Chapter 5

Recognizing the Symptoms of Fraud

Discussion Questions
1. With fraud, it is not always apparent that a crime has been committed. Therefore, it is
important that observers watch for red flags, or symptoms, in order to detect fraud. Without fraud
symptoms, it would be very difficult to detect fraud.
2. When internal controls are absent or overridden, an opportunity is created, and the risk for
fraud increases greatly. By focusing on the internal controls that are absent or overridden, we can
identify possible areas and suspects, helping us to detect possible fraud.
3. Accounting symptoms or anomalies involve problems with source documents, faulty journal
entries, and inaccuracies in ledgers. These also include any record, electronic or paper, that is
unusual.
4. Analytical symptoms or anomalies are procedures or relationships that are unusual or too
unrealistic to be believable. They include transactions or events that happen at odd times or
places, or that include odd procedures, policies, or practices. They also include transactions and
amounts that are too large or too small, that occur too often or too rarely, that are too high or too
low, or that result in too much or too little of something. Basically, analytical anomalies are
anything out of the ordinary.
5. Most people who commit fraud do so under financial pressure. Sometimes the pressures are
real; sometimes they represent simple greed. Once perpetrators meet their financial needs,
however, they often continue to steal, using the embezzled funds to improve their lifestyles. They
buy new cars. They buy other expensive toys, take vacations, remodel their homes, or move into
more expensive houses. Fraud investigators can detect fraud by focusing on these changes in
suspected perpetrators lifestyles.
6. Research in psychology indicates that when people (especially first-time offenders, as many
fraud perpetrators are) commit a crime, they are overwhelmed by fear and guilt. When
perpetrators feel this fear and guilt, they change their behavior. For example, a nice person
suddenly becomes mean or angry. Or a person who normally has lots of patience no longer is
patient with anyone.
Although no particular behavior signals fraud, it is the changes in behavior that signal possible
fraud. By focusing on these changes, we can identify possible perpetrators of fraud.
7. Tips and complaints are categorized as fraud symptoms rather than actual evidence of fraud
because many tips and complaints turn out to be false. It is often difficult to know what
motivates a person to complain or provide a tip. Customers, for example, may complain because

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they think they are being taken advantage of. Employees may phone in tips for reasons of malice,
personal problems, or jealousy. Tips from spouses and friends may be motivated by anger,
divorce, or blackmail. Therefore, tips and complaints must be treated with care and initially only
as symptoms of fraud, not as evidence of it. Individuals must always be considered innocent until
proven guilty.
8. Theft is the actual taking of cash, inventory, information, or other assets. Theft can occur
manually, by computer, telephone, or other electronic means.
9. Conversion has to do with selling stolen assets or converting them into cash and then
spending the cash. If the asset taken is cash, conversion is the spending of the stolen funds.
10. Concealment involves the steps taken by the perpetrator to hide the fraud. In concealment,
financial records are altered, cash or inventory is miscounted, or evidence is destroyed.
11.
a) If you are an auditor, you are responsible to report internal control weaknesses to the
Board of Directors or management. If the company is a public company then you will be
required under Sarbanes-Oxley Act, Section 404, to audit the internal controls. The
severity of the weakness will determine the extent of your reaction to a control weakness.
Auditing concepts such as materiality come to play in this decision but that discussion is
beyond the scope of this text.
b) If you believe the coworker is exhibiting signs that he or she has been committing fraud
you might report this to someone in the organization who can investigate it. Many
companies have whistle-blowing systems in place that would allow you to report this
activity anonymously. You might also investigate the opportunities for this coworker to
commit fraud. Perhaps there is inadequate segregation of duties or other control
weaknesses that the company is not aware of.
c) If you are in a position to embezzle from the company then you will want to notify
someone above you of the control weakness so that you are not tempted to take
advantage of the situation. You can present this information to your superior in the spirit
of improving the companys controls and preventing future problems.
True/False
1.

False: Analytical anomalies help to detect fraud, but they do not have to be present for fraud
to occur.

2.

True

3.

True

4.

True

5.

True

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6.

False: Analytical fraud symptoms are an excellent way to detect fraud.

