The document discusses internal controls to prevent and detect fraud from a forensic accountant's perspective. It provides definitions of fraud, outlines common fraud techniques like improper revenue recognition, and describes fraud risk factors such as an employee living beyond their means. The document also discusses establishing strong control environments, implementing antifraud controls and activities, ensuring proper information and communication, and monitoring for fraud through analytical reviews and fraud detection procedures. Strong internal controls, following up on red flags, and creating an ethical organizational culture can help prevent and detect occupational fraud.

1. INTERNAL
CONTROLS TO
PREVENT AND
DETECT FRAUD
A Forensic Accountant’s Perspective
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2. FINANCIAL FORENSICS

3. Black’s Law Dictionary - “Fraud is a generic term, and embraces all the
multifarious means which human ingenuity can devise, which are resorted to
by one individual, to get an advantage over another by false representations.
No definite and invariable rule can be laid down as a general proposition in
defining fraud, as it includes surprise, trickery, cunning and unfair ways by
which another is cheated. The only boundaries defining it are those which
limit human knavery.”
Legal Elements of Fraud -
1. A material false statement
2. Knowledge that the statement was false when it was made
3. Reliance on the false statement by the victim, and
4. Damages as a result
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4. - The use of one’s occupation for
personal enrichment
- The misconduct of employees,
managers and executives
- Internal fraud
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5. It shall be unlawful for any person, directly or indirectly, by the use of
any means or instrumentality of interstate commerce, or of the mails
or of any facility of any national securities exchange,
a. To employ any device, scheme or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statements made,
in the light of the circumstances under which they were made, not
misleading, or
c. To engage in any act, practice or course of business which
operates or would operate as a fraud or deceit upon any person,
in connection with the purchase of sale of any security.
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6. O c c u p a tio n a l F r a u d a n d A b u s e
A ss e t F r a u d u le n t
C o r r u p ti o n
M i sa p p r o p r i at i o n S t a t em e n ts
C o n f l ic t s Ill e g a l E c o n o m ic N on -
B ri b e ry F i n a n c ia l
o f In t e re s t G ra t u it ie s E x t o rt io n F i n a n c ia l
P u r ch a s e In v o ic e A s s e t/R e ve n u e A s s e t/R e ve n u e E m p lo y m e n t
S chem es K ic k b a ck s O v e rs ta te m e n t U n d e rs ta te m e n t C re d e n tia ls
T im in g In te rn a l
S a le s
B ig R ig g in g D iffe r e n ce s
S chem es D o cu m e n ts
F ic titio u s
R e ve n u e s E x te rn a l
O th e r O th e r
D o cu m e n ts
C o n ce a le d
L ia b ilitie s &
E xpenses
Im p ro p e r
D is c lo su r e s
Im p ro p e r
A sset
In v e n t o ry
V a lu a tio n s
C ash
a n d a ll
O t her A ss ets
Larceny S k im m in g
M is u s e Larceny
C a sh S a le s R e ce iv a b le s R e fu n d s &
O n H and O th e r A sset R eq.
