Forensic and Investigative Accounting

Chapter 3
Fraudulent Financial Reporting

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 An International Problem
Fraud is an international phenomenon touching all
countries. Transparency International (TI) is a global
network including more than 90 locally established
national chapters and chapters-in-formation, whose
goal is to fight corruption in the national arena. TI
produces a Transparency International Corruption
Perception Index (CPI), which ranks more than 150
countries by their perceived levels of corruption, as
determined by expert assessments and opinion
surveys.
Chapter 3 Forensic and Investigative Accounting 2
 Michael Comer’s Types of Fraud
1. Corruptions (e.g., kickbacks).
2. Conflicts of interest (e.g., drug/alcohol abuse, part-time
work).
3. Theft of assets.
4. False reporting or falsifying performance (e.g., false
accounts, manipulating financial results).
5. Technological abuse (e.g., computer related fraud,
unauthorized Internet browsing).
Comer’s Rule: Fraud can happen to anyone at anytime.

Source: M.J. Comer, Investigating Corporate Fraud, Burlington, Vt.: Gower Publishing Co.,
2003, pp. 4-5.

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 The Cost of Fraud
 Organizations lose 5 percent of annual revenue
to fraud and abuse.
 Fraud and abuse costs organizations more than
$2.9* trillion annually.

* $994 billion in 2008 in U.S. $652 billion in 2006. $660

billion in 2004.

Source: 2012 Wells Report

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 Advantage of Compliance Spending

General Counsel Roundtable says that

each $1 of compliance spending saves
organizations, on the average, $5.21 in
heightened avoidance of legal liabilities, harm
to the organization’s reputation, and lost
productivity.

Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April 2004, p. 47.

Chapter 3 Forensic and Investigative Accounting 5

 Some Research on Fraud
Primary motivation to commit fraud [Dechow et al.]
1. Desire to obtain low-cost loans.
2. Weaker governance system.
3. Experience higher cost of capital after fraud discovered.

Summers and Sweeney [1998]:

In the presence of fraud, insiders reduce their holdings of
company stock through high levels of selling activity.
Also, growth, inventory, and ROA differ significantly.

Chapter 3 Forensic and Investigative Accounting 6

 The Methods - Frequency
 Asset misappropriation accounted for more than four
out of five offenses or 90% in 2010 (88.7% in 2008)
(91.5% in 2006) (92.7% in 2004). $135,000
 Bribery and corruption constituted about 30% (27.4%
in 2008) (30.8% in 2006) (30.1% in 2004) of
offenses. $250,000 ($375,000) ($538,000)
 Fraudulent statements were the smallest category of
offense 5% (10.3% in 2008) (10.6% in 2006) (7.9%
in 2004) (most costly). $4 million per scheme.

Source: 2010 Global Fraud Study, ACFE.

Chapter 3 Forensic and Investigative Accounting 7

 Transparency International Corruption
Perceptions Index 2012
Rank Country Score
1 New Zealand 9.5
2 Denmark 9.4
2 Finland 9.4
4 Sweden 9.3
5 Singapore 9.2
6 Norway 9
7 Netherlands 8.9
8 Australia 8.8
8 Switzerland 8.8
10 Canada 8.7
12 Hong Kong 8.4
14 Japan 8
16 United Kingdom 7.8
24 United States 7.1
32 Portugal 6.1
60 Malaysia 4.3
69 Italy 3.9
73 Brazil 3.8
75 China 3.6
80 Thailand 3.4
95 India 3.1
100 Indonesia 3
112 Vietnam 2.9
143 Russia 2.4
172 Burundi 1.9
182 Somalia (Lowest) 1

Chapter 3 Forensic and Investigative Accounting 8

 One Small Clue
A former Scotland Yard scientist tried to create the world’s
biggest fraud by authenticating $2.5 trillion worth of fake
U.S. Treasury bonds.
When two men tried to pass off $25 million worth of the
bonds in Toronto in 2001, a Mountie noticed the bonds bore
the word “dollar” rather “dollars.”
Police later raided a London bank vault and discovered that
the bonds had been printed with an ink jet printer that had not
been invented when the bonds were allegedly produced.
Zip codes were used even though they were not introduced
until 1963.
Sue Clough, “Bungling Scientist Is Jailed for Plotting World's Biggest Fraud,”
News.telegraph.co.uk, January 11, 2003.
Chapter 3 Forensic and Investigative Accounting 9
 Catch Me If You Can

Numbers Don’t Lie.