7. False: Generally, people who commit fraud use the embezzled funds to improve their
lifestyle.
8.

True

9.

False: When a first-time offender commits fraud, usually he or she becomes engulfed by
emotions of fear and guilt.

10. True
11. False: Sometimes you wont be able to observe that a perpetrator has incentive, opportunity
or rationalization. Rationalization is probably the most difficult element to observe.
12. False: The fraud elements consist of the theft act, concealment, and conversion.
13. False: Auditors can best help detect fraud in concealment.
14. True
15. True
16. False: Employees and coworkers are usually in the best position to detect fraud.
17. True
18. False: The most common control problem when frauds occur is the overriding of existing
internal controls.
19. True
20. True
21. True
22. True
23. True
24. True

Multiple Choice
1.

b
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2.

3.

4.

5.

6.

7.

8.

9.

10. d
11. b
12. a
13. b
14. c
15. d
16. d
17. b

Short Cases
Case 1.
1. The business is at risk because there is no separation of duties. Cal Smith, Jr. works the
night shift alone and then accounts for and deposits the money at the bank in the morning.
2.

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Possible symptoms:
Cal has never missed a day of work.
Cal feels he is overworked and underpaid.
Numerous doughnuts are thrown away for over baking.

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3.

Cal was hired because he was friendly; he is now often angry and frustrated.
Cal has not been getting very much sleep.
Cal recently purchased the car of his dreams.

Possible steps to reduce opportunities for fraud:

Have other employees work at night.
Do not allow Cal to make the deposits or handle cash.
Force Cal to take some time off periodically.
Pay Cal more money so he does not feel overworked and underpaid.

Case 2.
It is possible that James could be committing fraud.
1. Fraud symptoms:
Outstanding bills need to be paid.
Lawsuits are pending from lack of payment.
James drives nice cars.
James has a very expensive home.
James will not update equipment.
James is known for losing his temper.
Many customers are complaining.
2. Most businesses experience customer complaints. While customer complaints are common,
they can be possible fraud symptoms, especially if customers do not believe their accounts or
charges appear appropriate. Whenever tips or complaints are received, they must be treated with
care and considered as possible fraud symptoms but not as actual evidence of fraud.
Case 3.
Several symptoms of fraud exist. The first is the fact that the ranch has a patented new breeding
technique that can increase the population from twenty to 100 steers in two years. If this is true,
why has it not been chronicled on TV or in newspapers? Next, the business has just started, and
companies with a short history are not tried and tested by the business world. Performance seems
suspicious with the immediate growth and phenomenal success. If it seems too good to be true, it
probably is. The location in Hawaii is also suspicious, since most people cannot afford to fly to
the islands and observe operations. The large growth in assets and revenues, the pressure to
invest quickly, and the fact that investors only have ten days after the initial offering to invest are
all possible signs of fraud. Furthermore, the words double your money, sure thing, and very
exclusive should tip off any educated person to the possibility of fraud.
Case 4.

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Tips and complaints are categorized as fraud symptoms rather than actual evidence of fraud
because many tips and complaints turn out to be unjustified. It is often difficult to know what
motivates a person to complain or provide a tip. Customers, for example, may complain because
they feel they are being taken advantage of. Employee tips may be motivated by malice, personal
problems, or jealousy. Tips from spouses and friends may be motivated by anger, divorce, or
blackmail. Whenever tips or complaints are received, they must be treated with care and
considered only as fraud symptoms. Individuals should always be considered innocent until
proven guilty and should not be unjustly suspected or indicted.
Case 5.
First, vendors with the same address are a symptom in the source documents. Lack of the needed
signatures is a sign of weak internal controls or the overriding of controls. The expensive stereo
system could be a sign of an extravagant lifestyle, and these symptoms could indicate the
existence of fraud.
Case 6.
The potential for fraud is high in this situation. When one person is responsible for collecting and
depositing cash and adjusting account balances, fraud can easily occur. There is a serious lack of
segregation of duties. One solution might be to segregate Joannes duties. One employee should
open cash receipts and prepare a cash listing. Another employee should update customer
balances, and a third, possibly one of the owners, should make bank deposits.
Case 7.
Auditors are often criticized for not detecting more frauds. Yet, because of the nature of fraud,
auditors are often in the worst position to detect its occurrence. Remember that the three
elements of every fraud are theft act, concealment, and conversion. Who in an organization is in
the best position to recognize fraud in each of these elements? Certainly, with the theft act, it is
not the auditors. Auditors are rarely present when funds are stolen or fraud is committed. Rather,
they spend one or two weeks on periodic audits, and thefts typically stop during the audit
periods. Instead, coworkers, managers, and other employees are usually in the best position to
detect fraud in the theft act stage.
In concealment, auditors do have a chance to detect fraud. If audit samples include altered
documents, miscounts, or other concealment efforts, auditors may detect fraud. Similarly, they
may see internal control weaknesses or analytical relationships that do not make sense. However,
company accountants and even coworkers are probably in a better position to detect fraud in
concealment.
At the conversion stage, the auditors are definitely not in the best position to detect fraud. There
is no way, for example, that auditors could recognize certain changes, such as an employee who

