5. Inherent limitations of controls Comply with regulations and professional standards 1. PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements What makes a good fraud risk assessment? Collaborative effort of management and auditors 1. Expertise and influence of management a. Day-to-day business operations Assessing business risk and implementing organizational controls Culture and ethical atmosphere Expertise and influence of auditors Risk identification and assessment Evaluating internal controls The right sponsor 1. Respected, senior-level person 2. Objective and open-minded Independence and objectivity of the people leading and conducting the work 1. Mindfulness of biases 2. Cultural neutrality A good working knowledge of the business Access to people at all levels of the organization Engendered trust The ability to think the unthinkable A plan to keep it alive and relevant Considerations for developing an effective fraud risk assessment Packaging it right 1. Tailor the communication approach to the organization. 2. Be mindful of terminology used. One size does not fit all 1. Adapt the framework to the business model, culture, and language of the organization. Keeping it simple 1. Focus on areas that are most at risk for fraud. Preparing the company for the fraud risk assessment Assembling the right team to lead and conduct the fraud risk assessment 1. Accounting and finance personnel 2. Personnel who have knowledge of day-to-day operations 3. Risk management personnel 4. General counsel or other members of the legal department 5. Members of ethics or compliance functions 6. Internal auditors 7. External consultants with fraud and risk expertise 8. Business leaders charged with fraud risk management efforts Determining the best techniques to use in conducting the fraud risk assessment 1. Interviews 2. Focus groups 3. Surveys 4. Anonymous feedback mechanisms Obtaining the sponsor’s agreement on the work to be performed 1. Scope 2. Methods 3. Participants 4. Form of output Educating the organization and openly promoting the process Executing the fraud risk assessment Identifying potential inherent fraud risks 1. Incentives, pressures, and opportunities to commit fraud a. Position b. Incentives c. Performance pressures d. Weak internal controls e. Highly complex business transactions f. Collusion opportunities 2. Risk of management’s override of controls a. Management knows the controls and standard operating procedures in place to prevent fraud. b. Knowledge of controls can be used to conceal fraud. 3. Population of fraud risks a. Fraudulent financial reporting b. Asset misappropriation c. Corruption 4. Regulatory and legal misconduct 5. Reputation risk 6. Risk to information technology Assessing the likelihood of occurrence of identified fraud risks 1. Past instances of a particular fraud 2. Prevalence of fraud in the industry 3. Internal control environment 4. Available resources 5. Support of management 6. Ethical standards 7. Transaction volume 8. Complexity of the fraud risk 9. Unexplained losses 10. Complaints by customers or vendors Assessing the significance to the organization of the fraud risks 1. Financial statement and monetary significance 2. Financial condition of the organization 3. Value of the threatened assets 4. Criticality of the threatened assets 5. Revenue generated by the threatened assets 6. Significance to the organization’s operations, brand value, and reputation 7. Criminal, civil, and regulatory liabilities Evaluating which people and departments are most likely to commit fraud and identifying the methods they are likely to use Identifying and mapping existing preventive and detective controls to the relevant fraud risks 1. Preventive controls 2. Detective controls Evaluating whether the identified controls are operating effectively and efficiently 1. Review accounting policies and procedures. 2. Consider risk of management’s override of controls. 3. Interview management and employees. 4. Observe control activities. 5. Perform sample testing of controls compliance. 6. Review previous audit reports. 7. Review previous reports on fraud incidents, shrinkage, and unexplained shortages. Identifying and evaluating residual fraud risks resulting from ineffective or nonexistent controls 1. Lack of appropriate prevention and detection controls 2. Noncompliance with established prevention and control measures Addressing the identified fraud risks Establishing an acceptable level of risk Responding to residual fraud risks 1. Avoid the risk; for example, by eliminating an asset or exiting an activity. 2. Transfer the risk; for example, by purchasing fidelity insurance or a fidelity bond. 3. Mitigate the risk; for example, by implementing countermeasures such as prevention and detection controls. 4. Assume the risk. 5. Combine some of the above approaches. Reporting the results of the fraud risk assessment Considerations when reporting the assessment results 1. Report objective—not subjective—results. 2. Keep it simple. 3. Focus on what really matters. 