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Fraud 101


Fraud 101 Financial Fraud MGT 506-1 Course Overview Fraud Quiz Fraud Quiz (2) So, What Is Fraud? Black s Law Dictionary Intentional perversion of truth False ... – PowerPoint PPT presentation

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Title: Fraud 101

Fraud 101
  • Financial Fraud
  • MGT 506-1

Course Overview
Fraud Quiz
How many public companies over the last five
years had to restate their financial statements
due to material accounting irregularities?
Historically, what percentage of CFOs report that
the CEO has pressured them to misrepresent
A business school study showed what percentage of
CEO participation in SEC enforcement actions
involving fraud?
What percentage of SEC enforcement actions
involving fraud were perpetrated by senior
Fraud Quiz (2)
  • According to government and private studies, how
    much does the average company lose in terms of
    percentage of revenue to fraud and abuse?
  • Illustration Manufacturing Company A has 100
    million revenues earns 30 million per year.
    Comparable companies sell at 4x EBITDA
  • 1. What is 6 of Company As revenues?
  • What is the potential uplift if all fraud could
    be eliminated?
  • What is the potential percentage increase in
  • What is the potential uplift in enterprise value?

So, What Is Fraud?
  • Blacks Law Dictionary
  • Intentional perversion of truth
  • False representation of a matter of fact
  • Whether by words or conduct
  • False, misleading, concealment of that which
    should have been disclosed
  • For the purpose of inducing another
  • In reliance upon perversion of truth
  • To part with some valuable thing belonging to him
    or to surrender a legal right

So, What Is Fraud?
  • Blacks Law Dictionary
  • An intentional perversion of truth for the
    purpose of inducing another in reliance upon it
    to part with some valuable thing belonging to him
    or to surrender a legal right a false
    representation of a matter of fact, whether by
    words or by conduct, by false or misleading
    allegations, or by concealment of that which
    should have been disclosed, which deceives and is
    intended to deceive another so that he shall act
    upon it to his legal injury.

Perspectives On Fraud Prosecutors, Regulators
  • By the Corporation
  • Corporation as victimizer
  • Corporation benefits
  • Financially
  • Other
  • Corporation subject to potential civil and/or
    criminal liability
  • Against the Corporation
  • Corporation as victim
  • Corporate risks
  • Financial
  • Legal, and
  • Reputation
  • Potential civil recovery by Corporation

Perspectives On Fraud Bad Fraud Good Fraud
  • Bad Fraud
  • Acquirer Overpays
  • Earnings management
  • False revenue recognition schemes
  • Costs and expenses schemes
  • Understatement of liabilities
  • Illegal conduct
  • Liability for past conduct
  • Impact upon future earnings
  • Good Fraud
  • Acquirer Underpays
  • Misconduct that if discovered, reduces costs and
    increases earnings

Perspective On FraudPost-Sarbanes
Perspective On FraudPost-Sarbanes
  • Legal Regulatory Risk
  • U.S., state and foreign law
  • Sarbanes-Oxley
  • Final SEC Rules
  • FCPA et. al.
  • SAS 99
  • Financial Risk
  • U.S. Dept of Commerce/ACFE Average U.S. company
    loses equivalent of 6 of revenues to fraud
  • 6 of Revenue ?
  • Cost savings opportunities and potential
    despite statistical exaggeration
  • Reputation Risk
  • Management
  • Audit Committee
  • Audit
  • Internal Audit
  • External Audit

Roles, Responsibilities, Stakeholders
  • Management
  • C-Suite
  • Business Leaders
  • General Counsel, Ethics Compliance
  • The Board/Audit Committee
  • Oversight of prevention/mitigation
  • Supervision of special investigations
  • Auditors
  • External Auditor Integrated Audit
  • Internal Audit
  • External Audit
  • Government
  • Congress
  • SEC
  • Other Regulators
  • Federal and State Prosecutors

Fraudulent Financial Reporting a/k/a Earnings
Management, a/k/a Cooking The Books
  • Improper Revenue Recognition
  • Overstatement of Assets
  • Understatement of Liabilities
  • Management Disclosure Analysis Fraud

Common Revenue Recognition Schemes
  • Premature Revenue Recognition
  • Side agreements
  • Liberal return of product
  • Channel Stuffing
  • Fictitious Revenue Recognition
  • Fictitious sales
  • Round tripping
  • Construction Related Schemes
  • Sham related party transactions

Common Overstatement Asset Schemes
  • Cash Balance Schemes
  • Inventory Schemes
  • Inflating quantity
  • Inflating value
  • Accounts Receivable Schemes
  • Creating fictitious receivables
  • Artificially inflating value of receivables
  • Investment Schemes
  • Fictitious investments
  • Overstating value of investments

