Audit and fraud

by SIVARAM CHOUDHURY on 03 September 2010

Published in Audit | Comments

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WHAT IS FRAUD: In simple terms fraud is a mistake with a reason. To explain more
Fraud is an activity by a person who does his duty in a wrong way or refrains from doing his
duty for some favors i.e. financial, tangible, or anything else which is not due to him or
them in the normal course.
In simple words fraud is an intentional abnormal activity for undue gains. Or

Fraud as the name suggests refers to the intentional misrepresentation by employees or other
persons related to business, it can be both for monetary or non monetary gains.

WHY FRAUD IS DONE: GRID TO REACH THE GOAL WITH LEAST EFFORT, IS
THE MAIN DRIVING FACTOR.

As a human being everybody has some immediate goal. For example for a hungry person
global worming has nothing to do, he needs food as his first priority. Either he can steal it or
do something to make it available. Given a free will he will just eat and go. If there is a
person sitting there he may force and eat or work and it. Assuming that there is no law, based
on his personal power he will force and eat. That is the jungle rule.

Today we all live in some or other society and we want to live happily. However the jungle
rule mentality of the people are not gone. It is there deep inside us. It is forced to sleep under
the fear of, god, society, law and order. It wakes up when ever the fear elements are reduced
or zero. With modernization the human being has understood that same jungle rule can be
played even now with the polish of knowledge. But as always it remains shot lived since
somewhere or other it will be disclosed by another human having the same style and same
mentality.

It is as if, it is the only thing known to the maximum of the man kind and all those people do
it with the same intention, i.e. to gain something. Of course that is the reason they do it.

Please go though the study done and success achieved in a particular company. The company
had put a public phone at the staff common room with STD facility for the employees to use
it , where the bills were very high for this extra phone

Sl.no. What the company did Result for the action Reason for the result
1 Just telephone Huge bills The employees made calls lot of
call from here even during the
normal working hours for chatting
and other purposes.
2 A telephone and aThe telephone billPeople who were little conscious
register. A board isamount fell down byabout the lot of personal calls they
displayed requesting themore than 10%. were making through these calls,
employees record the preferred to refrain from making
number called. The huge number of calls and made
intention of the company even lesser and recorded it.
was to cross check theSome people registered
register with the billstheir calls and some
received from VSNL. people turnoff by seeing
the board. Some peopleSome people made calls but did
registered the othernot record it felling that who is
numbers. there to see.

Overally the registerSome people made calls but

never tallied with the billmentioned a different number.
even for a month in the
whole three month
period.
3 After six months AThe telephone billPeople considered the back
board is displayedamount fell down byground of the register. They
requesting themore than 25%. thought they may be questioned
employees record the based on their names and number
persons name , number of calls made. So the fear kept
called and the pupose as them away from the telephone.
official or personal. TheSome people registered
intention of the companytheir calls and some
was to contol thispeople turnoff by seeing
telephone bill withoutthe board. Some peoplePeople who were conscious about
disconnecting the serviceregistered the otherthe rules made only a very few
to the employees. numbers. personal calls , only when it is
required and can be explained.
Outside calls for chatting stopped
 since they had fear that some body
may question them.
Overally the register
again never tallied with
the bill even for a month
in the whole three monthSome people made calls but did
period. not record it felling that who is
there to see.

4 After three months theThe tel.bill fell down bySome People who were making
company appointed amore than 40% andcalls but not recording kept off
security guard to sit neareverybody had to recordfrom making any calls unless
the telephone. after he makes a call. otherwise it is necessary and can
be answered.

However the problem of

bill tally and numberSome people still wrote the
tally was not sorted out. number but a wrong number.
5 After seeing this forThe overall bill fell downAccountability and its monitoring
three months theby more than 50%.by clear rules achieved the
company made theActually the securitypurpose.
possessor of the phoneguard never wanted to
responsible for ensuringtake risk hence he
that the register talliesdecided to write the
with the bills. Anynumber first, dial the
difference will benumber and handed over
deducted from his salary. the phone to the
employee. The register
tallied with the bills
received and for other
differences the company
decided to talk with the
telephone company, to
avoid using its line for
bogus purpose.

