Managing Corporate Fraud: Detection & Prevention Strategies

1. FRAUD and Internal Controls Presented by Ron Fory To DFW IMA Chapter 16 May 2013

2. Learning Objectives Upon completion of this course, you should be able to: • Recognize the signs and red-flag issues of financial reporting fraud • Describe the corporate and psychological make-up of white collar criminals • Implement detection and practice procedures

3. What is Corporate Fraud? Defined by the U.S. Department of Justice: • Falsification of corporate financial information • Self-dealing by corporate insiders • Obstruction of justice, perjury, witness tampering or other obstructive behavior

4. Need Fraud Means Rationale CRESSEY’S FRAUD TRIANGLE

5. Major Categories of Corporate Fraud Financial Reporting Fraud (also known as management fraud). • Intentional misstatements • Primary purpose is to misstate the financials • To mislead statement users • To benefit from results of the misstatement

6. Major Categories of Corporate Fraud Misappropriation of Assets (also known as employee fraud). • Theft of assets • Manipulation of records to conceal misappropriation For example, when cash is diverted, an expense may be misstated to conceal the offsetting debit. • Misstatement of the financial statements is secondary to the main purpose of stealing assets.

7. Major Categories of Corporate Fraud External Fraud • Committed against an organization by nonemployees • For the financial gain of the perpetrators • Generally, the organization’s financial statements will not be misstated in these cases

8. Major Categories of Corporate Fraud Occupational Fraud • Committed by individuals or small groups • Criminologist, Edwin H. Sutherland • Learning of criminal behavior occurred in a process including: • Criminal techniques, and • The attitudes, drives, rationalizations, and motives of the criminal mind

9. Major Categories of Corporate Fraud • Organizational Fraud • Complex relationships and expectations • Among boards of directors, executives, and managers • Parent corporations, corporate divisions, and subsidiaries • Result of a myriad of decisions made by different persons and passing through a chain of command.

10. Major Categories of Corporate Fraud Organizational Fraud: • When corporate acts are contrary to the law, upper level executives take pains to avoid responsibility if a scheme is uncovered.

11. Aggressive Financial Tactics vs. Fraud • Perpetrators believe they are legitimate • Performing acceptable business practices • That were legal and necessary for survival of the organization • Sociologist Robert K. Merton’s theory on individual’s and corporate goals vs. society’s norm breed lawlessness

12. Some Notable Examples - TYCO • Dennis Kozlowski and Mark Swartz • Corporate Loans - $170 million + • Misstating Financials - $430 million

13. More Notable Examples –Parmalat • Among world’s largest dairy manufacturer • Forged letter of credit – 3.9 billion Euros • Overstatement EBITD by 530% • Understatement of Liabilities – 1.8 billion Euros • Nonexistent liquid assets – 7 billion Euros

14. More Notables –Global Crossing • Telecommunications giant • Insider trading - $1.5 billion • Disclosure failures

15. More Recently Notable –Thor Industries • 1999 SEC Cease and Desist Order • El Dorado $400,000 Embezzlement • Lack of Oversight • May 2011 SEC Cease and Desist Order • Dutchman Manufacturing - Inventory

16. Business and Fraud Risk Symptoms General Red-flags • Internal controls • Complaints • Discovery that warrants follow-up • Financial statement trends • Changes in an employee’s lifestyle • Abrupt changes in behavior

17. Case Study: Crazy Joe • Electronics empire begun in 1969 • Family recruited to help with: • Smuggled money from foreign banks recorded as sales • False entries to accounts payable • Accessed audit files to inflate inventory • Returned merchandise credited and counted in inventory • Inventory shuffled between stores • Discounts and advertising credits claimed on merchandise shipped and billing delayed • Allocated payments between stores as sales receipts

18. Case Study: Skimming Doctor • Doctor was top producer in Medical Office • Offices were run autonomously • Payments up front; no credit cards • Patient checks in with secretary, pays; secretary records payment • Location of office permitted unrecorded visits

19. Skimming: Distributorship Controller • Two cash streams: route collections and A/R payments by mail • Controller had sole authority over all cash • Lapping between deposits • Replacing cash with A/R checks • Manipulating A/R schedules • Loss = $358,000

20. Cash Larceny: Head Bank Teller • Authority to open night deposit vault with one other teller • Vault camera was activated when bank opened • Arrived early Monday morning, took two deposit bags, each with about $8,000 • Prime suspect; husband found money at home

21. Case Study: Check Tampering • Volunteer organization executive secretary working with a “lackadaisical” board • Wrote checks to herself, forging second signature • Would not convert manual system to automated • Moved financial operations to her home • Refused to provide financial information to board • Loss documented by check handling: $60,000

22. Case Study: Register Disbursement Scheme • Demoted management employee with financial problems, authorizing refunds • Documentation was lacking, policies not followed • Motivation was retaliation • Loss over 6 months: $10,000 • Detection by part-time bookkeeper’s report

23. Case Study: Med School Expenses • Business office supervisor was caught submitting forged expense documents • Search of offices revealed supplies sold to other offices and fake invoices to the school • Function of the office was to process vendor invoices • Checks for fake invoices were personally picked up • Gift from vendor who sent inflated invoices • Loss: $75,000 over two years

24. Summary • What are the different categories of corporate fraud? • Differences in fraud auditing and financial auditing? • Importance of the Fraud Triangle? • What do red flags do for you? • What are we doing here?