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Fraud _ Corruption1


									                        Fraud & Corruption
Dr. Ali Amani
   •   Member of Supreme Court of Iranian Association of Certified Public Accountants (IACPA)

Dr. Gholamhossein Davani
   •   Member of High council of Iranian Association of Certifeid Public Accountants (IACPA )

   Dayarayan Auditing & Financial Services Firm(RSMi Iran)

Ladies & Gentelman.
 I am very glad to have the opportunity to 
speak at this conference, as it gives me the
chance to stress the importance of “ Fraud &
Corruption” and specially thanks for Professor
Soals for inviting me to make the opening
address at this

Your honor,
Just now sitting at the patio with your honorable
sibling and having a bite of board with her honor, I
was informed that your honor has prattled and
reappointed price Movasegholdoleh, governor of
Qom, formerly deposed due to bribery and buying
I had him sent to Tehran under guard, so that your
Majesty will understand that one can not rule a
country on his aunt’ prescriptions.
Forgive me for being over impertinent,
“Amir Kabir’s (Current Pre minister) letter to King Naseraldin Shah”
If men were angels, no government
would be necessary. If angels were
to govern men, neither external nor
internal controls on government
would be necessary.
James Madison, The Federalist Papers, No. 51, 1788

Just as one can not let go of the taste of honey or
poison on the tip of his tongue, a governmental
agent dealing with governmental budget, can not
avoid tasting at least a little of the King’s wealth.

“Kaochila ertashsetra,”
Indian edifications, first decade Annone Domini

 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)

Definition of Fraud
A generic term, embracing all multifarious
means which human ingenuity can devise, and
which are resorted to by one individual to get
advantage over another by false suggestions or
by suppression of truth, and includes all
surprise, trick, cunning, dissembling, and any
unfair way by which another is cheated.
“Johnson v. McDonald, 39 P2d 150”

• 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.
• 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.)
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

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

  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
  entity's state of affairs.

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.
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

• corruption
    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
•   (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.

• 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
•   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

• 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
•   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.

Money Laundering:
Money laundering is the process by which
criminals attempt to conceal the true origin and
ownership of their criminal activities. If
undertaken successfully, it also allows them to
maintain control over those proceeds and
ultimately to provide a legitimate cover for their
source of funds. Their dirty funds appear clean.
It is generally linked with money required to
finance cross border drug trafficking, arms deal
or tax evasion or other similar crimes.
 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 one's 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.

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
• Sutherland believed that crime was a learned activity
  at a time when most experts believed that crime was
  genetically based.

• 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.”

White-collar crime is distinguished from other conventional crimes
like robbery by way of the following general characteristics:

•Unlike robbery which involves the use of force, white-collar offences are
characterized 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 to
prosecute; 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 he
works for;
•Although the element of fraud is usually found in most white-collar schemes, these
offences can go much further including corruption, forgery, theft and complicated
statutory 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
opportunities that may be exploited.
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

     The Fraud Triangle


Opportunities          Attitudes/Rationalization

   Types of Fraud

Fraudulent financial reporting

 Misappropriation of assets

               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
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.

                   2006 Identity Fraud Survey Report

  Source:Javelin                                       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.

• 1929 International Power's 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 1920's which were
 exposed in the 1929 stock market crash.

• 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

• 1937 Phillip Musica (aka Frank Donald
 Coster) was caught with $10 million of
 inventory and $9 million of accounts
 receivable that didn't exist.

• 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 Corporation's 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 didn't 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.

• 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 1980's. 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.

• 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 industry's
  most flamboyant CEO's, Michael Saylor, along with bogus financial
  statements. The share price was $3 one year later. 2001 Enron,


• 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.

     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 fraud

What gave accountants an advantage in the past is no longer nearly as valuable!   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 ability
Today’s winners are those who have access to the best information a fraud course teaches how
to access information                                                                 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

• 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.

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.

Risk & Fraud cycle

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.

Fraud Conditions
According to SAS 99, three fundamental
conditions are generally present when fraudulent
financial 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.

        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

• 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

Three of these ISAs (UK and Ireland), which concern the
areas of audit risk and fraud, include a number of
requirements that are additional to those set out in the
SASs theory replace. This Bulletin provided
supplementary guidance for auditors of charities on
these additional requirements, by replacing the sections
of Practice Note (PN) 11 “The Audit of Charities in the
United 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’.

