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Fraud Schemes

1. Fraudulent Statements

associated with management fraud.

statement is not simply a vehicle for obscuring or covering a fraudulent

Example: Misstating the cash account balance to cover the theft of cash is not
financial statement fraud. On the other hand, understating liabilities to present a
more favorable financial picture of the organization to drive up stock prices does fall
under this classification.
Underlying problems:
1. Lack of auditor independence.
2. Lack of director independence.
3. Questionable executive compensation schemes.
Ex. Abuse of share-based compensation. Excessive use of short-term
stock options to compensate directors and executives may result in shortterm thinking and strategies aimed at driving up stock prices at the expense
of the firms long-term health.
4. Inappropriate accounting practices


involves an executive, manager, or employee of the organization in

collusion with an outsider.
four types: bribery, illegal gratuities, conflicts of interest and economic
a. Bribery
involves giving, offering, soliciting or receiving
things of value to influence an official in the performance of his or her
lawful duties.
Ex. The manager of a meat-packing company offers a U.S. health
inspector a cash payment. In return, the inspector suppresses his report
of health violations discovered during a routine inspection of the meatpacking facilities.

b. Illegal gratuities
involves giving, offering, soliciting something of
value because of an official act that has been taken.
Ex. The plant manager in a large corporation uses his influence to
ensure that a request for proposals is written in such a way that only one
contractor will be able to submit a satisfactory bid. As a result, the
favored contractors proposal is accepted at a noncompetitive price. In
return, the contractor secretly makes a financial payment to the plant

c. Conflicts of Interest
occurs when an employee acts on behalf of a third
party during the discharge of his or her duties or has self-interest in the
activity being performed.
Ex. a purchasing agent for a building contractor is also part owner in a
plumbing supply company. The agent has sole discretion in selecting
vendors for the plumbing supplies needed for buildings under contract.
The agent directs a disproportionate number of purchase orders to his
company, which charges above-market prices for its products.
d. Economic Extortion
is the use (or threat) of force (including economic
sanctions) by an individual or organization to obtain something of value.
Ex. a contract procurement agent for a state government threatens to
blacklist a highway contractor if he does not make a financial payment to
the agent. If the contractor fails to cooperate, the blacklisting will
effectively eliminate him from consideration for future work. Faced with a
threat of economic loss, the contractor makes the payment.


Asset Misappropriation
the most common fraud schemes involve some form of asset
misappropriation in which assets are either directly or indirectly
diverted to the perpetrators benefit.
examples: skimming, cash larceny, billing schemes, check
tampering, payroll fraud, expense reimbursements, theft of cash
and non-cash misappropriations.

a. Skimming
stealing cash from an organization before it is
recorded on the organizations books and records.
b. Cash Larceny (ex. Lapping)
cash receipts are stolen from an organization after
they have been recorded in the organizations books.
c. Billing schemes (known as Vendor Fraud)
perpetrated by employees who cause their employer
to issue a payment to a false supplier or vendor by submitting invoices for

fictitious goods and services, inflated invoices, or invoices for personal


Shell company
establish false supplier on the books of the victim.
there is no legitimate transaction but the system recorded
it as legitimate.

same with the shell company but the transaction actually
took place.
the false vendor actually purchases from a legitimate
the false vendor charges the victim company a much
higher than market price for the items, but pays only the market
price to the legitimate vendor.

this typically involves a clerk with check writing authority
who pays a vendor twice for the same products received. The
vendor, recognizing that its customer made a double payment,
issues a reimbursement to the victim company, which the clerk
intercepts and cashes.

d. Check Tampering
involves forging or changing in some material way a
check that the organization has written to a legitimate payee.
e. Payroll Fraud
is the distribution of fraudulent paychecks to existent
and/or nonexistent employees.
f. Expense Reimbursements
an employee makes a claim for reimbursement of
fictitious or inflated business expenses.
g. Thefts of Cash
h. Non-Cash Misappropriations

1. The theft, misuse or misappropriation of assets by altering computerreadable records and files
2. The theft, misuse or misappropriation of assets by altering the logic of
computer software.
3. The theft or illegal use of computer-readable information
4. The theft, corruption illegal copying or intentional destruction of
computer software.
5. The theft, misuse or misappropriation of computer software.

1st Stage: Data Collection

Objective: To ensure that transaction data entering the system are valid,
complete, and free from material errors

Relevance - the information system should capture relevant data only.

Efficiency - collect data only once.

Fraud techniques in networked systems done from remote locations:

Masquerading perpetrator gaining access to the system from a remote

site by pretending to be an authorized user.

