Fraud & corruption


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Fraud & corruption

  1. 1. Fraud & CorruptionByAli Amani • Member of Supreme Court of Iranian Association of Certified Public Accountants (IACPA) • IICA,IMA,AAA,CFE,IIA,BAA,EAA,CAAAGholamhossein Davani • Member of High council of Iranian Association of Certifeid Public Accountants (IACPA ) • IICA,IMA,AAA,CFE,IIA,BAA,EAA,CAAA Dayarayan Auditing & Financial Services Firm(RSMi Iran) 1
  2. 2. Your honor,Just now sitting at the patio with your honorablesibling and having a bite of board with her honor, Iwas informed that your honor has prattled andreappointed price Movasegholdoleh, governor ofQom, formerly deposed due to bribery and buyingoff.I had him sent to Tehran under guard, so that yourMajesty will understand that one can not rule acountry on his aunt’ prescriptions.Forgive me for being over impertinent,Taghi“Amir Kabir’s (Current Pre minister) letter to King Naseraldin Shah” 2
  3. 3. If men were angels, no governmentwould be necessary. If angels wereto govern men, neither external norinternal controls on governmentwould be necessary.James Madison, The Federalist Papers, No. 51, 1788 3
  4. 4. Just as one can not let go of the taste of honey orpoison on the tip of his tongue, a governmentalagent dealing with governmental budget, can notavoid tasting at least a little of the King’swealth.“Kaochila ertashsetra,”Indian edifications, first decade Annone Domini 4
  5. 5. Fraud: Any illegal act characterized by deceit, concealment, or violations of trust to obtain money, property, services, avoid payment; or secure personal or business advantage (IIA) 5
  6. 6. Definition of FraudA generic term, embracing all multifariousmeans which human ingenuity can devise, andwhich are resorted to by one individual to getadvantage over another by false suggestions orby suppression of truth, and includes allsurprise, trick, cunning, dissembling, and anyunfair way by which another is cheated.“Johnson v. McDonald, 39 P2d 150” 6
  7. 7. • In the broadest sense, a fraud is a deception made for personal gain, although it has a more specific legal meaning, the exact details varying between jurisdictions. Many hoaxes are fraudulent, although those not made for personal gain are not best described in this way. Not all frauds are hoaxes - electoral fraud, for example. Fraud permeates many areas of life, including art, archaeology and science. In the broad legal sense a fraud is any crime or civil wrong for gain that utilises some deception practiced on the victim as its principal method. 7
  8. 8. • In criminal law, fraud is the crime or offense of deliberately deceiving another in order to damage them — usually, to obtain property or services from him or her unjustly. Fraud can be accomplished through the aid of forged objects. In the criminal law of common law jurisdictions it may be called "theft by deception," "larceny by trick," "larceny by fraud and deception" or something similar. Fraud can be committed through many methods, including mail, wire, phone, and the internet (see computer crime and internet fraud.) 8
  9. 9. Acts which may constitute criminal fraud include:• bait and switch• confidence tricks such as the fraud, Spanish Prisoner, and the shell game• false advertising• identity theft• false billing• forgery of documents or signatures• taking money which is under your control, but not yours (embezzlement)• health fraud, selling of products of spurious use, such as quack medicines• creation of false companies or "long firms"• false insurance claims• bankruptcy fraud, is a US federal crime that can lead to criminal prosecution under the charge of theft of the goods or services• investment frauds, such as Ponzi schemes• securities frauds such as pump and dump 9
  10. 10. Fraud means:• Inducing a course of action by deceit or other dishonest conduct• Involves acts or omissions or the making of false statements• Can be orally or in writing• Object – to obtain a benefit or evade a liability 10
  11. 11. Fraud: The term fraud may be defined as intentional misrepresentation of financial information by one or more individuals among management, employees or third parties. Fraud may involve: Falsification or alteration of accounting records or other documents Misappropriation of assets or theft; Suppression or omission of the effects of transactions from records or documents. Recording of transactions without substances. Intentional misapplication of accounting policies or Willful misrepresentations of transactions or of the entitys state of affairs. 11
  12. 12. Nature of the Frauds (Source:Coso report)• Cumulative amounts of frauds were relatively large in light of the relatively small sizes of the companies involved. The average financial statement misstatement or misappropriation of assets was $25 million and the median was $4.1 million. While the average company had assets totaling $533 million, the median company had total assets of only $16 million.• Most frauds were not isolated to a single fiscal period. Most frauds overlapped at least two fiscal periods, frequently involving both quarterly and annual financial statements. The average fraud period extended over 23.7 months, with the median fraud period extending 21 months. Only 14 percent of the sample companies engaged in a fraud involving fewer than 12 months.• Typical financial statement fraud techniques involved the overstatement of revenues and assets. Over half the frauds involved overstating revenues by recording revenues prematurely or fictitiously. Many of those revenue frauds only affected transactions recorded right at period end (i.e., quarter end or year end). About half the frauds also involved overstating assets by understating allowances for receivables, overstating the value of inventory, property, plant and equipment and other tangible assets, and recording assets that did not exist. 12
  13. 13. Fraud and abuse covers various issues including: • Conflicts of interests e.g. a corrupt relationship can involve an employee setting up a company, the company supplies goods and services to the organization, the employee does not tell the organization about it • Breach of trust e.g. leaking of confidential or sensitive information • Employee malpractice e.g. excessive use of the telephone for private calls, e-mail abuse • Criminal offence 13
