Fraud Examination 5th Edition Albrecht Solutions Manual

Fraud Examination 5th Edition Albrecht Solutions Manual

richard@qwconsultancy.com

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Table of Contents

Chapter 1

The Nature of Fraud

Chapter 2

Who Commits Fraud and Why

Chapter 3

Fighting Fraud: An Overview

Chapter 4

Preventing Fraud

Chapter 5

Recognizing the Symptoms of Fraud

Chapter 6

Data-Driven Fraud Detection

Chapter 7

Investigating Theft Acts

Chapter 8

Investigating Concealment

Chapter 9

Conversion Investigation Methods

Chapter 10

Inquiry Methods and Fraud Reports

Chapter 11

Financial Statement Fraud

Chapter 12

Revenue- and Inventory-Related Financial Statement Frauds

Chapter 13

Liability, Asset, and Inadequate Disclosure Frauds

Chapter 14

Fraud Against Organizations

Chapter 15

Consumer Fraud

Chapter 16

Bankruptcy, Divorce, and Tax Fraud

Chapter 17

e-Commerce Fraud

Chapter 18

Legal Follow-Up

Albrecht: Fraud Examination, 5e

Chapter 1 THE NATURE OF FRAUD Discussion Questions 1. Fraud always involves deception, confidence, and trickery. The following is one of the most common definitions of fraud: a. “Fraud is a generic term, and embraces all the multifarious means which human ingenuity can devise, which are resorted to by one individual, to get an advantage over another by false representations. No definite and invariable rule can be laid down as a general proposition in defining fraud, as it includes surprise, trickery, cunning and unfair ways by which another is cheated. The only boundaries defining it are those which limit human knavery.”

Fraud is deception that includes the following elements: 1.

2.

3.

4.

5.

6.

7.

A representation About a material point That is false, Intentionally or recklessly so, Which is believed And acted upon by the victim To the victim’s damage.

2. Fraud affects individuals, consumers, and organizations in various ways. Fraud usually lowers organizations’ net income dollar for dollar. To recover these costs, consumers and individuals must pay more for goods and services. For example, health care fraud and insurance fraud increase premiums that individuals must pay.

The cost of fraud eventually reaches every part of the economy, including individuals, consumers, and organizations.

The 2008 study by The Association of Certified Fraud Examiners estimates that U.S. organizations lose roughly 7 percent of their annual revenues to fraud. Applied to the U.S. gross domestic product (GDP), this 7 percent figure translates to approximately $994 billion in fraud losses.

3. a. Employee Embezzlement: In this type of fraud, employees deceive their employers by taking company assets. Embezzlement can be either direct or indirect.

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b. Management Fraud: Distinguished from other types of fraud both by the nature of the perpetrators and by the method of deception. In its most common form, management fraud is deception perpetrated by top management’s manipulation of financial statements. The victims of management fraud are typically stockholders, lenders, and others who rely on financial statement information. c. Investment Scams or Consumer Scams: A type of fraud that is perpetrated when fraudulent and usually worthless investments are sold to unsuspecting investors. d. Vendor Fraud: Perpetrated by vendors; comes in two main varieties: fraud perpetrated by vendors acting alone, and fraud perpetrated through collusion between buyers and vendors. Vendor fraud usually results in an overcharge for purchased goods, the shipment of inferior goods, or the nonshipment of goods even though payment was made. e. Customer Fraud: Usually involves customers not paying for goods purchased, getting something for nothing, or deceiving organizations into giving them something they should not have.

4. a. Criminal law is the branch of law that deals with offenses of a public nature.

Criminal laws generally deal with offenses against society as a whole.

Violators of criminal laws are prosecuted either federally or by a state for violating a statute that prohibits some type of activity. b. Civil law is the body of law that provides remedies for violations of private rights. Civil law deals with rights and duties between individuals. The purpose of a civil lawsuit is to compensate for harm done to an individual. Unlike criminal cases, where juries consist of 12 jurors, juries in civil cases may have as few as six jurors, and the verdict of the jury need not be unanimous.

Additionally, judges often hear civil cases instead of juries. In civil lawsuits, plaintiffs must only prove their case by the “preponderance of the evidence.”

In other words, there need be only slightly more evidence supporting the plaintiff than supporting the defendant.

5. a. Civil b. Criminal c. Civil d. Criminal e. Criminal f. Civil g. Criminal h. Civil

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6. Charles Ponzi was successful for several reasons. First, Charles Ponzi built confidence in his scheme by giving early investors a return on their initial investments. Second, Charles Ponzi presented his coupon scheme in a way that was easy for investors to understand. Although the coupon scheme never made any real profits, investors believed that it had. Third, Ponzi was extremely talented at manipulating victims’ emotions. Ponzi was able to capitalize on individuals’ greed.

When people began to see their friends and family members receive dividends from investments, they too wanted in on the investment scam.

7. As the number of frauds and the amounts of fraud losses increase, so do the opportunities for successful careers in fraud prevention and detection. In Chapter 1, we have listed five areas in fraud fighting that will be rewarding and have high demand in the future. They include the following: a. Government: This includes FBI, postal inspectors, Criminal Investigation Division of the IRS, U.S. Marshals, inspectors general of various governmental agencies, state investigators, and law enforcement officials. b. CPA Firms, Forensic Accounting Firms, Litigation Support Firms, and Law Firms: These individuals will conduct investigations, support firms in litigation, do bankruptcy-related fraud work, serve as expert witnesses, consult in fraud prevention and detection, and provide other fee-based work. c. Corporations: Individuals who work for corporations will prevent, detect, and investigate fraud within a company. This category includes internal auditors, corporate security officers, and in-house legal counsels. d. Lawyers: Lawyers will defend or prosecute organizations in civil and criminal cases. e. Consulting: University Professors, Hospital Management, Technology Corporations, etc. People who work in these areas will consult, serve as expert witnesses, extract evidence from computers and servers, investigate public records, and serve on grand or trial juries.

