CH-6 Payroll Schemes – Principles of Fraud Examination : Chapter Notes

Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 6 – Payroll Schemes Payroll Schemes – are occupational frauds in which a person, who works for an organization, causes the organization to issue a payment by making a false claim for compensation. Ghost employee – refers to someone on the payroll who does not actually work for the victim company. 1. Adding the ghost to the payroll – opportunities exist in: a. personnel department – those with hiring and supervisory authority payroll accounting i. creating a fictitious employee with a name very similar to that of a real employee ii. failing to remove the names of terminated employees 2. Collecting timekeeping information – the key to this stage of the fraud is obtaining approval of the timekeeping document. a. supervisor is the fraudster b. non-supervisor is the fraudster 3. Issuing the ghost’s paycheck – the perpetrator does not generally take an active roll in the issuance of the check. 4. Delivery of the paycheck a. hand delivered to employee at work mailed to employee's home address direct deposited to employee's bank account Preventing and detecting ghost employee schemes a. separation of duties personnel department should verify any changes to payroll personnel department should also conduct background checks and reference checks on all prospective employees in advance of hire run a report looking for employees who lack: i. social security numbers ii. deductions on their paychecks for withholding taxes or insurance iii. physical address or phone number in their personnel records run a report looking for multiple employees who have the same: i. social security number ii. bank account number iii. physical address Falsified hours and salary – For hourly employees, both the number of hours worked and rate of pay are susceptible to fraud. For salaried employees, fraudulent wages may be generated by increasing their rates of pay. 1. manually prepared timecards a. forging a supervisor’s signature b. collusion with a supervisor c. rubber stamp supervisors d. poor custody procedures 2. Time clocks and other automated timekeeping systems – collusion with another employee is usually required for this type of fraud. 3. Rates of pay – access to personnel or payroll records is essential to this fraud. Preventing and detecting falsified hours and salary schemes a. enforce controls – segregation of duties is key: i. payroll preparation ii. authorization iii. distribution iv. reconciliation run tests that actively seek out fraudulent payroll activity test for overtime abuses utilize trend analysis exception reports testing verify payroll taxes with federal tax forms Commission schemes – may be committed by either: 1. Falsifying the amount of sales made a. fictitious sales b. altered sales 2. Increasing the rate of commission Detecting commission schemes run reports to confirm a linear relationship between sales and commission expenses use comparative analysis tests for commissions earned by each salesperson track uncollected sales generated by each member of the sales department use random sampling to confirm sales to customers Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 7 – Expense Reimbursement Schemes Expense Reimbursement Schemes – are occupational frauds in which employees make false claims for reimbursement of fictitious or inflated business expenses. Mischaracterized expense reimbursements – e.g., claiming that a personal expense is business-related 1. Preventing mischaracterized expense reimbursement schemes a. Require detailed information for expense reimbursement Require that a direct supervisor of the requestor review all travel and entertainment expenses Establish a policy that clearly states what types of expenses will and will not be reimbursed Require that employees sign a statement acknowledging that they understand the policy and will abide by it Detecting mischaracterized expense reimbursement schemes a. Compare the employee’s expense reports to his work schedule Scrutinize any expense report that was approved by a supervisor outside the requestor’s department Compare expense reimbursement levels to prior years and to budgeted amounts Compare expense reimbursements per employee to identify any particular employee whose expenses are excessive Overstated expense reimbursements 1. Altered receipt – occurs when an employee doctors a receipt or other supporting documentation to reflect a higher cost than what he actually paid 2. Overpurchasing 3. Overstating another employee’s expenses – likely to occur in a system in which expenses are reimbursed in currency rather than by a check 4. Orders to overstate expenses – employees falsify their own reports at the direction of their supervisors Preventing and detecting overstated expense reimbursement schemes a. Require original receipts for all expense reimbursements Generate comparison reports that show reimbursed expenses per employee Spot check expense reports with customers, confirming business dinners, meetings, etc. Fictitious expense reimbursement schemes 1. Fictitious receipt – occurs when an employee creates phony support documents 2. Obtaining blank receipts from vendors a. by requesting them b. by stealing them 3. Claiming the expenses of others – submitting expense reports for expenses that were paid by others Preventing and detecting fictitious expense