4. Identify actions that are clear and measurable. Making an impact with the fraud risk assessment Begin a dialog across the company to promote awareness, education, and action planning aimed at reducing the risk of fraud. Look for fraud in high-risk areas. Hold responsible parties accountable for progress. Keep the assessment alive and relevant. The fraud risk assessment and the audit process Auditors should validate that the organization is managing the moderate-to-high fraud risks identified. 1. Design and perform tests to evaluate whether controls are operating effectively and efficiently. 2. Identify whether there is a moderate-to-high risk of management override of internal controls. 3. Develop and deliver reports that incorporate the results of validation and testing of controls. Instructor’s Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 14 – Conducting Investigations and Writing Reports When Is an Investigation Necessary? – Internal investigations can arise from a number of circumstances, including determining the source of and losses from an alleged fraud, complying with federal statutes, and mitigating the company’s liability related to employee misconduct. Officers and directors of companies are bound by duties of loyalty and reasonable care in overseeing the operations of their companies. Companies may have to conduct internal investigations before they can dismiss an employee who has committed fraud or violated company rules and policies. A company’s managers may find that the best way to fulfill legal duties and requirements is to conduct an internal investigation of known or suspected misconduct. Planning the Investigation – Once the decision has been made to pursue an investigation, it is important to consider how the company can carry out the investigation in the most efficient, effective manner. Selecting the Investigation Team – team should be limited to only those persons who are vital to the fraud examination process. Typical investigation team may include certified fraud examiners, legal counsel, internal auditors, human resources personnel, and management representatives. Certified Fraud Examiners – CFEs are trained to conduct complex fraud examinations from inception to conclusion. Legal Counsel – crucial to have counsel involved in “directing” the investigation. Internal Auditors – internal auditors are often used to review internal documentary evidence. IT and Computer Forensics Experts – computer forensics professionals are used to capture and analyze digital data. Human Resources Personnel/Management Representative – advice from a human resources specialist or management representative might be needed. Developing Evidence – The investigation process gathers evidence to prove or disprove the allegations of fraud. Investigative techniques include: Covert Operations – the investigator assumes a fictitious identity to gather evidence. Pretexting – obtaining information through some sort of falsehood or deception. Using Informants – can be used successfully in private investigations if handled properly. Subpoenas – call for the production of documents and records. Search Warrants – used when a law enforcement officer believes certain records have been used in the commission of a crime. Voluntary Consent – is often the simplest means to obtain documentation, and the preferred method in many fraud examinations. Preserving Documentary Evidence – The investigator must take care to properly preserve the evidence to ensure its admissibility in a court of law. Chain of Custody – a record must be made when the evidence is received or when it leaves the care, custody, or control of the fraud examiner. A memorandum of interview should state: What items were received When they were received From whom they were received Where they are maintained Preserving the Document – the examiner should never write or mark on the original document other than his unobtrusive initials for identification. Photocopies and laser-printed documents should always be stored in paper folders or envelopes. If fingerprint examinations are anticipated, gloves should be used to handle the documents. Organizing Documentary Evidence – Documents obtained must be properly organized early on in an investigation, and they should continuously be reorganized. Good organization includes: Segregating documents by either witness or transaction Making a “key document” file for easy access to the most relevant documents Establishing a database of a large amount of information early on in the case Chronologies – a chronology of events should be commenced early in the case in order to establish the chain of events leading to the proof. To-Do Lists – the list should be kept in a manner which allows a cumulative record of investigation tasks. Using Computer Software to Organize Documents and other Data – investigators can establish a database in which to store pertinent information about the case and the documents that have been assembled. Sources of Information – A variety of information sources is available to the fraud examiner to assist in locating individuals, researching