The same was used to monitor the senior management in an Indian company and it helped
the company to recover most of the STD personal calls made by the senior officials , there by
bringing the telephone bills up to 50% down. Recovery amounting to more than the salary
amount was seen in some cases. Further in some cases even the employees were asked to
leave for not giving a proper reason to the computerized telephone statements for their desk
telephone. In short all these people were doing smaller level frauds for years and the
company accepted it saying that everybody does the same, hence it is common.

Some times fraud could be happening just in front of our eyes and we just get used to it as a
normal practice. All that is required is to ask, WHY AND WHERE IS IT WRITTEN , then
may be in the process of finding the written document the whole normal practice will change
and you will drive your point home.

The point is no level of management is honest and clean if they are not monitored. In other
words in most of the cases the fear element keeps the person away from doing a fraud or
misusage of the employers assets and position.

HOW PEOPLE ARE CONVINCED TO DO FRAUD: The truth is everybody can be

bought at the right price and for the right reason and at the right time. Every body has a need
for something or other. Even the sacred saints have been convinced to earn money by
defrauding people in the name of religion.

The point I am driving home is , everybody has some need and he wants to fulfill that in the
normal, legal, and peaceful way, since he is scared of the society-defamation, law and order
for not following the rules, the inner voice i.e. the almighty, if he believes.

Normally people are convinced that they donot have all these fears in some particular
situation or location hence they agree. May it be in the name of religion, for the sake of a
community, for sake of the country, for money, or for anything else.
HOW IS FRAUD DONE: There are various trigger points for fraud:

1.ACCIDENTAL UNINTENTIONAL: To err is human. If you work then you will

definitely do some mistakes . This is a normal procedure for human beings. If the same is
noted and rectified with or without declaring the same then the mistake becomes an error and
a learning point.

If the error is cought by another person and brought to the table, than again it will depend
whether the person commiting the mistake has gained anything due to this mistake and if yes,
then whether the immediate employers or any other person in this planet has incurred any
loss instantly or remotely. If both are confimed as positive, then it can be termed as fraud
irrespective of the persons intention since it will be very difficult for him to prove otherwise.
In such a cases it becomes very hard for a person to explain and prove that it was not fraud
and he is honest.

But if unintentional mistake committed by one person is not cought by any other person and
if the person commiting the errors learns to use the same mistake for making money or other
favours , then the classification changes and the same error becomes a fraud.

2. PLANNED FRAUD: Planned fraud is again divided in to two catergories

2.1. A single person planning and executing the whole fraud this can be controlled to some
what extent , by efficient internal controls where every transaction goes through multiple
levels and authorities. However due to saving on employees cost we become very much
susceptible to such fraud.
2.2. A GROUP OF PEOPLE: This category is famous for even killing all the internal
controls. Where an outsider only can do something may be a private investigator. But all the
organizations cannot really afford to put some undercover agent in the working floor due to
the cost factor. Evethough it is seen that some companies do this, where the promoters interest
is very high. Further these type of frauds never comes out unless otherwise an outsider or
perpetrators themselves disclose the same. Proper Record keeping and monitoring of
employees by some trustworthy outside agency can help to some extent. Whether done or not
the employment letter should get their legal permission just to make them aware of the fact
that this is being regularly done by the employer.

2.3. Forced Fraud: Some good people also get involved with the fraudsters innocently and
then of course get punished too. Blackmailed people are such instances. They committed a
innocent or illegal act and got caught by these famous fraudsters and then get used by them.
Fear is one of the most driving agent, since some people get involved for the sake of saving
their job, family, friends etc. Usually these people are the most weakest links in the whole
chain and often disclose the whole chain of fraudulent activities

