Deep Dive Workshop 21507 Common Fraud Schemes

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Deep Dive Workshop 2/15/07 Common Fraud Schemes

• Frank Nekrasz, Jr., Ph.D., CFE, CPA, DABFA, DABFE

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A First Step

• FRAUD PROFILING
• A first step in preventing and detecting fraud
  within your organization is to develop base-rate
  knowledge of fraud types.
• Your base-rate knowledge interacts with the
  characteristics of your organization to help you
  develop a rational risk-based assessment of fraud.

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Primary Data Sources

• Association of Certified Fraud Examiners, Report
  to the Nation on Occupational Fraud and Abuse
  (1996, 2002, 2004, 2006)
• (See http//www.acfe.com/fraud/report.asp for
  downloads.)
• SEC Report Pursuant to Section 704 of the
  Sarbanes-Oxley Act of 2002).
• (See http//www.sec.gov/news/studies/sox704report
  .pdf.)
• Fraudulent Financial Reporting 1987-1997 An
  Analysis of U.S. Public Companies (Beasley,
  Carcello, Hermanson) (See http//www.coso.org/pu
  blications/FFR_1987_1997.PDF for download.)

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Association of Certified Fraud Examiners, Report
to the Nation on Occupational Fraud and Abuse
(1996, 2002, 2004, 2006)
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ACFEs Fraud Categories

• Misappropriation of Assets
• involve the theft or misuse of an organizations
  assets. (Common examples include skimming
  revenues, stealing inventory, and payroll fraud.)
• Corruption
• fraudsters wrongfully use their influence in a
  business transaction in order to procure some
  benefit for themselves or another person,
  contrary to their duty to their employer or the
  rights of another. (Common examples include
  accepting kickbacks and engaging in conflicts of
  interest.)
• Fraudulent Financial Statements
• falsification of an organizations financial
  statements. (Common examples include overstating
  revenues and understating liabilities or
  expenses.)

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Types of Fraud ( cases)

• Type 1996 2002 2004 2006
• Asset
• Misappropriation 81.1 85.7 92.7
  91.5
• Corruption
• Schemes 14.8 12.8 30.1 30.8
• Fraudulent F/S 4.1 5.1 7.9
  10.6
• Some may sum gt 100 due to fraud affecting more
  than one category (e.g., asset misapprop. related
  to corruption).

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Types of Fraud (median cost in 1,000s)

• Type 1996 2002 2004 2006
• Asset Misapprop. 65 80 93
  150
• Corruption 440 530 250
  530
• Fraudulent F/S 4,000 4,250 1,000
  2,000

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Occurrence Rates for Types of Frauds (2004 2006
ACFE Data Averages)
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Asset Misappropriation Cash Schemes

• Cash Larceny Intentional taking away of an
  employers cash (includes checks) without the
  consent and against the will of the employer.
• Theft of on-book cash
• Skimming Theft of cash from a victim entity
  prior to its entry in an accounting system.
• Known as off-book fraud
• No direct audit trail (since the missing cash is
  never recorded).
• Its principal advantage is its difficulty to
  detect.

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Asset Misappropriation Cash (Fraudulent
Disbursement) Schemes

• Billing Schemes The perpetrator uses false
  documentation to cause a payment to be issued for
  a fraudulent purpose
• Among the most costly and most common forms of
  occupation fraud.
• Payroll Schemes a person who works for an
  organization causes that organization to issue a
  payment by making false claims for compensation.
• Expense Reimburse Employees make false claims
  for reimbursement of fictitious or inflated
  business expenses

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Asset Misappropriation Cash (Fraudulent
Disbursement) Schemes

• Check Tampering Check tampering occurs when an
  employee converts on entitys funds by either
• Fraudulently preparing a check drawn on the
  entitys account for his own benefit or
• Intercepting a check drawn on the entitys
  account that is intended for a 3rd party and
  converting that check to his own benefit
• (One of the most common fraudulent disbursement
  schemes.)
• Register Disburse These schemes involve the
  taking of money from a cash register, however,
  when money is taken from the cash register, the
  removal of the money is recorded on the register
  tape and made to look like a legitimate
  disbursement (false refunds, false voids).