  14. 14. • corruption    noun 1 [U] illegal, immoral or dishonest behavior, especially by people in positions of power• corroput    verb [T] to make someone or something become dishonest or immoral:• n.) The act of changing, or of being changed, for the worse; departure from what is pure, simple, or correct; as, a corruption of style; corruption in language.• (n.) The act of corrupting or of impairing integrity, virtue, or moral principle; the state of being corrupted or debased; loss of purity or integrity; depravity; wickedness; impurity; bribery.• (n.) The product of corruption; putrid matter.• (n.) The act of corrupting or making putrid, or state of being corrupt or putrid; decomposition or disorganization, in the process of putrefaction; putrefaction; deterioration. 14
  15. 15. • corruption as ‘doing something beyond the existing rules regulation intending personal or group interest or doing something illegally for personal or group interest. Respondents think that terrorism, theft, snatching, robbery, bribing are the different forms of corruption. Vote rigging, use of muscles power in election, trafficking of children and women, rape, cheating, abduction- these are the another form of corruption.• Respondents also comment that corruption can be economic, social as well as political.• The following comments by the participants support this finding: • doing something illegally is corruption • doing something violating existing set of rules regulations and law is corruption • doing something beyond principles is corruption • doing something for the personal interest violating the prevailing system and social values is corruption • vote rigging is a corruption • dispute of land is corruption • (terrorism), bribing, theft is corruption • bribing, nepotism in the case of employment is corruption • unconsciousness is one sort of corruption • drug abuse, drug smuggling is a corruption • for the sack of own interest, all the economical, social injustice is corruption • negligence of duty is corruption • misuse of political power is corruption 15
  16. 16. • Corruption is defined in section 83 of the Criminal Code (WA) and is taken to mean any public officer who, without lawful authority or a reasonable excuse:• acts upon any knowledge or information obtained by reason of his or her office or employment;• acts in any matter, in the performance or discharge of the functions of his or her office or employment, in relation to which he or she has, directly or indirectly, any pecuniary interest; or• acts corruptly in the performance or discharge of the functions of his or her office; or• employment, so as to gain a benefit, whether pecuniary or otherwise, for himself or herself or any person, or so as to cause a detriment, whether pecuniary or otherwise, to any person, is guilty of a crime and is liable to imprisonment for 3 years. 16
  17. 17. Money Laundering:Money laundering is the process by whichcriminals attempt to conceal the true origin andownership of their criminal activities. Ifundertaken successfully, it also allows them tomaintain control over those proceeds andultimately to provide a legitimate cover for theirsource of funds. Their dirty funds appear clean.It is generally linked with money required tofinance cross border drug trafficking, arms dealor tax evasion or other similar crimes. 17
  18. 18. THEORIES OF FRAUD: A number of theoretical models have been constructed in the past in an attempt to explain why people commit fraud. Some of the key characteristics of recent models include the following: A perceived opportunity such as the absence of or circumvention of controls that enable fraud to be prevented or detected. An offender with a motivation to steal money, whether through cupidity, living beyond ones means, the existence of debts some times associated with drug or gambling addiction, presence of a financial crisis or various work related pressures. The presence of a rationalization for acting illegally, such as belief that the victim can afford the loss, that the funds stolen will be repaid or that the money will be used for a good purpose by the offender; and finally. The absence of a capable guardian, whether through proper business administration, lack of fraud prevention resources or the absence of an effective police service or regulatory authority. 18
  19. 19. History of Fraud• Considering the enormous impact, relatively little research has been done on the subject of occupational fraud and abuse. Much of the current literature is based on the early works of Edwin H. Sutherland (1883-1950), a criminologist at Indiana University. Sutherland coined the term “Wite-Collar” crime in 1939.• Sutherland believed that crime was a learned activity at a time when most experts believed that crime was genetically based. 19
  20. 20. WHITE COLLAR CRIME• In 1995, Albanese explained white-collar crime as: “Planned or organized illegal acts of deception or fraud, usually accomplished during the course of legitimate occupational activity, committed by an individual or corporate entity.” It is clear from these two definitions that a certain form of behavior is required for white-collar offences, which distinguishes it from conventional crimes like robbery and assault. For practical reasons, it is proposed that the definition of white- collar crime be as follows: “White-collar crime is the unlawful, intentional commitment of deceit, deception, concealment, manipulation, breach of trust, subterfuge or any other similar trickery, by an individual, syndicate or organization, normally after meticulous planning, with out the use of physical violence which causes actual economic prejudice or potential economic prejudice to another.” 20
  21. 21. White-collar crime is distinguished from other conventionalcrimes like robbery by way of the following generalcharacteristics:•Unlike robbery which involves the use of force, white-collar offences arecharacterized by careful planning and deception, usually without the use of violence;• Some form of premeditation and fraudulent activity is typical;•There is usually an element of concealed misappropriation or deception;•The white-collar offence is often of a complicated nature which makes it difficult toprosecute; the crime normally has low visibility in order to obscure its existence;•There is usually a diffusion of responsibility for the crime;•Diffusion of victimization is also a characteristic of theses types of crimes•There does not seem to be a true “victim” when a person defrauds the company heworks for;•Although the element of fraud is usually found in most white-collar schemes, theseoffences can go much further including corruption, forgery, theft and complicatedstatutory offences like money laundering of which deceit is usually an element; −White-collar offences are often demarcated as “rational crimes”;•A white-collar criminal’s occupation or working conditions often provides 21opportunities that may be exploited.