8. When employee fraud takes place, employees deceive their employers by taking company assets. Management fraud is distinguished from employee fraud and other types of fraud in that top management typically commits it to deceive financial statement users. Employee fraud is usually committed against an organization, whereas management fraud is perpetrated on behalf of an organization.

9. As the numbers of frauds committed and the total dollar amounts lost from fraud increase, the demand for careers to prevent and detect such fraud will increase. In fact, a few years ago, Fortune magazine identified forensic accounting or fraud examination as one of the fastest growing and most financially rewarding careers.

The American Institute of Certified Public Accountants recently touted forensic

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accounting/fraud examination as one of the six fastest growing and most profitable opportunities for accountants.

10. There are a number of reasons why accurate fraud statistics are hard to find. First, it is impossible to know what percentage of fraud perpetrators are actually caught. Are there perfect frauds that are never discovered, or are all frauds eventually exposed?

Second, many frauds that are discovered are handled quietly within the victim organizations and are never made public. In many cases, companies merely hide frauds due to public relations concerns and terminate or transfer perpetrators quietly.

11. Losses incurred from fraud reduce a firm’s income on a dollar-for-dollar basis, reducing net income by $1 for every dollar that is lost to fraud. To make up for the damage fraud does to net income, a company has to have much more revenue come in. For example, if a company has a profit margin of 10%, to make up for a $1,000,000 fraud, the company would have to have additional revenue of $10,000,000.

12. Since confidence is typically needed for fraud to occur, people who are not trusted will not be in a position to commit a fraud.

13. While answers may vary, the following is one possible answer: The case of Charles Ponzi involved deception, greed on behalf of the investors and the perpetrator and confidence in the perpetrator. These are traits that are common in many different cases of fraud.

14. The Association of Certified Fraud Examiners (ACFE) provides the opportunity for individuals to become a Certified Fraud Examiner or “CFE”. CFEs are considered to be leaders in the antifraud community and have recognition as such throughout the world. They represent the highest standards held by the ACFE and possess expertise in all aspects of the antifraud profession. The CFE designation is acknowledged globally and preferred by many employers. The ACFE states that becoming a CFE immediately sets an individual apart from others and launches him or her to the top of the profession.

15. While answers may vary, the following is one possible answer: When an individual becomes a CFE, he or she automatically becomes a member of the ACFE. The ACFE is the world’s largest antifraud organization and the premier provider of antifraud training and education. Together with more than 70,000 members throughout the world, the ACFE works toward the reduction of fraud and corruption around the globe.

True/False 1. False. In many cases, companies merely hide the frauds to avoid public relations issues and quietly terminate or transfer perpetrators rather than make them public.

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2. True 3. True 4. True 5. False. Using physical force to take something from someone is robbery. Fraud involves deceit or trickery, not force.

6. False. Identity theft is stealing someone's personal information so the thief can pretend to be that person.

7. True 8. True 9. True 10. True 11. False. In civil cases, fraud experts often serve as expert witnesses.

12. True 13. False. Banks are required to report their frauds to the government because of their FDIC Insurance.

14. False. Technology has tended to increase the size and frequency of frauds committed.

15. True 16. False. Confidence is the single most critical element for a fraud to be successful.

17. True 18. False. Unintentional errors in the financial statements are not considered fraud. There must always be "intent" for something to be fraud.

19. False. Occupational fraud is usually committed against an organization.

20. True 21. False. Direct fraud does not involve third parties; indirect fraud involves a third party.

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22. False: Customer fraud involves a customer who does not pay for goods or services.

Vendor fraud involves a vendor who provides inferior goods, overcharges, or pays bribes to get favored treatment.

23. False. Only criminal lawsuits result in jail time for the perpetrator. Negative outcomes in civil lawsuits result in restitution and damage payments.

24. True 25. False. One of the seven elements of a fraud is that the deception must be intentional.

26. False. Fraud perpetrators come in all kinds and varieties, but always have to be trusted. If they did not have the trust of their victims, they would not have been put in a position where they could commit a fraud.

27. False: Management fraud most often means the deceptive manipulation of a company’s financial statements.

28. True 29. True 30. False. A Certified Fraud Examiner (CFE) is considered to be a leader in the antifraud community. A CFE focuses on the prevention and detection of fraud. A Certified Public Accountant, on the other hand, focuses on all aspects of accounting.

Multiple Choice 1. a 2. d 3. a 4. d 5. a 6. b 7. b 8. c 9. d

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10. d 11. d 12. b 13. b 14. c 15. b 16. b 17. c 18. d 19. a 20. d 21. c 22. d 23. a 24. d 25. b Short Cases Case 1 Clever, Inc., would have to generate up to another $10,000, calculated as follows, to recover the losses from the fraud: Profit Margin = Net Income Divided by Revenue Profit Margin = $2,000/$20,000= 10%

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With a profit margin of 10%, and especially being a manufacturing company, it could take up to another $10,000 in revenue to recover the $1,000 fraud loss.

