Internal Controls to Prevent and Detect Fraud
6 likes7,369 views
The document discusses internal controls to prevent and detect fraud from a forensic accountant's perspective. It provides definitions of fraud, outlines common fraud techniques like improper revenue recognition, and describes fraud risk factors such as an employee living beyond their means. The document also discusses establishing strong control environments, implementing antifraud controls and activities, ensuring proper information and communication, and monitoring for fraud through analytical reviews and fraud detection procedures. Strong internal controls, following up on red flags, and creating an ethical organizational culture can help prevent and detect occupational fraud.
Internal Controls to Prevent and Detect Fraud
- 1. INTERNAL CONTROLS TO PREVENT AND DETECT FRAUD A Forensic Accountant’s Perspective FINANCIAL FORENSICS
- 3. Black’s Law Dictionary - “Fraud is a generic term, and embraces all the multifarious means which human ingenuity can devise, which are resorted to by one individual, to get an advantage over another by false representations. No definite and invariable rule can be laid down as a general proposition in defining fraud, as it includes surprise, trickery, cunning and unfair ways by which another is cheated. The only boundaries defining it are those which limit human knavery.” Legal Elements of Fraud - 1. A material false statement 2. Knowledge that the statement was false when it was made 3. Reliance on the false statement by the victim, and 4. Damages as a result FINANCIAL FORENSICS
- 4. - The use of one’s occupation for personal enrichment - The misconduct of employees, managers and executives - Internal fraud FINANCIAL FORENSICS
- 5. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, a. To employ any device, scheme or artifice to defraud, b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or c. To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase of sale of any security. FINANCIAL FORENSICS
- 6. O c c u p a tio n a l F r a u d a n d A b u s e A ss e t F r a u d u le n t C o r r u p ti o n M i sa p p r o p r i at i o n S t a t em e n ts C o n f l ic t s Ill e g a l E c o n o m ic N on - B ri b e ry F i n a n c ia l o f In t e re s t G ra t u it ie s E x t o rt io n F i n a n c ia l P u r ch a s e In v o ic e A s s e t/R e ve n u e A s s e t/R e ve n u e E m p lo y m e n t S chem es K ic k b a ck s O v e rs ta te m e n t U n d e rs ta te m e n t C re d e n tia ls T im in g In te rn a l S a le s B ig R ig g in g D iffe r e n ce s S chem es D o cu m e n ts F ic titio u s R e ve n u e s E x te rn a l O th e r O th e r D o cu m e n ts C o n ce a le d L ia b ilitie s & E xpenses Im p ro p e r D is c lo su r e s Im p ro p e r A sset In v e n t o ry V a lu a tio n s C ash a n d a ll O t her A ss ets Larceny S k im m in g M is u s e Larceny C a sh S a le s R e ce iv a b le s R e fu n d s & O n H and O th e r A sset R eq. & T ra n s fe r W r ite - o ff U n re c o rd e d F ro m th e S chem es D e p o sit F a ls e S a le s & S h ip p in g U n d e rs ta te d L a p p in g S chem es O th e r F r a u d u le n t P u r ch a s in g & D is b u r s e m e n ts R e ce iv in g U n co n c e a le d U n co n c e a le d L a rc e n y B illin g P a y ro ll E xpense C h e ck R e g is te r S chem es S chem es R e im b u r se m e n ts T a m p e rin g D is b u rs e m e n ts S h e ll G host M isc h a ra c te riz e d F o rg e d C om pany E m p lo y e e s E xpenses M aker F a ls e V o id s N o n -A c c o m p lic e F o rg e d F a ls e C o m m is s io n O v e rs ta te d V endor E n d o r se m e n t R e fu n d s S chem es E xpenses P e r so n a l A lte re d W o r ke r s F ic titio u s P u r ch a s e s P ayee C o m p e n sa tio n E xpenses C o n ce a le d F a ls ifie d M u ltip le C h e ck s W ages R e im b u r se m e n ts A u th o r iz e d M aker