Iranian Auditor’s Responsibility to Consider Fraud &
Error in an audit of Financial statements Accordance
with Iran audit standards sec.24

SAS Says:
•Its management’s responsibility:
   •Setting the proper tone
   •Creating and maintaining a culture of honesty and ethics
   •Establishing appropriate controls

    Auditor's Responsibility under Generally
         Accepted Auditing Standards
It is important for audit committees to understand what
an audit is and what it is not. Usually, audit committees
are most concerned about the system of internal control
and that the financial statements are free of material
misstatement. The auditor should make sure the audit
committee understands the level of responsibility that
the auditor assumes for the system of internal control
and the financial statements under generally accepted
auditing standards (GAAS). It is also important that the
auditor make sure that the audit committee understands
that an audit is designed to obtain reasonable rather than
absolute assurance about the financial statements.

The following statistics about fraud and white-collar crime are from the
Association 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 to
fraud and abuse.
The average organizations lose about 6% of its total annual revenue to
fraud 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 their employees
The highest median losses occur in the real estate financing sector.
Occupational fraud and abuses fall into these main categories; asset
misappropriation, fraudulent statements and bribery and corruption.

                   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)

             Auditors under fire
Andrew Ratcliffe Chairman of the ICAEW Audit and Assurance
• “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."

Introduction to Fraud Detection
There are more advanced techniques on this site, but
this is the place to start to get some idea what
techniques 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.

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.                                                          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.

• 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 doesn't 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!

      Beware discontinuities that become
• An extraordinary loss or gain should not
  become a regular feature of a business's income
  statement. If a business is having major
  lawsuits, abandoning product lines, or
  undergoing major restructuring, that's a sign
  that management is either up to something
  (fraud), or don't know what they are doing
  (poor management).

• 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 don't want to
    get caught in the bath.

              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 you're dealing
  with a type of business that depends heavily on
  short-term debt.

• 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

           Beware "free cash flow"
• Free cash flow has no officially defined
  meaning determined by any authoritative
  accounting rule-making body.

• 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.

• Look for "window dressing" on the balance
• 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.

       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.

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

  Look for unnecessary dilution of stock.
• If a company is creating shares of stock for sale,
  but doesn't 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).

Beware of LLC's
• Limited Liability Corporations, or LLC's, can
  have extremely complicated ownership

• Examine how indirect costs are allocated.
 Indirect costs are costs that cannot be
 obviously attributed to specific products,
 organizational units, or activities. A book
 publisher's phone bill is a cost of doing
 business, but it can't 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.
• 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.

• Examine how indirect costs are allocated.
 Indirect costs are costs that cannot be
 obviously attributed to specific products,
 organizational units, or activities. A book
 publisher's phone bill is a cost of doing
 business, but it can't 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.

• 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.

     Watch out for LIFO inventory.

LIFO is usually the wrong accounting method for
 inventory, because:
  • most businesses don't 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.

• Make sure the company is using "Lower of
  Cost or Market" (LCM) to calculate their
• 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.

• 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.

• 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.

• 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.

• See if earnings per share kept up with profit.
• If profit increased by a larger percentage than
  earnings per share, and there wasn't any stock
  split, or stock offering (with a clearly
  explained justification), then management is
  diluting the shares. While this doesn't
  necessarily mean fraud, it is a red flag that
  management doesn't care about shareholder

• Compare profit increase with cash flow.
 These should increase in lockstep. Usually if
 cash flow is low (or negative) it's because all
 the profits are in accounts receivable and
 haven't been collected yet.

• Check that increases in assets and liabilities
  are consistent with the business's 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.

• 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!

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

      What did the auditor say?
Just because the auditor says the books are clean
doesn't mean they are, of course. You should
never trust the auditor. But if the auditor did
raise a red flag, take it very, very seriously! If
the auditor's opinion is qualified by anything,
you should be more skeptical of the entire
financial statement -- not just the item that the
auditor expressed concern about. If the auditor
expresses concern about the company's ability to
be a "going concern", the auditor is saying the
business is about to be forced into bankruptcy.

    What Arthur Anderson Said
Bauer, 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

• 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.

           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

       Financial Statement Frauds
• Revenue/Accounts Receivable Frauds (Global
    Crossing, Quest, ZZZZ Best)
•   Inventory/Cost of Goods Sold Frauds
•   Understating Liability/Expense Frauds (Enron)
•   Overstating Asset Frauds (WorldCom)
•   Overall Misrepresentation (Bre-X Minerals)

                  Revenue-Related Transactions and Frauds
      Transaction                 Accounts Involved                                 Fraud Schemes

1. Estimate all            Bad debt expense, allowance for      1. Understate allowance for doubtful accounts, thus
uncollectible accounts     doubtful accounts                    overstating receivables
receivable and/or
2. Sell goods              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 customers
from customers                                                6. Record returned goods after the end of the period

4. Write off receivables as Allowance for doubtful accounts,    7. Not write off uncollectible receivables
uncollectible               accounts receivable                 8. Write off uncollectible receivables in a later period