Alexander, Inc., would have to generate no more than another $4,000, calculated as follows, to recover the loss from the fraud: Profit Margin = Net Income Divided by Revenue

Profit Margin = $5,000/$20,000= 25% Because its profit margin is 25%, and because it is a service firm with no cost of goods sold, it would not take more than another $4,000 to recover the $1,000 fraud loss.

These amounts are different because the profit margins of these companies are different.

Clever, Inc., is a manufacturing company, and for every $1,000 of net income it must generate $10,000. On the other hand, Alexander, Inc., must generate no more than $4,000 for each $1,000 lost from the fraud. It is usually easier for a service corporation with a higher profit margin to recover from fraud losses than it is for manufacturing companies that must generate more money to recover fraud losses, such as Clever.

Case 2 1. Unintentional errors and fraud are quite different from each other. An unintentional error is an error made by accident or without intent. Fraud, on the other hand, is intentional and most often involves trickery or deceit.

2. While advances in technology have helped to prevent and detect some fraud, these advances have opened up new ways for perpetrators to commit fraud that before were unthinkable. Computers, the Internet, and complex accounting systems have made it so easy that perpetrators need only to make a telephone call, manipulate a computer program, or press a key on the keyboard to commit fraud.

Case 3 1. Customer fraud 2. Investment scam/consumer fraud 3. Employee embezzlement 4. Management fraud 5. Vendor fraud

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6. Miscellaneous fraud Case 4 Fraud statistics are hard to obtain for several reasons. First, we can never know exactly what percentage of fraud is discovered. Are there “perfect frauds” that are never discovered, or do all frauds eventually come to light? Second, the victim organization quietly handles many frauds that are discovered, never making them public. Victim organizations often like to avoid publicity and the costs associated with investigating and prosecuting fraud. These and other factors make it very difficult to research fraud and for accurate statistics to be obtained.

Case 5 As the number of frauds and amounts of fraud losses increase, so do the opportunities for successful fraud-fighting careers. Many believe that fraud examination and forensic accounting will be among the fastest growing and most rewarding careers in the future.

Government fraud-fighters, consultant fraud-fighters, corporate employee fraud-fighters, and defense and plaintiff lawyers are just a few of the possible careers related to fraud prevention and detection.

Case 6 When fraud is detected, companies should prosecute if possible, both in criminal and civil courts. By proceeding in a civil suit, the company can try to recover some of the money lost from the fraud. By pursuing a criminal suit, the company can ensure that when other companies hire the perpetrator, those companies will know that the employee has committed fraud in the past and will be able to prevent the prospective employee from being in a position that provides the opportunity to commit fraud again. Firms do not often pursue both civil and criminal remedies, and sometimes do neither because of litigation costs, time involved, or the desire to avoid negative press.

Case 7 1. Fraud occurs when individuals intentionally cheat or deceive others to their advantage. In this case, Bob is committing a fraud. Regardless of the magnitude of the charges, he is intentionally charging nonbusiness lunches to his employer. This is also known as employee fraud, or occupational fraud.

2. As an employee, you have an ethical responsibility to your employer to report Bob’s fraudulent behavior. Fortunately, in this case nothing has been done that cannot be corrected easily. Since Bob is justifying his behavior by saying the recent memo pertaining to meal expenses does not apply to him because he is an intern, you should try to help Bob see the error of his logic and encourage him to correct the charges. If Bob is unwilling to change his behavior, the appropriate superior should probably be notified.

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Case 8 In the worst case, the additional revenue needed will be the fraud loss divided by the profit margin, or $50,000 divided by 0.07, which equals $714,286.

Case 9 1. At 5%, a maximum of $50,000,000 in additional revenue is needed. At 10%, a maximum of $25,000,000 in additional revenue is needed. At 15%, a maximum of $16,666,667 in additional revenue is needed.

2. Some of the various types of fraud that can affect an insurance company are: a. Employee fraud—individuals involved in the benefits area can create false claims for nonexistent policyholders. The victim is the company, and the perpetrator is the employee. b. Management fraud—the company can create nonexistent policyholders to make their revenues appear greater. The victims are the stockholders and other financial institutions that rely on the financial statements. The perpetrators are members of management with the company. c. Customer fraud—policyholders can create false claims to collect money. The victim is the company, and the perpetrators are the customers.

Case 10 Fraud examiners investigate suspected fraudulent activity, whereas auditors are concerned about the overall fairness of the financial statements. One of the biggest differences between auditing and fraud examination is that with auditing, sampling is used to assess whether management’s assertions are reasonable. The auditor uses sampling to test the account balances to make sure the accounts are not overstated or understated. Fraud examination cannot be done effectively through sampling. In fraud examination, each transaction should be reviewed and evaluated.

Case 11 1. There are many reasons why Cesar should be terminated from employment.

However, one of the most apparent reasons is that organizations that do not work proactively at fraud prevention and detection find themselves as frequent targets of fraud schemes, with the fraud becoming more and more costly. A message that perpetrators will be prosecuted deters other potential fraud by reducing the perceived opportunity.

2. An individual who commits fraud and is not punished or is merely terminated suffers no significant penalty and often resumes the fraudulent behavior. If prosecuted, the individual suffers significant embarrassment when family, friends, and business

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associates find out about his or her offenses. Humiliation is often the strongest factor in deterring future fraud activity.

Case 12 Nancy should be concerned. First, the bank has a mandatory one-week long vacation policy.