assets, discovering creditor relationships, and uncovering litigation history. In-House Sources – investigators can learn a great deal about a subject by examining records of his employing organization, if they can gain access to those records. Public Information – records that a governmental unit is required by law to keep to discharge its duties imposed by law. Voter registration and marriage license records Real property records – if an individual buys or sells a house or piece of property, or becomes subject to a state or federal lien, the transaction will be reflected in the county real property indexes. Property tax records Health and fire departments Utility company records Permits – will be on file with local building authority if a business/individual constructs a new building. State Records Business filings – the law requires the filing of documents of business ownership to conduct business in a name other than one’s own Articles of incorporation – corporations are formed by filing articles of incorporation with the Secretary of State in the state where the company does business. These records are public. Fictitious names/DBA registrations – DBA information for proprietorships or partnerships is usually filed at the county level, but some states require filing at the state level also Uniform Commercial Code filings – can disclose when/where a person obtained a personal loan and the type of property that he or she pledged to secure the loan Workers’ compensation information – documents that show the date of the incident, the employer at the time, type of injury, and the job-related disability State tax filings – Licenses and applications for permits may reveal hidden assets or investments Professional associations and licensing boards – maintain records identifying individuals holding special licenses or memberships Litigation history – files on all active and closed lawsuits are maintained by court clerks Bankruptcy records – bankruptcy documents are usually located in the federal bankruptcy court for the district where the debtor resided The Internet – provides access to a wealth of information; however, investigators should remember that much of the information on public websites is questionable Report Writing – Fraud examinations usually conclude with a formal written report of the investigation results. Purpose of the Report – A good investigation report must be accurate and understandable so that others may know what transpired without having to talk to the report’s author. It should: Convey evidence Add credibility Accomplish objectives of case Know the Reader – the investigator must identify the expected reader to ensure the report appears professional and achieves its purpose. The report should: State only the facts Not contain errors Have a follow-up section Format – Using a standard report format will reduce the amount of time spent writing a report, while ensuring that all significant information is included. A standard report should include the following sections: Author/date Summary – should set out the main points of the report in a few sentences and include the findings and outcome of the investigation Introduction/purpose – should give more detail on what the report is about and prepare the reader for what is to come Body – identifies the employee(s) and other individuals implicated/involved in the matter Results – this section may include only a sentence or two, or be supplemented with spreadsheets or graphics Follow-up/recommendation – identifies any investigation procedures that remain outstanding, and makes any recommendations related to procedures and controls Opinions or Conclusions in Report – no opinions of any kind should be included in the written report, other than on technical matters Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 15 – Interviewing Witnesses Interviewing Witnesses – the process of asking questions of individuals who might have information to resolve allegations of wrongdoing. Introductory Questions Provide the introduction a. avoid using titles b. create a comfortable atmosphere Establish rapport – e.g., engage in small talk to break the ice Establish the interview theme – the goal is to motivate the subject to assist in the interview Observe reactions a. Establish a baseline by first posing nonsensitive questions b. Attempt to determine the cause of any changes in reactions when sensitive questions are asked General rules for the introductory phase of the interview Don’t interview more than one person (at the same time) Privacy – conduct the interview out of the sight and sound of others Ask nonsensitive questions Get a commitment for assistance Make a transitional statement – to describe the purpose of the interview Seek continuous agreement Do not promise confidentiality Negotiations – listen to what the subject may want, but don't negotiate Discussing the source of allegations – do not discuss any allegations or from where the information originated Informational Questions – to gather unbiased factual information; these questions should be non-confrontational and