- 14. – Typical organization loses 5% of revenues to fraud – Median loss was $160,000 – Nearly 25% involved losses of at least $1 million – Frauds lasted a median of 18 months before detection – Asset misappropriation schemes were in 90% of cases – Financial statement schemes were less than 5% but caused median losses of more than $4 million – More likely to detected by tip – More than 80% were committed in accounting, operations, sales, upper management, customer service or purchasing – More than 85% had never been charged or convicted – Most common red flags were living beyond means and financial difficulties FINANCIAL FORENSICS
- 15. Common Financial Statement Fraud Techniques Improper Revenue Recognition 61% Overstatement of Assets 51% Understatement of Expenses/Liabilities 31% Misappropriation of Assets 14% Inappropriate Disclosures 1% Other Miscellaneous Techniques 20% Disguised Through Related Party Trans 18% Insider Trading Cited 24% FINANCIAL FORENSICS
- 16. Improper Revenue Recognition Sham sales Conditional sales Round-tripping Loans as sales Bill and hold Revenue before sale completed Improper cutoff of sales Improper use of percentage of completion Unauthorized shipments Consignment sales FINANCIAL FORENSICS
- 17. CRESSEY’S HYPOTHESIS FRAUD TRIANGLE Trusted persons become trust violators when… They conceive of themselves as having a problem which is non-sharable Are aware this problem can be secretly resolved by violation of the position of financial trust Are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons FINANCIAL FORENSICS
- 18. Opportunity Incentive/Pressure Rationalization FINANCIAL FORENSICS
- 19. Opportunity Incentive/Pressure Rationalization Capability FINANCIAL FORENSICS
- 20. Reputation Legal Strategic Operational FINANCIAL FORENSICS
- 21. Model Behavior Label Hire Behavior Assess Risk and Eliminate Opportunity Positive Communicate Policies Create Awareness FINANCIAL FORENSICS
- 22. O c c u p a tio n a l F r a u d a n d A b u s e A ss e t F r a u d u le n t C o r r u p ti o n M i sa p p r o p r i at i o n S t a t em e n ts C o n f l ic t s Ill e g a l E c o n o m ic N on - B ri b e ry F i n a n c ia l o f In t e re s t G ra t u it ie s E x t o rt io n F i n a n c ia l P u r ch a s e In v o ic e A s s e t/R e ve n u e A s s e t/R e ve n u e E m p lo y m e n t S chem es K ic k b a ck s O v e rs ta te m e n t U n d e rs ta te m e n t C re d e n tia ls T im in g In te rn a l S a le s B ig R ig g in g D iffe r e n ce s S chem es D o cu m e n ts F ic titio u s R e ve n u e s E x te rn a l O th e r O th e r D o cu m e n ts C o n ce a le d L ia b ilitie s & E xpenses Im p ro p e r D is c lo su r e s Im p ro p e r A sset In v e n t o ry V a lu a tio n s C ash a n d a ll O t her A ss ets Larceny S k im m in g M is u s e Larceny C a sh S a le s R e ce iv a b le s R e fu n d s & O n H and O th e r A sset R eq. & T ra n s fe r W r ite - o ff U n re c o rd e d F ro m th e S chem es D e p o sit F a ls e S a le s & S h ip p in g U n d e rs ta te d L a p p in g S chem es O th e r F r a u d u le n t P u r ch a s in g & D is b u r s e m e n ts R e ce iv in g U n co n c e a le d U n co n c e a le d L a rc e n y B illin g P a y ro ll E xpense C h e ck R e g is te r S chem es S chem es R e im b u r se m e n ts T a m p e rin g D is b u rs e m e n ts S h e ll G host M isc h a ra c te riz e d F o rg e d C om pany E m p lo y e e s E xpenses M aker F a ls e V o id s N o n -A c c o m p lic e F o rg e d F a ls e C o m m is s io n O v e rs ta te d V endor E n d o r se m e n t R e fu n d s S chem es E xpenses P e r so n a l A lte re d W o r ke r s F ic titio u s P u r ch a s e s P ayee C o m p e n sa tio n E xpenses C o n ce a le d F a ls ifie d M u ltip le C h e ck s W ages R e im b u r se m e n ts A u th o r iz e d M aker
- 23. Control Environment Antifraud Information Fraud Risk Control and Monitoring Assessment Activities Communication FINANCIAL FORENSICS
- 25. • Separation of duties • Proper authorization • Adequate documentation • Physical control over assets and information systems FINANCIAL FORENSICS
- 26. • Reviews of performance • Analyses • Reconciliations • Physical observations • Information systems • Proactive fraud detection FINANCIAL FORENSICS
- 27. • Controls which help eliminate risk factors which many lead to fraud FINANCIAL FORENSICS