& T ra n s fe r
W r ite - o ff
U n re c o rd e d
F ro m th e S chem es
D e p o sit F a ls e S a le s
& S h ip p in g
U n d e rs ta te d L a p p in g
S chem es
O th e r F r a u d u le n t P u r ch a s in g &
D is b u r s e m e n ts R e ce iv in g
U n co n c e a le d
U n co n c e a le d
L a rc e n y
B illin g P a y ro ll E xpense C h e ck R e g is te r
S chem es S chem es R e im b u r se m e n ts T a m p e rin g D is b u rs e m e n ts
S h e ll G host M isc h a ra c te riz e d F o rg e d
C om pany E m p lo y e e s E xpenses M aker F a ls e V o id s
N o n -A c c o m p lic e F o rg e d F a ls e
C o m m is s io n O v e rs ta te d
V endor E n d o r se m e n t R e fu n d s
S chem es E xpenses
P e r so n a l A lte re d
W o r ke r s F ic titio u s
P u r ch a s e s P ayee
C o m p e n sa tio n E xpenses
C o n ce a le d
F a ls ifie d M u ltip le C h e ck s
W ages R e im b u r se m e n ts
A u th o r iz e d
M aker

14. – Typical organization loses 5% of revenues to fraud
– Median loss was $160,000
– Nearly 25% involved losses of at least $1 million
– Frauds lasted a median of 18 months before detection
– Asset misappropriation schemes were in 90% of cases
– Financial statement schemes were less than 5% but
caused median losses of more than $4 million
– More likely to detected by tip
– More than 80% were committed in accounting, operations,
sales, upper management, customer service or purchasing
– More than 85% had never been charged or convicted
– Most common red flags were living beyond means and
financial difficulties
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15. Common Financial Statement Fraud Techniques
 Improper Revenue Recognition 61%
 Overstatement of Assets 51%
 Understatement of Expenses/Liabilities 31%
 Misappropriation of Assets 14%
 Inappropriate Disclosures 1%
 Other Miscellaneous Techniques 20%
 Disguised Through Related Party Trans 18%
 Insider Trading Cited 24%
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16. Improper Revenue Recognition
 Sham sales
 Conditional sales
 Round-tripping
 Loans as sales
 Bill and hold
 Revenue before sale completed
 Improper cutoff of sales
 Improper use of percentage of completion
 Unauthorized shipments
 Consignment sales
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17. CRESSEY’S HYPOTHESIS
FRAUD TRIANGLE
Trusted persons become trust violators when…
 They conceive of themselves as having a problem
which is non-sharable
 Are aware this problem can be secretly resolved by
violation of the position of financial trust
 Are able to apply to their own conduct in that situation
verbalizations which enable them to adjust their
conceptions of themselves as trusted persons
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18. Opportunity
Incentive/Pressure Rationalization
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19. Opportunity
Incentive/Pressure Rationalization
Capability
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20. Reputation
Legal
Strategic
Operational
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21. Model
Behavior
Label
Hire
Behavior
Assess Risk
and Eliminate
Opportunity
Positive
Communicate
Policies
Create
Awareness
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22. O c c u p a tio n a l F r a u d a n d A b u s e
A ss e t F r a u d u le n t
C o r r u p ti o n
M i sa p p r o p r i at i o n S t a t em e n ts
C o n f l ic t s Ill e g a l E c o n o m ic N on -
B ri b e ry F i n a n c ia l
o f In t e re s t G ra t u it ie s E x t o rt io n F i n a n c ia l
P u r ch a s e In v o ic e A s s e t/R e ve n u e A s s e t/R e ve n u e E m p lo y m e n t
S chem es K ic k b a ck s O v e rs ta te m e n t U n d e rs ta te m e n t C re d e n tia ls
T im in g In te rn a l
S a le s
B ig R ig g in g D iffe r e n ce s
S chem es D o cu m e n ts
F ic titio u s
R e ve n u e s E x te rn a l
O th e r O th e r
D o cu m e n ts
C o n ce a le d
L ia b ilitie s &
E xpenses
Im p ro p e r
D is c lo su r e s
Im p ro p e r
A sset
In v e n t o ry
V a lu a tio n s
C ash
a n d a ll
O t her A ss ets
Larceny S k im m in g
M is u s e Larceny
C a sh S a le s R e ce iv a b le s R e fu n d s &
O n H and O th e r A sset R eq.
