Welcome to

1. Welcome to ACG6686 Fraud Examination

2. Introduction to Fraud Examination

3. Why Study Fraud Examination? • AICPA called fraud examination (Forensic Accounting) one of the seven hot new “sizzling” career areas in accounting. • The size and the number of frauds is increasing. • Great Job Opportunities: there will be a shortage of between 25,000 and 50,000 security professionals in the next few years in the United States.

4. Fraud Examination, 3E Why People Commit Fraud

5. Learning Objectives Know the types of people that commit fraud Explain why people commit fraud Describe the Fraud Triangle Understand how pressure contributes to fraud Tell why people rationalize Understand how people are recruited to participate in fraud 5

6. Type of People That Commit Fraud What type of people commit fraud? • Anyone! • Not demographically or psychologically differentiated • Have the profile of other honest people 6

7. Reasons to Commit Fraud • A combination of the following (Fraud Triangle): • Pressure • Rationalization • Opportunity • Immediate financial need • The fraud gets larger and larger as confidence in the fraud gets higher and higher 7

8. The Fraud Triangle Pressure Fraud Triangle Opportunity Rationalization 8

9. The Fraud Triangle Heat Fire Triangle Fuel Oxygen 9

10. The Fraud Triangle Pressure High Low Opportunity High Low Integrity Low High Small Chance High Chance The Fraud Scale 10

11. Pressure Divided into four main groups: • Financial pressures • Vices • Work-related pressures • Other pressures 11

12. Pressure Financial Pressures Common Financial Pressures: • Greed • Living beyond one’s means • High bills or personal debt • Poor credit • Personal financial losses • Unexpected financial needs 12

13. Pressure 13

14. Pressure Vice Pressures Worse kind of pressures to commit fraud Examples include: Gambling Drugs Alcohol Expensive extramarital relationships 14

15. Pressure Vice Pressures Real-life examples: • Dad that embezzled his six-year-old son’s allowance • Women who stole money to fund her children's drug addiction • Man that used company money to fund his drug addiction • The parents who took their new-born baby from the hospital with heroine under its tongue 15

16. Pressure Work-related Pressures “Get even with the employer” Motivated by these factors: • Getting little recognition • Feeling job dissatisfaction • Fear of losing one’s job • Being overlooked for a promotion • Feeling underpaid 16

17. Pressure Work-related Pressures Real-life examples: • The worker that worked 12-14 hour days, received a promotion, and accepted kickbacks to compensate for his “over working.” 17

18. Pressure Other Pressures Spouse Pressures • Spouse’s lifestyle demands Life Pressures • Family Crisis Social Pressures • “Being successful” 18

19. Opportunity Six major factors that increase opportunity: • Lack of controls • Inability to judge performance quality • Fail to discipline fraudsters • Lack of access to information • Ignorance, apathy and incapacity • Lack of audit trail 19

20. Recruitment of Fraudsters Many frauds are committed by more than one person Collusion 20

21. Recruitment of Fraudsters A Business Week forum for CFOs: At the forum, participants were queried about whether or not they had ever been asked to “misrepresent corporate results.” Of the attendees, 67 percent of all CFO respondents said they had fought off other executives’ requests to misrepresent corporate results. Of those who had been asked, 12 percent admitted they had “yielded to the requests,” while 55 percent said they had “fought off the requests.” 21

22. Recruitment of Fraudsters Reward Power Legitimate Power Power Coercive Power Expert Power Referent Power 22

23. Recruitment of Fraudsters Types of Power • Reward Power • A’s ability to provide benefits to B • Coercive Power • A’s ability to punish B if B does not comply with A • Expert Power • A’s possession of special knowledge or expertise • Legitimate Power • A’s legitimate right to prescribe behavior for B • Referent Power • The extent to which B identifies with A 23

24. Recruitment of Fraudsters Pressure Conspirator (A) Potential Co-Conspirator (B) Perceived Reward Power Desire for Reward or Benefit Perceived Coercive Power Fear of Punishment Successful Collusion (Recruitment) Perceived Expert Power Lack of Knowledge Perceived Legitimate Power Level of Obedience Perceived Referent Power Relationship Needs 24

25. Controls to Prevent/Detect Fraud Internal Control Framework (from COSO) Control Environment Risk Assessment Control Activities Information and Communication Monitoring 25

26. Controls to Prevent/Detect Fraud The Internal Control Structure Control Environment • Management’s Role and Example • Management Communication • Appropriate Hiring • Clear Organizational Structure • Effective Internal Audit Department 26

27. Controls to Prevent/Detect Fraud The Internal Control Structure Accounting System Transactions are… • Valid • Properly authorized • Complete • Properly classified • Reported in the proper period • Properly valued • Summarized correctly 27

28. Controls to Prevent/Detect Fraud The Internal Control Structure Control Activities or Procedures: • Segregation of duties, or dual custody • System of authorizations • Independent checks • Physical safeguards • Documents and records 28

29. What If I Don’t Want to Be a Fraud Expert? • Even if you decide not to become a fraud expert, the topics covered in this course will help you be a better professional in whatever career path you choose. The technology, interviewing, document examination, public records, and other tools you will learn will make you a better consultant, auditor, tax professional, or manager, as well as a better and more astute investor.