Bob should not be allowed to be an exception. Bob also fits many of the demographics for a fraud perpetrator: he has a lot of experience with the bank and is in a trusted position, he often works late into the night all by himself, everyone trusts him, and he likes to give the impression that he is tough on credit. Nancy should not assume that Bob has committed fraud; however, she should demand that Bob take a mandatory vacation, and she should be alert for additional signs of fraud.

Case 13 While answers may vary, the following is one possible answer: The management frauds to which your friend refers involve much more than just stealing money. They are sometimes simple, sometimes very complicated schemes which misstate financial statements and are intended to deceive the public, but that are also orchestrated so that the fraud is difficult to detect in an audit. Financial statement fraud can be very difficult to detect because of the sophistication of the perpetrators and their positions of trust and authority in the company.

Case 14 As fraud detection methods get more sophisticated, so do fraud perpetration techniques.

Fraud examination is one of the fastest-growing and most financially rewarding careers. It is not part of a financial statement audit but a distinct profession.

Case 15 Fraud examiners are hired by many different kinds of organizations. Examples include the government, CPA firms, law firms, insurance companies, public and private corporations, universities and hospitals. Fraud examiners are hired to do a variety of tasks, and fraud examination is an exciting and intriguing career.

Case 16 This is a real investment scam that was perpetrated on an American university campus a few years ago. Before it was stopped, hundreds of students had invested hundreds of thousands of dollars. There are many warning signs that would suggest this “investment opportunity” is a scam, including: • The promised rate of 44% is too high and unreasonable. If it seems too good to be true, it probably is. This promised rate of return does not make business sense.

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• •

The nature of the investment is complicated and can’t be easily understood.

Making the investment seem complicated is one way perpetrators try to conceal their frauds.

You are excited about the investment because several of your friends have invested. Just because they didn’t exercise due care doesn’t mean you should also be stupid.

Case Studies Case Study 1 1. Jane had suspicions of fraud for several reasons. First, she noticed that the accounts payable checks, which were payable to dual payees, lacked the required endorsement of both payees. Next, Jane observed that several different people wrote all the checks in similar handwriting. Then, both Jane and Gus realized that each of the five checks had been cashed at the same convenience store less than five miles from the home office, even though the mailing address of one of the payees was over 200 miles away. Finally, after beginning investigation, Jane and Gus found that there were no existing documents to support the payments made from the checks.

2. Fraud is often caught through inconsistencies in financial data. Therefore, any discrepancy, however small it seems, may have the potential of assisting the auditor in discovering fraud.

3. There is always motivation for a fraud perpetrator’s dishonest actions. Some of these motivations might include, but are not limited to, financial pressures, incomeconsuming addictions (e.g., gambling, drugs, alcohol, and extramarital relationships), family struggles, work-related strains, tax liens, garnishment of wages, or other pressures. While researching the personnel files of employees, the auditors would be looking for any patterns, characteristics, or past occurrences in the lives of the employees that would indicate any possible motivations for committing fraud.

Case Study 2 1. Fraud occurs when someone deceives someone else through confidence and trickery in order to get gain. This appears to be fraud.

2. By using phrases like “guaranteed winner,” Publishers Clearing House deceived many individuals into believing that they had won when in reality they hadn’t. By doing so, prosecutors believed that Publishers Clearing House committed fraud.

Case Study 3 1. Those involved in the late-trading scheme have committed both a civil and a criminal offense. By performing trades after approved trading hours, the perpetrators have allowed certain traders to trade with perfect information and have prevented other

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traders and brokers from trading equities at a price at which they normally would. As such, this case is in violation of civil law. If proven guilty, the perpetrators will be forced to compensate monetarily for the damages they caused to others. They have also committed a criminal offense by breaking the law that regulates approved trading hours. If proven guilty, the perpetrators could be sent to jail.

2. While the Prudential traders involved in the late-trading scheme realized quick and easy profits, other stock and mutual fund traders were hurt. They had an apparent disadvantage to those traders and brokers who practiced late trading. The other traders were forced to buy stocks and invest in mutual funds at a higher price and then sell them at a lower price than they would have if there were no fraud involved.

Eventually, however, the perpetrators will incur the most damage as they are forced to fulfill their civil obligations and endure tarnished reputations.

Case Study 4 This is a real case that happened to a U.S. company. The answers to the questions are as follows: 1. In this case, you must do whatever is necessary to determine if there is any validity to the whistle-blower complaint. You must discover the truth and then do the right thing, whatever that is. In this case, that probably means that you hire an investigative law or forensic firm to perform interviews, image hard drives and servers and gather other evidence to determine if, in fact, costs are being understated.

You would do as much of this as possible without arousing suspicion.

2. Unfortunately, because top management of the company may be involved, you cannot initially involve them in the investigation. Only after you are certain they are not involved can you bring them “over the wall” and let them know and even participate in the investigation. If this problem is contained to one country it is one thing; if it also involves the top management of the company, you have a much bigger problem.

3. If the fraud is real and is material to the financial statements, then the company will probably have to restate its financial statements. Restatements usually result in a drop in the company’s stock price and shareholder class action lawsuits against the company. Regardless of the cost, as a board member, you must take the high road and get to the bottom of this issue. You must find the truth and then do the right thing.

Debate Due to the subjective nature of this ethics case, no exact solution is provided. However, the authors do believe that in this situation, students have a proactive responsibility to at least terminate employment. (You may later be sued if you do not).