& T ra n s fe r
W r ite - o ff
U n re c o rd e d
F ro m th e S chem es
D e p o sit F a ls e S a le s
& S h ip p in g
U n d e rs ta te d L a p p in g
S chem es
O th e r F r a u d u le n t P u r ch a s in g &
D is b u r s e m e n ts R e ce iv in g
U n co n c e a le d
U n co n c e a le d
L a rc e n y
B illin g P a y ro ll E xpense C h e ck R e g is te r
S chem es S chem es R e im b u r se m e n ts T a m p e rin g D is b u rs e m e n ts
S h e ll G host M isc h a ra c te riz e d F o rg e d
C om pany E m p lo y e e s E xpenses M aker F a ls e V o id s
N o n -A c c o m p lic e F o rg e d F a ls e
C o m m is s io n O v e rs ta te d
V endor E n d o r se m e n t R e fu n d s
S chem es E xpenses
P e r so n a l A lte re d
W o r ke r s F ic titio u s
P u r ch a s e s P ayee
C o m p e n sa tio n E xpenses
C o n ce a le d
F a ls ifie d M u ltip le C h e ck s
W ages R e im b u r se m e n ts
A u th o r iz e d
M aker

23. Control Environment
Antifraud Information
Fraud Risk
Control and Monitoring
Assessment
Activities Communication
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24. Control Environment
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25. • Separation of duties
• Proper authorization
• Adequate
documentation
• Physical control over
assets and information
systems
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26. • Reviews of performance
• Analyses
• Reconciliations
• Physical observations
• Information systems
• Proactive fraud
detection
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27. • Controls which help
eliminate risk factors
which many lead to
fraud
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28. Do not ignore a red flag – Studies of fraud cases
consistently show that red flags were present, but were
either not recognized or were recognized but not acted
upon by anyone.
Sometimes an error is just an error – Red flags should
lead to some kind of appropriate action, i.e. an
investigation by a measured & responsible person, but
sometimes an error is just an error and no fraud exists
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29. Inc reas ing D ec reas ing
purc has es from purc has es from
fav ored v endor other v endors
1099s from
D ec reas ing
v endor c om pany
quality
to buy er relativ es
Inc reas ing pric es
A nalyt ical D ocum en ts and
S ym pt om s R eco rd s
Larger order
quantities
A ll trans ac tions
eith one buy erand
one v endor
B uy er does n't
relate w ell to
other buy ers or
v endors B eh avio ral
S ym pt om s
K ic k b a c k s In ternal C o nt ro ls
U s e of
unapprov ed
E m ploy ee w ork
v endors
habits c hange
Q uality B uy er building
c om plaints about Tips and Lyfestyle ex pens iv e hom e
purc has ed C om p lain ts S ym pt om s (bey ond
produc ts ex pec tations )
U ns uc c es s ful B uy er ow ning
v endor A nony m ous tips B uy er liv ing m ore ex pens iv e
c om plaints about buy ers or bey ond k now n autom ibiles
v endors s alary

30. • Trust is placed in employees
• Employees have detailed knowledge of the accounting systems and their
weaknesses
• Management domination subverts normal internal controls
• Management adds pressure to “make the numbers”
• Expected moral behavior is not communicated to employees
• Unduly liberal accounting practices
• Ineffective or nonexistent internal auditing staff.
• Lack of effective internal controls.
• Poor accounting records.
• Related party transactions.
• Incomplete and out of date procedural documentation.
• Management sets a bad example.
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31. • Cash flow does not match net • Decrease in the Asset Quality Index
income – Noncurrent Assets, exclusive of
• Receivables spike relative to sales – PPE, relative to total assets in given
Days’ Sales in Receivables year
• Management earning tied to • Exceptionally strong sales growth
performance from one year to next
• Significant increase in Gross • Low Total Accruals to Total Assets –
Margin Index Working Capital, less Cash, less
• High turnover of key management Current Taxes Payable, less Current
• Sales allowances, warranties and Portion of LTD, less AD and
other reserves out of line compared Amortization, divided by Total Assets
with others in industry
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32. • Employee lifestyle changes • High employee turnover
• Significant personal debt and • Refusal to take vacation or
credit problems sick leave
• Behavioral changes • Lack of segregation of duties
in a high-risk (vulnerable)
• Defensive area
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33. • Reluctance to provide information to • Weak internal control environment
auditors • Unexpected overdrafts or declines in
• Photocopied or missing documents cash balances
• Decisions dominated by an individual or • Accounting personnel are lax or
small group inexperienced
• Excessive number of year-end • High employee turnover rate
transactions • Compensation is out of proportion
• Management displays significant • Decentralization without adequate
disrespect for regulatory bodies monitoring
• Excessive number of or frequent • Frequent changes in external auditors
changes in checking accounts
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34. • Inconsistent overtime hours for a • Overtime charged during a slack
