Download Chapter 5 Employee Fraud: The

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Chapter 5
Employee Fraud: The Misappropriation of Assets
CHAPTER SUMMARY
Overview
There are many ways employees can commit fraud and often, they involve false documents that help skirt
internal controls. Accountants are perhaps the most valuable employee-fraud fighters because they possess the best
understanding of how businesses operate and how transactions flow through the financial or "central nervous system"
of the operation.
Fraud Schemes and Their Schemers
1)5001 Company Susceptibility to Fraud
There are a number of schemes that employees and outsiders may use to commit fraud, so fraud detection
is important for most organizations. Often misappropriations are accomplished by false or misleading records or
documents, possibly created by circumventing internal controls. Sometimes random events will bring the fraud to light.
Auditors must be more skeptical as well, employing forensic procedures in their audits. Internal and external auditors
must demand evidentiary support for all questionable transactions. This chapter surveys the types of misappropriation
of assets and explains ways to combat such fraud.
1)5011
Employee Fraudsters
Those involved in forensic accounting continue to research information on employee fraud perpetrators that
is helping to develop some characteristics even if these are not yielding what might be described as a true profile.
One difficulty in trying to "sketch out" the type of employee who turns to fraud is that given the right pressures,
opportunities, and rationalizations, a large percentage of employees are capable of committing some types of fraud.
Types of Misappropriations
1)5021
Embezzlement
Embezzlement is the fraudulent appropriation of money or property lawfully in one's possession to be used
personally by the embezzler. An embezzler steals from his or her employer.
1)5031 Cash and Check Schemes
Cash is the favorite target of fraudsters. Fraud perpetrators use an amazing array of techniques to cipher cash
from their employers, such as larceny, skimming, theft of incoming checks, or kiting. Segregation of duties, mandatory
vacations, and rotation of duties all help to prevent these schemes.
Larceny of Cash. Larcenv of cash schemes involve the numerous types of theft of cash after the cash has
been recorded on the books, such as directly from a cash register or petty cash. Prevention by segregation of duties is
important for stopping cash larceny.
Skimming. Skimming is an "off-book" technique to remove cash before a company records the receipts.
Skimming schemes can involve unrecorded sales, understated sales, theft of incoming checks, and swapping checks
for cash. Prevention of skimming can be as simple for some businesses as numbering receipts sequentially and tracking
down any missing numbers. Strong internal controls and separation of duties are two vital preventive measures.
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Swapping Checks for Cash. A person may take cash, but leave personal checks in the register or petty cash box
to cover the money taken in case of a surprise audit. Thus, the cash receipts and register tapes or petty cash records
appear to balance. The perpetrator removes the checks before they are cashed, so any personal checks by the cashier
found in a register may flag cover-up of a theft. An auditor should check for reversing transactions, altered cash
counts, or register tapes that are "lost."
Check Tampering. Not all check tampering occurs when the person entrusted to issue checks goes bad. Many
phony checks or phony recipients are created by others in a company who gain access to blank checks. Accounts
payable groups must practice separation of responsibilities and forced vacations.
Kiting. Another cash scheme, kiting, involves building up balances in two or more bank accounts based upon
floating checks drawn against the other accounts. Forensic investigators detect this type of scheme by looking for
frequent deposits and checks in the same amount, large deposits on Fridays, and/or short time lags between deposits
and withdrawals. A bank reconciliation audit is an important accounting tool; the bank should send the bank statements
directly to the fraud auditor.
Credit Card Refund and Cancellation Schemes. Fraudulent credit card refunds are common ploys of
employees to divert refunds to their own credit card accounts. Fraudsters substitute their own credit card numbers
on customers' refund slips. Another misuse of credit card transactions occurs when a customer service or cashier
employee marks actual credit card sales receipts as voided, then withdraws cash for that amount from the cash drawer.
Prevention of these scams requires diligence by supervisors and strong internal controls for cash disbursements.
Businesses that accept large numbers of credit card transactions should require immediate approval of voided sales.
1)5041 Accounts Receivable Fraud
Accounts receivable schemes may include lapping, fictitious receivables, borrowing against receivables, and
improper posting of credits to receivables.
Lapping. Lapping involves recording of payment on a customer's account some time after the receipt of the
payment. To catch this scheme, the forensic investigator compares the checks on a sample of deposit slips to the detail
of the customer credits that are listed on the day's posting to the customers' account receivables.