non-threatening Open questions – call for a monologue response Closed questions – require a "yes" or "no" answer Leading questions – ask the subject to confirm what is already known Question sequences – proceed from the general to the specific Informational question techniques TEACHING TIP "Informational Question Techniques" on page 347 provides a listing of suggested techniques to improve the interview process. Methodology Begin with background questions Observe verbal and nonverbal behavior Ask nonleading (open) questions Approach sensitive questions carefully Dealing with difficult people Do not react Disarm the person Change tactics Volatile interviews – have the potential to bring about strong emotional reactions in the interviewee. Suggested approaches include: Have two interviewers in the room Interview should be conducted on a surprise basis The order of questions should be out of sequence the questions should be phrased hypothetically Closing Questions Reconfirming facts – generally, the use of leading questions is suggested Gathering additional facts – the use of open questions provides the subject an opportunity to furnish other relevant facts or opinions Concluding the interview Maintain goodwill Leave the door open to additional cooperation Invite the subject to contact you if he or she remembers other relevant information Assessment Questions – to establish the credibility of the respondent Norming or calibrating – the process of observing behavior before asking critical questions Physiology of deception – lying produces stress, and in order to relieve this stress, the body will exhibit certain behavioral quirks Verbal clues to deception Changes in speech patterns i. speed ii. tone iii. pitch Repetition of the question – to gain more time to respond Comments regarding the interview – complaints about: i. physical environment ii. length of interview Selective memory Making excuses Oaths – to attempt to add credibility to their lies Character testimony – to add credibility to a false statement Answering with a question – rather than deny allegations outright Overuse of respect – when accused of wrongdoing, this reaction is unnatural Increasingly weaker denials – common reaction from a dishonest person Failure to deny – qualifying the denial (e.g., to the best of my recollection or as far as I remember) Avoidance of emotive words – (e.g., “steal,” “lie,” “crime”) Refusal to implicate other suspects Tolerant attitudes – toward illegal or unethical conduct Reluctance to terminate interview Feigned unconcern Nonverbal clues Full-body motions – change of posture, moving away from interviewer Anatomical physical responses i. increased heart rate ii. shallow or labored breathing iii. excessive perspiration Illustrators – motions made primarily with the hands Hands over the mouth Manipulators – displacement activities done to reduce nervousness Fleeing positions – lower portion of the body facing toward the door Crossing the arms – defensive reaction Reaction to evidence – feigned disinterest in the evidence Fake smiles – confined to the upper half of the mouth TEACHING TIP "Typical Attitudes Displayed by Respondents" on page presents a comparison of the demeanor of truthful versus untruthful interviewees. Methodology – proceed from least to most sensitive questions Admission-Seeking Questions – designed to: Clear an innocent person, or Encourage the culpable person to confess Presence of outsiders May present legal problems in “broadcasting” allegations to a third party May make it more difficult to obtain a confession Miranda warnings – does not apply to private employers’ investigations Theme development – offers a morally acceptable reason for the confessor’s behavior Steps in the admission-seeking interview Direct accusation should be phrased as a statement, not a question avoid emotive words, such as “steal,” “fraud,” and “crime” should be phrased as though the guilt of the accused has already been established Observe reaction – a guilty person will react with silence or a weak denial Repeat accusation Interrupt denials – It is difficult for the accused to change a denial because he or she would be admitting to lying. Therefore, by preventing an outright denial, it makes it easier for the accused to confess. This may be accomplished through: Delays Interruptions Reasoning Establish rationalization – This (morally acceptable) explanation allows the accused to justify the offense with his or her conscience. Unfair treatment Inadequate recognition Financial problems Aberration of conduct Family problems Accuser’s actions Stress, drugs, alcohol Revenge Depersonalizing the victim Minor moral infraction Altruism Genuine need Diffuse alibis – Use of one of the following methods may be employed to convince the accused of the weight of the evidence against him or her. Display physical evidence Discuss witnesses Discuss deceptions Present alternative – forces the accused to make a choice between a morally acceptable reason for the offense and one that offers no (good) excuse Benchmark admission i. A subconscious decision