CHAPTER 7: FRAUD

THEORIES:

• FRAUDS- are illegal acts characterized by deceit, concealment or violation of trust.

• FRAUD- is 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.

• FRAUD- 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

• FRAUD- a generic term, embracing all multifarous means which human ingenuity can devise, and
which are resorted to by one individual to get advantage over another by false suggestions or by
suppression of truth, and includes all surprise, trick, cunning, dissembling, and any unfair way by
which another is cheated.

• ERROR- an unintentional misstatement of financial statements

• FRAUD- refer to an intentional act by one or more individuals among management involving the use
of deception to obtain an unjust or illegal advantage

• FRAUD- encompasses a range or irregularities and illegal acts characterized by "intentional"

deception or misrepresentation which an individual "knows" to be false or does not believe to be
true

• FRAUD RISK- (red flags) the probability that fraud will occur and the potential severity or
consequences to the organization when it occurs.

• DEFALCATIONS- rationalizations that revolve around personal issues

• FRAUDULENT FINANCIAL REPORTING- rationalizations that involves personal and organizational

issues

• DEFALCATIONS OR MISAPPROPRIATIONS OF ASSET- employee takes assets from the organization

for personal gain

• CORRUPTION- fraudsters use their influence in a transaction to gain personal benefit

• LARCENY- stealing cash after it has been recorded on the books

• SKIMMING- stealing cash before it is recorded on the books

• FRAUDULENT FINANCIAL REPORTING- intentional manipulations of financial statements

• OFFICIAL BRIBERY- corruption of a public official

• COMMERCIAL BRIBERY- corruption of a private individual to gain a commercial or business

advantage

• EMBEZZLEMENT- the wrongful appropriation of money or property by a person to whom it has been
lawfully entrusted.
• LARCENY- the wrongful taking of money or property of another with the intent to convert or to
deprive the owner of its possession and use

• THEFT OR MISAPPROPRIATION OF TRADE SECRETS- includes secret formulas, processes, proprietary

information and information that has a value to the business and would be potentially harmful if
disclosed

• BREACH OF FIDUCIARY DUTY- not abiding by the duty of loyalty or the duty of care that exist in a
fiduciary relationship

• DUTY OF LOYALTY- requires the employee/ agent act solely in the best interest of the employer/
pricipal, free of any self- dealing, conflicts of interest, or other abuse of the principal for personal
advantage

• DUTY OF CARE- requires the employee/ agent to conduct business affairs prudently with the skill
and attention normally exercised by people in similar positions

• RED FLAGS- conditions which are normally present whenever a fraud is committed

• FINANCIAL SHENANIGANS- are actions that intentionally distort reported financial performance and
financial condition

• BENIGN FS- changes in accounting estimate

• EGREGIOUS FS- fraudulent recognition of bogus revenue

• FRAUD- any intentional act or omission designed to deceive others, resulting in the victim suffering a
loss and/or the perpretator achieving a gain

• COLLUSIVE SCHEME- a scheme performed by two or more individuals working together.

• RISK APPETITE- the amount of risk, on a broad level, an organization is willing to accept in pursuit of
value.

• RISK TOLERANCE- acceptable level of variation relative to achievement of a specific objective, and
often is best measured in the same units as those used to measure the related objective.

• FORENSIC ACCOUNTING- accounting that is sustainable in some adversarial legal proceedings or

within some judicial or administrative review.

• WHISTLEBLOWING- act of disclosing adverse information to someone in the organiation who is

outside of the individual's normal chain of command, or to a governmental agency or other
authority that is wholly outside of the organization.

ENUMERATION:

• DUE PROFESSIONAL CARE

1. extent of work needed

2. relative complexity, materiality, or significance of matters

3. adequacy and effectiveness of governance, risk management, and control processes

4. probability of significant errors, fraud, or noncompliance

5. cost of assurance in relation to potential benefits

• EXAMPLES OF ERRORS:

1. mistake in gathering or processing data

2. incorrect accounting estimate arising from oversight or misinterpretation of facts

3. mistake in the application of accounting principles relating to measurement, recognition,

classification, presentation of disclosure

• EXAMPLES OF FRAUD:

1. theft

2. unauthorized or illegal use of company assets

3. claims for services or goods not actually provided

4. sale or assignment of fictitious or misrepresented assets

5. intentional failure to act in circumstances where action is required by company policies or law