Fictitious Receivables. Fictitious receivables involve covering a phony sale with an equally phony receivable,
which may eventually be written off. A forensic auditor should obtain evidence of the existence of accounts receivable
and sales, then scrutinize any exception responses from accounts receivable confirmations.
Borrowing Against Accounts Receivable. In these fraud cases, the perpetrator puts up accounts receivable
as collateral for a loan. Auditing steps to uncover the illegal loan setups include independently verifying accounl
balances of customers who have not paid, reviewing receivables write-offs, and reviewing customer complaints about
unrecorded payments or excessive billing.
1)5051 Inventory Fraud
Stealing Inventory. Employees may steal inventory and supplies for personal use or sell the stolen items
to outsiders at flea markets and garage sales. Signs the investigator looks for include multiple checks for the same
vendor, charged prices that are higher than for other vendors, a purchasing agent who does not take a vacation, or
availability of only photocopied invoices.
Short Shipments with Full Prices. Fraud by short shipments of inventory/partial shipment occurs when
payment is made in full to an outside accomplice. In another type of shipment scheme, once they are entered into
inventory at full price, smaller fixed assets may be stolen outright or converted to unlawful personal use. Companies
should prevent the opportunity for shorting shipments by implementing systems of using prenumbered inventor}' tags
matched to count sheets, counting procedures for work-inprocess items, and separation of duties between purchasing
and logging receipt of shipments.
1)5056 Accounts Payable Fraud
Accounts payable fraud occurs when the victim is double-billed or pays false invoices. Employees can set up
shell companies to create false invoices for their employers in pass-through schemes. In such cases, the intermediary
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shell company pays a vendor's invoice before passing along an inflated invoice to the victim business. Companies
can prevent accounts payable fraud by matching invoice numbers, dates, or values; looking for rounded amounts;
looking for amounts just below approval amounts; searching for abnormal invoice volume activity; remaining wary
of vendors with sequential invoice numbers; and looking for above average payments per vendor.
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Fictitious Disbursements
Doctored Sales Figures. Fraudulent sales schemes include: unrecorded sales, understated sales, creating
fictitious sales, and padding prices to increase commissions. Various analytical techniques are used to detect phony
sales figures: ratio analysis, statistical sampling, and horizontal and vertical analysis of the sales account.
Sham Payments. Fraud perpetrators invent myriad fictional accounts payable. Sham payments involve a broad
spectrum of transactions and prevention will require some specific tactics depending upon whether payment is a
vendor, a benefit claimant, a customer, or employee.
Price Manipulations: Land Flipping, Pump and Dump, and Cybersmearing. A land flip involves a situation
where a company decides to purchase land for a project. A person or group will find the land and buy it using a front
name or company. The fraudster then increases the price of the land before selling it to his or her company. This same
concept may be used for stock manipulation between related entities or pump-and-sell schemes. The Internet, with
stock chat message boards and online news services, allows people to quickly provide false or misleading information
that can cause stock to move rapidly up or down. Numerous messages (or spam) can hype thinly traded stock in what
is called pump and dump, causing the stock to move up rapidly, at which time the perpetrator sells the stock at a huge
gain. Bashing a stock, called cybersmear, causes the stock to decline. A forensic investigator must always question
the valuation figure of land by comparing with similar property (comparables). Proactive measures are key to fighting
cybersmears.
Money Laundering. Money laundering is the use of techniques to take money that comes from one source,
hide that source, and make the funds available in another setting so that the funds can be used without incurring legal
restrictions or penalties. Accountants use a gross profit analysis to spot money laundering.
Bid Rigging. Bid rigging occurs when a vendor is given an unfair advantage in an open competition for a
certain contract. Companies should implement policies prohibiting vendor gifts or discounts to employees involved in
contract decision making. Policies should explicitly state opposition to bribery and bid rigging. Employees exhibiting
a sudden, more extravagant lifestyle should raise red flags.
H5071
Walking the Walk of Fraud Detection Programs
Efforts to create employee fraud prevention programs are not always sufficient to deter the crimes that have
been discussed. However, there are actions that should be considered.
Business Policies. Many organizations today look at an ethics policy to set the proper tone towards motivating
positive behaviors as well preventing negative ones. Often the rules of conduct that might be found in an Employee
Handbook or other document for employee consumption reflect a company's position on fraud.