HOW TO PREVENT OR CHECK FRAUD: Fraud in any form affects somebody or other,
instantly or remotely and is one of the biggest problems that is faced by the mankind. It is, as
if the only thing known to the maximum number of people in some form or other and all
those people do it with the same intention, i.e. to gain something. Ofcouse that is the reason
they do it. The only way to refrain them from doing this is The Element of Fear . Fear can be
of any type, but the fraudsters should know that they will be caught irrespective of their
position and power.
Normally we try to prevent fraud by implementing internal control systems in our business
and our surrounding, but everthing is breakable since it is operated through human beings,
and most peoples ethics are sold or bought at the right price. Internal controls to work
efficiently needs to be updated regularly based on the new developments for which again it
should be monitored on a continuous basis. There is no one formula which may suit all
business, since the fraud detection techniques also need a continuous update. However some
are listed :

1. Evaluation of all internal control: There should be regular evaluation of all internal controls
which are specifically prone to fraud risk. A responsible person should be nominated to keep
and eye on the controls where it is easy for someone to commit a fraud. Area where cash
handling is involved are particularly prone to frauds.

2. Check on business assets: A good business man is one who keeps a control on his assets
and liabilities. It is necessary to keep an inventory of all business assets at regular intervals,
so that no misappropriation like theft, pilferage etc can take place. Regular stock take and
physical verification of the assets will deter employees from theft.

3. Keep check on the code of ethics or conduct of your employees: Businessmen should keep
a check on their employees conduct and from time to time they should keep a note of their
behaviors especially if they are related to financial transactions area. The best practice is
definitely training and setting examples. Employees involved in accounts payable functions or
purchasing functions and any employee who submits expense reports are the most susceptible
to fraud. Training these individuals, as well as all employees, on company policies,
procedures and code of conduct is imperative. Accountability plays a large role in deterrence.
When employees realize the company will take a hard stance on fraudsters, they will think
twice about committing an abonormal act i.e fraud.

4. Check on illegal acts: Every act of an organization matters, a single illegal act can affect
the business and may destroy its reputation and goodwill in the market. Therefore it is
imperative for the owners to be sure that no illegal acts are taking place in their organization.
Especially in wide spread business houses it should be ensured that the responsibility is fixed
on the chief-in-charge for the place, to ensure that no violation of the local statute is being
done at his place.

5. Auditors recommendations: Both statutory as well as internal auditors are third party
person who are independent from your business and hence do not have any vested interest in
the business, hence any finding by them should be taken very seriously as these are
professional people who have in depth knowledge of their subject and can add substantial
value to your business. However this is applicable when management other than top
management is committing the fraud.

6. Review of audit committee: Audit committee is one key source which outlines the major
issues of your business. Management should seriously take the recommendations and reviews
made by the audit committee.

7. Maintain adequate business procedures for handling complains: most of the times frauds
are brought to the notice by employees who do not want to appear in public. So it is necessary
that there should be some mechanism in the organization for the employees to anonymously
report any complains or information that they may have. A complain box or hotline can
effectively serve this purpose.

8. Now a days there are so many software companies who have designed products that
perform fraud tests on real-time, daily transactions. They can also conduct tests on companys
last one or two years data just by attaching the same.

AUDITORS ROLE IN COMPANYS FRAUDS: This can be classified in to two different

categories:

A. FRAUDS COMMITTED BY EMPLOYEES: Normally a statutory auditor is appointed

as per the government rules in all Ltd companies. The common publics understanding is that
if it is audited then it is free from errors i.e error includes intentional errors and unintentional
error. However as per the CA institute and Companies Act the auditor is not meant to be a
blood hound and supposed to be only a watch dog. Ofcourse there are valid reasons for this
assumption. This gives a clear escape route to the auditors to turn their back on the frauds
unearthed latter on.

As per Indian law a auditor cannot be held responsible for most of the fraudulent activities.
Since as per statute the auditor does an audit based on books and accounts and if he can prove
that he followed the standard auditing guidelines and had nothing to doubt the records
provided , in that particular scenario then, he is free from his liability.

All auditors reports and certificates are based on books and records only.

When ever a fraud comes out mostly, unearthed by somebody other than the auditors,
everybody say what the auditors were doing, without even knowing that they have got a big
shield to cover themselves. Most of the times the auditors are not equipped with equipment
and qualified people to detect fraud which are perpetrated very deeply or in very chaos
manner, or outside the company and very outside the books and accounts. Any introduction
of layer of audit and re-audit only will increase the cost and induce the fraudsters to do a
deep level planning.