  22. 22. Some reasons why fraud happens include: • failure to look for it • internal audit cover and fraud risk management skills not always adequate • poor data integrity and security • inappropriate authority levels • recruitment of dishonest employees • abuse of separation of duties 22
  23. 23. The Fraud Triangle Incentives/PressuresOpportunities Attitudes/Rationalization 23
  24. 24. Types of FraudFraudulent financial reporting Misappropriation of assets 24
  25. 25. TYPES OF FRAUD Frauds can be categorized by the type of victim involved. The most common groups of victims encountered by investigators include:• Investors• Creditors• Businesses• Banks or other financial institutions• Central or local government• Fraud by manipulating financial markets 25
  26. 26. Stock Fraud• A crime in which securities investing or trading laws have been violated. Stock fraud encompasses many things including stocks, bonds, commodities and other investments. Stock fraud is illegal and can be described as deceptive practices in the stock and commodity markets. Stock fraud occurs when investors are enticed to buy securities based upon false statements or records. Stock fraud includes providing false information on a companies financial statement, profit and loss statements, SEC filings, lying to an auditor, stock manipulation schemes, insider trading, and embezzlement. Stock fraud is otherwise known as securities fraud. 26
  27. 27. Identity Fraud Survey Report 2006 Source:Javelin 27Stratgy&Research
  28. 28. Brief History of Financial Fraud• 1907 to 1919 Charles Ponzi, inventor of the pyramid or "Ponzi" scheme, was sentenced to 10 years in prison for larceny and fraud. He had raised $15 million before he was caught. 28
  29. 29. • 1929 International Powers stock price dropped 78% in one day when it was revealed that they "cooked the books". The Securities and Exchange Commission (SEC) was created in response to the rampant fraud of the go-go 1920s which were exposed in the 1929 stock market crash. 29
  30. 30. • 1932 Ivar Kreuger was caught switching assets and liabilities and making up assets. He raised $500 million before he was caught. In March 1932 he shot himself in Paris. 30
  31. 31. • 1937 Phillip Musica (aka Frank Donald Coster) was caught with $10 million of inventory and $9 million of accounts receivable that didnt exist. 31
  32. 32. • 1963 Anthony (Tino) De Angelis of Allied Crude Vegetable Oil Refining Co. used bottles of water, not oil, as collateral for $175 million in loans. 1973 Equity Funding Corporations net worth of $143.4 million was discovered to be negative $42.1 million. The company had been recording fictitious income since• 1965. Stanley Goldblum and 22 other people were sentenced for fraud. 1988 Wedtech (Welbilt Electronic Die Co) was caught using the percentage of completion method to record revenue that didnt exist, bribing government officials, lying on government proposals and contracts, and falsifying invoices. The scandal involved Congress and the Reagan administration. Auditors sued for $105 million in damages. 32
  33. 33. • 1987 Lincoln Savings and Loan costs taxpayers $2.5 billion for fraud schemes that involved members of Congress. Charles Keating recorded profits on junk bonds and real estate loans that they knew were worthless, and he his family received $34 million in salary and sales of American Continental Corporation stock before the scheme crashed. Savings and Loan scandals cost taxpayers an estimated $500 billion during the 1980s. 1989 MiniScribe Corporation, a disk drive manufacturer, fooled their auditors for 2 years by filling their inventory boxes with bricks. The auditing company, Coopers & Lybrand, had to pay $100 million in an out-of-court settlement. 33
  34. 34. • 1991 The Bank of Commerce and Credit International (BCCI), known today as "The Bank of Crooks and Criminals International", was used to launder money by drug smugglers and embezzling dictators throughout the world. When the bank was finally shut down, in July 1991, it was found to have stolen, lost, or swindled $20 billion. 1991 Maxwell Communications president Robert Maxwell resorted to looting when his publishing empire started to collapse, taking $1.4 billion including $800 million from the employee pension fund alone. He was found dead on November 5, 1991. 1998 When Cendant was created from the 1997 merger of HFS and CUC, HFS management discovered that CUC (Comp-U-Card) had been cooking the books, by reporting false membership sales, since at least 1983. They were charged with fraud on April 16, 1998. The company had to pay billions to defrauded investors, and the auditor, Ernst & Whinny, paid $335 million in an out-of-court settlement. 2000 Micro Strategy had their share price collapse from $333 to $86 when they announced their financial reports would be restated to show huge losses. Investors had pushed the price up based on the hype from one of the tech industrys most flamboyant CEOs, Michael Saylor, along with bogus financial statements. The share price was $3 one year later. 2001 Enron, WorldCom. 34
  35. 35. BETTER AUDITS, LESS FRAUD• As financial and economic pressures tighten for corporate executives, it is more important than ever for auditors to develop sound fraud-detection audit techniques. The audit deficiencies alleged by the SEC between 1987 and 1997 are, in our view, issues the profession and individual firms can effectively address. The recommendations included in this article may help firms reduce the chance of undetected material financial statement fraud as they strive to continually improve fraud risk assessment tools. The audit deficiencies the SEC identified also have important implications for standard setters as they seek to strengthen professional standards related to the auditor’s fraud detection responsibilities. 35
  36. 36. The result was the following new set of skills needed by accountants • Better technology skills • Better analytical skills—to understand complex transactions (derivatives, reserves, leverage, etc.) • Better communication skills – to participate in decision- making teams • Better interviewing skills • Better skills working in teams • A better global understanding • Better understanding of fraudWhat gave accountants an advantage in the past is no longer nearly as valuable! 36
  37. 37. Competencies/Skills Learned • Risk analysis • Controls and control environment • Better auditing skills • Knowledge of the legal system • Availability of information (public, private, databases, etc.) • Problem-solving abilityToday’s winners are those who have access to the best information a fraud course teacheshow to access information 37