Criminals are another story.
Money talks. But more often it whispers. When
shady characters are up to no good, they often
leave a trail of questionable financial
transactions.

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Three M’s of Financial Reporting Fraud
 Manipulation, falsification, or alteration of
accounting records or supporting documents
from which financial statements are prepared.
 Misrepresentation in or intentional omission
from the financial statements of events,
transactions, or other significant information.
 Intentional misapplication of accounting
principles relating to amounts, classification,
manner of presentation, or disclosure.
Source: D.S. Hilzenrath, “Forensic Auditors Find What Some Companies Try
to Hide,” The Washington Post, November 23, 2002, p.19.
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 Fraud Schemes Based on
SEC Releases
1. Fictitious and/or overstated revenues and
assets.
2. Fictitious reductions of expenses and liabilities.
3. Premature revenue recognition.
4. Misclassified revenues and assets.
5. Overvalued assets or undervalued expenses and
liabilities.
(continued on next slide)
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 Fraud Schemes Based on
SEC Releases
6. Omitted liabilities.
7. Omitted or improper disclosures.
8. Equity fraud.
9. Related-party transactions.
10. Alter ego.
11. Minimizing income or inflating expenses to
reduce tax liabilities.

Chapter 3 Forensic and Investigative Accounting 13

 Shenanigans to Boost Earnings
 Recording revenue before it is earned.
 Creating fictitious revenue.
 Boosting profits with nonrecurring
transactions.
 Shifting current expenses to a later period.
 Failing to record or disclose liabilities.
 Shifting current income to a later period.
 Shifting future expenses to an earlier period.
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 Rationalization
Sherron Watkins provides an excellent
comment about rationalization with respect to
Enron’s Jeff Skilling and Andy Fastow.
At what point did they turn crooked? “But
there is not a defining point where they became
corrupt. It was one small step after another, with
more and more rationalizations. There was a slow
erosion of values over time.”

Source: Pamela Colloff, “The Whistle-Blower,” Texas Monthly,

April 2003, p. 141.

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 Reframing
Behavioral psychologists call this rationalization
“reframing,” where someone who is about to cheat
will adjust the definition of cheating to exclude his or
her actions. Dan Ariely says “people who would
never take $5 from petty cash have no problem
paying for a drink for a stranger and putting it on a
company tab.”

Source: S.L. Mintz, “The Gauge of Innocence,”

CFO, April 2009, p. 56.
Chapter 3 Forensic and Investigative Accounting 16
 Internal vs. External Fraud
Internal External
Employee Management
Stock theft Lapping Check forgery
Misappropriation Expense accounts False insurance
of cash assets claims
Lapping False financial Credit card fraud
statements
Check forgery Misappropriation False invoices
of cash/assets
Expense accounts Unnecessary Product
purchases substitution
Chapter 3 Forensic and Investigative Accounting 17
 Internal vs. External Fraud (contd.)
Internal External
Employee Management
Petty cash Check forgery Bribes/secret
commission
Kickbacks Kickbacks Bid rigging/price
fixing
Loans/ Ghost vendors False representation
investments of funds
Ghost Diversion of sales
employees
Source: KPMG, Fraud Awareness Survey, Dublin: KPMG, 1995, pp. 10-12.
Chapter 3 Forensic and Investigative Accounting 18
 Four Factors Contributing to
Business Fraud
1. Motive
2. Opportunity
3. Lack of integrity (or rationalization)
4. Capacity—the person must have the
necessary traits, abilities, or positional
authority to commit the crime

Source: Wolfe and Hermanson, “The Fraud Diamond,” The CPA J., December 2004, pp. 38-42.