reimbursement schemes – Red flags include: a. Consecutively numbered receipts Cash payments for high dollar expenses Expenses that are consistently rounded off Expenses that are consistently for the same amount Reimbursement requests that consistently fall at or just below the organization's reimbursement limit Receipts that do not look professional or that lack certain vendor information Multiple reimbursement scheme – involves the submission of a single expense several times to receive multiple reimbursements. In order to prevent and detect multiple reimbursement schemes, organizations should: 1. Enforce a policy against accepting photocopies as support for business expenses Check the expense against previous requests before issuing a reimbursement Require that expense reports be reviewed and approved by a direct supervisor Establish a policy that expenses must be submitted within a certain time frame Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 8 – Register Disbursement Schemes Register Disbursement Schemes – Money is removed from the register, and a false transaction is recorded on the register as though it were a legitimate disbursement to justify the removal of the money. False refund – a disbursement of money from the register to the customer for, presumably, returning an item of merchandise purchased from that store Fictitious refund – 1. Cash is removed from the register in the amount of the false return 2. No merchandise is actually returned, therefore, inventory is overstated Overstated refund – overstating the amount of a legitimate refund and stealing the excess money Credit card refund – processing false refunds on credit cards instead of physically taking cash from the register. This may be achieved in a number of ways: 1. The fraudster inserts his own credit card number on the refund instead of the customer’s 2. The fraudster processes merchandise refunds to the accounts of other people, and in return receives a portion of the refunds as a kickback False voids – the essential components for the success of this type of scheme are: "Rubber stamp" manager, Fraudster forging supervisor's signature, or Manager collusion with register employee Concealing register disbursements A. Overstating inventory during the physical count (to conceal shrinkage) B. Small disbursements (below the required management review limit) C. Destroying records (to prevent identification of the thief) Preventing and detecting register disbursement schemes Maintain appropriate separation of duties Require distinct login codes for work at the register Place signs or institute store policies encouraging customers to ask for and examine their receipts Conduct a physical inventory count regularly for excessive shrinkage Review records for the processing of an excessive number of voided sales Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 9 – Non-Cash Assets Non-cash misappropriation schemes – Occupational frauds in which employees misuse or steal inventory, supplies, equipment, and other non-cash company assets. Misuse of non-cash assets – unauthorized use of company assets 1. Non-cash assets that are typically misused include: a. company vehicles company supplies computers other office equipment The costs of inventory misuse – difficult to quantify a. loss of productivity additional employee wages (for more hires) lost business (from competition of employee) additional wear and tear on equipment possible non-return (theft) of asset Unconcealed larceny schemes – occur when an employee takes property from the company premises without attempting to conceal it in the books and records 1. Misappropriation of assets in front of coworkers a. coworkers do not suspect fraud coworkers are aware of the fraudulent activity but ignore the illegal conduct because of: i. sense of loyalty to their friends "management vs. labor" mentality intimidation poor channels of communication collusion lack of proper whistleblowing procedures 2. Misappropriation of company assets from an off-site location – mailing to a location where they can be picked up, prevents the fraudster from risking being caught physically taking the assets The fake sale – uses an accomplice to achieve the fraudulent goal a. employee does not ring up the sale b. accomplice takes the merchandise without paying c. accomplice may also "return" merchandise for cash Preventing and detecting larceny of non-cash assets a. separation of duties (e.g., purchasing, payables, and receiving) physical control of non-cash assets conduct physical inventory counts on a periodic basis monitor and follow up on customer complaints regarding "short" shipments Asset requisitions and transfers – internal documents that facilitate the transfer of non-cash assets from one location in the company to another, may also be used to misappropriate those assets by: overstating the amount of supplies or equipment needed for a project fabricating a project falsifying property transfer forms Purchasing and receiving schemes – involve the theft of non-cash assets that were intentionally and legitimately purchased by the company 1. Falsifying incoming shipments – marking the shipments as "short" and taking the excess 2. Concealment issue – if the receiving report does not match the vendor’s invoice, there will be a problem with payment False shipments of inventory – involves creating false shipping and sales documents 1. A false