Proactive Data Analysis Techniques to Detect Financial Statement Fraud

1/22/2014
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Copyright © FraudResourceNet LLC
Proactive Data Analysis Techniques to
Find Financial Statement Fraud
Special Guest Presenter: Richard Cascarino, CFE, CIA,
CISM, CRMA Richard Cascarino & Associates
Jan 22, 2014
President and Founder of White Collar Crime 101
• Publisher of White-Collar Crime Fighter
• Developer of FraudAware® Anti-Fraud Training
• Monthly Columnist, The Fraud Examiner, ACFE Newsletter
Member of Editorial Advisory Board, ACFE
Author of “Fraud in the Markets”
• Explains how fraud fueled the financial crisis.
About Peter Goldmann, MSc., CFE

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About Jim Kaplan, MSc, CIA, CFE
• President and Founder of
AuditNet®, the global resource for
auditors (now available on Apple
and Android devices)
• Auditor, Web Site Guru,
• Internet for Auditors Pioneer
• Recipient of the IIA’s 2007
Bradford Cadmus Memorial
Award.
• Author of “The Auditor’s Guide to
Internet Resources” 2nd Edition
• Principal of Richard Cascarino & Associates
based in Colorado USA
• Over 28 years experience in IT audit training
and consultancy
• Past President of the Institute of Internal
Auditors in South Africa
• Member of ISACA
• Member of Association of Certified Fraud
Examiners
• Author of Auditor's Guide to Information
Systems Auditing
About Richard Cascarino, MBA, CIA,
CISM, CFE

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Disclaimers

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 Introduction: Fraud Statistics: The Growing
Fraud Threat
 Where & How Financial Statement Fraud
Occurs
 Detection/Auditing/Investigative Techniques –
Including Automation
 Entity-Level Red Flags of Fraud
 Prevention and Deterrence
 Your Questions
 Conclusion
Today’s Agenda
According to major accounting firms, professional fraud
examiners and law enforcement: jumps significantly during
tough economic times
 Business losses due to fraud increased 20% in last 12
months, from $1.4 million to $1.7 million per billion dollars
of sales. (Kroll 2010/2011 Global Fraud Report)
 Average cost to for each incident of fraud is $160,000
(ACFE) Of Financial Statement fraud: $2 million
Approx. 67% of corporate fraud committed by insiders
(Kroll)
Approx. 50% of employees who commit fraud have been
with their employers for over 5 years (ACFE)
Fraud: The Big Picture

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 Victims of financial fraud are stakeholders with claims
against the entity: shareholders, lenders, regulators.
 Financial fraud occurs less frequently than asset
misappropriation but the losses are substantially higher.
Financial Statement Fraud:
The Big Picture
Source: ACFE 2008 Report to the Nation
 Selling More (Overstating revenue)
 Costing Less (Understating/not reporting
expenses)
 Owing More (Overstating debt to reduce taxes)
 Owing Less (Understating debt to boost share
price)
 Inappropriate Disclosure (Depreciation/asset
value, etc)
 Other Miscellaneous Techniques (Concealment)
Accounting Fraud

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 Falsification, alteration, manipulation of material
financial records, supporting documents or business
transactions
 Material intentional omissions or misrepresentations of
events, transactions, accounts or other significant
information from which financial statements are
prepared
 Deliberate misapplication of accounting principles,
policies and procedures used to measure, recognize,
report and disclose economic events and business
transactions
 Intentional omission of disclosures or presentation of
inadequate disclosures regarding accounting principles
and policies and related financial amounts
Jim Gravitt and Jennifer Johnson, “Recognizing Financial Statement Fraud”
Financial Statement
Fraud Schemes
 Missing documents
 Excessive voids or credits
 Increased reconciliation items
 Alterations on documents
 Duplicate payments
 Common names or addresses of payees or
customers
 Increased past due accounts
 Unusual spikes in payables or receivables
 Odd patterns in key ratios
Accounting Fraud: Red Flags

