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1/22/2014
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Proactive Data Analysis Techniques to Find Financial Statement Fraud
Special Guest Presenter: Richard Cascarino, CFE, CIA, CISM, CRMA Richard Cascarino & AssociatesJan 22, 2014
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President and Founder of White Collar Crime 101
• Publisher of White-Collar Crime Fighter• Developer of FraudAware® Anti-Fraud Training • Monthly Columnist, The Fraud Examiner, ACFE Newsletter
Member of Editorial Advisory Board, ACFE
Author of “Fraud in the Markets”
• Explains how fraud fueled the financial crisis.
About Peter Goldmann, MSc., CFE
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About Jim Kaplan, MSc, CIA, CFE
• President and Founder of AuditNet®, the global resource for auditors (now available on Apple and Android devices)
• Auditor, Web Site Guru,
• Internet for Auditors Pioneer
• Recipient of the IIA’s 2007 Bradford Cadmus Memorial Award.
• Author of “The Auditor’s Guide to Internet Resources” 2nd Edition
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• Principal of Richard Cascarino & Associates based in Colorado USA
• Over 28 years experience in IT audit training and consultancy
• Past President of the Institute of Internal Auditors in South Africa
• Member of ISACA
• Member of Association of Certified Fraud Examiners
• Author of Auditor's Guide to Information Systems Auditing
About Richard Cascarino, MBA, CIA, CISM, CFE
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This webinar and its material are the property of FraudResourceNet LLC. Unauthorized usage or recording of this webinar or any of its material is strictly forbidden. We are recording the webinar and you will be provided with a link access to that recording as detailed below. Downloading or otherwise duplicating the webinar recording is expressly prohibited.
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The views expressed by the presenters do not necessarily represent the views, positions, or opinions of FraudResourceNet LLC (FRN) or the presenters’ respective organizations. These materials, and the oral presentation accompanying them, are for educational purposes only and do not constitute accounting or legal advice or create an accountant‐client relationship.
While FRN makes every effort to ensure information is accurate and complete, FRN makes no representations, guarantees, or warranties as to the accuracy or completeness of the information provided via this presentation. FRN specifically disclaims all liability for any claims or damages that may result from the information contained in this presentation, including any websites maintained by third parties and linked to the FRN website
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Disclaimers
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Introduction: Fraud Statistics: The Growing Fraud Threat
Where & How Financial Statement Fraud Occurs
Detection/Auditing/Investigative Techniques –Including Automation
Entity-Level Red Flags of Fraud Prevention and Deterrence Your Questions Conclusion
Today’s Agenda
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According to major accounting firms, professional fraud examiners and law enforcement: jumps significantly during tough economic times
Business losses due to fraud increased 20% in last 12 months, from $1.4 million to $1.7 million per billion dollars of sales. (Kroll 2010/2011 Global Fraud Report)
Average cost to for each incident of fraud is $160,000 (ACFE) Of Financial Statement fraud: $2 million
Approx. 67% of corporate fraud committed by insiders (Kroll)
Approx. 50% of employees who commit fraud have been with their employers for over 5 years (ACFE)
Fraud: The Big Picture
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Victims of financial fraud are stakeholders with claims against the entity: shareholders, lenders, regulators.
Financial fraud occurs less frequently than asset misappropriation but the losses are substantially higher.
Financial Statement Fraud: The Big Picture
Source: ACFE 2008 Report to the Nation
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Selling More (Overstating revenue)
Costing Less (Understating/not reporting expenses)
Owing More (Overstating debt to reduce taxes)
Owing Less (Understating debt to boost share price)
Inappropriate Disclosure (Depreciation/asset value, etc)
Other Miscellaneous Techniques (Concealment)
Accounting Fraud
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Falsification, alteration, manipulation of material financial records, supporting documents or business transactions
Material intentional omissions or misrepresentations of events, transactions, accounts or other significant information from which financial statements are prepared
Deliberate misapplication of accounting principles, policies and procedures used to measure, recognize, report and disclose economic events and business transactions
Intentional omission of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts
Jim Gravitt and Jennifer Johnson, “Recognizing Financial Statement Fraud”
Financial Statement Fraud Schemes
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Missing documents Excessive voids or credits Increased reconciliation items Alterations on documents Duplicate payments Common names or addresses of payees or
customers Increased past due accountsUnusual spikes in payables or receivablesOdd patterns in key ratios
Accounting Fraud: Red Flags
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Example: Interactive Data Extraction and Analysis
21 years young
Database limitations:
2.1 billion records (100,000 records for IDEA Express) depending on the operating system
1.8 Exabytes file size (Tera, Peta, Exa) (Quintillion)
Some facilities not available in IDEA (Server)
The Power of Automation
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Example: Orders Over Credit Limit
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1) Improper Revenue Recognition
Common Types of Financial Statement Fraud
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Backdating agreements Stock options and other time-sensitive
valuation issues that may result in fraudulently high revenue or low cost basis
Need for controls in recording contracts/sales, including independent verification of the terms of the agreement and contemporaneous recording of transactions when they are approved
Need for in-house legal, corporate board approval
Revenue Recognition
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Sham Sales
Falsify inventory records, shipping records, and invoices and record the fictitious transactions as sales
Company may pretend to ship the inventory and hide it from company auditors
Revenue Recognition