packing slip causes the merchandise to be delivered to the fraudster or his or her accomplice The fraudulent "sales" are made to: a fictitious person a fictitious company, or an accomplice Concealment issue - a fake receivable account is created on the books for the price of the misappropriated inventory Other schemes Assets are written off in order to make them available for theft New equipment is taken instead of the old (scrap) asset that was to be replaced Concealing inventory shrinkage – Hiding significant differences between the perpetual inventory amount (what should be on hand) and the physical inventory count (what is actually on hand) is essential for the fraud to remain undetected. This may be accomplished by: Altered inventory records - changing the perpetual inventory record so that it will match the physical inventory count (i.e., forced reconciliation) Fictitious sales and accounts receivable TEACHING TIP In order to conceal inventory shrinkage, the perpetrator would need to make it appear as though the missing inventory had been sold by recording the following entry: DR Accounts Receivable xxx CR Sales xxx Concealment issue – payment on the fictitious sales charge the “sales” to an existing (large) account charge the “sales” to accounts that are already aging and will soon be written off write-off to discounts and allowances or bad debt expense Write off inventory and other assets – writing-off inventory as "obsolete" eliminates the inherent problem of shrinkage in asset misappropriation schemes Physical padding – involves creating the illusion of more inventory than is actually on hand (e.g., empty boxes) Preventing and detecting non-cash thefts that are concealed by fraudulent support Segregation of duties 1. ordering goods receiving goods maintaining perpetual inventory records issuing payment Match invoices to receiving reports before payments are issued Match packing slip (sales order) to an approved purchase order Match every outgoing shipment to the sales order before the merchandise is shipped Monitor any significant increase in bad debt expense Review any unexplained entries in perpetual inventory records Reconcile materials ordered for projects to the actual work done Periodically perform trend analysis on the amount of inventory that is being designated as scrap Control should be maintained over assets during disposal Misappropriation of intangible assets A. Misappropriation of information – theft of proprietary information 1. Can undermine value, reputation, and competitive advantage, and can result in legal liabilities 2. Biggest threats are often internal 3. Includes theft of competitively sensitive information (e.g., customer lists, marketing strategies, trade secrets) 4. Companies must identify their most valuable information and take steps to protect it B. Misappropriation of securities 1. Companies must maintain proper internal controls over their investment portfolio, including separation of duties, restricted access, and account reconciliations Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 10 – Corruption Corruption – an act in which a person uses his or her position to gain a personal advantage at the expense of the organization he or she represents. Bribery – “offering, giving, receiving, or soliciting anything of value to influence an official act or business decision.” Kickback schemes – consist of undisclosed payments made by vendors to employees of purchasing companies. involve collusion between employees and vendors almost always attack the purchasing function of the victim company 1. Diverting business to vendors – Most bribery schemes end up as overbilling schemes even if they do not start that way, because once a vendor knows it has an exclusive purchasing arrangement, it ultimately will raise prices to cover the cost of the kickback. 2. Overbilling schemes Employees with approval authority – the ability to authorize purchases is key to a kickback scheme Fraudsters lacking approval authority – need to be able to circumvent accounts payable controls filing a false purchase requisition preparing false vouchers creating a purchase order that corresponds to the vendor’s fraudulent invoice Other kickback schemes – Bribes may be paid: to accept substandard merchandise to receive a lower price from the victim company Slush funds – are created by diverting company money into a non-company account for the purpose of making illegal (bribe) payments NOTE: The diversion of company funds is usually accomplished by charging an account such as "consulting fees." Preventing and detecting kickback schemes In an effort to prevent kickback schemes, the following may be helpful: segregation of duties maintenance of an updated vendor list proper review and matching of all support for disbursement vouchers all contracts with suppliers should contain a “right to audit” clause written policies should be established prohibiting employees from soliciting or accepting any gift or favor from a customer or supplier In addition, look for the specific red flags and characteristics of kickback schemes: price inflation the purchase of excessive quantities of goods or services from a corrupt supplier inventory shortages the purchase of inferior quality inventory or merchandise budget overruns B. Bid-rigging schemes – occur when an employee fraudulently assists a vendor in winning a contract through the competitive bidding process. The level of influence of the corrupt employee determines how the bidding process is rigged. 