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Example: Interactive Data Extraction and Analysis
 21 years young
 Database limitations:
 2.1 billion records (100,000 records for IDEA
Express) depending on the operating system
 1.8 Exabytes file size (Tera, Peta, Exa)
(Quintillion)
 Some facilities not available in IDEA (Server)
The Power of Automation
Example: Orders
Over Credit Limit

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1) Improper Revenue Recognition
Common Types of Financial
Statement Fraud
Backdating agreements
 Stock options and other time-sensitive
valuation issues that may result in
fraudulently high revenue or low cost
basis
 Need for controls in recording
contracts/sales, including independent
verification of the terms of the agreement
and contemporaneous recording of
transactions when they are approved
 Need for in-house legal, corporate board
approval
Revenue Recognition

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Sham Sales
 Falsify inventory records,
shipping records, and
invoices and record the
fictitious transactions as sales
 Company may pretend to
ship the inventory and hide it
from company auditors
Revenue Recognition
Sales to Fictitious Customers

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Channel Stuffing
 Shipping excess merchandise
to distributors
 Right of return exists/ Side
agreements
 Need to examine conditions
of sale, analyze sales returns
during cutoff period/after year-
end, review of sales and
contract files to determine if
side agreements exist
Revenue Recognition
Bill and Hold Schemes
 Recording fictitious sales
and shipping goods to
third-party warehouse
 Need to examine shipping
documents and analyze
real estate rental costs
Look for evidence of side
agreements
Review inventory changes
Revenue Recognition

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Holding Books Open
 Failure to match revenues with
related expenses in the period
in which they were incurred
(CA’s “35-day month)
 Examine cut-off procedures for
month, quarter and year-end
 Need for oversight and
approval controls in recording
contracts/sales
Revenue Recognition
Not Recording Detailed
Transactions on Sub-ledger
 Overstating Sales and A/R
 Where sub-ledger does not
reconcile to General Ledger
control account
 Examine reconciliation and
top-side journal entries
Revenue Recognition

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A side agreement would NOT be a typical
part of which of the following:
 Channel Stuffing
 Holding the Books Open
 Bill and Hold Schemes
 All of the above
Polling Question 1
2. Management Estimates
Statement Fraud

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Allowance for Bad Debts
 Altering underlying A/R aging to manipulate
computation
 Refreshing of receivables by writing off aged A/R
and booking new, fictitious sales
 Use of credit memos
 Analyze Bad Debt expense and Sales accounts,
looking for similar levels of transaction activity for
the same customers
Management Estimates
A/R Inquiries

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Overstatement of assets by:
 Understating allowances for
receivables
 Overstating the value of inventory,
property, plant, equipment, and
other tangible assets,
 Recording assets that did not exist
Fraudulent Input from Sales or
Credit Department on Credit
Quality
 Lack of independent review of
customer’s creditworthiness
 Inadequate documentation in credit
file
 Credit analyses should be
performed by individuals who are
independent of the sales process,
periodic review of credit files

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3. Expense Manipulation
Statement Fraud
Under-Accruing Expenses
 Lack of monthly or quarterly reconciliation
of accruals to actual amounts
 Charging accrual “true-ups” to other,
infrequently-used accounts
 Compare monthly accruals to actual
expenses and cash disbursements, noting
variations in the adequacy of accruals
 Capitalizing expenses
Expense Manipulation

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Expense Examination
Overstating assets can be achieved by
(Choose all that apply):
A. Understating allowances for receivables
B. Overstating the value of inventory, property,
plant, equipment, and other tangible assets
C. Recording assets that do not exist
D. All of the above
Polling Question 2

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Not Recording Expenses
 Paying unrecorded expenses
must be offset by not paying
other expenses
 Need to ensure adequate
segregation of duties in the
receipt of invoices and the
recording of expenses, review
invoice file for past due
invoices and collection notices
Not Recording Detailed
Transactions on Sub-ledger
 Understating Expenses and
A/P
 Where sub-ledger does not
reconcile to General Ledger
control account
 Examine reconciliation and
search for unrecorded
expenses