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Sales to Fictitious Customers
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Channel Stuffing
Shipping excess merchandise to distributors
Right of return exists/ Side agreements
Need to examine conditions of sale, analyze sales returns during cutoff period/after year-end, review of sales and contract files to determine if side agreements exist
Revenue Recognition
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Bill and Hold Schemes
Recording fictitious sales and shipping goods to third-party warehouse
Need to examine shipping documents and analyze real estate rental costs
Look for evidence of side agreements
Review inventory changes
Revenue Recognition
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Holding Books Open
Failure to match revenues with related expenses in the period in which they were incurred (CA’s “35-day month)
Examine cut-off procedures for month, quarter and year-end
Need for oversight and approval controls in recording contracts/sales
Revenue Recognition
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Not Recording Detailed Transactions on Sub-ledger
Overstating Sales and A/R
Where sub-ledger does not reconcile to General Ledger control account
Examine reconciliation and top-side journal entries
Revenue Recognition
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A side agreement would NOT be a typical part of which of the following:
Channel Stuffing
Holding the Books Open
Bill and Hold Schemes
All of the above
Polling Question 1
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2. Management Estimates
Common Types of Financial Statement Fraud
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Allowance for Bad Debts
Altering underlying A/R aging to manipulate computation
Refreshing of receivables by writing off aged A/R and booking new, fictitious sales
Use of credit memos
Analyze Bad Debt expense and Sales accounts, looking for similar levels of transaction activity for the same customers
Management Estimates
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A/R Inquiries
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Overstatement of assets by:
Understating allowances for receivables
Overstating the value of inventory, property, plant, equipment, and other tangible assets,
Recording assets that did not exist
Management Estimates
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Fraudulent Input from Sales orCredit Department on Credit
Quality
Lack of independent review of customer’s creditworthiness
Inadequate documentation in credit file
Credit analyses should be performed by individuals who are independent of the sales process, periodic review of credit files
Management Estimates
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3. Expense Manipulation
Common Types of Financial Statement Fraud
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Under-Accruing Expenses
Lack of monthly or quarterly reconciliation of accruals to actual amounts
Charging accrual “true-ups” to other, infrequently-used accounts
Compare monthly accruals to actual expenses and cash disbursements, noting variations in the adequacy of accruals
Capitalizing expenses
Expense Manipulation
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Expense Examination
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Overstating assets can be achieved by (Choose all that apply):
A. Understating allowances for receivables
B. Overstating the value of inventory, property, plant, equipment, and other tangible assets
C. Recording assets that do not exist
D. All of the above
Polling Question 2
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Not Recording Expenses
Paying unrecorded expenses must be offset by not paying other expenses
Need to ensure adequate segregation of duties in the receipt of invoices and the recording of expenses, review invoice file for past due invoices and collection notices
Expense Manipulation
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Not Recording DetailedTransactions on Sub-ledger
Understating Expenses and A/P
Where sub-ledger does not reconcile to General Ledger control account
Examine reconciliation and search for unrecorded expenses
Expense Manipulation
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Capitalizing Expenses
Moving expenses from the P&L to the Balance Sheet and amortizing them over an extended period
WorldCom – telecom line charges
Examine capitalized asset accounts for year-on-year changes
Expense Manipulation
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Changing InventoryValuation Methods
May result in lower COGS and higher sales margins
Review calculation of inventory valuation and related disclosures
Expense Manipulation
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Manipulating Non-CashExpenses
Changing depreciation and amortization methods
Review calculation of depreciation and related disclosures
Expense Manipulation
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Moving expenses from the P&L to the Balance Sheet is a form of…
A. Improper revenue recognition
B. Expense manipulation
C. Capitalization of expenses
D. None of the above
Polling Question 3
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4. Detection and Investigative Techniques For Auditors, Fraud Investigators,
Legal Staff, HR and Senior Management
Detection and Investigation Techniques
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What are you looking for? (Avoid spinning your wheels).
Where are you going to find it?
Choose the best technique (interviewing, audit, CAAT’s)
Select the tool
Detection and InvestigationTechniques
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Where are the weakest links in the system’s controls?
What deviations from conventional good accounting practices are possible?
How are off-line transactions handled and who has the ability to authorize these transactions?
What would be the simplest way to compromise the system?
What control features in the system can be bypassed by higher authorities?
What is the nature of the work environment?
Ask These Questions…
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Be Skeptical!!!!
Analytical Procedures
Other Investigative Techniques
CAATs
Tools and Techniques
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Always request originals.
Ask yourself whether transactions make sense.
Have documents been altered?
Look to see where the documents are maintained.
Do employees have close personal relationships with vendors?
Is there a lack of supporting documentation?
Do background checks identify related parties and DBAs?
Does an answer not make sense?
Are you avoided more than usual?
When asking a relatively simple question, are you unexpectedly referred to someone high up in the organization?
Go with your gut!
BE SKEPTICAL!!!!!
