Describe Fraud in the Context of Financial

Misappropriation of Assets and Fraudulent Financial Reporting Loscalzo s September 24, 2014 2012 Template for PowerPoint Slides A SmartPros Ltd. Company www.loscalzo.com (732) 741 1600 1 CPE Instructions / Polling Questions 1. SmartPros, our CPE partner, manages all CPE Administration for this event. 2. To receive CPE credit, you must validate your attendance in one of two ways: a) If you are logged in to your own individual computer, you will need to answer (4) polling questions as they are presented during the event b) If you are watching in a GROUP, and NOT logged in to your own computer, you will need to write down the (4) polling question keywords and enter them AFTER THE EVENT by going to www.smartpros.com/adpwebinars 3. Upon meeting the CPE participation requirements above, you will receive an email from SmartPros within 10 days of the event with instructions on how to login and print your online CPE certificate NOTE: You can download a copy of this presentation at : www.smartpros.com/adpwebinars 2 Program Objectives Describe fraud in the context of corporate financial fraud Identify red flags associated with financial statement fraud Describe the fraud triangle Describe asset misappropriation as it relates to occupational fraud Summarize the 2012 Report to the Nations from the Association of Fraud Examiners Identify common internal control weaknesses Describe Fraud in the Context of Financial Statement Fraud 3 4 What is Fraud? Common Legal Definition: A false representation of a matter of fact, whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed that deceives and is intended to deceive others so that the individual will act upon it to her or his advantage What is Fraud? Deliberate misstatement Intentional Misappropriation of assets Fraudulent financial reporting Deliberate concealment 5 6 1

Deliberate Misstatement Fraud is deliberate Fraud is not a mistake Fraud is designed to benefit one party while harming another party (company or individual) Intentional Fraud is intentional As stated earlier, fraud is not a mistake Fraud is planned Fraud does not happen by accident 7 8 Misappropriation of Assets Fraud is the theft of assets (cash/inventory, equipment) When controls are poor, theft can be concealed by manipulating the accounting records Normally can take place when there is a lack of segregation of duties Fraudulent Financial Reporting Fraud is preparing misleading financial statements Fraud is the intentional omission or mischaracterization of facts and circumstances concerning transaction activity Fraudulent financial reporting results in a misstatement of financial statements Normally committed by upper management 9 10 Fraudulent Financial Reporting Deliberate Concealment Categories: Fraud is concealed/hidden Fictitious Revenues The fraudster creates misleading information Timing Differences Hidden Liabilities and Expenses Improper Disclosures The fraudster uses the confidence others have in he/she to hide the fraudulent actions taken place Conflicts of Interest Improper Asset Valuation 11 12 2

Examples of Fraud Concealment Strategies Examples of Fraud Concealment Strategies Ship product to a company owned/controlled warehouse obtaining third party shipping documents and creating a false bill Borrow monies from third parties and record the borrowings as sales or customer payments Ship product to company that did not order the product obtain third party shipping document and create a false bill Use of side agreements between customers or related parties False or improper inputs used for significant estimates or fair values Collusion within the company or with outside parties to provide false evidence Source documentation for customer payments is altered to appear to have came from the customer 13 14 Soft Red flags Weak sense of ethics Identify Red Flags Associated with Financial Statement Fraud Risk-taking Beating the system Refusal to take time off Coming in early and/or staying late Discussing personal financial problems Abuse of drugs or alcohol Sudden or unusual mood swings Possessions beyond their financial means 15 16 Discrepancies in Accounting Records: Discrepancies in Accounting Records: Transactions that are not completed in a complete or timely manner Last minute adjustments that significantly affect financial results Transactions that are improperly recorded as to amount, accounting period, classification, or company policy Evidence of employees access to systems and records inconsistent with their duties and responsibilities Unsupported or unauthorized balances or transactions 17 18 3

Conflicting or Missing Evidence: Conflicting or Missing Evidence: Missing documents Documents that appear to have been altered Unavailability of original documents Significant unexplained items on reconciliations Unusual balance sheet changes from period to period Large number of credit entries and other adjustments made to accounts receivable records Unexplained differences between subledgers and control accounts Unexplained differences between customer statements and the accounts receivable subledger Unusual changes in trends or relationships 19 20 Conflicting or Missing Evidence: Other Indicators: Missing inventory or physical assets of significant magnitude Accounting policies that appear to be at variance with industry norms Unavailable or missing electronic evidence Frequent changes in accounting estimates Inability to produce evidence of key systems development and program change testing 21 22 Detecting the Risks and Red Flags of External Fraud Answer the following key questions about your organization s vulnerability to external fraud: What types of external fraud have occurred in the past and could occur again? What types of fraud could be committed against the organization? What are the specific ways outsiders could commit fraud against your organization by acting alone? What specific ways could vendors commit fraud in your area? How could vendors working in collusion with your employees commit fraud? Detecting the Risks and Red Flags of External Fraud Rank the likelihood of each external fraud scheme occurring. Assess each external fraud risk within the context of your existing controls against outside fraudsters. 23 24 4

Fraud Triangle Pressure Describe the Fraud Triangle Opportunity Rationalization 25 26 The Fraud Triangle Pressure Why People Steal: Pressure in the context of the Fraud Triangle, typically is the direct result of financial difficulties Opportunity exists when an employee discovers a weakness in the organization s anti-fraud controls Rationalization person who has committed fraud convinces himself or herself that the act is not wrong Financial/Use of Credit Cards Drugs/Gambling/Sex Excessive Life Style/Social Pressure/Ego Child College Tuition Meeting Corporate Performance Goals Job/Position Loss of Job/Position Divorce/Elder Care/Sickness Poor Planning for Retirement 27 Recession 28 AU 240 Consideration of Fraud in a Financial Statement Audit Opportunity Pressures Fraud Risk Factors: Tone at the Top Personal financial obligations Member of Management Adverse relationships between management and employees with access to cash or other assets: Known or anticipated future layoffs Recent or anticipated changes to employee compensation or benefit plans Ineffective Internal Controls Poor Separation of Duties Inadequate Supervision Trusted Employee Crises Atmosphere Promotions, compensation, or other awards inconsistent with expectations Decentralized Operating Structure 29 30 5