Chapter 3 Forensic and Investigative Accounting 19

 Components of Internal Controls
 Control environment
 Risk assessment
 Control activities or control procedures
 Information and communication systems
support
 Monitoring

Source: SAS No. 94, The Effect of Information Technology on the

Auditor’s Consideration of Internal Control in a Financial Statement Audit,
New York: AICPA.

Chapter 3 Forensic and Investigative Accounting 20

 Types of Controls
Preventive Controls
 Segregation of duties
 Required approvals
 Securing assets
 Passwords
 Using document control numbers
 Drug testing
 Job rotation
 Computer backup
Chapter 3 Forensic and Investigative Accounting 21
 Types of Controls

Detective Controls
 Reconciliations
 Reviews
 Event notifications
 Surprise cash count
 Counting inventory

Chapter 3 Forensic and Investigative Accounting 22

 Types of Controls

Corrective Controls
 Training
 Process redesign
 Additional technology
 Quality circle teams
 Budget variance reports

Chapter 3 Forensic and Investigative Accounting 23

 Earnings Management

Earnings management may be defined as the

“purposeful intervention in the external
financial reporting process, with the intent of
obtaining some private gain.”

– Katherine Schipper, “Commentary on Earnings Management,” Accounting Horizon,

December 1989, p. 92.

Chapter 3 Forensic and Investigative Accounting 24

 Difficult to Measure Integrity
Richard Davis says there is no psychometric way to
measure integrity, so forget about personality tests
to pick the fraudsters. They are easily faked.

He is more hopeful about new methods involving

microexpressions, or those brief facial expressions
that may reveal a person’s predisposition to fraud.

Source: S.L. Mintz, “The Gauge of Innocence,” CFO, April 2009, p. 57.
Chapter 3 Forensic and Investigative Accounting 25
 Psychology of Fraud
 Fraud can be explained by three factors:
• Supply of motivated offenders.
• Availability of suitable targets.
• Absence of capable guardians (e.g., internal controls).

 The three B’s -- babes, booze, and bets.

 Some fraudsters wish to make fools of their victims. They

take delight in the act itself.

 Risk of fraud is a product of both personality and

environmental (or situational) variables.

Grace Duffield and Peter Grabosky, “The Psychology of Fraud,” Australian Institute of Criminology,
No. 19.

Chapter 3 Forensic and Investigative Accounting 26

 Parallel Universe: Two Opinions
External auditors must do a regular audit of a company
(e.g., financial statements are fairly stated) and must also
audit the internal controls to ensure that the financial
statements are accurate (e.g., issue two opinions).
Prior to the external auditors’ arrival, the company itself
must review its internal controls and issue a report on the
effectiveness of these controls.
There will be two external opinions: on management’s
assessment of the internal controls over financial reporting
and another one on the effectiveness of the internal controls
themselves (e.g., statements are fairly stated).
PCAOB Release 2004-001.

Chapter 3 Forensic and Investigative Accounting 27

 Anti-Fraud Program

An auditor must perform “company-wide anti-fraud

programs and controls and work related to other
controls that have a pervasive effect on the company,
such as general controls over the company’s electronic
data processing.”
Further, the auditor must “obtain directly the ‘principal
evidence’ about the effectiveness of internal controls.”
PCAOB endorses the COSO Cube.

Source: PCAOB Release 2004-001.