  38. 38. :For better Audits educators must• Need to teach Ethics more• Need to teach students about fraud—offer a “fraud” course• Need to teach students how to think • We have taught them how to copy, not think • We have asked them to memorize, not think • We have done what is easiest for us and easiest for our students 38
  39. 39. • First and foremost is the urgent need for change:• External and internal auditors must train thoroughly in fraud- detection procedures and attitudes.• The university education of the next generation of auditors should reflect the new emphasis on fraud deterrence, detection, and investigation.• The formal standards governing audit processes and objectives should evolve without delay to an updated and more rigorous approach to fraud detection.• Executives and directors must become fully aware of the threat of fraud and do all they can to institute measures to deter it, ranging from robustly enforced codes of ethics to internal controls that make fraud less likely and easier to detect. 39
  40. 40. The six key drivers of audit quality (identified in Audit Quality) are:• Leadership, including tone at the top and audit firm strategy;• People of competence, quality and integrity;• Client Relationships, including effective management of client portfolios and working with individual clients;• Working Practices and quality control procedures;• Internal Monitoring by audit firms of leadership, people, client relationships and working practices; and• External Monitoring under public oversight to encourage and assist firms to improve audit quality. 40
  41. 41. 41
  42. 42. Risk & Fraud cycle 42
  43. 43. Role of Internal & External auditors in fraud detection• Internal Auditors’ Assessment of Fraud Implications for External Auditors• Warning Signs: Implications for External Auditors• External Auditors Can Partner with Internal Auditors• The AICPA’s have issued SAS 99, Consideration of Fraud in a Financial Statement Audit, directs external auditors to ask a company’s internal audit personnel about the risk of fraud and any knowledge of actual or suspected fraud. The impetus for this directive comes from the important role internal auditors play in corporate governance. As recognized by the Treadway Commission Report in 1987, internal auditors are expected to assume an active role in preventing and detecting fraudulent financial reporting. 43
  44. 44. Fraud ConditionsAccording to SAS 99, three fundamentalconditions are generally present when fraudulentfinancial reporting occurs: 1) incentive or pressure to perpetrate fraud, 2) an opportunity to carry out the fraud, 3) attitude or rationalization to justify the fraudulent action. Within each of the three fundamental conditions, there are a number of specific warning signs of fraud, including some factors directed toward corporate governance. 44
  45. 45. Auditor’s Professional responsibility• Certified auditors are required by Statement on Auditing Standards no. 99, Consideration of Fraud in a Financial Statement Audit, to assess the risk that financials are materially misstated.• The Association of Chartered Certified Accountants (ACCA) welcomes the opportunity to comment on the revised International Standard on Auditing 240 The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements proposed by the International Auditing and Assurance Standards Board (IAASB).• The Institute of Chartered Accountants in England and Wales (ICAEW) issued comprehensive guidance notes for Chartered Accountants following the Money Laundering Regulations enactment in 1993. Regarding conventional frauds, ICAEW issued SAS 110.1 on fraud and error and fixed up the responsibility of auditors 45
  46. 46. • In February 1997, the AICPA auditing standards board (ASB) will issue Statement on Auditing Standards (SAS) no. 82, Consideration of Fraud in a Financial Statement Audit (product no. 060675). The new standard articulates the independent auditor’s responsibility to plan and perform the audit to obtain reasonable assurance as to whether the financial statements are free of material misstatement, whether caused by error or fraud, and provides expanded operational guidance in fulfilling that responsibility.• Specifically, SAS no. 82• Describes two types of fraud fraudulent financial reporting and misappropriation of assets.• Requires the auditor to specifically assess the risk of material misstatement due to fraud. It provides categories of risk factors that should be considered and examples that might indicate the presence of fraud.• Provides guidance on how the auditor responds to the results of the assessment and provides guidance on how this should be done and on how to evaluate test results.• Requires the auditor to document identified risk factors and any related response. 46
  47. 47. Three of these ISAs (UK and Ireland), which concern theareas of audit risk and fraud, include a number ofrequirements that are additional to those set out in theSASs theory replace. This Bulletin providedsupplementary guidance for auditors of charities onthese additional requirements, by replacing the sectionsof Practice Note (PN) 11 “The Audit of Charities in theUnited Kingdom (Revised)” Which cover: • SAS 210: ‘Knowledge of the business’, • SAS 300: ‘Accounting and internal control systems and audit risk assessments’; and • SAS 110: ‘Fraud and error’. 47
  48. 48. Iranian Auditor’s Responsibility to Consider Fraud &Error in an audit of Financial statements Accordancewith Iran audit standards sec.24SAS Says:•Its management’s responsibility: •Setting the proper tone •Creating and maintaining a culture of honesty and ethics •Establishing appropriate controls 48
  49. 49. Auditors Responsibility under Generally Accepted Auditing StandardsIt is important for audit committees to understand whatan audit is and what it is not. Usually, audit committeesare most concerned about the system of internal controland that the financial statements are free of materialmisstatement. The auditor should make sure the auditcommittee understands the level of responsibility thatthe auditor assumes for the system of internal controland the financial statements under generally acceptedauditing standards (GAAS). It is also important that theauditor make sure that the audit committee understandsthat an audit is designed to obtain reasonable rather thanabsolute assurance about the financial statements. 49