AU 240 Consideration of Fraud in a Financial Statement Audit Opportunities Fraud Risk Factors: Large amount of cash on hand or processed Easily convertible assets into cash Inadequate internal control over assets: Inadequate segregation of duties Inadequate oversight by management Inadequate system of authorization and approval of transactions Inadequate physical safeguard over cash, investment, inventory or fixed assets Inadequate access controls over automated records 31 Rationalization If I Benefit, Others Also Benefit Issue of Entitlement Feel Poorly Treated by Someone I Can Correct it at a Later Time Poor Ethics Decision Process I Will Only do it Once Confident I Will Not Get Caught 32 AU 240 Consideration of Fraud in a Financial Statement Audit Rationalizations Fraud Risk Factors: Behavior indicating displeasure or dissatisfaction with the entity or its treatment of employees The belief by some in the organization that their level of authority justifies a certain level of compensation and personal privileges Organization tolerates petty theft Describe Asset Misappropriation as it Relates to Occupational Fraud 33 34 The Insider Threat Majority of frauds committed against organizations are perpetrated by employees Most internal fraudsters have been with their employer for more than five years and are often seen as trusted employees Who Commits Fraud? A major factor that often directly causes organizations to become victims of fraud is the trust factor Many employees exploit this trust to commit fraud against their employers Rookie criminals never stole a dime from anyone until they committed fraud against the company Others that are well known in the organization and have never been known to do anything illegal or unethical 35 36 6

Asset Misappropriation Red Flags Asset Misappropriation - Poor Internal Controls Example Dissatisfied or Upset Employees Past History of Fraud or Illegal Acts Existence of Employee Financial Pressures Changes in Lifestyle or Behavior Koss Corporation: Designer and marketer of stereo phone earphones CFO embezzled $31 million of the company s cash over 6 years Poor internal controls CFO used company funds to support an elaborate life style CFO charged personal items on her corporate American Express card Made wire transfers of company cash to pay the American Express bills 37 38 Asset Misappropriation - Poor Internal Controls Example Koss Corporation: The payments to American Express were charged to cost of sales CFO was a 17 year veteran of the company highly respected and trusted Misappropriation of Asset Frauds 1. Procurement and Payment Processes 2. Payroll 3. Revenue and Cash Receipts 4. Expense and Cash Disbursements se e Board and management paid little attention to the finances of the company Poor internal controls and poor segregation of duties 5. Accounts Receivable 6. Bribery and Corruption The company received unqualified audit opinions during the period of the fraud 39 40 1 -Procurement and Payment Processes Check Fraud Billing Fraud Check Fraud Favored Vendor Fraud Fictitious Vendor Fraud Conflict of Interests Some of today s most common types of check fraud: Creating Forged Checks Check Interception and Forged Endorsement Check Altering by Inserting Numbers or Letters Theft of Assets Hidden Check Fraud Automated Clearing House (ACH) Fraud 41 42 7

Fictitious Employees Payroll Office Fraud Inflated Hours Fraud COBRA Fraud 2 - Payroll COBRA Fraud Employee resigns or is terminated Human resources conducts the exit interview Employee leaving signs up to continue their health care coverage through COBRA Employee leaving is instructed to deliver the payment to HR staff to extend the coverage for the next month Accounting personnel are left out of the cash receipt process HR staff open up a bank account and deposits the ex employee s checks 43 44 3 - Revenue and Cash Receipts Skimming Kiting Skimming Skimming takes place when cash is removed from the company before it enters the accounting system. Examples include: Unrecorded sales Understated sales Theft of incoming checks Temporarily intercepting customer checks, depositing the money, earn interest, then after a time remove the money and apply it against the customer s account 45 46 Kiting Kiting or float is when cash is deposited in more than one bank account and the cash is either non-existent or in transit Fraudster is living off of the float. The fraud scheme can only be maintained by developing larger and larger false deposits The fraudster is just buying time hoping to be able generate enough cash from other sources to eventually pay any amounts overdrawn 4 - Expense and Cash Disbursements Procurement Cards Dummy Vendors ACH 47 48 8

5 Accounts Receivable Lapping Lapping Fictitious receivables (fictitious sales) Improper posting of credits Borrowing against accounts receivable (personal borrowing) Lapping exists when an employee steals a customer payment and then applies future payments from other customers to the original customer 49 50 6 Bribery and Corruption Bid rigging No-bids Substandard products Product substitution Inflated prices Fictitious invoices Summarize the 2012 Report to the Nations from the Association of Fraud Examiners 51 52 2012 Report to the Nations The typical organization loses 5% of its revenue to fraud each year The frauds reported in the study lasted a median of 18 months before being detected The industries most commonly victimized were the banking and financial services, government and public administration, and manufacturing Fraudsters with higher levels of authority tend to cause significantly larger losses The longer a fraudster has worked for an organization, the higher the fraud losses tend to be Most fraudsters are first-time offenders with clean employment histories Areas of fraud identified in the study include billing, expense reimbursements, check tampering, payroll and disbursements Identify Common Internal Control Weaknesses 53 54 9

Common Internal Control Weaknesses Lack of segregation of duties Lack of physical safeguards Lack of independent checks and observations Lack of proper authorization on documents and records Overriding existing controls Poorly designed accounting systems 55 10