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used to drive a used Ford Focus now drives a new BMW or Lexus. Likewise, auditors will not
recognize a perpetrators unusual activities, such as wearing designer suits, taking expensive
vacations, buying expensive jewelry, or buying a new home with stolen funds. Auditors do not
have a reference point from which to see these changes in lifestyle. Again, it is coworkers,
friends, and managers who should detect fraud in conversion.
Case 8.
1. As stated in the answer above, there are three elements of every fraud: theft act, concealment,
and conversion. Certainly, during the theft act, it is not the auditors who have the greatest
opportunity to detect fraud. Auditors are rarely present when funds are stolen or fraud is
committed. Rather, they spend one or two weeks on periodic audits, during which time thefts
usually stop. Instead, coworkers, managers, and other employees are usually in the best
position to detect fraud in the theft act stage. In concealment, auditors do have a chance to
detect fraud. If audit samples include altered documents, miscounts, or other concealment
efforts, auditors may detect fraud. Similarly, they may see internal control weaknesses or
analytical relationships that do not make sense. However, company accountants and even
coworkers are probably in a better position to detect fraud in concealment. At the conversion
stage, the auditors are definitely not in the best position to detect fraud. There is no way, for
example, that auditors could recognize certain changes, such as an employee who used to
drive a used Ford Focus now drives a new BMW or Lexus. Likewise, auditors will not
recognize a perpetrators unusual activities, such as wearing designer suits, taking expensive
vacations, buying expensive jewelry, or buying a new home with stolen funds. Auditors do
not have a reference point from which to see these changes in lifestyle. Again, it is
coworkers, friends, and managers who should detect fraud in conversion.
2. Not surprisingly, it is the auditors who are absent or nearly absent in each element. Although
most people believe that auditors should detect fraud, they have less opportunity to do so
than employees, friends, management, internal audit, and others. For this reason, it is crucial
that organizations are proactive in combating fraud. Organizations should have fraud
awareness programs, anonymous tip hotlines, and other programs in place to prevent fraud.
Case 9.
Possible reasons include:
She may have been unsure about the facts of the fraud.
She may have been afraid of the reactions of other employees to whistle-blowers.
The perpetrator may have intimidated her.
She may not have wanted to be labeled as a squealer.
She may have been unsure of how management would react.
The organization may not have a program facilitating the reporting of fraud.
Case 10.
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Although fraud could be occurring, there is no conclusive proof. Several fraud symptoms do
exist, but all of these symptoms could have other possible explanations. You may want to discuss
possible symptoms identified in the case and even how the students would proceed in
investigating the symptoms. For example, the missing receiving documents may be for goods
that were personal items but recorded as inventory or legitimate business expenses. You could
investigate this possibility by looking at the other supporting documents for these purchases
including vendor invoices and/or cancelled checks. Also, overcharging customers may be a
means for John to take funds out of the company. He may be refunding money when the
customers complain but keeping it when they dont notice. You could investigate this possibility
by reviewing customer complaints and ensuring that customers are sent monthly statements for
amounts due to the store.
Case 11.
Potential responses may include the following:

Attitude / Rationalization
o Hire honest people
o Develop a good tone at the top
o Conduct training or education
o Establish an ethics policy or codes of conduct

Motivation / Pressure
o Fair pay
o Eliminate accounting-based incentives
o Establish employee assistance programs
o Make realistic budgets and goals

Opportunity
o Prosecute/Punish offenders
o Actively search for fraud
o Control activities
o Whistle-blowing systems
o Monitoring controls (e.g., internal audit and security)

Extensive Cases
Extensive Case 1.
The following are four possible symptoms:
1. ABCs revenues increased by 53% in 2007, while inventory decreased by 27%.
2. ABC has increased revenues in 2007, while receivables decreased by 23%.
3. ABC has increased revenues in 2007, while payables decreased by 47%.

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4.

Warehousing costs have increased while inventory balances have decreased.

Extensive Case 2.
1.

The following could have been symptoms of Daniel Jones fraud:

a. Extravagant LifestyleDaniel drove expensive vehicles. It is clear from his Web site
that Feussner enjoyed telling people about his toys. It is likely he showed or talked
about his various cars to his fellow employees. A clue to Jones fraud is that he began to
purchase most of these expensive cars in the last ten months of the fraud, not over the
period of time he worked for his company.
b. Analytical AnomaliesJones received large amounts of software free of charge to be
used on developmental projects. Someone should have discovered that Jones was
receiving larger quantities of materials than his colleagues. His company could also
require seeing the projects Jones was working on and the reasons why he needed such
large amounts of materials.
c. Internal Control WeaknessesHis company had no internal control checks for amounts
under $1,000.
d. Unusual BehaviorsIt is not one particular behavior that signals fraud but rather a
change in entire behavior. Jones had worked for the company long enough that
employees and coworkers would be able to tell if he was experiencing behavioral
changes.

2. Positive Consequencesbecause managers are encouraged to have tighter control over

costs, their scrutiny may deter potential fraud perpetrators. Also, managers will take more
ownership of their department because they will be in charge of a greater portion of the balance
sheet and will likely be more careful with cost and expenses, especially if a bonus is given for
keeping costs low.
Negative ConsequencesManagers may be more tempted to commit their own form of financial
statement fraud, especially if a bonus is attributed to keeping cost low/revenues high. Controls
will need to be in place as deterrents.
3. PressureFraud pressures can be divided into four types: financial pressures, vices, workrelated pressures, and other pressures. Jones had a perceived pressure to drive nice cars and have
other nice luxuries. His desire for luxuries was enough to motivate him to commit fraud.
OpportunityHis company had a weakness in its controls. It only required approval for software
or hardware of more than $1,000. Jones had ordered software in the past for legitimate purposes.
He saw that no one really checked up on him, since he was director of a very secret project.
RationalizationAlthough we do not know the exact way he rationalized his acts, we do know
that he rationalized his unethical acts in one way or another.
4. It appears that his company tries very hard to create a culture of honesty, openness, and
assistance by focusing on hiring honest people. However, his company could benefit from
developing a code of ethics. In this situation, there was no overriding of existing controls; rather
there were no internal controls in place on purchases of less than $1,000. His company could
benefit from having some type of internal control to prevent this type of fraud from occurring in

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the future. His employer did prosecute Jones in this case, which will help discourage future
perpetrators.
Extensive Case 3.
The balance sheet reports two liabilities: accounts payable and notes payable. These liabilities
arise from two transactions: purchasing and borrowing. When purchasing, the retailer may
choose not to record purchases and understate accounts payable. If that were the case, we might
expect that accounts payable as a percentage of inventory would go down. In 2006, the ratio of
accounts payable to inventory was 16.47%. In 2007, the ratio rose slightly to 16.56%. The
accounts payable are probably fairly stated. Notes payable, however, shows a different story.
First of all, it appears that ABC retired over $1.2 million in debt during 2007. The large change
could be a symptom of understatement. Second, if ABCs cost of borrowing is in line with other
companies of similar credit standing, then in 2007 it ought to have paid around $1,134,000 in
interest on its average balance of notes payable (9% x [$13,200,000 + $12,000,000/2]). Instead,
it paid $1.7 million in interest charges. At 9%, interest of $1.7 million would represent average
obligations of $18.9 million, not the $12.6 million reported. Therefore, ABC may be understating
its liabilities by over $6 million.
Extensive Case 4.
1.