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Answers to Stop and Think Questions: 1. Why is it more difficult to tell if someone can be trusted on the Internet than in person? a. When you are dealing with someone in person, you can learn much from their personality, body language, and mannerisms. You can also get to know them better. You can see the person you are dealing with. On the Internet, you have no idea who you are dealing with or whether the person or organization is an imposter. Because Internet perpetrators cannot see their victims, such frauds seem more like a victimless crime.

2. Why do you think it is easier for top management to manipulate the financial statements than for other individuals in an organization? a. Top management can more easily override internal controls than others can in an organization. Also, it is easier for others to follow the instructions of top management than others because employees will say, “it doesn’t make sense to me but if the boss is asking me to do it, he or she probably knows what is right or wrong, so I better do it.” The combination of deference to executives and the ease of overriding controls make it easier for top management to manipulate financial statements than it is for others. They also see the entire financial picture of an organization where as others would only see parts.

3. O.J. Simpson was tried for murder both criminally and civilly. He was found innocent in the criminal trial but guilty in the civil trial. Why do you think that is the case? a. In a criminal case, the jury must reach a unanimous verdict—even one person who feels differently can cause a hung jury or an innocent verdict. In a civil case, only the majority of the jurors must believe that the person was guilty.

The conviction standard is lower in civil cases.

Internet Assignment One solution is to search the home page of the Association of Certified Fraud Examiners at www.acfe.com for more information about careers. There, you will find several links to companies and government agencies that are involved in combating fraud and other whitecollar crime.

The Federal Bureau of Investigation (FBI) is probably the largest government agency that employs fraud-fighters. The FBI’s Web site can be found at www.fbi.gov. By clicking on “employment” and “special agent vacancy” links, students can see what an FBI agent actually does.

The Internal Revenue Service (IRS) is another government agency that offers careers in fraud examination. Their employment Web site contains a page giving a description of and

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qualifications needed to become a criminal investigator. Search www.jobs.irs.gov and then click on the link entitled Criminal Investigation “Special Agent” opportunities.

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Chapter 2 WHY PEOPLE COMMIT FRAUD Discussion Questions 1. Research shows that anyone can commit fraud. Fraud perpetrators usually cannot be distinguished from other people on the basis of demographic or psychological characteristics. Most fraud perpetrators have profiles that look like those of honest people. In other words, the types of people who commit fraud are ordinary people, just like you and me.

2. People can be motivated to commit fraud because of financial pressures, vices, or because of work-related pressures. As well, perpetrators of fraud can be motivated by a perceived opportunity to commit fraud and the ability to rationalize that what they are doing is not wrong. Their motivations are usually combined into the fraud triangle of perceived pressure, perceived opportunity, and rationalization.

3. The fraud triangle includes three elements that almost always must be present in order for someone to commit fraud: a perceived pressure, a perceived opportunity, and some way to rationalize the fraud as acceptable. The fraud triangle is important because it helps us to determine the motives, reasons, and opportunities that someone had in committing fraud. By using the fraud triangle, we can better focus on areas in an organization that will help us detect and prevent fraud.

4. The fraud scale illustrates the relationship between the three elements of the fraud triangle. It shows that perceived pressure, perceived opportunity, and rationalization are interactive. In other words, the greater the perceived opportunity or the more intense the perceived pressure, the less rationalization it takes to motivate someone to commit fraud. Likewise, the more dishonest a perpetrator is, the less opportunity and/or pressure it takes to motivate fraud.

5. Many types of pressures motivate someone to commit fraud. They include financial pressures, vices, work-related pressures, and other types of pressures. Financial pressures include greed, living beyond one’s means, high bills or personal debt, poor credit, personal financial losses, and unexpected financial needs. Vices include addictions, such as gambling, drugs, alcohol, and extramarital relationships. Workrelated pressures include feeling overworked or underpaid.

6. The controls that prevent and/or detect fraudulent behavior have to do with providing deterrence to those who are thinking about committing fraud. Having an effective control structure is probably the single most important step that organizations can take to prevent and even to detect fraud. There are five components in a company’s

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control structure: the control environment, risk assessment, information and communication, control procedures or activities, and monitoring.

7. Many factors provide opportunities for fraud including the inability to judge the quality of performance; failure to discipline fraud perpetrators; lack of access to information; ignorance, apathy, and incapacity; and lack of an audit trail.

8. Nearly every fraud involves the element of rationalization. Most perpetrators are firsttime offenders who would not commit other types of crimes. Rationalizing helps minimize the perceived dishonesty of their acts. Common rationalizations include: • • • • • • •

The organization owes me.

I am only borrowing the money—I will pay it back.

Nobody will get hurt.

I deserve more.

It’s for a good purpose.

We’ll fix the books as soon as we get over this financial difficulty.

Something has to be sacrificed.

When interviewed, most fraud perpetrators say things like, “I intended to pay the money back. I really did.” They are sincere. In their minds, they rationalize that they will repay the money, and since they judge themselves by their intentions and not by their actions, they do not see themselves as criminals.

9. Jim Bakker rationalized his actions by convincing himself that the PTL network had a good purpose and that he was helping others. Bakker believed that any money he received would directly or indirectly benefit his followers. He had numerous pressures, including greed, selfishness, and a lust for power, and Bakker was in a position of trust. As with most people in positions of trust, he had numerous opportunities to commit fraud.

10. Dr. Sam Waksal committed fraud by transferring shares into his daughter’s trading account and then having her trade in his company’s stock (insider trading). Because he had insider information, he understood that it would be unethical for him to make trades. However, he rationalized that if he had his daughter make the trades, rather than himself, then his actions would be legal and ethical.