cost center / department period
• Overtime charges for employees • Budget variations for payroll by
who normally would not have cost center / department
overtime wages
• Employees with duplicate Social • Employees with few or no payroll
Security numbers, names, and deductions
addresses
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35. • Excessive number of voids • Excessive or unjustified cash
• Presence of personal checks in transactions
petty cash • Large number of account write-offs
• Sudden activity in a dormant • Bank accounts not reconciled on a
account timely basis
• Taxpayer complaints that they are • Unauthorized bank accounts
receiving non-payment notices
• Discrepancies between bank • Abnormal number of expense items
deposits and postings or reimbursement to an employee
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36. • Remittance to PO Box • Use of consecutive invoice
• Telephone does not match physical numbers
address • Invoice numbers and dates do not
correspond
• Consistent billing in round numbers • Increasing purchases to same
• Address matches employee vendor
address • Incomplete vendor master
information
• Invoices consistently under • Unspecified consulting or other
approval limits services
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37. • Voided or missing checks • Altered or dual endorsements
• Invoices posted to inconsistent • Customer complaints regarding
accounts payments
• Checks used out of order • Checks payable to cash
• Journal entries to cash • Altered payee on checks
• Duplicate check numbers on bank • Checks payable to employees
reconciliations
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38. • Increasing number of complaints • Abnormal inventory shrinkage
about services • Purchases that bypass normal
• Vendors without physical address procedures
• Lack of physical security over • Charges without shipping
assets / inventory documents
• Excessive inventory or slow-moving • Vendor payments picked up rather
inventory than having it mailed
• Payments to vendors not included • High volume of purchases from
on an approved vendor list new vendors
• Vendor address matching
employee address
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39. CASE STUDY #1
Asset Misappropriation - Billing Scheme
• A Large retail company
• Director of IT
• 10-year employee
• Could authorize expenditures up to $15,000
• Computer consultants contract ran out in prior year
• Suspect set up computer consulting in current year
budget
• Created shell company and incorporated
• Self approval of invoices
• Losses were $365,000
• Asked AP to hold that check!
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40. CASE STUDY #2
Asset Misappropriation – Check Tampering
• A Medium size manufacturing company
• Suspect was Assistant Controller
• 8-year employee
• Responsible for accounts payable and payroll
• Suspect has purchased new car and traveled each year
• Approximately 7 years prior, suspect has tax lien
• Check numbers and dates out of sequence
• Vendor name on check was different than records
• Losses were $650,000
• Backed up system, produced checks, restored system
• Made JEs prior to period close
• Removed checks from statement
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41. CASE STUDY #3
Asset Misappropriation - Inventory
• Large parts manufacturing company
• Perpetrator was warehouse manager
• 18-year employee
• Was considered very knowledgeable about all
inventory in the warehouse
• Rarely took vacations
• Obtained pass word from wife
• Had product picked up during third shift
• Arrived early and removed inventory and shipping
information from system
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42. CASE STUDY #4
Fraudulent Financial Reporting
• Large manufacturer of computer components
• CFO was 12-year employee of the company
• Several years before, the company was very profitable
• CFO was very aggressive in setting up loss
contingency and other reserves
• When there was a downturn in the economy, company
needed additional financing
• Loss contingencies and reserves were reversed into
income
• After financing obtained, company subsequently
declared bankruptcy
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43. CASE STUDY #5
Asset Misappropriation – Skimming Sales
• Chain of 10 drug stores
• 5-year employee of the company and college student
• Was considered a very trusted employee and friend of
the family
• Prescription system was not tied to cash register
• Entered “no sale” to open the register for cash sales
• Many times would enter “no sale” for friends and
family
• Closed the store and insisted on closing the register
for prescription sales
• Bought several cars and boat
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44. Implement Positive Pay and
electronic and Laser Printing Check Stock Payee Positive
get rid of checks Pay
Reconcile Bank Open a separate
Use at least 12
Statement Within Outsource your accounts for
point font for
A Reasonable payables incoming wire
payee
Time transfer
Use only one
Establish
color, size and
maximum dollar
type of check for
parameters
each account
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