Piggybacking perpetrator at the remote sit taps into the

telecommunications lines and latches onto an authorized user.

Hacking breaking into the system rather than the theft of assets.

2nd Stage: Data Processing


processing data to produce information.

include mathematical algorithms used for production scheduling

applications, statistical techniques for sales forecasting, and posting and
summarizing procedures used for accounting applications.

Two classes: Program Fraud and Operations Fraud

Program Fraud

1. Creating illegal programs that can access data files to alter, delete, or insert
values into accounting records.
2. Destroying or corrupting a programs logic using a computer virus.
3. Altering program logic to cause the application to process data incorrectly.

Operations Fraud
misuse or theft of the firms computer resources.
involves using the computer to conduct personal business

Database Management

its physical repository for financial and nonfinancial data.

Database Management Fraud

- Includes altering, deleting, corrupting, destroying, or stealing an
organizations data.

3rd Stage: Information Generation

is the process of compiling, arranging, formatting, and presenting
information to users.

1. Relevance
2. Timeliness
3. Accuracy
4. Completeness
5. Summarization
Scavenging searching through the trash cans of the computer center for
discarded output.
Eavesdropping listening to output transmissions over telecommunications


SAS No. 99, Consideration of Fraud in a Financial Statement Audit, which
pertains to the following areas of a financial audit:
1. Description and characteristics of fraud
2. Professional Skepticism
3. Engagement personnel discussion
4. Obtaining Audit Evidence and information
5. Identifying risks
6. Assessing the identified risks
7. Responding to the assessment
8. Evaluating Audit Evidence and information
9. Communicating possible fraud
Documenting consideration of fraud
Fraudulent Financial Reporting
1. Managements characteristics and influence over the control
2. Industry Conditions
3. Operating characteristics and financial stability
External auditors should look the following schemes:
1. Improper revenue recognition
2. Improper treatment of sales
3. Improper asset valuation
4. Improper deferral of costs and expenses

5. Improper recording of liabilities

6. Inadequate disclosures
Misappropriation of Assets
Schemes related:
1. Personal purchases
2. Ghost employees
3. Fictitious expenses
4. Altered payee
5. Pass-through vendors
6. Theft of cash or inventory
7. Lapping
Auditors Response to Risk Assessment
The auditors judgments about the risk of material misstatements due
to fraud may affect the audit in the following ways.
1. Engagement staffing and extent of supervision
2. Professional Skepticism
3. Nature, timing, and extent of procedures performed
Response to Detected Misstatements Due to Fraud

Influenced by the degree of assessed risk

Some instances, may determine the currently planned audit

procedures are sufficient to respond to the risk factors.

In other cases, may extend the audit and modify planned


In rare cases, the auditor may conclude that procedures cannot

be sufficiently modified to address the risk, in which case the
auditor should consider withdrawing from the engagement and
communicating the reasons for withdrawal to the audit

If the auditor has determined that fraud exist and had no material
effect to the financial statements:
1. Refer the matter to an appropriate level of management at least one
level above those involved.

2. Be satisfied that implications for other aspects of the audit have been
adequately considered.
When the fraud had a material effect to the financial statements or the
auditor is unable to evaluate the degree of materiality, the auditor
1. Consider the implications for other aspects of the audit
2. Discuss the matter with the senior management and with board of
directors audit committee
3. Attempt to determine whether the fraud is material
4. Suggest that the client consult with the legal counsel, if appropriate.

Documentation Requirements
1. Risk factors identified
2. The auditors Response to them

Payments to Fictitious Vendors
1. Sequential invoice numbers
2. Vendors with P.O. Boxes
3. Vendors with Employee Addresses
4. Multiple Companies with the same address
5. Invoice amounts slightly below the review threshold
Payroll Fraud
1. Test of Excessive Hours Worked
2. Test for duplicate payments
3. Test for Nonexistent employees
Lapping of Accounts Receivable
Use ACLs expression builder to select items from each file version whose
Remittance Amount field is greater than zero and less than the Invoice Amount field.
These sets of records may contain legitimate items that are being disputed by the
customers. For example, damaged goods, overcharges, and refused deliveries may

result in customers making only partial payments. The auditor will need to sift
through these legitimate issues to identify lapping.
Merge the resulting carry-forward files into a single file reflecting activity for the
entire period.
Create a calculated field of the amount carried forward (Invoice Amount
Remittance Amount).
Use the duplicates command to search the file for calculated carry-forward
amounts that are the same.

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