Chapter 3 Forensic and Investigative Accounting 28

 Perceived Root Causes
of Misconduct

Chapter 3 Forensic and Investigative Accounting 29

 PWC Global Fraud Surveys
Incentive/pressures to commit fraud:
 Financial targets more difficult to achieve. 47%
 Fear of losing job. 37%
 Desire to earn personal performance
bonuses. 27%
 For senior executives to achieve desired
financial results. 25%
 Bonuses not paid this year. 23%
 Maintain financial performance to avoid
debt cancelation. 18%

Chapter 3 Forensic and Investigative Accounting 30

 PWC Global Fraud Surveys
Opportunity factors to commit fraud:
 Staff reductions resulting in fewer resources 62%
being deployed on internal controls.
 Shift of management’s focus towards survival 49%
of business.
 Increased workload of internal audit staff. 34%
 Weakening of IT controls resulting in increased 22%
vulnerability of external penetration.
 Transfer of operations to new territories. 22%
 Diversification of product portfolio. 15%
 Reduced regulatory oversight. 12%
 Other factors. 6%

Chapter 3 Forensic and Investigative Accounting 31

 Fraud’s Fatal Failings
 85% of fraud victims never get their money
or property back.
 Most investigations flounder, leaving the
victims to defend for themselves against
counter-attacks by hostile parties.
 30% of companies that fail do so because of
fraud.

Source: Michael J. Comer, Investigating Corporate Fraud,

Burlington, VT: Gower Publishing, 2003, p. 9.
Chapter 3 Forensic and Investigative Accounting 32
 COSO Study Findings
 Financial fraud affects companies of all sizes, with the
median company having assets and revenues just under $100
million.
 The median fraud was $12.1 million. More than 30 of the
fraud cases each involved misstatements/misappropriations
of $500 million or more.
 The SEC names the CEO and/or CFO for involvement in 89
percent of the fraud cases. Within two years of the
completion of the SEC investigation, about 20 percent of the
CEOs/CFOs had been indicted. Over 60 percent of those
indicted were convicted.
 Motivations include meeting expectations, concealing
deteriorating financial conditions, and preparing for
debt/equity offerings.
Chapter 3 Forensic and Investigative Accounting 33
 COSO Study Findings
 Revenue frauds accounted for over 60 percent of the cases.
Overstated assets, 51%. Understatement of expenses/
liabilities (31%). Misappropriation of assets, 14%.
 Many of the commonly observed board of director and audit
committee characteristics such as size, meeting frequency,
composition, and experience do not differ meaningfully
between fraud and no-fraud companies. Recent corporate
governance regulatory efforts appear to have reduced
variation in observable board-related governance
characteristics.
 Twenty-six percent of the firms engaged in fraud changed
auditors during the period examined compared to a 12
percent rate for no-fraud firms.

Chapter 3 Forensic and Investigative Accounting 34

 COSO Study Findings
 Initial news in the press of an alleged fraud resulted in an
average 16.7 percent abnormal stock price decline for the
fraud company in the two days surrounding the
announcement.
 News of an SEC or Department of Justice investigation
resulted in an average 7.3 percent abnormal stock price
decline.
 Companies engaged in fraud often experienced bankruptcy,
delisting from a stock exchange, or material asset sales at
rates much higher than those experienced by no-fraud firms.
 50% of the stock traded on NASDAQ over a variety of
industries.

Chapter 3 Forensic and Investigative Accounting 35

 COSO Study Findings
 20% of the fraud companies were in the computer
hardware/software industry and 20% were in financial
service providers. 11% were in health care and health
products.
 45% of the Section 404 opinions indicated effective controls
and 45% indicated ineffective controls.

Source: COSO News Release, Alamonte Springs, May 20, 2010,

www.coso.org/documents.

Chapter 3 Forensic and Investigative Accounting 36

 Fraud Pentagon

Source: P.D. Goldman, Fraud in the Markets (John Wiley & Sons: 2010), pp. 24-25.

Chapter 3 Forensic and Investigative Accounting 37

 A Thin Line

There certainly is a thin line between legal

earnings management and abusive earnings
management. Where does a company cross
the line between criminal behavior and merely
conduct that is beneficial to the organization?

Chapter 3 Forensic and Investigative Accounting 38