FRAUD RISK & THE AUDIT COMMITTEE

FRAUD RISK & THE AUDIT COMMITTEE Presented by Andrea St.Rose, LLB(Hons), FCIS,CFE,MBA,CGA,CA Bay Gardens Hotel – JUNE 22, 2007 Andrea St. Rose & Associates

FRAUD RISK & THE AUDIT COMMITTEE Agenda 1. The Internal Audit Function 2. Risk Management and Internal Audit 3. Fraud – An Overview 4. Categories of Occupational Fraud and Abuse

FRAUD RISK & THE AUDIT COMMITTEE Agenda 5. Fraud Red Flags 6. Fraud Prevention Programs 7. ACFE’ s Annual Fraud Check Up 8. Conclusion

FRAUD RISK & THE AUDIT COMMITTEE Agenda 9. Case Studies in Detection and Prevention 10. ACFE’s Annual Fraud Check Up 11. Wrap up – Questions and Answers

FRAUD RISK & THE AUDIT COMMITTEE THE INTERNAL AUDIT FUNCTION

Fraud Risk & The Audit Committee What is Internal Audit? • Internal Audit is an independent, objective, assurance and consulting activity designed to add value and improve the operations of an organization. ( The IIA)

FRAUD RISK & THE AUDIT COMMITTEE • How is value added? • Conducts risk-based reviews of an organization’s business activities providing assessments and comments on risk management techniques/ internal controls and governance processes. • Works consultatively with management to ensure risk management issues are addressed. • Provides constructive recommendations.

Risk Management and Internal Audit • The Institute of Internal Auditors • ECCB Guidelines • Sarbanes-Oxley Act - USA

Risk Management and Internal Audit The IIA • IIA Performance Standard 2100 “The internal audit activity should evaluate and contribute to the improvement of risk management, control and governance processes using a systematic and discipines approach” ( Source: The IIA).

Risk Management and Internal Audit The IIA • IIA Performance Standard 2110 “The Internal Audit activity should assist the organisation by identifying and evaluating significant exposures to risk”. (Source: The IIA)

Risk Management and Internal Audit ECCB - Guidelines For Internal Auditing of Institutions Licensed Under The Banking Act (Sec.7.0) “ An Internal Audit function in the financial institution assists management in evaluating and improving the risk management, control and governance systems”. (Source: ECCB)

Risk Management and Internal Audit RISK Management Decisions to accept exposure or to reduce vulnerabilities by either mitigating the risks or applying cost effective controls.(Source: www.utmb.edu/is/security/glossary.htm )

Risk Management and Internal Audit What are some of the vulnerabilities that an organisation faces? • Business Continuity • Liquidity Risk • Market Risk • Fraud Risk

Risk Management and Internal Audit Legislation/ Standards – Fraud Risk • IIA • ISA • SOX

Risk Management and Internal Audit The IIA Standards and Fraud Risk Sec 1210.A.2 The internal auditor should have sufficient knowledge to identify the indicators of fraud but is not expected to have the expertise of a person whose primary responsibility is detecting and investigating fraud. (Source: The IIA)

Risk Management and Internal Audit Standard External Auditors’ Report • Management’s Responsibilities – ( paragraph) “ this responsibilities include designing,implementing,and maintaining internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to FRAUD or ERROR….”

Risk Management and Internal Audit Sarbanes –Oxley Act ( USA) Section 404 As a deterrence to fraudulent financialreporting, the Act requires CFO and CEO of public companies to personally certify their quarterly and annual Sec filings.

FRAUD – AN OVERVIEW • What is it? • Why is it committed?

FRAUD – AN OVERIEW FRAUD – What is it? There are 4 basic elements: • A false representation of a material nature. • Knowledge that the representation is false • Reliance – the person receiving the represenation reasonably relied on it. • Damages – financial, resulting from above . (source: A Guide to Forensic Investigation – Golden,Skalak and Clayton)

FRAUD AN OVERVIEW • Why Fraud is commited: “Trusted persons become trust violators when they conceive of themselves as having a financialproblem which is nonsharable, are aware that this problem can be secretely resolved by violation of the position of financial trust and are able to apply their own conduct in that situation,…”(Cressey)

FRAUD AN OVERVIEW • Nonshareable Problems: • Inability to meet debt obligations • Bad judgement resulting in losses • Status Ambitions – cont’d associations • Relations with Employer – working conditions etc. • Drug abuse

THE FRAUD TRIANGLE Hypothesis – The Fraud Triangle Opportunity Pressure Rationalization

THE FRAUD TRIANGLE • Pressure • Opportunity • Rationalisation

CATEGORIES OF OCCUPATIONAL FRAUD AND ABUSE • Asset misappropriation • Fraudulent statements • Corruption

ASSET MISAPPROPRIATION • According to ACFE in its 2006 report to the Nation : Asset Misappropriation- Any scheme that involves the theft or misuse of an organizations assets. e.g. payroll fraud

ASSET MISAPPROPRIATION • Most common form of fraud • Target – cash, cheques, money orders (87% of reported cases in 2006) • Non cash – 23% of reported cases in 2006

ASSET MISAPPROPRIATION • CASH • Larcency – cash stolen after recorded • Skimming – cash stolen before recorded • Fraudulent disbursements – non bona fide payments • Other Assets • Misuse • Larcency – outright stealing e.g theft of inventory

CATEGORIES OF OCCUPATIONAL FRAUD AND ABUSE • Fraudulent statements

FRAUDULENT FINANCIAL STATEMENTS • What happened at Enron? • Creation of SPE’s to hide losses • Questionable accounting treatments

FRAUDULENT STATEMENTS • What is it? • How detected? • How prevented?