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Asset Misappropriation Detail (1,000s)

• Scheme 2004 2002 1996
• Cash Schemes 98 80 60
• Cash Larceny 80 25 22
• Skimming 85 70 50
• Fraud Disb. (total) 125 100 75
• Billing Schemes 140 160 250
• Payroll Schemes 90 140 50
• Expense Reimburse 92 60 20
• Check Tampering 155 140 96
• Register Disburse 18 18 22
• Non-Cash Schemes 100 200 100

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Cash vs. Non-Cash (scaled)

• 2006 2004 2002 1996
• Cash Schemes 71.1 77.9 89.5 86.8
• Non-Cash Schemes 19.0 6.6 9.2 13.2
• Cash Non-Cash 9.9 15.5 1.3 0.0

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Cash vs. Non-Cash Frequency
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Non-Cash Schemes

• Typically misuse and/or larceny of employers
  assets (other than cash).
• Principally inventory, equipment, supplies, and
  information.

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Frequency of Non-Cash Areas
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Corruption

• Corruption An act in which a person uses his
  position to gain some personal advantage at the
  expense of the organization he represents.
• Generally, an outsider is involved (e.g., vendor)

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Corruption

• Corruption schemes include
• Bribery
• Illegal gratuities
• Economic extortion
• Conflicts of interest

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I. Bribery

• Bribe Offering, giving, receiving or soliciting
  any thing of value to influence an official act
  (govt)
• Buys influence of the recipient
• Commercial bribery (business)
• Schemes classified in two basic ways
• Kickbacks
• Bid-rigging schemes

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II. Illegal Gratuities

• Given to reward a decision rather than influence
  it
• Decision made to benefit a person or company but
  is not influenced by any sort of payment
• May influence future decisions

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III. Economic Extortion

• Pay up or else
• Employee demands payment from a vendor in order
  to make a decision in the vendors favor

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IV. Conflicts of Interest

• Employee, manager or executive has an undisclosed
  economic or personal interest in a transaction
  that adversely affects the company
• Victim organization is unaware of the employees
  divided loyalties

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IV. Conflicts of Interest

• Distinguished from bribery in a conflict of
  interest the fraudster approves the invoice
  because of his own hidden interest in the vendor
• Direct transfer from organization to vendor to
  employee Kickback
• Direct transfer from organization to vendor and
  indirect transfer to employee (thru hidden
  economic interest) Conflict of Interest

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Frequency of Corruption Schemes
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Similarities Differences Between the Schemes

• Bribery is traditionally related to the influence
  of official acts.
• Official acts refer to acts of govt agents or
  employees
• Bribery related to business is referred to as
  commercial bribery.

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Similarities Differences Between the Schemes

• Illegal gratuities are when something of value is
  given to the employee to reward a decision rather
  than influence it.
• Similar to a bribe
• Bribe Value received before the event
• Illegal Gratuity Value received after the event

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Similarities Differences Between the Schemes

• Economic extortion involve pay up or else
  schemes.
• Similar to a bribe
• Bribe Motivated by vendor
• Economic Extortion Motivated by corrupt employee

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Similarities Differences Between the Schemes

• Conflicts of interest are a little different and
  are related to self-dealing schemes.
• No vendor may be involved
• Perp may share the wealth transfer with others

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The BIG Picture

• Asset misappropriation accounted for more than
  four out of five offenses.
• Bribery and corruption constituted about 13-30
  of the offenses.
• Fraudulent F/S were the smallest category of
  offenses (5-10 of offenses, but they tend to be
  large dollar-wise).

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Fraud Detection

• 2004 2002
• Tips from Employee 39.6 43.0
• By Accident 21.3 18.8
• Internal Audit 23.8 18.6
• Internal Controls 18.4 15.4
• External Audit 10.9 11.5
• Notified by Law
• Enforcements 0.9 1.7

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Fraud Detection

• Notice that tips account for about 40 of the
  detection methods and accidental discovery about
  20.
• Essentially, luck detects 60 and overt
  activities (IC, audits) detect 40.
• There is much room for improvement in prevention
  detection.