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Capitalizing Expenses
 Moving expenses from the P&L to the
Balance Sheet and amortizing them over
an extended period
 WorldCom – telecom line charges
 Examine capitalized asset accounts for
year-on-year changes
Changing Inventory
Valuation Methods
 May result in lower COGS
and higher sales margins
 Review calculation of
inventory valuation and
related disclosures

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Manipulating Non-Cash
Expenses
 Changing depreciation and
amortization methods
 Review calculation of
depreciation and related
disclosures
Moving expenses from the P&L to the
Balance Sheet is a form of…
A. Improper revenue recognition
B. Expense manipulation
C. Capitalization of expenses
D. None of the above
Polling Question 3

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4. Detection and Investigative Techniques
For Auditors, Fraud Investigators,
Legal Staff, HR and Senior Management
Detection and Investigation
Techniques
 What are you looking for? (Avoid spinning
your wheels).
 Where are you going to find it?
 Choose the best technique (interviewing,
audit, CAAT’s)
 Select the tool
Detection and Investigation
Techniques

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 Where are the weakest links in the system’s
controls?
 What deviations from conventional good
accounting practices are possible?
 How are off-line transactions handled and
who has the ability to authorize these
transactions?
 What would be the simplest way to
compromise the system?
 What control features in the system can be
bypassed by higher authorities?
 What is the nature of the work environment?
Ask These Questions…
 Be Skeptical!!!!
 Analytical Procedures
 Other Investigative Techniques
 CAATs
Tools and Techniques

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 Always request originals.
 Ask yourself whether transactions make sense.
 Have documents been altered?
 Look to see where the documents are maintained.
 Do employees have close personal relationships with
vendors?
 Is there a lack of supporting documentation?
 Do background checks identify related parties and DBAs?
 Does an answer not make sense?
 Are you avoided more than usual?
 When asking a relatively simple question, are you
unexpectedly referred to someone high up in the
organization?
 Go with your gut!
BE SKEPTICAL!!!!!
 Increased scrap.
 Excessive purchases.
 Unexplained inventory shortages or
adjustments.
 Significant increase or decrease in account
balances.
 Cash shortages or overages.
 Deviations from specifications.
Analytical Red Flags

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WorldCom’s massive accounting fraud
was characterized PRIMARILY by:
A. Not recording detailed transactions on sub-
ledger
B. Not recording expenses
C. Capitalizing expenses
D. None of the above
Polling Question 4
Range from simple to complex;
Identify trends or anomalies
Four Key Steps:
1. Develop an expectation/hypothesis
2. Determine the acceptable deviation from the
expected value
3. Compare the result of the analytical procedure to the
expected value
4. Investigate and evaluate any significant differences
Analytical Procedures

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Unusual Financial statement ratios such as:
 Increased revenues with
• decreased inventory.
 Increased revenues with
• decreased receivables.
 Increased inventory with
• decreased payables.
 Increased volume with
• increased cost per unit.
Analytical Anomalies
Financial Statement Analysis
 Vertical – a/k/a “common-sized statements”
 Analyzes each line as a % of its relevant total
 Income items as a % of total revenue
 Expenses as a % of total expense
 Identifies disproportionate items
 Identifies fluctuations between periods
 Horizontal – a/k/a “time-series analysis”
 Measures $ and % changes from period to period
 Identifies fluctuations and seasonality
Data Analysis: Testing for Red Flags

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 Data Selection.
 Data Cleaning.
 Data Enrichment.
 Data Coding/Reduction.
 Data Mining.
 Interpretation/Reporting.
 Action.
 Measurement and Evaluation.
Knowledge Discovery
Data Mining/Analysis
 Using file interrogation software to
examine underlying data
 General Ledgers
 Vendor files
 Payroll
 A/P and A/R
Data Analysis –
Testing for Red Flags