Later on, when explaining his actions, Waksal said the following: “I could sit there and think that I was the most honest CEO that ever lived. And, at the same time, I could glibly do something and rationalize it because I cut a corner, because I didn’t think I was going to get caught. And who cared? Look at me. I’m doing “X,” so what difference does it make that I do a couple of things that aren’t exactly kosher?”

Waksal’s rationalization allowed him to have a long history of ethical lapses, reckless behavior, and embellishing the truth. He had been dismissed from a number of academic and research positions for questionable conduct, for example. One former

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colleague said “cutting corners for Sam was like substance abuse. He did it in every aspect of his life, throughout his entire life.”1 11. Power is defined as the ability to influence someone else. When a fraud takes place, the conspirator has the desire to carry out his or her own will—influence another person to act and do as the perpetrator wishes—regardless of resistance.

12. Fraud perpetrators use power to influence and persuade individuals to participate in fraud. Fraud perpetrators can get potential co-conspirators to join the fraud by promising a reward or benefit (reward power), by following the orders of a person who is in a position of authority (legitimate power), by making the potential recruit feel fear for not joining the fraud scheme (coercive power), or through deceiving someone because the potential recruit has a lack of knowledge (expert power).

Finally, perpetrators can get potential perpetrators to join the scheme through the influence of a relationship (referent power).

True/False 1. True 2. True 3. False. Management’s example is a very important part of the control environment.

4. False. Good controls usually decrease opportunities for individuals to commit fraud within an organization.

5. False. Effective fraud-fighters put their efforts into trying to eliminate all three parts of the fraud triangle, especially reducing opportunities.

6. True 7. True 8. False. Fraud perpetrators who are prosecuted, incarcerated, or severally punished usually do not commit fraud again. In fact, they have a very low rate of recidivism, while perpetrators who aren’t prosecuted have a high rate of recidivism.

9. True 10. False. Appropriate hiring will decrease an organization’s risk of fraud because people with high integrity are less likely to rationalize and commit fraud.

CBSNews.com, “Sam Waksal: I Was Arrogant,” 6 October 2003, <www.cbsnews.com/stores/2003/10/02/60 minutes/main576328.shtml>, accessed on May 22, 2004.

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11. False. An individual who owns his or her own business and is the sole employee probably does not need many control procedures. While such people may have ample opportunity to defraud their companies, they have no incentive to do so.

12. True 13. False. Documents rarely serve as preventive controls, but they provide excellent detective controls.

14. True 15. False. Power is almost always used to influence another person to participate in an already existing fraud scheme.

Multiple Choice 1. b 2. d 3. c 4. a 5. d 6. d 7. c 8. e 9. b 10. a 11. b 12. c 13. c 14. b 15. b

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16. e 17. e 18. c 19. c 20. b Short Cases Case 1 1. Authorization. The managers of the stores should follow the authorization policy and review all requests for large amounts of credit and the approval of new credit customers.

2. Segregation of duties and independent check on performance. A second individual, preferably someone not in the accounting department, should perform the bank reconciliation.

3. Segregation of duties and/or independent checks. With respect to separation of duties, various functions should be assigned to different people. If two separate individuals performed the record keeping and physical handling of inventory, the opportunity for theft would be greatly reduced. With respect to independent checks, test counts of his record keeping could be performed.

4. Adequate document and records. A well-designed document should be formatted so that it can be handled quickly and efficiently.

Case 2 While many people would question whether the accounting is appropriate, there is a ready market for the refined products, and both the selling prices and the cost of refining the oil can be reasonably quantified or determined. Accounting rules actually allow recognition in this case. This is a good case to debate because it provides students with experience regarding the impreciseness of accounting rules. In this instance, experts for the plaintiffs argued that the treatment was inappropriate, while experts for the defense argued that the treatment was appropriate. There are many examples concerning revenue recognition, inventory, and other issues where the proper accounting treatment is not absolutely determined. These examples show that accounting is not an exact science. However, aggressive accounting often is motivated by pressure to “cook the books” and is a precursor to and warning of fraud. It certainly was in this case.

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Case 3 1. The company lacks good control activities or procedures. Mainly, it lacks segregation of duties, a good system of authorizations, independent checks, physical safeguards, and documents or records. Helen was allowed to sign the payment voucher for services rendered, and she was also allowed to sign for all voucher payments less than $10,000.

2. Helen was a trusted employee. The company also lacked good control activities. To perpetrate the fraud, all she had to do was continue to process the checks to the terminated vendor and sign the vouchers.

3. The fraud would have been detected if the company had possessed a good internal audit department, combined with security or loss prevention programs. A good accounting system would have helped in the discovery of the fraud and would have made it difficult for Helen to conceal.

Case 4 1. Ruth Mishkin was a trusted employee and she was in charge of paying bills, balancing accounts, and handling cash management.

2. A gambling addiction caused Ruth to have an immense pressure to commit fraud so that she would have additional funds with which to gamble.

3. Because Ruth was a trusted employee, her bosses put her in charge of paying bills, balancing bank accounts, and handling other cash management chores. This lack of segregation of duties provided an easy opportunity to commit fraud.

4. When people are addicted to a vice such as gambling, they feel tremendous pressure.

With so much pressure, it takes only a little rationalization and a small opportunity for someone to perpetrate a fraud.