Common Understatement of Liability Schemes
  • Improper Capitalization of Expenses
  • Software development
  • Research and development
  • Start Up Costs
  • Improper Expensing of Capitalized Costs
  • Off Balance Sheet Entity Schemes
  • Overstatement of Liability Reserves (Cookie Jar

Common Misappropriation of Assets Schemes
  • Cash
  • Theft of cash receipts
  • Unrecorded/understated sales or receivables
  • Lapping
  • Fraudulent Disbursements
  • Payroll
  • Inventory
  • Fixed Assets

Expenditures For An Improper Purpose
  • Payments to Government Officials
  • Domestic payments
  • Political Campaign Violations
  • FCPA bribery payments
  • FCPA books and records violations
  • Commercial Bribery

Assets/Revenue Obtained By Fraud
  • Fraud Against Employees/Joint Venture Partners
  • Fraud Against Suppliers
  • Fraud Against Customers
  • Government
  • Commercial parties
  • Consumers
  • Sample Schemes
  • Antitrust
  • Defective pricing
  • Shipment of damaged goods

Expenses Avoided By Fraud
  • Tax Crimes
  • Failure to Pay
  • False Statements
  • Evasion
  • Fraud Against Suppliers Customers
  • Improper Labor Practices
  • Environmental, Health Safety Violations
  • Money Laundering

Senior Management Fraud
  • Use of Corporate Assets to Commit Illegal Conduct
  • Insider Trading
  • Unauthorized Compensation
  • Failure to Pay Taxes
  • Travel Expense Fraud or Abuse
  • Receipt of Free or Below Market Goods and
    Services From Vendors, Suppliers, Etc.
  • Related Party Transactions
  • Conflicts of Interest
  • CV and Academic Deception

The Legal Landscape Reactive to Proactive
  • 1970s Before Standard Reactive Approach
  • Federal Mail Wire Fraud, SEC Fraud
  • State General Business Fraud Statutes
  • Inchoate Crimes Conspiracy/Aiding Abetting
  • Corporate Criminal Liability
  • Beginning of Corporation As Cop CTRs
  • 1980s 1990s Shift Toward Proactive
  • Organized Crime Techniques Applied to Economic
  • More Specialized Criminal Legislation
  • RICO
  • Money Laundering Statute
  • Corporate As Cop Continues SARs

The 21st Century Landscape
  • Civil and Criminal Legislation
  • FCPA
  • Patriot Act
  • Sarbanes-Oxley Act of 2002
  • Rules Regulations
  • SEC Final Rules for Implementation of
  • SEC Audit Committee Rules
  • U.S. Sentencing Guidelines
  • SEC Accounting Bulleting (SAB) 99
  • Professional Standards
  • COSO I
  • Statement of Auditing Standards (SAS) 99
  • Public Company Accounting Oversight Board
    Standards For Integrated Audit
  • Institute for Internal Auditors (IIA) Standards
  • ABA Rules for Professional Responsibility

2004 Hot Topic Prevention and Timely Detection
  • What Are The Elements of An Effective Antifraud

2004 Hot Topic Prevention and Timely Detection
  • Final SEC Rules Require Antifraud Programs
  • Independent Auditor Evaluates and Tests on Annual
  • Also Relevant to Private Company, Particularly If
  • Aspires to Best Practices
  • Anticipates Public Debt Offering, IPO or Sale to
    Public Company

Snapshot of New Rules Standards
  • Migration From Federal Sentencing Guidelines to
  • FSG Define 7 Criteria of Effective Compliance
  • COSO Define Effective Controls
  • Final SEC Rules
  • Managements Assessment of Internal Controls Must
    Consider Fraud Prevention and Detection Controls
  • SAS 99
  • Requires Fraud Auditing If Antifraud Controls Do
    Not Adequately Mitigate Fraud Risk
  • Proposed PCAOB Standard
  • Evaluation/ Testing of Design and Operating
    Effectiveness of Antifraud Programs and Controls
  • Mandatory Significant Deficiency If Internal
    Audit or Risk Assessment Is Inadequate, of If
    Senior Management Engages in Fraud of Any
    Magnitude (126)

Applying The COSO Framework
  • Control Environment
  • Code of conduct/ethics
  • Ethics hotline
  • Hiring and promotion
  • Audit committee oversight
  • Investigative process
  • Remediation
  • Fraud Risk Assessment
  • Systematic process
  • Level within organization
  • Likelihood and significance
  • Control Activities
  • Linking controls to identified fraud risks
  • Information/Communication
  • Information systems technology
  • Knowledge management
  • Training
  • Monitoring
  • Ongoing monitoring by management
  • Separate after the fact evaluations by internal