FRAUDULENT STATEMENTS • Manipulation of financial statements : • Overstatement of revenues • Understatement of expenses/ liabilities • Timing differences • Asset valuations • Non disclosure of material transactions

FRAUDULENT STATEMENTS DETECTION: • Disgruntled Employee • Employee Hot Line • Internal Audit • External Audit

FRAUDULENT STATEMENTS • HOW CAN WE PREVENT?

FRAUDULENT STATEMENTS PREVENTION Apply the Fraud Triangle: • Reduce Pressures - How? • Reduce Opportunities – How? • Reduce rationalisation - How?

FRAUDULENT STATEMENTS REDUCE PRESSURES Tone at the top organisation • Set realistic targets • Pay system - fair – • Performance Systems • Reduce pressure from stock brokers

FRAUDULENT STATEMENTS • REDUCE OPPORTUNITIES • Background checks for prospective employees • KYE • Proper system Internal Controls • Segregation of incompatible duties • Physical security for assets • Procedures manual – clear • Accounting policies and procedures clear • Monitoring Controls – internal audit • Protect whistleblowers • Job rotation – vacation policy

FRAUDULENT STATEMENTS • REDUCE RATIONALIZATION • Code of Conduct clearly communicated • Communication of Values – Zero tolerance • Clear communication regarding non compliance with accounting polices/procedures • Promote Integrity throughout the organisation • Training

FRAUDULENT STATEMENTS • DETECTION • Financial Statement Analysis • Ratio Analysis • Trend Analysis • Horizontal Analysis – yr to yr • Vertical Analysis – analyzing relationships • Surprise Audits

FRAUDULENT STATEMENTS • RED FLAGS • Weak internal control environment • Unsupported adjusting journal entries – near end of financial period • Missing support for disbursements/purchases • Forgery of supporting documentation • No background checks performed for employees • Bonuses tied to profitability

CATEGORIES OF OCCUPATIONAL FRAUD AND ABUSE • CORRUPTION

CORRUPTION • Corruption – “Any scheme in which a person uses his or her influence in a business transaction to obtain an unauthorised benefit contrary to that person’s duty to his employer” (source: ACFE 2006 Report to the Nation)

CORRUPTION • Conflicts of interest – most common • Bribery • Illegal gratuties • Extortion

CORRUPTION • Conflicts of interest: • Employee or executive has not disclosed an interest in a transaction that negatively impacts on the entity. e.g. Employee A, the purchasing manager of Company B enters into a contract with Company C, however Company C is owned by Employee A. The costs incurred are 10 per cent above market rates.

CORRUPTION • BRIBERY • Usually takes the form of a gift/kickback which is geared at influencing a party – the employer has not consented. Includes Offers. e.g. Employee A disloses to Company B that the terms of a contract out for tender will change. Company B submits a low bid, gets the contract. Variation orders submitted eventually increase the cost of the contract. Company B pays $5,000 to employee A’s Offshore Bank account for awarding the contract.

CORRUPTION • ILLEGAL GRATUTIES • The giving of a gift as a result of securing a favourable business decision – the principal has no knowledge. • Company A offers an all expenses paid vacation to Loan Officer B of Int’L Bank C. Company A is a delinquent debtor of the Bank.

CORRUPTION • EXTORTION • “The coercion of another to enter into a transaction or deliver property based on wrongfuluse of actual or threatened force, fear or economic duress” – (source: ACFE) • Company A, a large company is the major purchaser of furniture manufactured by B, a sole proprietor. Purchasing manager Peter indicates that quality is poor and the company will discontinue purchases unless B hires a Quality consultant – who happens to be Peter’s Mistress.

CORRUPTION • DETECTION: - BRIBERY • General purchasing • Prebid solicitation • Bid Solicitation • Bid or Contract Acceptance • Behaviour profile of recipient • ( source: Corporate Fraud Handbook – J.T. Wells -299)

CORRUPTION • PREVENTION - BRIBERY • Bribery prevention policy • Gift Acceptance Policy • Entertainment Policy (Source: Corporate Fraud Handbook – J.T.Wells 302)

CORRUPTION • DETECTON - CONFLICT OF INTEREST • Tips and complaints • Comparison of Vendor addresses with employee addresses • Vendor ownership review • Interview Purchasing Staff

CORRUPTION • PREVENTION – Conflicts of interests • Annual disclosures • Independence Statements • Vendor “Right to Audit Clauses” • Code of Ethics – clearly communicated

FRAUD RISK & THE AUDIT COMMITTEE