30. An Important Source • http://www.cfenet.com • The website for the Association of Certified Fraud Examiners (ACFE)

31. Seriousness of the Fraud Problem • It is difficult to give you a definite answer. • ACFE conducted a fraud study in the mid-1990s. Based on voluntary reports of over 2,600 frauds, the ACFE estimated that fraud costs U.S. organizations more than $400 billion annually. It is estimated that the average organization’s fraud losses are more than $9 per day per employee, and that about 6% of a company’s total annual revenue is lost to fraud.

32. Seriousness of the Fraud Problem • The FBI has labeled fraud the fastest growing crime. • Not only the number of fraud cases seems increasing, the size of discovered fraud is increasing too. • Fraud is very costly to organizations.

33. Given that the frauds are very costly, the best way to maximize profits for companies is to eliminate fraud. • The best way to minimize fraud is to prevent it from occurring. • Therefore, we will cover fraud prevention, as well as fraud detection and investigation.

34. What Is Fraud? • Black’s Law Dictionary defines fraud as: “… all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprise, trick, cunning or dissembling, and any unfair way by which another is cheated.”

35. What Is Fraud? • A victim • Details of the deceptive act thought to be fraudulent • The victim’s loss • A perpetrator • Evidence that the perpetrator acted with intent • Evidence that the perpetrator profited by the act(s)

36. Can we sue the contractor for fraud? • Assume that an entity contracted to have the roof of a warehouse redone, specifying that an expensive rubberized sheeting be used. The job is advertised and contractor A submits the lowest bid. After the job is completed, the entity discovers that the roof leaks. Further investigation discloses that a much cheaper roofing material was installed, inferior to the quality of product that was specified in the contract. The cost difference between the two grades of roof sheeting was $10,000 and it will cost $5,000 to repair the leak.

37. Types of Fraud • Misrepresentation of material facts • Concealment of material facts • Bribery • Conflicts of interest • Theft of money or property • Theft of trade secrets or intellectual property • Breach of fiduciary duty • Statutory offenses

38. Misrepresentation of Material Facts • Deliberate making of false statements to induce the intended victim to part with money or property • The elements normally include • A material false statement • Knowledge of its falsity • Reliance on the false statement by the victim • Damages suffered. • Opinions, speculative statements about future events, even if made with intent to mislead, may not be the basis for a fraud case.

39. An Accountant May Be Prosecuted for Fraud who: • Certifies that a financial statement fairly presents the financial condition of the audited company when the accountant knows it does not. • Falsely states that the audit was conducted in accordance with GAAS. • Deliberately distorts the audit results

40. Concealment of Material Facts • The essential elements of fraud based on failure to disclose material facts are • That the defendant had knowledge • Of a material fact • That the defendant had a duty to disclose • And failed to do so • With the intent to mislead or deceive the other party

41. Bribery • Bribery includes official bribery, which refers to the corruption of a public official and commercial bribery, which refers to the corruption of a private individual to gain a commercial or business advantage. • Elements: • Giving or receiving • A thing of value • To influence • An official act

42. Extortion • Obtaining of property from another with the other party’s “consent” having been induced by wrongful use of actual or threatened force or fear. • A demand for a bribe or kickback might constitute an extortion. • In most states and federal system, extortion is not a defense to bribery.

43. Conflict of Interest • An agent taking an interest in a transaction • That is actually or potentially adverse to the principal • Without full and timely disclosure to an approval by the principal • An agent includes any person who, under the law, owes a duty of loyalty to another, including employees of a corporation, brokers, accountants.

44. Embezzlement • The wrongful appropriation of money or property by a person to whom it has been lawfully entrusted. Embezzlement implicitly involves a breach of trust. • The defendant took or converted • Without the knowledge or consent of the owner • Money or property of another • That was properly entrusted to the defendant

45. Larceny • Taking or carrying away • Money or property of another • With the intent to permanently deprive the owner of its use of possession • Without the consent of the owner

46. Theft of Trade Secrets • That a party possessed information of value to the business • That was treated confidentially • That the defendant took or used by breach of an agreement, confidential relationship, or other improper means.

47. Breach of Fiduciary Duty • People in a position of trust or fiduciary relationship, such as officers, directors, owe certain duties imposed by law to their principals or employers.The principal fiduciary duties are loyalty and care.

48. Duty of Loyalty • Requires that employee/agent act solely in the best interest of the employer/principal, free of any self-dealing, conflicts of interest, or other abuse of the principal for personal advantage. • Embezzlements, thefts, acceptance of kickbacks, and conflicts of interest also violate the duty of loyalty and may be prosecuted as such in addition to or instead of the underlying offense.

49. Duty of Care • People in a fiduciary relationship must conduct business affairs prudently with the skill and attention normally exercised by people in similar positions. • People in a fiduciary relationship are not guarantors against all business reverses or errors in judgment. • The Business Judgment Rule protects corporate officers and directors from liability for judgment that were made in good faith and appeared to be prudent

50. Federal Legislation Related to Fraud • Most white-collar crimes are prosecuted under the state systems. Prosecution under the criminal fraud statutes in the U.S. Code requires a federal jurisdictional basis, such as an effect on interstate commerce or mail uses. • Example: mail fraud, wire fraud, Racketeer Influenced and Corrupt Organizations (RICO)