Fraud and Forensic Accounting The Basics October 23, 2008 Economic Crime Institute

1. Fraud and Forensic Accounting The Basics October 23, 2008 Economic Crime Institute Dr. Richard A. (Dick) Riley West Virginia University Tanner Distinguished Professor of Public Accounting

2. Opening Remarks In God We Trust Everyone Else, We Examine Adapted from Michael Connelly’s Void Moon Ronald Reagan: Trust, but Verify

3. Internal and ExternalAuditing Planning Risk Assessment Internal controls Audit Evidence Reporting Forensic Accounting Accounting and Legal Matters Fraud Prevention and Deterrence Detection Investigation Remediation Definitions and Interrelationships

4. Forensic Accounting Intersection of accounting and the law asset misappropriation corruption / abuse / conflicts of interest financial statement fraud (fraudulent representations) broader legal engagements – civil litigation

5. Fraud Professional • Prevention & Deterrence • Detection • Investigation • Remediation

6. Auditing • F/S free from material misstatement • Planning • Risk Assessment • Internal Controls • Audit Evidence • Reporting

7. Fraud and Forensic Accounting Skills Working knowledge of: Accounting The legal system Criminology Investigative Techniques Detail oriented Organized Think critically Excellent communication skills

8. Critical Thinking Exercise Assuming the following are true statements about a deck of cards, what can a deck of cards be likened to? • 12 face cards (excluding ace) • 52 cards in a deck • 4 suits Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

9. Critical Thinking Exercise What if I provide the following piece of information? • Assume that an ace has a value of 1, jack=11, queen=12 and king=13, add up the value of all 52 the cards and add one for the joker: • 1+2+3+4+5+6+7+8+9+10+11+12+13=91 • 91 * 4 = 364 • 364 + 1 (joker) = 365 Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

10. Critical Thinking Exercise Assuming the following are true statements about a deck of cards, what can a deck of cards be likened to? • 365 • 12 face cards • 52 cards in a deck • 4 suits Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

11. Critical Thinking Exercise Assuming the following are true statements about a deck of cards, what can a deck of cards be likened to? • 365 • 12 face cards • 52 cards in a deck • 4 suits • Days in a year • Months in a year • Weeks in a year • Seasons in a year Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

12. Critical Thinking Exercise Final question about a deck of cards? • Why is the ace, the card with the lowest numerical value, considered more valuable than the king in most cards games? Source: Card Games for Smart Kids (Margie Golick, PhD, Sterling Publishing, NY)

13. Critical Thinking What is the lesson learned? (1) Persons who commit fraud do not think like us so we need to be flexible in how we approach other people’s worlds! A question of values… (2) Pull on a thread…sometimes it’s that one little piece of data that makes it all make sense. Keep digging, gathering information until you have an adequate explanation?

14. Investigating Fraud

15. Division of Accounting What would you do? • Thomas Coughlin • Vice-Chairman of Walmart • Long-time Family Friend of Sam Walton • Need: Alligator Books, Dog Pen, Hunting Vacations • Is it OK to Make Walmart Pay for this?

16. Division of Accounting What would you do? • Losses? • Income?

17. Estimated Losses to the US Economy $994 Billion • 7% Revenue • 25% losses > $1M ACFE 2008 Report to the Nation: Occupational Fraud

19. Length of Time With Company • Less Than 3 Years…………………..26 Percent • 3-5 Years……………………………14 Percent • 5-10 Years………………………….. 30 Percent • 10-20 Years………………………… 20 Percent • Over 20 Years……………………… 10 Percent

20. Perpetrators’ Ages • Under 26 Years Old……………...……14 Percent • 26-35 Years Old……………………… 28 Percent • 36-45 Years Old……………………… 36 Percent • 46-55 Years Old……………………… 12 Percent • Over 55 Years Old…………………… 10 Percent Combining Pressure & Opportunity is Like Mixing Diesel Fuel & Fertilizer!

21. Fraud Observations • ** People who commit fraud never stop. It’s hard to be dishonest the first time; but once one crosses the line, he or she never stops until caught. • Embezzlers seldom save their stolen goods. 3. *** Embezzlers get more greedy and sloppy over time.