  50. 50. The following statistics about fraud and white-collar crime are from theAssociation of Certified Fraud Examiners (US) report:Fraud and abuse costs US organizations more than $400 billion annually.The average organization loses more than $9 per day per employee tofraud and abuse.The average organizations lose about 6% of its total annual revenue tofraud and abuse committed by its own employees.The median loss caused by mails is about $185000; by females about$48000 and thus men commit nearly 75% of the offenses.Losses caused by managers are four times those caused by employees.Median losses caused by executives are 16 times those of theiremployeesThe highest median losses occur in the real estate financing sector.Occupational fraud and abuses fall into these main categories; assetmisappropriation, fraudulent statements and bribery and corruption. 50
  51. 51. Fraud effect in UK• It is estimated that fraud cost £13 billion in 2000 or £230 for every man, woman and child in Britain (figures exclusive of money laundering) (City of London Police, 2002; National Economic Research Associates for the Home office, 2000)• False motor and household claims cost the insurance industry and policy holders £20 million per week (Association of British Insurers, April 2003)• 51% of British businesses have been the victims of fraud in the last two years (PricewaterhouseCoopers, July 2003)• Benefit fraud costs £2 billion a year, £80 for every family in the country (Department of Work and Pensions, June 2003)• Plastic card fraud alone cost £424.6 million in 2002 – 30% up on the year before (Association for Payment Clearing Services, April 2003)• Card-not-present fraud is the largest type of card fraud in the UK. In 2003 losses were £116.4 million (Association for Payment Clearing Services, April 2004)• Fraud wrecks ordinary lives by destroying jobs, savings and pensions. 16 investors took their own lives in the aftermath of the Barlow Clowes fraud (The Serious Fraud Office, 2002) 51
  52. 52. Auditors under fireAndrew Ratcliffe Chairman of the ICAEW Audit and Assurance Faculty:• “Auditors are not, and indeed should not be, held responsible for detecting all fraud, but we must play our part to improve the overall detection rate to help maintain public trust in published accounts following the recent spate of US accounting scandals.• We are also concerned about companies that adopt aggressive accounting practices which might stop short of being clearly fraudulent. Faced with this risk, auditors will need to more actively search out aggressive accounting and help ensure that the right judgments are applied." 52
  53. 53. Introduction to Fraud DetectionThere are more advanced techniques on this site, butthis is the place to start to get some idea whattechniques you can use for spotting funny numbers. • Examine cash flow. • Watch out for "capitalizing" of assets. • Watch for "channel stuffing. • Beware "Pro Forma. • Look for routine write-offs. • Understand the business. 53
  54. 54. Frauds can also be categorized by the technique or activity used by the fraudster.These include:•Advance fee frauds•Bogus invoices•Computer hacking of information or property•Corruption and bribery•Counterfeiting, forgery, or copyright abuse•Credit Card fraud•False Accounting - manipulation of accounts and accounting records•Fraudulent bankruptcy - exploitation of cross-border corporate structures•Insurance fraud•Internet online scams - auctions, credit card purchases, investment scams•Investment fraud•Long Firm fraud•Misappropriation of assets•Money laundering•Mortgage Fraud•Payroll fraud•Principal agents - failure of systems to restrict key individuals•Pyramid schemes•Unsolicited letter frauds. 54
  55. 55. Fraud Detection: Basic Techniques• Watch out for two or more businesses controlled by the same person.• Revenue and expenses can be arbitrarily shifted between the two businesses. For example, if a person controls a retail business and a real estate business, he can shift revenue from the real estate business when the retail business has a bad year. Public corporations frequently share board members and executives with other corporations. 55
  56. 56. • Check their income tax expense and footnotes. Fraudulent corporations have an incentive to make their profit number as big as possible for their annual and quarterly reports, but they have an incentive to make that number as small as possible for the IRS, because they have to pay income tax on it! So if the corporation is reporting large profits but is paying next to nothing on income tax, they might be lying either to you, or to the IRS. NOTE: Unfortunately, this doesnt prove fraud, as the tax code is so ridden with loopholes that multi-billion-dollar corporations like General Electric routinely get away with paying no income tax at all! 56
  57. 57. Beware discontinuities that become “continuities”• An extraordinary loss or gain should not become a regular feature of a businesss income statement. If a business is having major lawsuits, abandoning product lines, or undergoing major restructuring, thats a sign that management is either up to something (fraud), or dont know what they are doing (poor management). 57
  58. 58. • Beware discontinuities that become opportunities to dump too many write-downs and losses.• This is the "big bath" theory. The company may run losses for years, without reporting them, and then take a "big bath" and write down the losses all at once. If the company has done this is the past, they might do it again, and as an investor you dont want to get caught in the bath. 58
  59. 59. Watch for high debt• A company with too high debt is walking on the edge of a cliff. Any major problem, and they get pushed over. Note: Even an acid-test ratio .• 1-to-1 may not be enough if youre dealing with a type of business that depends heavily on short-term debt. 59
  60. 60. • Pay attention to the accounting methods. What method are they using to determine• inventory,• cost of goods sold, and• depreciation of assets.• Are they using "mark-to-market" for accounting their sales revenue? (Enron was.) Companies do not have to report what their income would have looked like if they were using different accounting rules. 60
  61. 61. Beware "free cash flow"• Free cash flow has no officially defined meaning determined by any authoritative accounting rule-making body. 61
  62. 62. • Look for special gains and losses on the statement of stockholders equity.• The general format of the statement of stockholders equity is to use a column for each class of stock (common stock, preferred stock, treasury stock, and so on), a column for retained earnings, and any other components of stockholders equity. Special gains and losses should be reported on the income statement, underneath the net income line. They should not be here, on the statement of stockholders equity. 62
  63. 63. • Look for "window dressing" on the balance sheet.• This is where numbers are nudged from one account to another, without changing the total amount. For example, money could be moved from accounts receivable to cash, to make the cash balance look better. 63
