Fraud and Forensic Accounting

The Basics

October 23, 2008

Economic Crime Institute

Dr. Richard A. (Dick) Riley

West Virginia University

Tanner Distinguished Professor of Public Accounting

Opening RemarksOpening Remarks

In God We Trust

Everyone Else, We Examine

Adapted from Michael Connelly’s Void Moon

Ronald Reagan: Trust, but Verify

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Definitions and InterrelationshipsDefinitions and Interrelationships

Internal and External

AuditingPlanning

Risk AssessmentInternal controlsAudit Evidence

Reporting

Forensic Accounting

Accounting and Legal Matters

FraudPrevention and Deterrence

DetectionInvestigationRemediation

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Intersection of accounting and the lawasset misappropriation

corruption / abuse / conflicts of interest

financial statement fraud (fraudulent representations)

broader legal engagements – civil litigation

Forensic AccountingForensic Accounting

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Prevention & DeterrenceDetectionInvestigationRemediation

Fraud ProfessionalFraud Professional

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F/S free from material misstatement

– Planning– Risk Assessment– Internal Controls– Audit Evidence– Reporting

AuditingAuditing

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Working knowledge of:AccountingThe legal systemCriminologyInvestigative Techniques

Detail orientedOrganizedThink criticallyExcellent communication skills

Fraud and Forensic Fraud and Forensic Accounting SkillsAccounting Skills

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Critical Thinking ExerciseCritical Thinking Exercise

Assuming the following are true statements about a deck of cards, what can a deck of cards be likened to?

12 face cards (excluding ace) 52 cards in a deck 4 suits

Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

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Critical Thinking ExerciseCritical Thinking Exercise

What if I provide the following piece of information?

Assume that an ace has a value of 1, jack=11, queen=12 and king=13, add up the value of all 52 the cards and add one for the joker:

1+2+3+4+5+6+7+8+9+10+11+12+13=91 91 * 4 = 364 364 + 1 (joker) = 365

Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

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Critical Thinking ExerciseCritical Thinking Exercise

Assuming the following are true statements about a deck of cards, what can a deck of cards be likened to?

Source: Card Games for Smart Kids

(Margie Golick, PhD, Sterling Publishing, NY)

365 12 face cards 52 cards in a deck 4 suits

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Critical Thinking ExerciseCritical Thinking Exercise

Assuming the following are true statements about a deck of cards, what can a deck of cards be likened to?

Source: Card Games for Smart Kids

(Margie Golick, PhD, Sterling Publishing, NY)

365 12 face cards 52 cards in a deck 4 suits

Days in a year Months in a year Weeks in a year Seasons in a year

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Critical Thinking ExerciseCritical Thinking Exercise

Final question about a deck of cards?

Why is the ace, the card with the lowest numerical value, considered more valuable than the king in most cards games?

Source: Card Games for Smart Kids

(Margie Golick, PhD, Sterling Publishing, NY)

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Critical ThinkingCritical Thinking

What is the lesson learned?

(1) Persons who commit fraud do not think like us so we need to be flexible in how we approach other people’s worlds! A question of values…

(2) Pull on a thread…sometimes it’s that one little piece of data that makes it all make sense. Keep digging, gathering information until you have an adequate explanation?

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Investigating FraudInvestigating Fraud

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What would you do?What would you do?

Thomas Coughlin– Vice-Chairman of Walmart

– Long-time Family Friend of Sam Walton

– Need: Alligator Books, Dog Pen, Hunting Vacations

– Is it OK to Make Walmart Pay for this? Division ofAccounting

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What would you do?What would you do?

Losses?

Income?

Division ofAccounting

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Estimated Losses to the US Estimated Losses to the US EconomyEconomy

$994 Billion

7% Revenue25% losses > $1M

ACFE 2008 Report to the Nation:

Occupational Fraud

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Length of Time With CompanyLength of Time With Company

Less Than 3 Years…………………..26 Percent 3-5 Years……………………………14 Percent 5-10 Years………………………….. 30 Percent 10-20 Years………………………… 20 Percent Over 20 Years……………………… 10 Percent

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Perpetrators’ AgesPerpetrators’ Ages

Under 26 Years Old……………...……14 Percent 26-35 Years Old……………………… 28 Percent 36-45 Years Old……………………… 36 Percent 46-55 Years Old……………………… 12 Percent Over 55 Years Old…………………… 10 Percent

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Fraud ObservationsFraud Observations

1. ** People who commit fraud never stop. It’s hard to be dishonest the first time; but once one crosses the line, he or she

never stops until caught.

2. Embezzlers seldom save their stolen goods.

3. *** Embezzlers get more greedy and sloppy over time.

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Size of Victim OrganizationSize of Victim Organization

Size Percent Dollars

< 100 employees 46% $98,000

100-999 21% $78,500

1,000-9,999 20% $87,500

10,000+ 13% $105,500

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Type of FraudType of Fraud

Type Frequency Dollars

Financial Statement Fraud

8% $1,000,000

Corruption 30% $250,000

Theft of Cash / Non-Cash Assets

93% $93,000

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PerpetratorPerpetrator

Perpetrator Percent Dollars

Owner / Executive

12% $900,000

Manager 34% $140,000

Employee 68% $62,000

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DiscoveryDiscovery

Discovery Percent Dollars

Tip / Accident 61% $120,000

Internal Audit 24% $98,000

Internal Control 18% $40,000

External Audit 11% $113,500

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Who Commits FraudWho Commits Fraud --DemographicsDemographics

Married Active Church

Members Children

Conclusion:

Good Education First-Time Offenders Good Employees Don’t Abuse Alcohol

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GenderGender

Male……………..53 Percent $160K Female…………. 47 Percent $60K

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Why People Commit FraudWhy People Commit Fraud

FraudTriangle

Perceived Pressure

Perceived Opportunity Rationalization

+

+

+

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The Accidental Fraudster

The Predator

Why People Commit Fraud?Why People Commit Fraud?