Special Emphasis Is Placed On The Control
  • Codes of Conduct / Ethics
  • Must Meet Requirements of Final SEC Rules
  • Should Apply to All Accounting and Financial
    Oversight Personnel
  • Must Be Communicated Effectively
  • Whistleblower Hotlines
  • Must Meet Requirements of Final SEC Rules
  • Audit Committee Oversight and Independent of
  • Hiring and Promotion Procedures
  • Background Investigations for Persons of Trust
  • Also Consider Process for Agents, Vendors, Etc.
  • Audit Committee Oversight
  • Passive Not Adequate
  • Active Discussion of Fraud
  • Investigation / Remediation
  • Standard Investigative Process
  • Adequate Remediation to Prevent Recurrence

Companies Must Now Specifically And Explicitly
Assess Fraud Risk
  • Systematic Rather Than Haphazard or Informal
  • Scheme and Scenario Approach
  • Address
  • Financial reporting
  • Misappropriation of assets
  • Expenditures and liabilities for improper
  • Fraudulently obtained revenues and assets, and
    costs and expenses avoided by fraud
  • Fraud by senior management
  • Extend to Business Unit and Significant Account
  • Likelihood Identify Fraud Risks That Are More
    Than Remote
  • Significance Identify Fraud Risks That Are More
    Than Inconsequential in Amount
  • Consider Risks of Management Override

Linking Control Activities To Fraud Risk
  • Management Should Identify Processes, Controls,
    and Other Procedures That Are Needed to Mitigate
    Identified Risks
  • Should Occur Throughout Organization, at All
    Levels and in All Functions
  • Very Broad, e.g., Approvals, Authorizations,
    Verifications, Reconciliations, Segregation of
    Duties, Reviews of Operating Performance,
    Background Investigations, Physical Security

Sample Tools Incentives Inventory
Incentives Pressure Attitudes/ Rationalization Opportunity to Commit Potential Scheme
Audit committee
In-house counsel
President of BU A
Controller of BU A
VP of Sales
Sample Tools Opportunities Inventory
Financial Statement Fraud Misappropriation of Assets Expenditure Liabilities for an Improper purpose Revenue and Assets Obtained By Fraud Financial Misconduct By Senior Mgmt
Senior management
Management Unit A
Treasury cycle
Revenue cycle
Purchasing cycle
Investments cycle
Inventory cycle
Payroll cycle
Management Unit B
Sample Tools Fraud Risk Matrix
Description of Fraud Risk (from Incentives and Opportunities Inventories) Likelihood (Remote, More Than Remote, Reasonably Possible, Probable) Significance (Inconsequential, More Than Inconsequential, Material) Preventive Control Activity Detective Control Activity

Information and Communication
  • Information Systems Technology Controls
  • Technology enabled fraud , e.g., holding books
  • Prevention and detection of unauthorized access
  • Inappropriate modification of computer programs
  • System override
  • Ability to investigate computer misuse
  • Knowledge Management
  • Identified fraud risks
  • Strengths and weaknesses of antifraud control
  • Suspicions and allegations about fraud and
  • Remediation efforts.
  • Training
  • Frequency
  • Scope and sufficiency

Fraud Monitoring and Auditing
  • Management On-going, Day to Day Monitoring
  • Embedded into normal operating activities
  • Includes regular management and supervisory
  • Should leverage available information technology
  • Internal Audit Separate, After-the-Fact
  • Scope and frequency contingent upon risk and
    effectiveness of ongoing monitoring
  • Must address fraud risk in planning and executing
    internal audit cycle
  • IA must include knowledgeable and experienced
    fraud professionals
  • Fraud auditing is different than forensic

Fraud Auditing Is Different From Fraud
Determination by Area
Determination by Scheme
Determine area of operations at risk
Determine schemes to which you are most vulnerable
Identify potential fraud schemes
Identify units/processes where schemes most
likely to occur
Identify red flags and indicators associated with
Build audit steps to search for indicators
Analytics, External and Internal Interviews,
Tests of Details, Computer Assisted Auditing
Conduct further inquiry if red flag is detected
or suspected
Next Week Improper Revenue Recognition
  • Team Assignments
  • Team A Xerox
  • Team B Lernout Hauspie
  • Team C Dynergy
  • Team D Qwest Communications
  • Team E Royal Ahold
  • Components
  • Describe Fraud Scheme Resolution With
  • How Was It Detected?
  • What Went Wrong, e.g.No Controls / Circumvention
    / Override?
  • How Can This Type of Scheme Be Prevented or
    Timely Detected?