- 28. Do not ignore a red flag – Studies of fraud cases consistently show that red flags were present, but were either not recognized or were recognized but not acted upon by anyone. Sometimes an error is just an error – Red flags should lead to some kind of appropriate action, i.e. an investigation by a measured & responsible person, but sometimes an error is just an error and no fraud exists FINANCIAL FORENSICS
- 29. Inc reas ing D ec reas ing purc has es from purc has es from fav ored v endor other v endors 1099s from D ec reas ing v endor c om pany quality to buy er relativ es Inc reas ing pric es A nalyt ical D ocum en ts and S ym pt om s R eco rd s Larger order quantities A ll trans ac tions eith one buy erand one v endor B uy er does n't relate w ell to other buy ers or v endors B eh avio ral S ym pt om s K ic k b a c k s In ternal C o nt ro ls U s e of unapprov ed E m ploy ee w ork v endors habits c hange Q uality B uy er building c om plaints about Tips and Lyfestyle ex pens iv e hom e purc has ed C om p lain ts S ym pt om s (bey ond produc ts ex pec tations ) U ns uc c es s ful B uy er ow ning v endor A nony m ous tips B uy er liv ing m ore ex pens iv e c om plaints about buy ers or bey ond k now n autom ibiles v endors s alary
- 30. • Trust is placed in employees • Employees have detailed knowledge of the accounting systems and their weaknesses • Management domination subverts normal internal controls • Management adds pressure to “make the numbers” • Expected moral behavior is not communicated to employees • Unduly liberal accounting practices • Ineffective or nonexistent internal auditing staff. • Lack of effective internal controls. • Poor accounting records. • Related party transactions. • Incomplete and out of date procedural documentation. • Management sets a bad example. FINANCIAL FORENSICS
- 31. • Cash flow does not match net • Decrease in the Asset Quality Index income – Noncurrent Assets, exclusive of • Receivables spike relative to sales – PPE, relative to total assets in given Days’ Sales in Receivables year • Management earning tied to • Exceptionally strong sales growth performance from one year to next • Significant increase in Gross • Low Total Accruals to Total Assets – Margin Index Working Capital, less Cash, less • High turnover of key management Current Taxes Payable, less Current • Sales allowances, warranties and Portion of LTD, less AD and other reserves out of line compared Amortization, divided by Total Assets with others in industry FINANCIAL FORENSICS
- 32. • Employee lifestyle changes • High employee turnover • Significant personal debt and • Refusal to take vacation or credit problems sick leave • Behavioral changes • Lack of segregation of duties in a high-risk (vulnerable) • Defensive area FINANCIAL FORENSICS
- 33. • Reluctance to provide information to • Weak internal control environment auditors • Unexpected overdrafts or declines in • Photocopied or missing documents cash balances • Decisions dominated by an individual or • Accounting personnel are lax or small group inexperienced • Excessive number of year-end • High employee turnover rate transactions • Compensation is out of proportion • Management displays significant • Decentralization without adequate disrespect for regulatory bodies monitoring • Excessive number of or frequent • Frequent changes in external auditors changes in checking accounts FINANCIAL FORENSICS
- 34. • Inconsistent overtime hours for a • Overtime charged during a slack cost center / department period • Overtime charges for employees • Budget variations for payroll by who normally would not have cost center / department overtime wages • Employees with duplicate Social • Employees with few or no payroll Security numbers, names, and deductions addresses FINANCIAL FORENSICS
- 35. • Excessive number of voids • Excessive or unjustified cash • Presence of personal checks in transactions petty cash • Large number of account write-offs • Sudden activity in a dormant • Bank accounts not reconciled on a account timely basis • Taxpayer complaints that they are • Unauthorized bank accounts receiving non-payment notices • Discrepancies between bank • Abnormal number of expense items deposits and postings or reimbursement to an employee FINANCIAL FORENSICS