Fraud and Company's Risk Assessment. An organization's profile of business risks should be comprehensive
and include consideration of fraud. Appropriate systems need to be in place to effectively manage the risks.
Proactive Is More Beneficial. There are two major types of fraud investigations: reactive and proactive.
Reactive refers to an investigation after there is suspicion of fraud. Proactive is preventive investigation when there
is no reason to suspect fraud. The threat of a future investigation reduces the occurrence of fraudulent behavior from
75 percent to only 43 percent.
Company's Response to Risk. Getting all capable parties working together to fight fraud is important to
controlling risk. It is also important to have adequate plans and procedures in place to deal with fraud once it has been
discovered.
Fraud and Security Policy. Another way the forensic accountant can assist in the fight against fraud is in
reviewing or helping to audit the company's security measures.
Staffing Role in Fraud Detection and Prevention. Staff selection and promotion based on sound employment
practices can fight fraud and help insure that if fraud is detected, it is reported.
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Company Fraud Prevention, Detection, and Mitigation Measures
1)5081 Companies on the Front Lines in Preventing Employee Fraud
Certified Fraud Examiners (CFEs) rank the controls' importance in detecting and limiting fraud situations as
follows:
Control
Internal Audit/FE Department
Surprise Audits
Management Review of 1C
Fraud Hotline
Mandatory Job Rotation/Vacations
Rewards for Whistleblowers
Audit of ICOFR
Audit of F/S
Average Score
3.81
3.51
3.17
3.03
3.02
2.86
2.65
2.53
Source: 2008 Wells Report, ACFE
Nonprofit Entities as Special Fraud Targets
1)5091
Reasons for Fraud in Not-for-Profits
The website of Clark, Schaefer, Hackett & Company pinpointed a couple of major reasons why nonprofit
entities are increasingly becoming targets of fraud: "Many smaller not-for-profits just don't have the personnel size
required for a real segregation of duties. They often don't require much approval for disbursements. And, when fraud
is discovered, they frequently don't prosecute it very aggressively because of the perceived negative publicity."
1)5101 Prevention Programs for Not-for-Profits
In the vast majority of employee fraud situations, in corporate or not-for-profit settings, prevention is the best
medicine. An Enterprise Care Not-for-Profit Services website provides many practices under which unsuspecting notfor-profits can fall prey to fraud.
1)5111
Fraud in Federal, State, and Local Governments
The concept of revitalizing governments is sweeping the world, and forensic accountants can play a key role
in this effort. Constituents are holding governments accountable for the resources entrusted to them. Often these
resources are misused; when that occurs, the only recourse is the court system. In the 2001 GAO report, the government
watchdog said that many federal agencies are mismanaged and unprepared for audit. The same is true for state and
local governments. Hence there is great need for forensic accountants who can assist attorneys in recovering misused
or stolen assets.
When It's Time to Call in Professionals
1)5121
Forensic Accountant's Techniques
The crisis in accounting is again focusing attention on fraud detection and the use of forensic accounting
techniques. As described earlier in this chapter, companies and their auditors should focus not only on detection of
fraud, but also on deterrence and prevention.
There are a number of forensic techniques and tools which may be used by forensic accountants. Some of these
tools are:
• Game theory and strategic reasoning.
• Continuous monitoring.
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• Timeline analysis.
• Link analysis.
• Invigilation.
• Genogram.
1)5124
•
Proof of cash.
•
•
Entity charts.
Full—and false—inclusion tests.
Game Theory and Strategic Reasoning
Game theory and strategic reasoning concepts may be used to detect fraud.
Fraud Risk Assessment. Auditors who use long lists and checklists of fraud cues are generally inaccurate
in their fraud risk assessments. Auditors should consider how management might manipulate perceptions of fraud
cues.
Audit Planning. Auditors should develop unpredictable audit strategies that do not follow procedures from
prior audits or standard audit programs. Strategic reasoning should be used to conceive of what fraud could be
perpetrated by management and how it would be concealed from the audit.
Implementation of the Audit. Learning from experience and interactions with clients is critical to an auditor's
effective performance. Audit standards can improve learning by requiring activities such as documenting and
communicating the nature of interactions with management.