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Anti-Fraud Measures

• The ACFE found that organizations that used
  anti-fraud measures, such as
• fraud hotlines,
• internal audits,
• surprise audits, and
• fraud awareness/ethics training,
• had median fraud losses half the size of the
  losses for entities without these anti-fraud
  measures.

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SEC Report Pursuant to Section 704 of the
Sarbanes-Oxley Act of 2002)
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SEC Enforcement Actions (7/31-7/31 periods)
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Enforcement Action Areas

• Improper Revenue Recognition 126 36.4
• Improper Expense Recognition 101 29.2
• Business Combinations 23 6.7
• Inadequate Disclosures
• General Disclose 43 12.4
• Fail to Disclose RP Trans 23 6.7
• Non-Monetary Trans 19 5.5
• Foreign Payments 6 1.7
• Off-Balance Sheet Arrangements 3 0.9
• Non-GAAP Financial Measures 2 0.6

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Improper Revenue Recognition

• Improperly Timed Rev. Recog. 45
• Fictitious Revenue 44
• Improper Valuation 11

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Improper Expense Recognition

• Improper Capitalization/Defer
• or Lack of Accrual 43
• Overstate Ending Inventory 22
• Understate Bad Debts 17
• Restructuring/Other Reserves 15
• Fail to Record Asset Impair 4

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People Charged by SEC

• CEO 21
• President 21
• CFO 20
• Chairman 14
• Controller 9
• VP Finance 5
• COO 4
• CAO 3
• General Counsel 2

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Auditor Failures

• Failure to obtain sufficient, competent
  evidential
• matter to support audit opinion 31
• Failure to exercise professional skepticism on
  unusual,
• last minute, or related party transactions 25
• Failure to maintain independence 16
• Failure to respond adequately to red flags 13
• Failure to communicate adequately with
• predecessor auditor 5
• Failure to supervise assistants 3
• Failure to respond adequately to IC
  deficiencies 2.5
• Failure to perform appropriate inventory
  observations 1.7
• Failure to confirm accounts receivable
  sufficiently 1.7

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Fraudulent Financial Reporting 1987-1997 An
Analysis of U.S. Public Companies (Beasley,
Carcello, Hermanson)
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Preliminaries

• Time 1987-1997
• Source SEC AAERs (Accounting and Auditing
  Enforcement Releases)
• Identified nearly 300 companies involved in
  alleged instances of fraudulent financial
  reporting,
• Randomly selected 204 to serve as the final basis
  for the study.

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Length of Time

• Length of fraud period
• Mean 23.7 months.
• Median 21 months.
• Most fraud spanned across at least two fiscal
  periods.
• Only 14 issued fraudulent F/S involving a period
  less than 12 months.
• Many frauds began with a misstatement of interim
  F/S that were continued in annual F/S filings.

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Fraud Methods

• Improper Revenue Recognition 50
• Fictitious revenues 26
• Premature recognition 24
• No description 16
• Overstatement of Assets 50
• Overstate existing assets 37
• Fictitious assets/not owned 12
• Capitalized items that should
• Be expensed 6
• Not including accts. rec. overstatements due to
  revenue fraud.

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Fraud Methods

• Understatement of Exp//Liab. 18
• Misappropriation of Assets 12
• Inappropriate Disclosure 8
• Other 20

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Accounts Typically Involved

• Assets frequently misstated
• Inventory 24.2
• Accounts receivable
• (other than revenue fraud) 21.2
• PPE 15.2
• Loans/Notes receivable 11.1
• Cash 7.1
• Investments 7.1
• Patents 7.1
• Oil, Gas, Mineral reserves 7.1

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Control Environment Executives Involved

• CEO 72
• CFO 43
• CEOCFO 83
• Controller 21
• COO 7
• Other VPs 18
• BOD (non-mgt.) 11
• Lower Level Personnel 10
• Outsiders (auditors, customers) 38
• Other 12
• No titles given 15