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Increased scrap.
Excessive purchases.
Unexplained inventory shortages or adjustments.
Significant increase or decrease in account balances.
Cash shortages or overages.
Deviations from specifications.
Analytical Red Flags
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WorldCom’s massive accounting fraud was characterized PRIMARILY by:
A. Not recording detailed transactions on sub-ledger
B. Not recording expenses
C. Capitalizing expenses
D. None of the above
Polling Question 4
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Range from simple to complex;
Identify trends or anomalies
Four Key Steps:
1. Develop an expectation/hypothesis
2. Determine the acceptable deviation from the expected value
3. Compare the result of the analytical procedure to the expected value
4. Investigate and evaluate any significant differences
Analytical Procedures
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Unusual Financial statement ratios such as:
Increased revenues with
• decreased inventory.
Increased revenues with • decreased receivables. Increased inventory with • decreased payables. Increased volume with
• increased cost per unit.
Analytical Anomalies
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Financial Statement Analysis
Vertical – a/k/a “common-sized statements”
Analyzes each line as a % of its relevant total
Income items as a % of total revenue
Expenses as a % of total expense
Identifies disproportionate items
Identifies fluctuations between periods
Horizontal – a/k/a “time-series analysis”
Measures $ and % changes from period to period
Identifies fluctuations and seasonality
Data Analysis: Testing for Red Flags
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Data Selection.
Data Cleaning.
Data Enrichment.
Data Coding/Reduction.
Data Mining.
Interpretation/Reporting.
Action.
Measurement and Evaluation.
Knowledge Discovery
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Data Mining/Analysis
Using file interrogation software to examine underlying data
General Ledgers
Vendor files
Payroll
A/P and A/R
Data Analysis –Testing for Red Flags
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Using File Interrogation Software is an example of:
a) Data Mining / Analysis
b) Knowledge Discovery
c) Vertical Analysis
d) Horizontal Analysis
Polling Question 5
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Public Document Reviews & Background Investigations
Interviews of Knowledgeable Persons
Confidential Sources
Other Investigative Techniques
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Entity-Level Red Flags
Internal control gaps, deficiencies, weaknesses
Business results that continually outperform expectations
Management override of controls Rapid or significant turnover of
resources, especially senior management or employees in key positions
Employee, customer or vendor complaints
Inadequate segregation of duties
Unusual end‐of‐month or end‐of‐quarter variations
High‐level of related‐party transactions
Systems are manual and/or decentralized
Repeated changes of independent public accountants
Continuous problems with various regulatory agencies
Disclosures of Investigations Suspicion of illegal activities
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Prevention, Deterrence and Detection
Prevention
Tone at the top Value system (“Code of
Ethics / Conduct”) Positive workplace
environment Hiring, promoting and
retaining appropriate employees
Training and awareness programs
Confirmation / affirmation of Code of Conduct/Ethics
Ombudsman programs Whistleblower programs Incident response / case
management processes Investigative procedures Discipline, prosecution and
recovery guidelines
Prevention
Tone at the top Value system (“Code of
Ethics / Conduct”) Positive workplace
environment Hiring, promoting and
retaining appropriate employees
Training and awareness programs
Confirmation / affirmation of Code of Conduct/Ethics
Ombudsman programs Whistleblower programs Incident response / case
management processes Investigative procedures Discipline, prosecution and
recovery guidelines
Deterrence
“Active” oversight by Board and/or Audit Committee
– Fraud risk assessment and related measures
– Code confirmation / affirmation process
– Management’s involvement in financial reporting process and override of control
– Process to receive, retain and treat complaints of fraud / unethical conduct
– Internal and external audit effectiveness
Internal audit– Evaluation of adequacy /
effectiveness of internal controls
Disciplinary examples
Detection
Identification and measurement of fraud risk (“fraud risk assessment”)
Processes &procedures to mitigate identified fraud risk
Effective internal controls at entity and process level
On-going monitoring activities
Computer-assisted audit techniques
Investigation of:– Internal control
weaknesses / breaches– Non-response to Code
confirmation / affirmation– Reported issues
Detection
Identification and measurement of fraud risk (“fraud risk assessment”)
Processes &procedures to mitigate identified fraud risk
Effective internal controls at entity and process level
On-going monitoring activities
Computer-assisted audit techniques
Investigation of:– Internal control
weaknesses / breaches– Non-response to Code
confirmation / affirmation– Reported issues
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CAATs IDEA
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CAATs ACL
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Common Analytical Mistakes
Failure to maintain proper documentation Failure to notify decision makers Failure to control digital evidence Failure to report incidents in a timely manner Underestimating the scope of the incident No incident response plan in place Technical mistakes: Altering date and time stamps on evidence systems before
recording them Killing rogue processes Patching the system back together before investigation Not recording commands used Using untrusted commands and tools Overwriting evidence by installing tools
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Questions?
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Peter Goldmann
FraudResourceNet LLC
800-440-2261
www.fraudresourcenet.com
Jim Kaplan
FraudResourceNet LLC
800-385-1625
www.fraudresourcenet.com
Richard Cascarino
Cascarino Associates
Thank You!