Case 5 1. The company should implement independent checks and segregation of duties controls. The accountant should not be posting to the General Ledger, paying the bills, and signing the checks. The CEO or someone else should sign the checks. Also, the accountant’s work should be reviewed for errors and fraud by an independent source. The accountant should be prosecuted civilly and criminally for mail fraud, embezzlement, and money laundering. In addition, it would be a simple task to have the auditors run a computer analysis on the addresses of vendors to look for companies with the same addresses.

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2. The company should implement segregation of duties controls. The warehouse manager should not be able to both receive returned items and issue the credit memos. The accounts receivable department should create credit memos, which are then taken to the warehouse where additional goods can be issued. In addition, another worker must process returned defective merchandise. Both the manager and the worker should sign off. The warehouse manager should be prosecuted, and his son should spend more time in the gym.

3. A system of authorizations should be implemented. The board should not allow the CEO to fire his employees and rehire them as contractors. The accountant who prepares payroll records should notice this problem. In addition, if the CEO prepares payroll records, there is also no segregation of duties. The CEO should be prosecuted for tax fraud and money laundering.

4. Authorization and segregation of duties controls should be implemented. The accounts payable clerk should not have custody of the supplies she purchases.

Supplies should be logged into a warehouse and then distributed as needed. The accountant should also independently record the clerk’s activities. She should not be able to sign checks.

Case 6 1. The pharmacy has a high risk of fraud. Alexia has great pressure to provide well for her family. Alexia also has the opportunity to commit fraud, as she has the responsibility for accounting and is the only worker. She could easily steal cash and manipulate the accounting records.

2. While we don’t know if Alexia’s rationalization is high or low, we do know that the opportunity and pressure are high. By understanding the fraud scale, we can determine that if pressure and opportunity are high, it doesn’t take very much rationalization for someone to commit fraud. Therefore, the risk for fraud is high in this case.

3. It would be very important to explain to the owner the high risk of fraud at the pharmacy. Important control activities are missing. Background checks, segregation of duties, and other controls would lower the risk of fraud.

Case 7 1. Joel has many opportunities to commit fraud. He is a trusted friend of the family. At the restaurant, there is no segregation of duties, system of authorizations, independent checks, or physical safeguards to prevent Joel from committing fraud.

2. An increase in revenues accompanied by a decrease in profits may signal a possible fraud. The changed profit margin ratio (net income/revenues) is a possible symptom of fraud.

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3. In this case, as in most cases, a few simple controls could substantially reduce the opportunities for fraud. For example, Bob and Tom could install an automated register into which all sales would be recorded. They could have mystery shoppers eat at the restaurant and pay in cash in order to see if the receipts were recorded. They could make the deposits and reconcile the bank account themselves.

4. Possible answers might be: • • • •

Segregation of duties—do not allow Joel to do everything he is doing.

System of authorizations.

Independent checks.

Physical safeguards—such as automated registers.

Case 8 The major fraud opportunity in this case was the inability to judge the quality of performance of the optometrist. Although the insurance companies clearly could have said that the services rendered by the optometrist were not consistent with what they were paying for, they never had reason to believe they needed to assess the optometrist’s services.

Another factor was the lack of access to information. The insurance companies had no way of knowing that many of the services being billed for were not actually being performed, or that many of the patients did not even exist.

Case 9 A couple of possibilities may explain the rationalization element of the fraud triangle. First, since many of the clients were expatriates working outside the United States, there may have been rationalization on the part of Hammond and FCS that it was okay to sell them highyield investment schemes because they couldn’t follow the stock market on a daily basis. The second possibility is that Hammond knew that the accounts were or might be misleading, false, or deceptive. Although he may have thought this, if the other two factors are present, it is easy to rationalize that even though they may be false, they also may be real or genuine.

Instead of looking at the situation objectively, he probably rationalized the possibility of it being a legitimate opportunity.

Case 10 1. Reasons why Len should pursue prosecution: a. Prosecution sets precedence within the company that fraud will not be tolerated. b. Prosecution brings about justice. c. Prosecution may result in recovery of stolen funds because of ordered restitution payments.

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d. Prosecution will help prevent dishonest employees from defrauding other organizations.

2. Reasons Len might not want to pursue prosecution are: a. Fear that negative publicity will hurt the image of the CPA firm. b. He might feel badly for the employee or his family. c. He doesn’t want to accept responsibility for the lax internal controls that existed in his firm.

3. Answers may vary. However, prosecution is probably more beneficial in deterring future fraudulent activities within the firm.

Case 11 1. Yes, it is a fraud to charge the company for personal lunches that you submit as business expenses. Fraud is often defined by the rules of an organization, and charging the company for personal expenses is intentionally not following the rules.

2. In this example, all three elements of fraud may be present: pressure, opportunity, and rationalization. The opportunity to commit fraud is high, and certainly rationalization is present. It is difficult from the limited facts to know whether a pressure is present.

3. How one responds to the mentor is a subjective answer. If the new employee was aware that such charges represented fraud, she should decline to participate and let the mentor know that she does not agree with charging lunches against company policy. Additional steps could be taken to notify supervisors and suggest that they further educate company personnel regarding company policies.

Case 12 1. Opportunity and pressure are both present in this case. Although the owner of the store maintains close relationships with employees, controls are minimal, and should an employee choose to be dishonest (as this example illustrates), he or she would have ample opportunity to steal. The third ingredient for fraud to occur is rationalization, and given the high pressure and opportunity, rationalization only needs to be low to moderate in this case.