22. Size of Victim Organization

23. Type of Fraud

24. Perpetrator

25. Discovery

26. Who Commits Fraud -Demographics • Married • Active Church Members • Children • Good Education • First-Time Offenders • Good Employees • Don’t Abuse Alcohol Conclusion:

27. Gender • Male……………..53 Percent $160K • Female…………. 47 Percent $60K

28. Why People Commit Fraud PerceivedPressure Fraud Triangle + + PerceivedOpportunity Rationalization +

29. Why People Commit Fraud? • The Accidental Fraudster • The Predator The Accidental Fraudster The Predator!

30. Why People Commit Fraud? • M • I • C • E

31. Why People Commit Fraud PerceivedPressure Fraud Triangle + + PerceivedOpportunity Rationalization +

32. Elements of Fraud • Which element of fraud • is easiest to identify? • - The Act • - Concealment • - Conversion The Act Concealment Conversion

33. Elements of Fraud Search for the strongest possible evidence. The Act 1. Surveillance 2. Invigilation - baseline 3. Physical Evidence + Inquiry Methods Concealment 1. Interviewing/ Interrogation 2. Honesty Testing 1. Fraud Auditing 2. Document Examination 3. Physical Asset Counts 4. Computer Searches Conversion 1. Public Records 2. Direct 3. Indirect: e.g., Net Worth Analysis

34. Fraud Detection

35. Professional Skepticism • A recognition that fraud may be present • An attitude that includes a questioning mind and a critical assessment of audit evidence – Pull on the threads! • A commitment to persuasive evidence (whether or not fraud is present) – Go that extra mile

36. Assuming the Fraud May Be Present • Process to: (-) Identify the possibility of fraud (-) Convincingly resolve any badges, symptoms, red flags of fraud

37. Consider theRisk of Fraud • Brainstorm • Consider how and where financial information might be susceptible to fraud • Consider how and where fraud might be hidden – Targeted Risk Assessment • Exercise professional skepticism!

38. Red Flags - Approach

39. Targeted Fraud Risk Assessment Process • Step 1. Identify your business processes • Step 2. Consider differences in those processes in foreign operations, as well as among subsidiaries or decentralized divisions • Step 3. Identify the “Process Owner” for each of the identified processes • Step 4. Review fraud experience within the company and by process • Step 5. Process Owners identify how fraud may occur in each process at each location using Fraud Brainstorming Techniques • Step 6. Identify the Parties who have the ability to commit the potential fraud • Step 7. Process owners evaluate the likelihood that each of the identified frauds could occur • Step 8. Determine the level of mitigation so as to prevent, detect and deter fraud • Step 9. Investigate the characteristics of potential fraud manifestations within each process identified • Step 10. Quantify Fraud Risk

40. Obtain information needed to identify risk of fraud • Interview ownership, management, internal auditors, clericals – carefully document statements • Consider results of analytical and preliminary examination procedures • Consider badges, symptoms and red flags of fraud

41. Consider Policies, Procedures and Controls • Understand the internal control environment • Evaluate whether policies, programs and controls are operational • Evaluate whether policies, programs and controls address the identified risks of fraud • Draw conclusions about the risk of fraud

42. Respond to Results of the Assessment As risk increases • Overall response: • More creativity • More non-financial performance metrics • Specific response: • Consider need to gathering additional evidence: • the nature and extent of examination procedures

43. Evaluate Examination Evidence • Assess risk of fraud throughout the examination • Evaluate results of analytical and examination procedures performed • Re-evaluate risk of fraud near completion of fieldwork

44. Draw Conclusions • Obtain explanations for errors, misstatements / omission and other irregularities • Corroborate explanations • Make judgment: • Consult with manager • Consult with Fraud Technical Advisor

45. Communicate about Fraud • Document findings • Write report

46. The Power of Non-Financial Data • The power of using non-financial data to corroborate financial information cannot be understated: • Laundromat electricity usage • Laundromat cycle time • Gas produced • Tons of minerals mined • Invoice details (beer) • The Science • NORA (Non-Obvious Relationship Analysis) • Data mining technique

47. The Power of Non-Financial Data • The world revolves around p*g: • p = price • q = quantities • - Break down activity into p’s and q’s

48. Reasons Why Fraud Investigations Fail Lack of Factual Development (not proven intent) Reliance on “Bad Person” Theory * Pointing to Frivolous Arguments without Developing Complete Case

49. Interviewing

50. Interviewing • Combination of • Good questions! • Careful observations! • Good listening! • Documenting Results!