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Continuous Monitoring
Continuous monitoring (CM) can be used to detect fraud and abuse. Management hires an independent company
to install and manage software that continuously analyzes every business transaction in order to detect improper
activities and anomalies. Incidents can be sorted into errors, misuse, and fraud; suspicious transactions can be flagged
for follow-up. Although this practice is not widely used, it can save large companies money that would otherwise be
spent hiring several internal auditors.
1)5128
Some Forensic Techniques and Tools
Check spreads, deposit spreads, and credit card spreads may be used to track fraud. Check spreads show patterns
of activities and can gather data for the net worth method. Deposit spreads deal with receipts into a checking account,
show patterns of activities, and gather data for the net worth and expenditures methods. Credit card spreads may be
used for legal and stolen credit cards to show where a target has been geographically over time.
Timel ine analysis (TA) exam ines the details from the beginning of a fraud event until the apprehension of the target
and helps forensic accountants communicate the timing of case related events and summarize the investigation.
Tracing schedules show the flow of funds from one source to another and can be helpful in money laundering
cases.
Link analysis (LA) is a subset of network analysis which shows associations between people and data. It
provides crucial relationships between many objects of different types that are not apparent from isolated pieces of
data.
Invigilation. Invigilation involves keeping detailed records before and after an invigilation period in order to
determine the amount of fraud that has been committed. During the invigilation period, strict controls are imposed so
that the fraud is virtually impossible. The losses from the before, after, and invigilation periods are then compared to
gauge the extent of the fraud.
Genogram. A genogram is a pictorial display of personal relationships among related or unrelated parties.
Symbols and lines are used to chart everyone close to a suspect. Genograms can lead to determining the motive of a
crime or they can provide evidence that the person had no direct involvement in the fraud. A genogram could be useful
where there is a conspiracy involving vendors or fake vendors.
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Proof of Cash. This procedure, more detailed and extensive than a bank reconciliation, can be used to verify
that cash accounts on the books are in agreement with the cash transactions recorded by the bank.
Entity Charts. Entity charts show entities and owners with the relationship between them. The charts can show
how income and assets are diverted, particularly among seemingly unrelated parties and entities.
Full-and-False Inclusion Tests. These tests are used to ascertain the proper universe of data under investigation,
so that no appropriate data is excluded and no extraneous data is included. They may be helpful in finding hidden
assets.
Net Worth Method. Other forensic techniques, the net worth method and Source and Application of Funds
method, are covered in detail in Chapter 6.
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Conclusion
Auditors must be more skeptical and employ forensic techniques in their audits because only about 21 percent
of employees are honest. A combination of motive, opportunity, and rationalization cause the nicest people in the
world to commit fraud. If fraud prevention programs and internal controls do not work, companies should prosecute
and make a criminal referral.
SOLUTIONS TO CHAPTER EXERCISES
1. Misappropriation of assets involves the theft of an entity's assets by stealing, embezzling, misuse of company
assets, and causing a company to pay for goods or services that have not been received. Sometimes called
theft or defalcation.
2. Misappropriations are often accomplished by false or misleading records or documents, possibly created by
circumventing internal controls.
3.$1,200,000 =$48mi||ion
25%
4. SAS No. 99 states that assets may be misappropriated by embezzling receipts, stealing assets, or causing an
entity to pay for goods or services that have not been received. Often misappropriations are accomplished by
false or misleading records or documents, possibly created by circumventing internal controls.
5.
a. Skimming involves converting business receipts to one's personal use and benefit, by such techniques as
cash register thefts and swapping checks for cash.
b. Kiting involves building up balances in bank accounts based upon floating checks drawn against similar
accounts in other banks.
c. Lapping involves recording of payment on a customer's account some time after the receipt of the
payment.
i
*
d. Kickbacks involve a vendor/supplier and an employee which involves sale of unreported inventory or
payment of an inflated price.
6. Incentives/pressures; opportunity; attitudes/rationalizations.
7. An instructor may review these 10 items in the textbook.
8.
a. Transactions that are not recorded in a complete or timely manner or are improperly recorded as to amount,
accounting period, classification, or entity policy.
b. Unsupported or unauthorized balances or transactions.
c. Last-minute adjustments that significantly affect financial results.
d. Evidence of employees' access to systems and records inconsistent with that necessary to perform their
authorized duties.
SAS No. 99, page 39.
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