  64. 64. Watch out for profit smoothing• A company that has large changes in revenue will usually use profit smoothing. This involves moving current income to the future. For example, suppose the company is a video game company, and they get massive revenue "spikes" when a game is released, but relatively low sales the rest of the time. The company will spread the money from the "spikes" out over the year, so that their revenue shows a steady increase from year to year. Using profit smoothing is legal, but can be abused. 64
  65. 65. Look for sales skimming.• This is when the owners pocket sales money without reporting it. One way to spot this is to look at the gross profit and operating profit ratios. 65
  66. 66. Look for unnecessary dilution of stock.• If a company is creating shares of stock for sale, but doesnt actually need the money, then they could be doing something sneaky. Watch out for managers that give themselves stock options (and create new shares in the process) and then have the company buy back the company stock off the market. By doing this, they increase their own share of ownership in the company, at the expense of everybody else (including you). 66
  67. 67. Beware of LLCs• Limited Liability Corporations, or LLCs, can have extremely complicated ownership structures. 67
  68. 68. • Examine how indirect costs are allocated. Indirect costs are costs that cannot be obviously attributed to specific products, organizational units, or activities. A book publishers phone bill is a cost of doing business, but it cant be attributed to a particular book, or a particular step in the process of producing books. Allocation of indirect costs is ultimately arbitrary. Because it is arbitrary, it can be abused. For example, misclassification of manufacturing costs as operational costs will make the cost of producing a product look too low. 68
  69. 69. • Watch out for products sold "on approval" or with right of return. Revenues should only be booked after the sale is complete and the goods can no longer be returned. 69
  70. 70. • Examine how indirect costs are allocated. Indirect costs are costs that cannot be obviously attributed to specific products, organizational units, or activities. A book publishers phone bill is a cost of doing business, but it cant be attributed to a particular book, or a particular step in the process of producing books. Allocation of indirect costs is ultimately arbitrary. Because it is arbitrary, it can be abused. For example, misclassification of manufacturing costs as operational costs will make the cost of producing a product look too low. 70
  71. 71. • Watch out for products sold "on approval" or with right of return. Revenues should only be booked after the sale is complete and the goods can no longer be returned. 71
  72. 72. Watch out for LIFO inventory.LIFO is usually the wrong accounting method for inventory, because: • most businesses dont raise prices as soon as replacement costs increase, or base their sales price on the most recent purchase costs, • the inventory cost value can get seriously out of date, especially if the business sells products that have long lives (an equipment manufacturer, for example), • LIFO figures can be more easily manipulated by unscrupulous management. 72
  73. 73. • Make sure the company is using "Lower of Cost or Market" (LCM) to calculate their inventory.• Lower of Cost or Market gives a more conservative inventory value. Some managers cheat and use LCM to report an unusually low inventory for cheating on income tax. 73
  74. 74. • Did the company change depreciation rules? An unexplained change from accelerated depreciation to straight-line depreciation, or to mark-to-market depreciation should set off alarms. Companies can make funny money by playing with depreciation rules, either writing off too little (and boosting their balance sheet) or too much. If they write off too much, it makes their current financial results look bad, but gives them hidden cash reserves. They can use these reserves to boost future sales or offset future expenses. 74
  75. 75. • Compare profit ratios with past statements.• Calculate the gross margin (profit as a percentage of sales) and see if it changes from quarter to quarter. Normally it will not change suddenly. There are many other ratios you can look at. 75
  76. 76. • Examine extraordinary losses.• Often an extraordinary loss is not the result of a one-time event, but the cumulative result of years of bad accounting. 76
  77. 77. • See if earnings per share kept up with profit.• If profit increased by a larger percentage than earnings per share, and there wasnt any stock split, or stock offering (with a clearly explained justification), then management is diluting the shares. While this doesnt necessarily mean fraud, it is a red flag that management doesnt care about shareholder interests. 77
  78. 78. • Compare profit increase with cash flow. These should increase in lockstep. Usually if cash flow is low (or negative) its because all the profits are in accounts receivable and havent been collected yet. 78
  79. 79. • Check that increases in assets and liabilities are consistent with the businesss growth.• If the company is reporting profits quarter after quarter, but total assets is shrinking, something is wrong. If most balance sheet items increase by a few percentage each year, but one item has a huge jump• Positive or negative• Make sure you know the reason why. 79
  80. 80. • Look for "other." Most balance sheets have a catch-all category called "Other assets." Likewise, most income statements have a catch-all category called "Other expenses." These "other" categories should be small and insignificant. If a significant amount of assets is in the "other" category, beware! 80
  81. 81. 10 STEP ANTIFRAUD PLAN (PWC)1) Anticipate Questions and Manage Expectations.2) Assess existing antifraud programs and controls.3) Secure management and audit committee sponsorship.4) Assemble fraud expertise within internal auditing.5) Organize a fraud and reputation risk assessment.7) Evaluate and test the design and operating effectiveness of controls.8) Refine the audit plan to address residual risk and incorporate fraud auditing.9) Establish a standard process for responding to fraud allegations or suspicions.10) Remediate and prevent recurrence 81
  82. 82. What did the auditor say?Just because the auditor says the books are cleandoesnt mean they are, of course. You shouldnever trust the auditor. But if the auditor didraise a red flag, take it very, very seriously! Ifthe auditors opinion is qualified by anything,you should be more skeptical of the entirefinancial statement -- not just the item that theauditor expressed concern about. If the auditorexpresses concern about the companys ability tobe a "going concern", the auditor is saying thebusiness is about to be forced into bankruptcy. 82
