THE CORPORATE CON: INTERNAL FRAUD AND THE AUDITOR GLOBAL HEADQUARTERS THE GREGOR BUILDING 716 WEST AVE AUSTIN, TX 78701-2727 USA
TABLE OF CONTENTS I. INTRODUCTION Video Supplement... 1 Course Objectives and Overview... 1 Definition of Fraud... 2 Elements of Fraud... 2 Types of Victims... 3 Fraud Statistics... 3 Profile of Fraud Offenders... 4 Video... 5 Review Questions... 6 II. FUNDAMENTALS OF FRAUD Legal Elements of Fraud... 9 Criminal Versus Civil Fraud... 9 Subclassification of Internal Fraud Schemes... 10 Misappropriation Stages... 10 Types of Concealment... 10 Detecting Fraud... 11 Tips and Complaints... 11 Weaknesses in Internal Controls... 12 Video... 12 Behavioral Changes... 12 Lifestyle Changes... 12 Video... 13 Review Questions... 14 III. FRAUD AUDITING METHODOLOGY Fraud Auditing... 15 Auditing Versus Fraud Examination... 15 Fraud Theory... 15 Analyzing Available Data... 15 Creating a Hypothesis... 15 Testing the Hypothesis... 16 Refining and Amending the Hypothesis... 16 Steps in Fraud Examination... 16 Document Examination... 16 Neutral Third-Party Witnesses... 16 Corroborative Witnesses... 17 Co-Conspirators... 17 Potential Suspect... 17 Elements of Fraud Auditing... 17 The Environment... 17 The Accounting System... 18 Various Detection Techniques... 19 Financial Statements... 22 Video... 29 i
III. FRAUD AUDITING METHODOLOGY (CONT.) Net-Worth Methods... 29 Review Questions... 33 IV. AUDITORS RESPONSIBILITIES Introduction... 35 Certified Fraud Examiners Responsibilities... 35 Help Resolve Allegations of Fraud... 35 Obtain Evidence... 35 Take Statements... 36 Write Reports... 36 Testify to Findings... 36 Assist in the Detection and Prevention of Fraud... 36 External Auditors Responsibilities... 37 AU Section 240 Consideration of Fraud in a Financial Statement Audit... 37 PCAOB Auditing Standard No. 5 An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements... 47 PCAOB Auditing Standard No. 3 Audit Documentation... 52 AU Section 230 Audit Documentation... 53 Internal Auditors Fraud-Related Responsibilities... 54 Standard 1210 Proficiency... 54 Standard 1220 Due Professional Care... 55 Standard 2060 Reporting to Senior Management and the Board... 55 Standard 2110 Governance... 55 Standard 2120 Risk Management... 56 Standard 2130 Control... 56 Standard 2210 Engagement Objectives... 56 The IIA s IPPF Practice Guide: Internal Auditing and Fraud... 57 Review Questions... 59 V. CASH SCHEMES Introduction... 61 Skimming... 61 Voids and Under-Rings... 62 Swapping Checks for Cash... 63 Alteration of Cash Receipts Documentation... 63 Fictitious Refunds and Discounts... 64 Journal Entries... 64 Kiting... 64 Video... 66 Cash Fraud Detection Methods... 66 Bank Reconciliations... 66 Cut-Off Statements... 67 Surprise Cash Counts... 68 Customer Complaints... 68 Altered or Missing Documents... 69 Fictitious Refunds or Discounts... 69 ii
V. CASH SCHEMES (CONT.) Journal Entry Review... 70 Review and Analysis of Gross Sales and Returns and Allowances... 70 Analytical Review... 71 Deposit Dates... 72 Cash Advances... 72 Voids and Refunds by Employee Identification... 72 Cash Fraud Prevention Methods... 72 Segregation of Duties... 72 Assignment Rotation and Mandatory Vacations... 73 Surprise Cash Counts... 74 Review Questions... 75 VI. ACCOUNTS RECEIVABLE SCHEMES Introduction... 77 Lapping... 77 Fictitious Accounts Receivable... 79 Old or Written-Off Accounts Receivable... 80 Borrowing Against Accounts Receivable... 80 Video... 81 Accounts Receivable Fraud Detection... 81 Matching Deposit Dates... 81 Confirmations... 81 Accounting Cut-Off Analysis... 81 Trend Analysis on Written-Off Accounts Receivable... 82 Tracking System... 82 Accounts Receivable Fraud Prevention... 82 Segregation of Duties... 82 Lock-Box Arrangements... 83 Objective, Sales-Based Compensation Plans... 83 Review Questions... 84 VII. INVENTORY SCHEMES Introduction... 85 Theft of Inventory... 85 Larceny... 85 Video... 87 Appropriating Inventory for Personal Use (Theft)... 87 Theft of Scrap Proceeds... 87 Charging Embezzlements to Inventory... 88 Video... 88 Inventory Fraud Detection... 89 Statistical Sampling... 89 Physical Inventory Counts... 90 Analytical Review... 90 Computer-Generated Trend Analysis... 91 Inventory Fraud Prevention... 92 Proper Documentation... 92 iii