1. The pre-solicitation phase Need recognition schemes – In return for something of value, the fraudster recognizes a "need" for a good or service. Indications of this type of scheme might include: high requirements for stock and inventory levels writing off large numbers of surplus items to scrap defining a “need” in a way that can only be met by a certain supplier or contractor failure to develop a satisfactory list of backup suppliers Specifications schemes – the fraudulent tailoring of the elements, materials, dimensions, or other relevant requirements of the project to a particular vendor. Ways to restrict competition or give an unfair advantage at this stage include: the use of “pre-qualification” procedures sole-source or noncompetitive procurement justifications writing vague specifications, which will require amendments at a later date bid splitting – separating the project into several component contracts so that each sectional project falls below the mandatory bidding level showing the specifications to a vendor earlier than to its competitors 2. The solicitation phase – At this stage, an attempt is made to restrict the pool of competitors. This may be accomplished by: “Requiring” bidders to be represented by certain sales or manufacturing representatives Bid pooling – a process by which several bidders conspire to split contracts up and ensure that each gets a certain amount of work Fictitious suppliers – fictitious price quotes are used to validate the reasonableness of the conspirator's actual prices Other methods severely restricting the time for submitting bids soliciting bids in obscure publications The submission phase – At this stage, an attempt is made to win the contract for a particular supplier by: abuse of the sealed-bid process providing information on how to prepare the bid ensuring receipt of a late bid falsifying the bid log extending the bid opening date controlling bid openings Preventing and detecting bid-rigging schemes - specifically applicable to the competitive bidding process: unusual bidding patterns unusually high contract price low bid awards are frequently followed by change orders or amendments that significantly increase payments to the contractor very large, unexplained price differences among bidders if the last contractor to submit a bid repeatedly wins the contract predictable rotation of bid winners losing bidders frequently appear as subcontractors on the project qualified bidders fail to submit contract proposals avoidance of competitive bidding altogether, by splitting a large project into several smaller jobs that fall below a bidding threshold C. Something of value money currency checks promises of future employment percent of ownership in the supplier’s business gifts free liquor and meals free travel and accommodations cars other merchandise sexual favors paying off of a corrupt employee’s loans or credit card bills the offering of loans on very favorable terms transfers of property at substantially below market value Illegal gratuities – "something of value is given to an employee to reward a decision rather than influence it." Economic extortion – when one person demands payment from another. Conflicts of interest – occurs when an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the organization. Purchasing schemes – The fraudster (or accomplice) must have some kind of ownership or employment interest in the vendor that submits the invoice in order for the scheme to be categorized as a conflict of interest. Overbilling – the most common type of purchasing scheme Bid-rigging – Because the fraudster has access to the bids of his competitors, he can easily tailor his company's bid to win the contract. Turnaround sales (also known as flip sales) – occur when an employee knows that his employer is looking to purchase a certain type of asset and uses the information to purchase it himself with the intention of reselling it to the employer at an inflated price Sales schemes Underbillings – a scheme in which an employee induces her employer to sell goods or services at below market value to a company in which the employee maintains a hidden interest Writing off sales - tampering with the books of the victim company to decrease or write off the amount owed by an employee’s business TEACHING TIP Writing off sales might include decreasing the amount owed by an employee's business: e.g, DR Sales Discount xxx CR Accounts Receivable xxx OR Completely voiding the amount owed by an employee's business: e.g., DR Allowance for Uncollectible Accounts (Bad Debt Expense) xxx CR Accounts Receivable xxx Other conflict of interest schemes Business diversions – when an employee steers customers from his employer's business to his own Resource diversions – when an employee diverts funds and other resources of his employer to the development of his own business Financial disclosures significant fraud committed by officers, executives, and others in positions of trust criminal indictment of officers, executives, or other persons in trusted positions conflicts of interests related-party transactions Preventing and detecting conflicts of interest Institute a company ethics policy regarding conflicts of interest Require that employees complete an annual disclosure statement Establish an anonymous reporting mechanism to receive tips and complaints Periodically run comparison reports between vendor and employee addresses and phone numbers Instructor's Manual for PRINCIPLES OF FRAUD EXAMINATION Lecture Outline Chapter 11 – Accounting Principles and Fraud Fraud in Financial Statements Who commits financial statement fraud? 