  83. 83. What Arthur Anderson SaidBauer, the chief auditor of Enron’s wholesale division, “I did not know the company was using reserves to meet earnings targets and would not have approved if he had known, the Chicago Tribune reports. “No one gave me this information,” Bauer said. “That’s earnings management; that’s never OK. . . . Enron had an obligation to me to provide all documents, all agreements, oral or written and they didn’t do that,” - Mar-24-2006 83
  84. 84. • Is the auditor also doing consulting? Consulting may be referred to as "corporate finance," "eBusiness," "human capital," " legal services," "outsourcing," "risk management," "tax services", and so on. Doing audits and consulting is a deep conflict of interest, as the Enron scandal well demonstrates. 84
  85. 85. Consequences of Fraud• Lost confidence in capital markets• Lawsuits—one company has over 3,000• Firms going out of business—huge bankruptcies• Lost reputation and bad press• Longer and more expensive audits, special inquiries• Fines & investigations• Damaged employees & reputations• Lost retirement and pension funds—now down 45%• Directors with personal liability, forced resignations• Losses from fraud• Significant legislative activity 85
  86. 86. Financial Statement Frauds• Revenue/Accounts Receivable Frauds (Global Crossing, Quest, ZZZZ Best)• Inventory/Cost of Goods Sold Frauds (PharMor)• Understating Liability/Expense Frauds (Enron)• Overstating Asset Frauds (WorldCom)• Overall Misrepresentation (Bre-X Minerals) 86
  87. 87. Revenue-Related Transactions and Frauds Transaction Accounts Involved Fraud Sche me s1. Estimate all Bad debt expense, allowance for 1. Understate allowance for doubtful accounts, thusuncollectible accounts doubtful accounts overstating receivablesreceivable2. Sell goods and/or Accounts receivable, revenues 2. Record fictitious sales (related parties, sham sales,services to customers (e.g. sales revenue) (Note: cost of sales with conditions, consignment sales, etc.) goods sold part of entryh is 3. Recognize revenues too early (improper cutoff, included in Chapter 5) percentage of completion, etc.) 4. Overstate real sales (alter contracts, inflate amounts, etc.)3. Accept returned goods Sales returns, accounts receivable 5. Not record returned goods from customersfrom customers 6. Record returned goods after the end of the period4. Write off receivables as Allowance for doubtful accounts, 7. Not write off uncollectible receivablesuncollectible accounts receivable 8. Write off uncollectible receivables in a later period5. Collect cash after Cash, accounts receivable 9. Record bank transfers as cash received fromdiscount period customers 10. Manipulate cash received from related parties6. Collect cash within Cash, sales discounts, accounts 11. Not recognize discounts given to customersdiscount period receivable 87
  88. 88. Inventory/Cost of Goods Sold Frauds Transaction Accounts Involve d Fraud Sche me s1. Purchase inventory Inventory, accounts 1. Under-record purchase payable 2. Record purchases too late 3. Not record purchases2. Return merchandise to Accounts payable, 4. Overstate returnssupplier inventory 5. Record returns in an earlier period (cutoff problem)3. Pay vendor within discount Accounts payable, 6. Overstate discountsperiod inventory, cash 7. Not reduce inventory cost4. Pay vendor without discount Accounts payable, cash Considered in another chapter5. Inventory is sold; cost of Cost of goods sold, 8. Record at too low an amountgoods sold is recognized inventory 9. Not record cost of goods sold nor reduce inventory6. Inventory becomes obsolete Loss on write-down of 10. Not write off or write down obsolete inventory inventory, inventory7. Inventory quantities are Inventory shrinkage, 11. Over-estimate inventory (use incorrect ratios,estimated inventory etc.)8. Inventory quantities are Inventory shrinkage, 12. Over-count inventory (double counting, etc.)counted inventory9. Inventory cost is Inventory, cost of goods 13. Incorrect costs are useddetermined sold 14. Incorrect extensions are made 15. Record fictitious inventory 88
  89. 89. Role of Andersen in Enron Case• Was paid $52 million in 2000, the majority for non-audit related consulting services.• Failed to spot many of Enron’s losses• Should have assessed Enron management’s internal controls on derivatives trading—expressed approval of internal controls during 1998 through 2000• Kept a whole floor of auditors assigned at Enron year around• Enron was Andersen’s second largest client• Provided both external and internal audits• CFOs and controllers were former Andersen executives• Accused of document destruction—was criminally indicted• Went out of business• My partner friend “I had $4 million in my retirement account and I lost it all. ” Some partners who transferred to other firms now have two equity loans and no retirement savings. 89
  90. 90. Timeline of Arthur Anderson events1996 Arthur Andersen has an audit failure in Waste Management; Andersen paid a censure of $7 million.1997 Arthur Anderson has an audit failure in Sunbeam; Andersen paid $110 million to settle shareholder litigations.January 1997 Jeffery Schilling is named president and COO of Enron. Schilling implements his assets are bad intellectual assets are good campaign to “clean up” Enron’s financial statements. Begins using the LJM partnerships run by Andrew Fasted, Enron’s CFO.Early 2001 Jim Chinos takes note of Enron’s lack of money-making activities and begins to wonder about the LJM partnerships.February 2001 Skilling’s promotion to CEO takes effect, he replaced Charles Lay.June 2001 Enron executives sell shares as stocks slid 39% in the first quarter.August 2001 Schilling quits for personal reasons, and Charles Lay is named CEO again.Oct. 16, 2001 Enron reports a third quarter loss of $618 million. They cite the loss as being partially due to the LJM partnerships.Oct. 22, 2001 SEC starts an investigation into the LJM partnerships, and CFO Fasted leaves Enron.Nov. 8, 2001 Enron’s Net income back through 1997 is revalued by $586 million.Nov. 9, 2001 Synergy offers to buy Enron for $10 billion.Nov. 28, 2001 Synergy refuses to buy Enron.Dec. 2 ,2001 Enron Files for Bankruptcy. 90
  91. 91. Largest Bankruptcy Filings (1980 to Present) from Company Assets (Billions) When Filed1. World Com $103.9 July 20022. Enron $63.4 Dec. 20013. Conseco $61.4 Dec. 20024. Texaco $35.9 April 19875. Financial Corp of America $33.9 Sept. 19886. Global Crossing $30.2 Jan. 20027. PG&E $29.8 April 20018. UAL $25.2 Dec. 20029. Adelphia $21.5 June 200210. MCorp $20.2 March 1989 91