Symptoms of fraud:
demanding an increased number of contracts by SCI employees;
demanding faster processing time for these contracts;
some employees are quitting;
trying to divert the attention of the federal government.

2. Why are the employees quitting? Why is contract volume so high? Does the documentation
for the contracts make sense? Who are the subcontractors? What is their relationship to SCI?
3. The covert business, staffed by undercover agents, would give investigators the ability to
gain the best evidence of fraud through direct contact with those involved in the fraud.
Undercover operations are often necessary when massive, collusive fraud is occurring, especially
fraud involving kickbacks.
Extensive Case 5.
1.

Symptoms of fraud can be divided up into six different categories. These categories reveal
the following.

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Accounting Anomalies When searching for fraud, it is helpful to look for sudden
changes in account balances. Significant differences in accounts may arise from faulty
journal entries and inaccuracies in ledgers.

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Internal Control Weaknesses An analysis should be performed to identify areas that

have weak or no controls present. This is important because weak controls can be easily
overridden when pressure arises to commit fraud.

Analytical Anomalies An analysis of transactions can reveal amounts that are too
large or too small for accounts. These accounts should be examined for fraud.

Extravagant Lifestyles Managers should take time to analyze the lifestyles of their
employees. Unexpected and unexplained changes in lifestyle may suggest that fraud has
taken place. The activities and responsibilities of these employees should be monitored.

Unusual Behaviors Managers should take time to notice emotional changes of

employees. Stress and fear are good indicators that an employee may be committing
fraud.

Tips and Complaints Managers should review complaints and tips made by
employees. Complaints and tips may provide clues to who is committing fraud.

The different types of fraud symptoms that are present in this case are as follows:

Accounting Anomalies Hal is concerned that fraud may be occurring as he knows that
sales revenue may be higher than normal because the company lost one of its major
vendors at the start of the fourth quarter. Hal should check to see if the company
acquired new vendors that he is not aware of during the last quarter. Hal should also
check to see if sales are significantly higher for a current vendor. It may be possible that
vendor fraud is occurring.

Internal Control Weaknesses It is possible that controls have been overridden. Hal
noticed that many people around him have been pressured to meet earnings forecast. An
analysis should be performed to determine areas that have weak or no controls present.

Unusual Behaviors Hal noticed that his CEO has been meeting with one of his
internal auditors late at night. This is an irregular occurrence and should be
investigated.

3. Now that Hal has recognized some fraud symptoms, there are basic analyses that he can
perform to determine where fraud may be occurring. Hal can detect signs of fraud through
analyzing changes from one period to the next by conducting vertical and horizontal analysis as
well as performing ratio analysis. These analyses are useful because they allow one to identify
changes with ease because number account balances are converted into percentages. When
performing horizontal and ratio analysis it is important to look for sudden changes in account
balances from one period to the next, which must be examined in greater detail to determine the
reason for the change. Sudden changes may suggest fraud.

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Internet Assignments
1. Many Web site matches can be found that relate to fraud auditing and fraud detection. For
the most part, these sites are from individuals and companies offering their services as fraud
examiners. The Association of Certified Fraud Examiners site gives information about becoming
a CFE, about locating CFEs, and about the types of services offered by the association, including
educational seminars and conferences.
2. The American Society of Questioned Document Examiners (ASQDE) is an association of
professionals qualified in the study and examination of documents, such as disputed handwriting,
signatures, typewriting, and the identification of photocopiers, ink, and papers. The purpose of
the society is to foster education, sponsor scientific research, establish standards, exchange
experience, and provide instruction in the field of questioned document examination.
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What other unusual financial statement relationships may exist in the presence of a fraud?
o Decreased receivables with decreased cash
o Increased inventory without an increase in payables or a decrease in cash

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