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Using File Interrogation Software is an
example of:
a) Data Mining / Analysis
b) Knowledge Discovery
c) Vertical Analysis
d) Horizontal Analysis
Polling Question 5
 Public Document Reviews & Background
Investigations
 Interviews of Knowledgeable Persons
 Confidential Sources
Other Investigative Techniques

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Entity-Level Red Flags
 Internal control gaps, deficiencies,
weaknesses
 Business results that continually
outperform expectations
 Management override of controls
 Rapid or significant turnover of
resources, especially senior
management or employees in key
positions
 Employee, customer or vendor
complaints
 Inadequate segregation of duties
 Unusual end‐of‐month or end‐of‐
quarter variations
 High‐level of related‐party
transactions
 Systems are manual and/or
decentralized
 Repeated changes of
independent public accountants
 Continuous problems with
various regulatory agencies
 Disclosures of Investigations
 Suspicion of illegal activities
Prevention, Deterrence
and Detection
 Prevention
 Tone at the top
 Value system (“Code of
Ethics / Conduct”)
 Positive workplace
environment
 Hiring, promoting and
retaining appropriate
employees
 Training and awareness
programs
 Confirmation / affirmation
of Code of Conduct/Ethics
 Ombudsman programs
 Whistleblower programs
 Incident response / case
management processes
 Investigative procedures
 Discipline, prosecution and
recovery guidelines
 Prevention
 Tone at the top
 Value system (“Code of
Ethics / Conduct”)
 Positive workplace
environment
 Hiring, promoting and
retaining appropriate
employees
 Training and awareness
programs
 Confirmation / affirmation
of Code of Conduct/Ethics
 Ombudsman programs
 Whistleblower programs
 Incident response / case
management processes
 Investigative procedures
 Discipline, prosecution and
recovery guidelines
 Deterrence
 “Active” oversight by Board
and/or Audit Committee
– Fraud risk assessment and
related measures
– Code confirmation /
affirmation process
– Management’s involvement in
financial reporting process
and override of control
– Process to receive, retain and
treat complaints of fraud /
unethical conduct
– Internal and external audit
effectiveness
 Internal audit
– Evaluation of adequacy /
effectiveness of internal
controls
 Disciplinary examples
 Detection
 Identification and
measurement of fraud risk
(“fraud risk assessment”)
 Processes &procedures to
mitigate identified fraud risk
 Effective internal controls at
entity and process level
 On-going monitoring
activities
 Computer-assisted audit
techniques
 Investigation of:
– Internal control
weaknesses / breaches
– Non-response to Code
confirmation / affirmation
– Reported issues
 Detection
 Identification and
measurement of fraud risk
(“fraud risk assessment”)
 Processes &procedures to
mitigate identified fraud risk
 Effective internal controls at
entity and process level
 On-going monitoring
activities
 Computer-assisted audit
techniques
 Investigation of:
– Internal control
weaknesses / breaches
– Non-response to Code
confirmation / affirmation
– Reported issues

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CAATs IDEA
CAATs ACL

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Common Analytical Mistakes
 Failure to maintain proper documentation
 Failure to notify decision makers
 Failure to control digital evidence
 Failure to report incidents in a timely manner
 Underestimating the scope of the incident
 No incident response plan in place
 Technical mistakes:
 Altering date and time stamps on evidence systems before
recording them
 Killing rogue processes
 Patching the system back together before investigation
 Not recording commands used
 Using untrusted commands and tools
 Overwriting evidence by installing tools
Questions?

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Peter Goldmann
FraudResourceNet LLC
800-440-2261
www.fraudresourcenet.com
pgoldmann@fraudresourcenet.com
Jim Kaplan
FraudResourceNet LLC
800-385-1625
www.fraudresourcenet.com
jkaplan@fraudresourcenet.com
Richard Cascarino
Cascarino Associates
rcasc@rcascarino.com
Thank You!

Proactive Data Analysis Techniques to Detect Financial Statement Fraud

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