1. Senior management 2. Mid- and lower-level employees 3. Organized criminals Why do people commit financial statement fraud? 1. To conceal true business performance a. Overstate performance To meet or exceed earnings or revenue growth expectations of stock market analysts To comply with loan covenants To increase the amount of financing available from asset-based loans To meet a lender’s criteria for granting/extending loan facilities To meet corporate performance criteria set by the parent company To meet personal performance criteria To trigger performance-related compensation or earn-out payments To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding To show a pattern of growth to support a planned securities offering or sale of the business Understate performance To defer “surplus” earnings to the next accounting period To take all possible write-offs in one “big bath” now so future earnings will be consistently higher To reduce expectations now so future growth will be better perceived and rewarded To preserve a trend of consistent growth To reduce the value of an owner-managed business for purposes of a divorce settlement To reduce the value of a corporate unit whose management is planning a buyout 2. To preserve personal status/control 3. To maintain personal income/wealth How do people commit financial statement fraud? 1. Playing the accounting system – the accounting system is manipulated (e.g., change in depreciation methods or accounting estimates) to generate specific desired results (e.g., increase or decrease net income) 2. Beating the accounting system – false and fictitious information is input into the accounting system to manipulate reported results 3. Going outside the accounting system – the fraudster fabricates financial statements using equipment such as a personal computer Conceptual Framework for Financial Reporting A. Recognition and measurement concepts Assumptions a. Economic entity b. Going concern c. Monetary unit d. Periodicity Principles a. Historical cost b. Revenue recognition c. Matching d. Full disclosure Constraints a. Cost-benefit b. Materiality c. Industry practice d. Conservatism Qualitative Characteristics Relevance and reliability Comparability and consistency Responsibility for financial statements – Financial statements are the responsibility of the company's management. Users of financial statements Company ownership and management Lending organizations Investors Types of financial statements Balance sheet Statement of income or statement of operations Statement of retained earnings Statement of cash flows Statement of changes in owners’ equity Statement of assets and liabilities that does not include owners’ equity accounts Statement of revenue and expenses Summary of operations Statement of operations by product lines Statement of cash receipts and disbursements Other financial data presentations (e.g., pro forma, interim, or personal) The Sarbanes-Oxley Act of 2002 (signed into law on July 30, 2002) Certification obligations for CEOs and CFOs Criminal certifications Civil certifications Management assessment of internal controls New standards for audit committee independence Audit committee responsibilities Composition of the audit committee – must include a "financial expert" Establishing a whistleblowing structure New standards for auditor independence Restrictions on non-audit activity Mandatory audit partner rotation Conflict of interest provisions Auditor reports to audit committees Auditors’ attestation to internal controls Improper influence on audits Enhanced Financial Disclosure Requirements Off-balance sheet transactions Pro forma financial information Prohibitions on personal loans to executives Restrictions on insider trading Codes of ethics for senior financial officers Enhanced review of periodic filings Real-time disclosures Protections for corporate whistleblowers under Sarbanes-Oxley Civil liability whistleblower protection Criminal sanction whistleblower protection Enhanced penalties for white-collar crime Attempt and conspiracy Mail fraud and wire fraud Securities fraud Document destruction Freezing of assets Bankruptcy loopholes Disgorgement of bonuses Public Company Accounting Oversight Board – Established under Title I of the Sarbanes-Oxley Act, the Board is appointed and overseen by the SEC. Registration with the Board – Public accounting firms that audit publicly traded companies must register with the PCAOB. Auditing, quality control, and independence standards and rules – The PCAOB is responsible for establishing standards for auditing, quality control, ethics, independence, and other issues related to audits of publicly traded companies. Inspections of registered public accounting firms – Regular inspections are to be conducted by the Board to test for compliance with standards and rules. Investigations and disciplinary proceedings – The Board has the authority to investigate registered public accounting firms and issue sanctions for violations or non-cooperation. Instructor Manual for Principles of Fraud Examination 9780470646298, 9781118922347 Joseph T. Wells