5. Collect cash after      Cash, accounts receivable            9. Record bank transfers as cash received from
discount period                                                 customers
                                                                10. Manipulate cash received from related parties
6. Collect cash within     Cash, sales discounts, accounts      11. Not recognize discounts given to customers
discount period            receivable

                  Inventory/Cost of Goods Sold Frauds
         Transaction               Accounts Involved                        Fraud Schemes
1. Purchase inventory           Inventory, accounts      1. Under-record purchase
                                payable                  2. Record purchases too late
                                                         3. Not record purchases
2. Return merchandise to        Accounts payable,        4. Overstate returns
supplier                        inventory                5. Record returns in an earlier period (cutoff problem)

3. Pay vendor within discount Accounts payable,          6. Overstate discounts
period                         inventory, cash           7. Not reduce inventory cost
4. Pay vendor without discount Accounts payable, cash    Considered in another chapter

5. Inventory is sold; cost of   Cost of goods sold,      8. Record at too low an amount
goods sold is recognized        inventory                9. Not record cost of goods sold nor reduce inventory

6. Inventory becomes obsolete Loss on write-down of      10. Not write off or write down obsolete inventory
                              inventory, inventory
7. 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                       inventory
9. Inventory cost is          Inventory, cost of goods   13. Incorrect costs are used
determined                    sold                       14. Incorrect extensions are made
                                                         15. Record fictitious inventory
         Role of Andersen in Enron Case
• Was paid $52 million in 2000, the majority for non-audit related consulting
• 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.
 Timeline of Arthur Anderson events
1996            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
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.
                         Largest Bankruptcy Filings
                              (1980 to Present)

               Company                  Assets (Billions)   When Filed
1. World Com                                 $103.9          July 2002
2. Enron                                     $63.4          Dec. 2001
3. Conseco                                   $61.4          Dec. 2002
4. Texaco                                    $35.9          April 1987
5. Financial Corp of America                 $33.9          Sept. 1988
6. Global Crossing                           $30.2           Jan. 2002
7. PG&E                                      $29.8          April 2001
8. UAL                                       $25.2          Dec. 2002
9. Adelphia                                  $21.5          June 2002
10. MCorp                                    $20.2          March 1989
                           Fraud Trick
Revenue Recognition
One means of manipulating financial results is to record revenue before it has
been earned. This historically has been accomplished by recording revenue
early 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

Misuse of Estimates
The use of estimates is a normal occurrence in
accounting and can include the following:
   1. Allowance for bad debts
   2. Allowance for inventory obsolescence
   3. Allowance for anticipated warranty claims or returned
   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.

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.

    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.

South Sea Company               1720   Equitable Life       2000
Saving and Loan crisis          1980   Enron Corporation    2001
Braniff International Airways   1982   HIH Insurance        2001
Laker Airways                   1982   One.Tel              2001
De Lorean                       1983   Ansett               2001
Zzzz Best                       1987   Sabena               2001
First Jersey Securities         1987   TWA                  2001
Drexel Burnham Lambert          1990   Webvan               2001
BCCI                            1991   Arthur Anderson      2002
Eastern Air Lines               1991   Global Crossing      2002
Pan Am                          1991   Swissair             2002
Confederation Life              1994   WorldCom             2002
Barings Bank                    1995   Health South         2003
Fokker                          1996   IG Farben            2003
Bre-X Minerals                  1997   Parmalat             2003
Pixelon                         2000   Red Letter Day       2005
Lernout & Hauspie               2000   Jetsgo Corporation   2005

                     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


1.    Business Fraud (The Enron Problem), W.Stove Albert, Brigham Young University
2.    FSA Presentation Fraud, W.Stove Albert, May 2003, Chicago, Illunious
3.    Financial Institution Fraud and Failure report Fiscal year 2003
4.    Journal of Accountancy online year 2003-2004
5.    Journal of Accountancy online, 2002-2005
6.    AICPA address Fraud in audit committee guidance
7.    IIA Website
8.    AICPA Website
9.    ACFE Website
10.   Research of Dayarayan Auditing & Financial Services Firm about Fraud in Tehran Stock
11.   Website of financial reporting council (FRC)
12.   Audit Risk & Fraud Supplementary guidance for auditors of occupational pension schemes,
      Bulletin May 2005
13.   Audit Risk & Fraud Supplementary guidance for auditors of charities, Bulletin Feb. 2005
14.   Audit Risk & Fraud Supplementary guidance for auditors of investment business, Bulletin April
15.   The auditing practices board- Bulletin
16.   Fraud Examines Manual (ACFE) 2006, US edition
17.   Switzerland The largest Money Laundering Centre in The World By:Dr Ali Sahraeean
18.   Iran Audit Standard, sec. 24

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