6. illegal business activities

• ESTABLISHING APPROPRIATE CONTROL ENVIRONMENT:

1. code of conduct

2. ethics/ fraud policy to set the appropriate tone at the top

3. ethics and whistleblower hotline programs

4. hiring and promotion guidelines and practices

5. oversight by the audit committee, board or other oversight body

6. investigation of reported issues and remediation of confirmed violations

• 5 KEY PRINCIPLES IN MANAGING FRAUD

1. fraud risk management program should be in place including a written policy to convey the
expectations regarding managing fraud risk

2. fraud risk exposure should be assessed periodically to identify specific potential schemes and events
that the organization needs to mitigate

3. prevention techniques to avoid potential key fraud risk events should be established

4. detection techniques should be established to uncover fraud events when preventive measures fail
or umitigated risks are realized
5. a reporting process should be in place to solicit input on potential fraud

• 3 FACTORS OF FRAUD ( FRAUD TRIANGLE):

1. Incentives/ pressures/ motivation to commit fraud

2. opportunities to commit fraud

3. rationalization of the fraud as acceptable

• MOTIVATORS OF FRAUD

1. Power

2. Gratification of a desire

3. Pressure

• PRESSURE TO COMMIT FRAUD

1. management compensation schemes

2. personal wealth ties to financial results or survival of the company

3. financial pressures to improve earnings

4. personal factors

5. to meet a lender's criteria for granting/ extending loan facilities

6. to meet corporate performance criteria

7. to trigger performance- related compensation or earn- out payments

8. to preserve a trend of consistent growth

9. to reduce the value of an owner- managed business

• WARNING SIGNS INDICATING OPPORTUNITIES FOR FRAUD

1. weak or non- existent internal controls

2. complex or unstable organizational structure

3. ineffective monitoring of management

4. significant accounting estimates made by the management

5. significant related party transactions

6. industry dominance

7. simple transactions made complex

• TYPE OF FRAUD BASED ON RATIONALIZATIONS

1. defalcations

2. fraudulent financial reporting

• DEFALCATIONS (RATIONALIZATION)

1. personal financial problems

2. mistreatment by the company

3. sense of entitlement

4. everyone does it

• FRAUDULENT FINANCIAL REPORTING (RATIONALIZATION)

1. compensation based on financial results (personal)

2. ego (personal)

3. necessary for organization to survive

• TYPE OF FRAUD (AICPA)

1. Defalcations or Misappropriations of Asset (Theft)

2. Fraudulent Financial Reporting (Distortion of Financial Statements)

• FRAUDULENT FINANCIAL REPORTING

1. manipulation, falsification, or alteration of accounting records or supporting documents

2. misrepresentation or omission of events, transactions, or significant information

3. intentional misapplication of accounting principles

• TYPES OF FRAUD (ACFE)

1. misrepresentation of material facts

2. concealment of material facts

3. bribery

4. conflicts of interest

5. theft of money and property

• MISREPRESENTATION OF MATERIAL FACTS

1. material false statement

2. knowledge of its falsity

3. reliance on the false statement by the victim

4. damages suffered

• ESSENTIAL ELEMENTS BASED ON FAILURE TO DISCLOSE

1. defendant had knowledge

2. of a material fact

3. defendant had a duty to disclose

4. defendant failed to disclose

5. with the intent to mislead or deceive other party

• THEFT OF MONEY AND PROPERTY

1. embezzlement

2. larceny

3. misappropriation of trade secrets and proprietary information

• EXAMPLES OF RED FLAG

1. complex revenue recognition schemes

2. incorrect billings to the government

3. holding the books open (accelerated revenue recognition)

4. capitalizing expenses

• MOST COMMON FINANCIAL SHENANIGANS

1. recording revenue too soon or of questionable quality

2. recording bogus revenue

3. boosting income with one- time gains

4. shifting current expenses to a later or earlier period

5. failing to record or improperly reducing liabilities

6. shifting current revenue to a later period

7. shifting future expenses to the current period as a special charge

• RECORDING REVENUE TO SOON

1. recording revenue when future services are still to be provided (aggressive accounting)

2. recording revenue before shipment or before the customer's unconditional acceptance

• RECORDING REVENUE OF QUESTIONABLE QUALITY

1. recording revenue even though the customer is not obliged to pay

2. recording questionable and inflated revenue

• AGGRESSIVE ACCOUNTING:

1. changing method of revenue

2. reduced liabilities by changing accounting assumptions

3. backdating sales contract

4. created reserves and released them into income in a later period

• OPERATIONAL DETERIORATION

1. big jump in receivables

2. revenue growth is sluggish

3. bulge in inventory

4. operating cash flow down

• QUESTIONABLE AND INFLATED REVENUE

1. selling to an affiliated party

2. giving the customer something of value as a quid pro quo

3. recording

4. grossing up revenue

• SELLING TO AN AFFILIATED PARTY

1. unusual transactions with strategic partners

2. accounting standards require adequate disclosure of related party transactions

• RECORDING BOGUS REVENUE

1. recording sales that lack economic substance

2. recording cash received in lending transactions as revenue

3. recording investment income as revenue

4. recording as revenue supplier rebates tied to future required purchases

5. releasing revenue that was properly held back before merger

• BOOSTING INCOME WITH ONE- TIME GAINS

1. boosting profits by selling undervalued assets

2. include investment income or gains as part of revenue

3. reporting investment income or gains as a reduction in operating expenses

4. creating income by reclassification of balance sheet accounts

• SHIFTING CURRENT EXPENSES TO A LATER OR EARLIER PERIOD

1. capitalizing normal operating costs

2. changing accounting policies and shifting current expenses to an earlier period

3. amortizing costs too slowly

4. failing to write down or write off impaired assets

5. reducing asset reserves

• FAILING TO RECORD OR IMPROPERLY REDUCING LIABILITIES

1. failing to record expenses and related liabilities when future obligations remain

2. reducing liabilities by changing accounting assumptions

3. releasing questionable reserves into income

4. creating sham rebates

5. recording revenue when cash is received, even though future obligations remain

• SHIFTING CURRENT REVENUE TO A LATER PERIOD

1. creating reserves and releasing them into income in a later period

2. improperly holding back revenue just before an acquisiton close

• SHIFITNG FUTURE EXPENSES TO THE CURRENT PERIOD AS A SPECIAL CHARGE

1. improperly inflating amount included in a special charge

2. improperly writing off in- process R&D costs from an acquisition

3. accelerating discretionary expenses into current period

• PROCEDURES IN AUDITING FRAUD

1. Possibility of fraud

2. Obtaining information about fraud risk factors

3. Developing an audit plan

4. Evaluating evidence

5. Communicating the existence of fraud

6. Audit documentation

• THINGS TO CONSIDER WHEN THERE IS A POSSIBILITY OF FRAUD

1. greater susceptibility of evidence manipulation

2. greater skepticism of management responses

3. journal entries are important

4. new technology provides new ways to commit fraud

5. recognition that collusion may be likely

6. predictability of audit procedures

7. analytical procedures should tie to operational or industry data

• WAYS THAT COULD SIGNAL POSSIBILITY OF FRAUD

1. making inquiries of management and others to obtain their views about the risk and fraud and
controls set up to address those risks

2. perform analytical procedures and consider any unusual relationships

3. review risk factors

4. review management responses to recommendations for control improvements and internal audit
reports

• ANALYTICAL INDICATORS OF FRAUD RISK

1. large revenue increase

2. sales increasing faster than industry sales

3. unusually large increase in gross margin

4. large number of sales returns after year- end

5. increase in number of day's sales in receivables

6. increase in number of day's sales in inventory

7. significant increase in debt/ equity ratio

8. cash flow or liquidity problems

9. significant changes in non- financial performance measures

• REVIEW RISK FACTORS

1. identifying risks of fraud

2. relate internal control and fraud risk

• DEVELOPING AN AUDIT PLAN

1. develop hypotheses about how fraud could be committed and concealed

2. audit team should then develop and implement audit procedures that are directly responsive to the
fraud risks

3. changes

4. extent of audit procedures

5. review a proactive approach to fraud detection- planning the audit

• CHANGES DEPENDING ON THE HYPOTHESIZED FRAUD RISKS

1. audit procedures

2. timing of audit procedures

3. staffing of the engagement

• EXAMPLES OF EXTENT OF PROCEDURES

1. performing procedures on a surprise or unanounced basis

2. requiring inventories be counted and observed at year- end

3. making oral inquiries of major customers and suppliers

4.