- 36. • Remittance to PO Box • Use of consecutive invoice • Telephone does not match physical numbers address • Invoice numbers and dates do not correspond • Consistent billing in round numbers • Increasing purchases to same • Address matches employee vendor address • Incomplete vendor master information • Invoices consistently under • Unspecified consulting or other approval limits services FINANCIAL FORENSICS
- 37. • Voided or missing checks • Altered or dual endorsements • Invoices posted to inconsistent • Customer complaints regarding accounts payments • Checks used out of order • Checks payable to cash • Journal entries to cash • Altered payee on checks • Duplicate check numbers on bank • Checks payable to employees reconciliations FINANCIAL FORENSICS
- 38. • Increasing number of complaints • Abnormal inventory shrinkage about services • Purchases that bypass normal • Vendors without physical address procedures • Lack of physical security over • Charges without shipping assets / inventory documents • Excessive inventory or slow-moving • Vendor payments picked up rather inventory than having it mailed • Payments to vendors not included • High volume of purchases from on an approved vendor list new vendors • Vendor address matching employee address FINANCIAL FORENSICS
- 39. CASE STUDY #1 Asset Misappropriation - Billing Scheme • A Large retail company • Director of IT • 10-year employee • Could authorize expenditures up to $15,000 • Computer consultants contract ran out in prior year • Suspect set up computer consulting in current year budget • Created shell company and incorporated • Self approval of invoices • Losses were $365,000 • Asked AP to hold that check! FINANCIAL FORENSICS
- 40. CASE STUDY #2 Asset Misappropriation – Check Tampering • A Medium size manufacturing company • Suspect was Assistant Controller • 8-year employee • Responsible for accounts payable and payroll • Suspect has purchased new car and traveled each year • Approximately 7 years prior, suspect has tax lien • Check numbers and dates out of sequence • Vendor name on check was different than records • Losses were $650,000 • Backed up system, produced checks, restored system • Made JEs prior to period close • Removed checks from statement FINANCIAL FORENSICS
- 41. CASE STUDY #3 Asset Misappropriation - Inventory • Large parts manufacturing company • Perpetrator was warehouse manager • 18-year employee • Was considered very knowledgeable about all inventory in the warehouse • Rarely took vacations • Obtained pass word from wife • Had product picked up during third shift • Arrived early and removed inventory and shipping information from system FINANCIAL FORENSICS
- 42. CASE STUDY #4 Fraudulent Financial Reporting • Large manufacturer of computer components • CFO was 12-year employee of the company • Several years before, the company was very profitable • CFO was very aggressive in setting up loss contingency and other reserves • When there was a downturn in the economy, company needed additional financing • Loss contingencies and reserves were reversed into income • After financing obtained, company subsequently declared bankruptcy FINANCIAL FORENSICS
- 43. CASE STUDY #5 Asset Misappropriation – Skimming Sales • Chain of 10 drug stores • 5-year employee of the company and college student • Was considered a very trusted employee and friend of the family • Prescription system was not tied to cash register • Entered “no sale” to open the register for cash sales • Many times would enter “no sale” for friends and family • Closed the store and insisted on closing the register for prescription sales • Bought several cars and boat FINANCIAL FORENSICS
- 44. Implement Positive Pay and electronic and Laser Printing Check Stock Payee Positive get rid of checks Pay Reconcile Bank Open a separate Use at least 12 Statement Within Outsource your accounts for point font for A Reasonable payables incoming wire payee Time transfer Use only one Establish color, size and maximum dollar type of check for parameters each account FINANCIAL FORENSICS