B. AUDITORSS ROLE IN TOP MANAGEMENT FRAUD:

As per law the auditor is employed in Annual General Meeting by all the share holders.
However the reality is totally different. The auditor is only appointed by the Promoters or the
highest shareholder or the top management who represents the earlier two, in the company.
This is because 99% of the small share holders never make it to the AGM. Ofcourse there
are some companies who plan in advance to ensure that no share holder really takes part in
the AGM, by adopting different strategies.

Psychologically the auditor understand that if he is not cooperating fully with the promoters
then mostly he will be out from his auditors post either this year itself or next year. Hopefully
when ever there is a misrepresentation of the true results, 99% chance is, the auditor himself
is involved in the fraud for fat fees , other work and continuous audit business. We are not
discussing about the public sector here, that is a even different story. In the current scenario
the government and the ICAI only can help the common investors by introducing more
stringent rules and introducing a mechanism to represent the small share holders in the Board
too. This ofcourse we will discuss in some different article.

HOW TO LOOK FOR SYMTOMS OF FRAUD : This is a general articles based on the
writers own experience and combines lot of tips and tricks taken from different sources. Mail
me some notes if you have any idea or hypothesis of how a fraud can be committed or can be
cought, If you want than we will publish the same with your name you can also request to
keep the name anonymous.

Normally fraud is found by those people who have in-depth knowledge of the internal control
system governing a specific field of work and the personnel who are operating in the
company and have some earlier introduction and familiarity with the people in general. You
cannot just go to a company for the first time without knowing anything about that and the
people working in that company and discover a fraud. Normally auditors are praised and
respected when they detect fraud and it also send a red signal for all those not caught so far.
Hence it is necessary that you do your home work before deciding to catch somebody.
When you go for an audit or review look for the following signs of fraud:

If you observe any of the following items are occurring in your company, please intimate
your senior to do a in depth study or do a special audit yourself if you can,but do not alert the
fraudsters in advance.

1. Bank account statements and related registers, Stale Items in Reconciliations

In bank reconciliations, deposits or checks not included in the reconciliation could be

indicative of theft. Look for the cheque receipt register and dispatch register. Check when a
cheque is received and when it is deposited. Look for the cheque dispatch register and ensure
that non-of the addresses are any employees home address or mail box number. In case of
Missing deposits could mean the perpetrator absconded with the funds; and the company has
not intimated the same till date to the auditor, Look for the list of cheques made but not sent
to the payee or written as hand delivery, ensure that no hand delivery is entertained in the
company. Missing checks from the register could indicate one made out to a bogus payee.
Verify whether the company is receiving blank cheques from customers without dates, if yes,
look for the controls and when it is recorded in the cheque receipt register. These are the
main targets of fraudulent activity.

2. Review of Complaints against the company or any individual:

Review the complaints against the company by anybody and everybody. Frequently tips or
complaints will be received which indicate that a fraudulent action is going on. Complaints
have been known to be some of the best sources of fraud and should be taken seriously.
Although most of the times it could be with a wrong motive, however it is better to have a
detailed knowledge than feel sorry later on.
3. Unusual Behavior of any person :

The employee whom you knew earlier and who is showing a very unpredictable behavior
now is often stressed , try to find out whether any illegal activity is the reason. The fraudster
will often take very less or nil leaves. Will work very late always without assigning the work
to another employee even if he knows that he is overloaded. Since other employee carrying
out his job may discover the truth. Other symptoms may be, changes in behavior such as
increased drinking, smoking, defensiveness, and unusual irritability and suspiciousness.

4. Excessive Cancellation of Sales invoices after dispatch:

Cancelled sales slips could mean that the sale was rung up, the payment diverted to the use
of some other person involved, and the sales slip subsequently voided to cover the theft.
Ofcourse there are internal control to stop this in various companies, never the less review
that the same is effective in ensuring the repossession of the materials

5. Missing Documents

Documents which are unable to be located can be a red flag for fraud. Although it is expected
that some documents will be misplaced, the auditor should look for explanations as to why
the documents are missing, and what steps were taken to locate the requested items. All too
often, the auditors will select an alternate item or allow the auditee to select an alternate
without determining whether or not a problem exists.