The Accidental Fraudster

The Predator!

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Why People Commit Fraud?Why People Commit Fraud?

MICE

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Why People Commit FraudWhy People Commit Fraud

FraudTriangle

Perceived Pressure

Perceived Opportunity Rationalization

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+

+

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Elements of FraudElements of Fraud

The Act

Concealment Conversion

Which element of fraudis easiest to identify?

- The Act- Concealment- Conversion

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Elements of FraudElements of Fraud

The Act

Concealment

Conversion

Search for the strongest possible evidence.

1. Surveillance2. Invigilation - baseline3. Physical Evidence

1. Public Records2. Direct3. Indirect: e.g., Net Worth Analysis

1. Fraud Auditing2. Document Examination3. Physical Asset Counts4. Computer Searches

+ Inquiry Methods1. Interviewing/ Interrogation2. Honesty Testing

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Fraud DetectionFraud Detection

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Professional SkepticismProfessional Skepticism

A recognition that fraud may be present

An attitude that includes a questioning mind and a critical assessment of audit evidence – Pull on the threads!

A commitment to persuasive evidence (whether or not fraud is present) – Go that extra mile

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Assuming the Fraud May Be Assuming the Fraud May Be PresentPresent

Process to:

(-) Identify the possibility of fraud

(-) Convincingly resolve any badges, symptoms, red flags of fraud

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Consider theConsider theRisk of FraudRisk of Fraud

Brainstorm

Consider how and where financial information might be susceptible to fraud

Consider how and where fraud might be hidden – Targeted Risk Assessment

Exercise professional skepticism!

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Red Flags - ApproachRed Flags - Approach

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Targeted Fraud Risk Targeted Fraud Risk Assessment ProcessAssessment Process

Step 1. Identify your business processesStep 2. Consider differences in those processes in foreign operations, as well as among subsidiaries or decentralized divisionsStep 3. Identify the “Process Owner” for each of the identified processesStep 4. Review fraud experience within the company and by processStep 5. Process Owners identify how fraud may occur in each process at each location using Fraud Brainstorming TechniquesStep 6. Identify the Parties who have the ability to commit the potential fraudStep 7. Process owners evaluate the likelihood that each of the identified frauds could occurStep 8. Determine the level of mitigation so as to prevent, detect and deter fraudStep 9. Investigate the characteristics of potential fraud manifestations within each process identifiedStep 10. Quantify Fraud Risk

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Obtain information needed to Obtain information needed to identify risk of fraudidentify risk of fraud

Interview ownership, management, internal auditors, clericals – carefully document statements

Consider results of analytical and preliminary examination procedures

Consider badges, symptoms and red flags of fraud

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Consider Policies, Procedures and Consider Policies, Procedures and ControlsControls

Understand the internal control environment

Evaluate whether policies, programs and controls are operational

Evaluate whether policies, programs and controls address the identified risks of fraud

Draw conclusions about the risk of fraud

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Respond to Results of the Respond to Results of the AssessmentAssessment

As risk increases

Overall response:– More creativity– More non-financial performance metrics

Specific response:– Consider need to gathering additional evidence:

the nature and extent of examination procedures

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Evaluate Examination EvidenceEvaluate Examination Evidence

Assess risk of fraud throughout the examination

Evaluate results of analytical and examination procedures performed

Re-evaluate risk of fraud near completion of fieldwork

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Draw ConclusionsDraw Conclusions

Obtain explanations for errors, misstatements / omission and other irregularities

Corroborate explanations

Make judgment:– Consult with manager– Consult with Fraud Technical Advisor

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Communicate about FraudCommunicate about Fraud

Document findings

Write report

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The Power of Non-Financial DataThe Power of Non-Financial Data

– The power of using non-financial data to corroborate financial information cannot be understated:

Laundromat electricity usage Laundromat cycle time Gas produced Tons of minerals mined Invoice details (beer)

– The Science NORA (Non-Obvious Relationship Analysis) Data mining technique

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The Power of Non-Financial DataThe Power of Non-Financial Data

– The world revolves around p*g:

p = price q = quantities

– - Break down activity into p’s and q’s

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Reasons Why Fraud Reasons Why Fraud Investigations FailInvestigations Fail

Lack of Factual Development (not proven intent)

Reliance on “Bad Person” Theory

* Pointing to Frivolous Arguments without Developing Complete Case

InterviewingInterviewing

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InterviewingInterviewing

Combination of– Good questions!– Careful observations!– Good listening!– Documenting Results!

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Judging DeceptionJudging Deception

People are generally poor judges of deception.

Most people only correctly identify about 50% of the lies to which they are exposed.

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Remember!!Remember!!

No single symptom or behavior proves anything because even truthful subjects can generate a random symptom that is of no consequence.

Look for a “cluster” of symptoms – two or more behaviors occurring at the same moment

The behaviors should be “timely” in that they should occur or will occur at the same moment the mental and emotional stress level of the subject either peaks or dramatically ceases. 

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Fraud and Forensic AccountingFraud and Forensic Accounting

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