  92. 92. Fraud TrickRevenue RecognitionOne means of manipulating financial results is to record revenue before it hasbeen earned. This historically has been accomplished by recording revenueearly or recording transactions as sales that do not meet the criteria of sales.Some of the common revenue recognition schemes include: 1. Recognizing revenue before a sale has actually occurred 2. Keeping the books open at month’s end to record the first few days’ sales of the following month 3. Shipping to the company’s warehouses but billing as sales 4. Shipping goods to customers knowing they will be returned without providing appropriate return allowances 5. Shipping and billing goods not wanted by the customer until a later date 6. Shipping to accounts funded by the vendor 92
  93. 93. Misuse of EstimatesThe use of estimates is a normal occurrence inaccounting and can include the following: 1. Allowance for bad debts 2. Allowance for inventory obsolescence 3. Allowance for anticipated warranty claims or returned goods 4. Estimates of percentage of completion of a project Be warned, however, that estimates are open to bad faith manipulation. By means of adjusting estimates, earnings can be increased or decreased by a simple journal entry. 93
  94. 94. Purchase Reserves• In cases where a business has been acquired, it is acceptable under Generally Accepted Accounting Principles to set up a purchase reserve. For example, the reserve may be intended to cover costs identified with closing down part of the acquired company’s operations. Yet it is possible that the reserve can be deliberately overstated, with the intent of writing off current operating expenses against the reserve. This has the effect of understating expenses, thereby overstating income.Asset Overstatement• Each asset has a basis of valuation. By changing the valuation basis, the asset can be overstated. For instance, inventory may normally be valued at average cost. By changing the valuation to most recent cost, in a market where prices are rising, the inventory value can be adjusted upward. In other instances, companies have counted inventory in one location, then have simply moved the inventory to another location where it is counted again, thereby overstating inventory value.Liability Understatement• The simplest means of understating liabilities is to not record them in a timely manner. Liabilities may be understated by recording a reduced accrual for vacation pay or bonuses.Capitalization of Expenses• The bottom line can be manipulated by capitalizing expenses rather than recognizing them currently. Under GAAP, there are guidelines for determining when this is acceptable. On a legitimate basis, this may involve software development, costs associated with acquisition of capital assets and business start-ups. However, by capitalizing expenses inappropriately, the bottom line can be increased and the assets overstated. 94
  95. 95. Undertaking the financial investigation• Given the complexity of financial accounting and reporting today, the investigation may need a multifaceted team. Consider the following non-legal capabilities:• Forensic accountants are skilled in the reconstruction and analysis of accounting records and business transactions, as well as conducting detailed financial interviews. Knowing where to look and understanding what’s beneath the numbers is a skill gained through years of experience.• Computer forensics practitioners may be necessary to gather and recover evidence that may have been stored on computer hard drives or on servers. It has become increasingly common that critical evidence is found in recovered data files that users thought had been erased from their hard drives or email logs.• Technology specialists may be required due to the complexity of the computer systems. Whether the issue is analyzing data from multiple systems at multiple locations, or retrieving millions of relevant records and then effectively analyzing them, it takes special expertise to design the solution that will be required. Industry specialists may also be needed to provide insights into unique practices and industry norms. 95
  96. 96. South Sea Company 1720 Equitable Life 2000Saving and Loan crisis 1980 Enron Corporation 2001Braniff International Airways 1982 HIH Insurance 2001Laker Airways 1982 One.Tel 2001De Lorean 1983 Ansett 2001Zzzz Best 1987 Sabena 2001First Jersey Securities 1987 TWA 2001Drexel Burnham Lambert 1990 Webvan 2001BCCI 1991 Arthur Anderson 2002Eastern Air Lines 1991 Global Crossing 2002Pan Am 1991 Swissair 2002Confederation Life 1994 WorldCom 2002Barings Bank 1995 Health South 2003Fokker 1996 IG Farben 2003Bre-X Minerals 1997 Parmalat 2003Pixelon 2000 Red Letter Day 2005Lernout & Hauspie 2000 Jetsgo Corporation 2005 96
  97. 97.  ?Who turn next• SEC considers post-Big Four world• SEC ponders life after Big Four• E&Y fights for its future• Deloitte and Grant Thornton face £5bn Parmalat lawsuit• KPMG sorry for sheltering taxes for rich AIG reveals secretive executive pay• Grant Thornton expels Italian firm• Lawyers question PwC over Tyco• PWC faces $100m lawsuit over audit work• KPMG auditors to face SEC over Ahold• Former KPMG partner agrees Xerox settlement• KPMG pays the penalty for Xerox work• Deloitte hit with record $50m charge on audit of US telecoms company Adelphia• Deloitte could face tax probe over MG Rover accounts• Shell auditors (PWC & KPMG) and former FD face lawsuit• KPMG to Pay $456 Million for Criminal Violations 97
  98. 98. : Sources1. Business Fraud (The Enron Problem), W.Stove Albert, Brigham Young University2. FSA Presentation Fraud, W.Stove Albert, May 2003, Chicago, Illunious3. Financial Institution Fraud and Failure report Fiscal year 20034. Journal of Accountancy online year 2003-20045. Journal of Accountancy online, 2002-20056. AICPA address Fraud in audit committee guidance7. IIA Website8. AICPA Website9. ACFE Website10. Research of Dayarayan Auditing & Financial Services Firm about Fraud in Tehran Stock Exchange11. Website of financial reporting council (FRC)12. Audit Risk & Fraud Supplementary guidance for auditors of occupational pension schemes, Bulletin May 200513. Audit Risk & Fraud Supplementary guidance for auditors of charities, Bulletin Feb. 200514. Audit Risk & Fraud Supplementary guidance for auditors of investment business, Bulletin April 200515. The auditing practices board- Bulletin16. Fraud Examines Manual (ACFE) 2006, US edition17. Switzerland The largest Money Laundering Centre in The World By:Dr Ali Sahraeean18. Iran Audit Standard, sec. 24 98
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