to confess ii. Reinforce rationalization Verbal confession – occurs when the accused furnishes detailed information about the misdeed. The following information should be obtained: The accused knew the conduct was wrong Facts known only to perpetrator Estimate of number of instances/amounts Motive for offense When offense commenced When/if offense was terminated Others involved Physical evidence Disposition of proceeds Location of assets Specifics of each offense Taking a signed statement – has greater credibility than a verbal confession and should include a statement of: Voluntary confessions – no duress Intent – intention to commit the act Approximate dates of offense Approximate amounts of losses Approximate number of instances Willingness to cooperate Excuse clause – confessor’s moral excuse should be mentioned Have the confessor read the statement Truthfulness of statement Preparing a signed statement Should not be drafted by the confessor A separate written statement for each offense Instruct the confessor to read and sign the statement without delay Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 16 – Occupational Fraud and Abuse: The Big Picture Defining Abusive Conduct – any violation of the rules of an organization The problem of occupational fraud and abuse cannot be totally eliminated To reduce occupational fraud and abuse, standards should be clear and reasonable Measuring the Level of Occupational Fraud and Abuse – This is difficult because we only know about the frauds that are discovered and reported. The Human Factor – human failings that lead to a violation of trust Greed – cannot be measured to predict fraudulent behavior Wages in kind – the use of counterproductive behavior by employees to right what they perceive as workplace wrongs Unreasonable expectations – e.g., to eliminate lying; rather than to attempt to prevent lies from escalating to fraud Minimizing occupational fraud and abuse Establish adequate personnel screening procedures Introduce anti-fraud training Treat employees fairly Understanding Fraud Deterrence – the modification of behavior through the perception of negative consequences The impact of controls – only part of the answer to fraud deterrence The perception of detection – Increased perception of detection, whether real or imagined, will have a deterrent value. The following steps may help to increase the perception of detection: Employee education – should be factual not accusatory Proactive fraud policies A higher stance – encourage open discussion about: possible control and administrative weaknesses suspicions of fraud "hidden" controls Increased use of analytical review – smaller businesses benefit most from this technique Surprise audits where feasible – more difficult to plan and execute but have a greater impact on the perception of detection Adequate reporting programs – should emphasize these points: Fraud, waste, and abuse are common in most organizations The cost of fraud effects jobs, raises, and profits Employees are encouraged to report fraud There are no penalties for providing good-faith information on fraudulent activity There is an exact number for reporting – such as a hotline Essential to a good reporting program Some schemes would not be discovered by any other method Tips are the most common way to detect fraud Increases the perception of detection Helps comply, in part, with the federal Corporate Sentencing Guidelines for corporations A report does not have to be made by an employee to his or her immediate supervisor The Corporate Sentencing Guidelines Definition of corporate sentencing Seeks to make punishments more uniform Imposes stiff sanctions Allows for a more lenient sentence if the company has actively tried to prevent fraud from occurring Vicarious or imputed liability – corporations may be held criminally liable for the acts of their employees if: the acts are done in the course and scope of their employment, and for the apparent purpose of benefiting the corporation Requirements – for "due diligence" NOTE: A "reasonableness" standard is used for setting, communicating and enforcing policies and procedures. The Ethical Connection – ethics – “how you react to temptation when no one is looking" Moral philosophies Imperative principle – advocates following the rules regardless of the consequences Utilitarian principle – places the primary emphasis on the consequences of an action rather than on simply following the rules "Tone at the top" – management's example sends a stronger message to employees than any written ethics policy Written ethics policies – formal ethics policies are recommended for all organizations; may also be used as a mechanism for disciplinary action Conclusion There are no new audit techniques to detect fraud Red flags of fraud may also be the result of incompetence Don't overreach your authority in an investigation of fraud Consider new approaches to fraud deterrence ( e.g., Model Organizational Fraud Deterrence Program) Instructor Manual for Principles of Fraud Examination 9780470646298, 9781118922347 Joseph T. Wells