VII. INVENTORY SCHEMES (CONT.) Segregation of Duties... 93 Video... 94 Independent Checks... 94 Physical Safeguards... 94 Review Questions... 95 VIII. PURCHASING SCHEMES Introduction... 97 Fictitious Invoices... 97 Overbilling Schemes... 99 Checks Payable to Employees... 99 Conflicts of Interest... 100 Detecting Purchasing Schemes... 101 Analytical Review... 102 Statistical Sampling... 104 Vendor or Outside Complaints... 105 Site Visits and Observation... 105 Preventing Purchasing Schemes... 105 Education... 105 Compensation... 106 Other Measures... 106 Review Questions... 109 IX. INVESTMENT AND FIXED ASSET SCHEMES Introduction... 111 Investments... 111 Detecting Investment and Fixed-Asset Schemes... 112 Investments... 112 Fixed Assets... 113 Preventing Investment and Fixed Asset Schemes... 114 Custody of the Assets... 114 Approval to Sell or Dispose of Assets... 115 Control Over Physical Disposition of Assets... 115 Receipt of Sale Proceeds... 116 Periodic Physical Inspections... 116 Review Questions... 117 X. PAYROLL AND PERSONAL EXPENSE SCHEMES Introduction... 119 Payroll Fraud... 119 Ghost Employees... 119 Falsified Hours and Salary Schemes... 120 Commission Schemes... 120 Video... 121 Video... 122 Detecting Payroll Schemes... 122 Independent Payroll Distribution... 122 iv
X. PAYROLL AND PERSONAL EXPENSE SCHEMES (CONT.) Analysis of Payee Address or Accounts... 123 Screening for Duplicate Social Security Numbers... 123 Overtime Authorizations... 123 Detecting Commission Schemes... 124 Analysis of Deductions from Payroll Checks... 124 Preventing Payroll Schemes... 124 Segregation of Duties... 124 Video... 125 Periodic Review and Analysis of Payroll... 125 Personal Expense Reimbursement... 126 Detecting Personal Expense Schemes... 127 Review and Analysis of Expense Accounts... 127 Detail Review of Expense Reimbursements... 128 Preventing Personal Expense Schemes... 129 Strong Ethics Policy... 129 Detailed Expense Reports: Submission and Review... 129 Video... 130 Review Questions... 131 XI. BRIBERY AND CORRUPTION SCHEMES Introduction... 133 Bribery... 133 Illegal Gratuity... 134 Collusion... 134 Conflict of Interest... 134 Bribery and Corruption Schemes... 135 Kickbacks... 135 Gifts and Gratuities... 135 Methods of Making Illegal Payments... 136 Video... 138 Detection of Bribery and Corruption Schemes... 138 The Corrupt Recipient... 139 The Corrupt Payer... 139 Review Questions... 141 XII. THEORY OF FRAUD PREVENTION Introduction... 143 The Cressey Study... 143 Pressure... 143 Opportunity... 144 Rationalization... 144 Minimizing Pressures... 145 Have an Open-Door Policy... 145 Management s Attitudes... 145 Employee Support Programs... 146 Minimizing Opportunities... 146 Management Oversight... 146 v
XII. THEORY OF FRAUD PREVENTION (CONT.) Job Rotation... 147 Proactive Audit Policy... 147 Well-Defined and Understood Fraud Reporting Program... 147 Minimizing Rationalizations... 148 An Educational Program... 148 Written Ethics Policy... 148 Dishonest Acts Will Be Punished... 149 Video... 149 Create a Low-Fraud Environment... 150 Review Questions... 151 XIII. FRAUD ASSESSMENT QUESTIONING TECHNIQUES Introduction... 153 Questions and Responses... 153 Review Questions... 156 XIV. PRACTICAL PROBLEMS Practical Problem 1... 157 Practical Problem 2... 161 Practical Problem 3... 163 Practical Problem 4... 164 Practical Problem 5... 167 Practical Problem 6... 170 Practical Problem 7... 172 XV. APPENDIX A: SAMPLE FRAUD POLICY... 173 XVI. APPENDIX B: FRAUD RISK CHECKLIST... 177 XVII. APPENDIX C: VIDEO TRANSCRIPTS... 187 XVIII. SOLUTIONS TO REVIEW QUESTIONS I. Introduction... 201 II. Fundamentals of Fraud... 205 III. Fraud Auditing Methodology... 207 IV. Auditors Responsibilities... 209 V. Cash Schemes... 211 VI. Accounts Receivable Schemes... 214 VII. Inventory Schemes... 217 VIII. Purchasing Schemes... 219 IX. Investment and Fixed Asset Schemes... 221 X. Payroll and Personal Expense Schemes... 223 XI. Bribery and Corruption Schemes... 224 XII. Theory of Fraud Prevention... 227 XIII. Fraud Assessment Questioning Techniques... 228 vi
XVII. SOLUTIONS TO PRACTICAL PROBLEMS Practical Problem 1... 229 Practical Problem 2... 235 Practical Problem 3... 237 Practical Problem 4... 238 Practical Problem 5... 241 Practical Problem 6... 246 Practical Problem 7... 249 XX. FINAL EXAMINATION... E-1 XXI. INDEX... I-1 vii