Chapter 1

Core Foundation Related to Fraud Examination and Financial Forensics

Forensic Accounting and Fraud Examination

by Mary-Jo Kranacher, Richard Riley, Joseph T. Wells

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What is Fraud?
Fraud is an intentional deception, whether by omission or co-mission, that causes its victim to suffer an economic loss and/or the perpetrator to realize a gain. Simple Working Definition:
Theft by deception.

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Legal Elements of Fraud

A material false statement. Knowledge that the statement was false when it was spoken. Reliance on the false statement by the victim. Damages resulting from the victims reliance on the false statement.

LO #6

Three Ways to Relieve a Victim of Money Illegally

Force Trickery Larceny

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Legal Ramifications of Theft

Larceny felonious stealing, taking and carrying, leading, riding, or driving away with anothers personal property, with the intent to convert it or to deprive the owner thereof. Must Prove:
There was a taking or carrying away of the money or property of another without the consent of the owner and with the intent to deprive the owner of its use or possession.
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Legal Ramifications of Theft

Conversion an unauthorized assumption and exercise of the right of ownership over goods or personal chattels belonging to another, to the alteration of their condition or the exclusion of the owners rights.

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Legal Ramifications of Theft

Embezzle willfully to take, or convert to ones own use, another's money or property of which the key words in that definition are acquired possession lawfully

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Fiduciary Relationship
Fiduciary a person holding a character analogous to a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires. Simple working definition
Someone who acts for the benefit of another.

LO #1

Violating Fiduciary Relationship

Fiduciaries have a duty to act in the best interests of the person whom they represent. When they violate this duty, they can be liable under the tort of breach of fiduciary duty. Must prove:
A fiduciary relationship existed between plaintiff and defendant. The defendant (fiduciary) breached his or her duty to the plaintiff. The breach resulted in either harm to the plaintiff or benefit to the fiduciary.
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Major Categories of Fraud

Asset Misappropriation theft of misuse of an organization's assets. Corruption unlawful or wrongful misuse of influence in a business transaction to procure personal benefit, contrary to an individual's duty to his or her employer of the rights of another.

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Major Categories of Fraud

Financial Statement Fraud and other Fraudulent Statements involve intentional misrepresentation of financial or nonfinancial information to mislead others who are relying on it to make economic decision.

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Financial Statement Fraud

Major areas of financial statement fraud:
Fictitious revenue (related areas) Improper timing of revenue and expense recognition Concealed liabilities Inadequate and misleading disclosures Improper asset valuation Improper and inappropriate capitalization of expenses.
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Financial Statement Fraud

Characteristics of financial statement fraud:
The misstatement is material and intentional Users of the financial statements have been misled.

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Common Fraud Schemes

Asset Misappropriation

Corruption

False Statement

Specific Fraud Contexts

Noteworthy Industry-Specific Fraud

LO #7

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Fraud vs. Abuse

Defined very similarly:
Abuse a deceitful act, deception; a corrupt practice or custom; improper use or treatment, misuse.

Subjective interpretation by individual or company on difference.

LO #2

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Financial Forensics
Defined: the application of financial principles and theories to facts or hypotheses at issue in a legal dispute and consists of two primary functions:
Litigation advisory services, which recognizes the role of the financial forensic professional as an expert or consultant. Investigative services, which makes use of the financial forensic professionals skills and may or may not lead to courtroom testimony.
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Role of Auditing, Fraud Examination and Financial Forensics

Financial auditors ensure that financial statements are free from material misstatements. Fraud examiners assist in fraud prevention and deterrence efforts that ado not involve the audit of nonpublic companies or legal systems. Financial Forensic Professionals calculate economic damages, business or asset valuations, and provide litigation advisory services that may involve allegations of fraud.
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FIGURE 1-1 Auditing, Fraud Examination, and Financial Forensics DYNAMIC FORCES

Auditing
Risk Assessment Internal Controls

Planning FS Fraud Detection Fraud Prevention & Deterrence Gathering Evidence Interviewing Witnesses Reporting

Financial Forensics
Litigation Support calculation of economic damages, marital dissolution, business valuation, etc. Litigation Support related to fraud Fraud Detection Expert Witnessing Investigation Remediating

SOCIAL

POLITICAL

Fraud Examination

CULTURAL
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Fraud Triangle
Perceived Opportunity

Fraud Triangle

Perceived Pressure
LO #5

Rationalization

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M.I.C.E
Typical motivations of fraud perpetrators
Money Ideology Coercion Ego

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Non-Fraud Forensic and Litigation Advisory Engagements

Typical Services:
Workplace issues Damage claims Asset and business valuations Costs and lost profits

Insurance claims

Divorce and matrimonial issues Tax disputes

Antitrust actions

Intellectual property infringement

Environmental issues
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LO #8

The Investigation
Professional skepticism a mindset that recognizes the possibility that a material misstatement due to fraud could be present. Attributes
Recognition that fraud may be present. Attitude that includes a questioning mind and a critical assessment of the evidence. Commitment to persuasive evidence.
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The Investigation
Red flags a warning signal or something that demands attention or provokes an irritated reaction.

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The Investigation
Three categories of fraud risk factors:
Motivational: Is management focused on shortterm results or personal gain? Situational: Is there ample opportunity for fraud? Behavioral: Is there a company culture for a high tolerance of risk?

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The Investigation
Successful investigators base their conclusions and results on their investigations on evidence. Evidence anything perceived by the five senses and any proof such as testimony of witnesses, records, documents, facts, data, or tangible objects legally presented at trial to prove a contention and induce a belief in the minds of the jury.
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The Investigation
Elements of Fraud
Act

Elements Of Fraud Concealment Conversion

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The Investigation
Hypothesis-Evidence Matrix
Analyze available data Create hypotheses Test the hypotheses Refine and amend hypothesis Draw conclusions

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The Investigation
Methodologies Used in Fraud and Financial Forensic Engagements (3 tools):
Examination of financial statements, books and records and supporting documentation. Interviews to obtain relevant information Observation

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Fraud Examination Methodology

Predication Fraud prevention and deterrence Fraud detection and investigation Remediation: Criminal and Civil Litigation and Internal Controls

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