6. Excessive Credit Notes:

Credit notes is similar to Cancelled sales or part of the sales proceeds. This technique can be
used to cover the theft of cash. This could be used to adjust bank balance and cash balance.
Always check the internal control procedure for generation and disposal of the credit notes.
7. Common Names and Addresses for Refunds:

Sales employees frequently make bogus refunds to customers for merchandise. The address
shown for the refund is then made to the employee's address, or to the address of a friend or
co-worker.

8. Increasing Reconciling Items

Stolen deposits, or bogus checks written, are frequently not removed, or covered, from the
reconciliation. Hence, over a period of time, the reconciling items tend to increase.

9. Post Office Boxes as Shipping Addresses

In instances where merchandise is shipped to a post office box, this may indicate that an
employee is shipping to a bogus purchaser or himself. The same is also true when cheques
are sent to mail box.

10. Adjustments to Receivables or Payables

In cases where customer payments are misappropriated, adjustments to receivables can be

made to cover the shortage. Where payables are adjusted, the perpetrator can use a phony
billing scheme to convert cash to his or her own use. Always ensure that the customer
acknowledges not only the balance at the year end, but also all his transactions with the
company for the whole year. In case the customer says that 10 transactions donot pertain to
him, than it will show that the company has definitely made some more adjustments to tally
the closing balance.

11. Excess Purchases

Excess purchases can be used to cover fraud in two ways:

Fictitious payees are used to convert funds

Excessive purchases may indicate a possible payoff of purchasing agent;

Also check for , vendor address that is the same as an employee address, duplicate invoice
numbers and multiple changes in vendor identity fields.

12. Duplicate Payments

Duplicate payments are sometimes converted to the use of an employee. The employee may
notice the duplicate payment, then he or she may prepare a phony endorsement of the check.
Do a verification of chques issued but not realized and ask for the reason, may be there is a
double booking or a payment and since the supplier is not aware of this transaction hence he
is not collecting, he has his own fears.

13. Ghost Employees

Ghost employee schemes are frequently uncovered when an auditor, fraud examiner, or other
individual distributes paychecks to employees. Missing or otherwise unaccounted for
employees could indicate the existence of a ghost employee scheme. In case of cash payment
of wages please ensure that one months payment is done physically in front of you. This will
throw open a big picture of common problems happening during the payment session and the
kind of documentation and control which are not maintained by the company.

14. Employee Expense Accounts

Employees frequently conceal fraud in their individual expense account reimbursements.

These reimbursements should be scrutinized for reasonableness and trends, especially in the
area of cash transactions on the expense account. Look for the standard rules set by the
company. Specifically cross check those cases where the employee claims almost the full
amount of his eligibility every time. Check for the kind of expenses shown in their
reimbursement sheets on holidays. E.g. on a govt holiday whether lot of conveyance expenses
are claimed as visit to clients places.

15. Inventory Shortages

Normal shrinkage over a period of time can be computed through historical analysis.
Excessive shrinkage could explain a host of fraudulent activity, from embezzlement to theft
of inventory. Always ensure for a complete stock reconciliation in all companies.

16. Review Scrap Materials generation and disposal records: The control over scrap is very
important in a manufacturing set up. In fact a drop in the yield will result in more scrap
generation which may be due to following reasons:
A real drop without intention;

Intentional Planned drop in yield is done for

Material gain. This is normally combined with 1. no proper records for daily scrap
generation and 2. less recording of production in the main production register. This will
help the fraudster in sending these materials out of the company alongwith other valid
materials to be sold outside.

For MIS panipulation : The above technique also used for manipulating the MIS to the top
management.

For reselling the good raw materials as scrap : Scrap is a favorite target of embezzlers
because it is usually subject to less scrutiny than regular inventory.

17. Write-off of Accounts Receivable

Comparing the write-off of receivables by customers may lead to information indicating that
there may be an already misappropriated payment instance in the past which may be the
reason for a difference and closer of business with the debtor.