2. This fraud might have been detected earlier by implementing basic cash accounting and reconciliation techniques—separate employee ID numbers to log into registers, independent checks on register totals, two employees always being present to count cash, periodic employee rotations and vacations, and basic analytic reviews.

3. In the future, you should be more concerned with internal controls, greater emphasis on segregation of duties, potentially implementing better computer systems and login authorizations, and possibly even surveillance cameras.

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4. Fraud is always less costly to prevent or detect early, and anything you can do to reduce fraud would be wise.

Case 13 1. Lauersen could have felt some pressure to make fertility treatments affordable for his patients.

2. Lauersen perceived that the insurance company did not check carefully on the types of surgeries performed, and therefore it was easy for him to lie about the surgeries.

3. Lauersen may have felt that he was helping women who could not afford to have children. This was the primary factor in his decision to commit fraud.

4. Lauersen could have recommended different insurance companies that covered fertility surgeries. Or, to help maintain his and his clients’ integrity, he could have recommended adoption services for those patients unable to afford fertility surgeries.

Case 14 1. The fraud triangle includes perceived pressures perceived opportunity, and some way to rationalize the fraud as acceptable.

• Perceived Pressure: As a single mother of four, it may be difficult for Nancy to provide for her family. Additionally, she feels the pressure to provide some of the “finer things” for her children and give them the best possible care. These perceived financial pressures could motivate Nancy to take money from the doctor.

• Opportunity: Because there is no segregation of duties, Nancy has the opportunity to keep the cash she collects from the customers and write off the account when the books show that all funds have not been collected. Without appropriate controls in place, Nancy has several opportunities to commit fraud.

• Rationalization: Nancy does not feel that she is paid enough to meet her current financial needs. She may rationalize that she deserves an increase in pay to meet her needs. Furthermore, Nancy may feel that she deserves an increase in pay because she does so much work for the doctor’s office. Nancy may rationalize that she is just borrowing the money and will repay it later. As a trusted employee, she may rationalize that the doctor would want her to take a little extra money for her needs; after all, she needs the money much more than the doctor.

2. The critical duties of writing checks, making bank deposits, and reconciling bank statements should be segregated and dual custody control should be implemented.

Nancy should not be collecting, recording, and depositing payments all by herself. An additional employee may need to be hired. Commonly, an outsourced billing office is used as a check and balance. Each of these activities can be given dual custody by both Nancy and another person. Although this control can often be expensive, it may

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be worth it to the doctor. The doctor should analyze the risk/benefits of hiring another person.

Case 15 1. Joe had several financial pressures: his wife just had a fourth child; they had just purchased a new home; and he had experienced a severe drop in commissions earned.

His opportunity arose from the fact that the company had poor internal controls over petty cash. Shortages were usually written off. Joe’s rationalizations could have been that his thefts were only temporary; the company owed him more money; or he worked hard and deserved the money.

2. The company could have prevented the fraud from occurring by having better controls over the petty cash. For example, the company could have had one person be the petty cash custodian requiring anyone with a need for petty cash to go through that person. There should also have been periodic reconciliations of the petty cash fund.

Case Studies Case Study 1 1. The office manager works alone and has significant opportunities to alter the books or accounts of customers and pocket money for himself. Employees working unaccompanied can also take side jobs and pocket the receipts for themselves.

Additionally, they can use the chemicals to provide lawn care to family and friends at no cost.

2. Fraud symptoms that should be looked for or that are evident in this case include: less time with office manager, more chemicals being used than necessary, employee homes receiving unpaid services, and increased revenues with declining profits.

Employees may have taken on new customer jobs and pocketed the money because the customers are not entered on the computer system.

3. The office manager should be monitored more closely, and the accounts should be checked on a more regular basis. The owner will have to spend more time ensuring that the office work is done correctly. Daily checks on supplies may be necessary to make sure employees are not using chemicals for personal gains. Employees’ work habits should be watched. Putting these controls in place will cost more employee time but may provide greater benefit by reducing costs.

Case Study 2 1. Pressures, opportunities, and rationalizations for James’s fraud:

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• • •

Pressures: James was heavily in debt. Also, the financial position of Best Club was declining significantly.

Opportunities: Complexities in insurance policies and procedures, James’s management position, and “a reputation as an entrepreneurial talent.”

Rationalizations: Despite his debt, James thought that it was temporary. He had confidence in Best Club/Red House’s future potential to bring him financial success.

2. Some of the fraud symptoms are: no equipment and work order contracts existed to secure loans; money orders disappeared; there were unusual zeros in the customers’ bills; James was living the “good life,” with an expensive house and a new sports car; and too many insurance claims were filed.

3. Controls or actions that might have detected the fraud are: independent checks by the insurance company, investigations of complaints by customers being charged too much, and investigations of the apparently rapid growth of his company.

Case Study 3 1. Johnson Manufacturing does not have a very active board of directors, and there is little monitoring of employees.

2. Employee compensation is dependent on the performance of the unit. If the division doesn’t do well, salaries and bonuses will be cut.

3. Harris’s rationalization was that she was providing a short-run solution to the profit decline resulting from the competitor’s price-cutting, and the decline would be only temporary.

Case Study 4 1. Mr. Armstrong had the trust of his investors. Because investors trusted him, they put substantial amounts of money into his funds. If the investors had trusted Mr. Armstrong less, they would not have given him unlimited control of their money.

2. If investors had known of Mr. Armstrong’s background, they would have been less likely to trust him and probably wouldn’t have allowed him complete control over so much money.

Case Study 5 1. You trust your cousin but how do you know that her friend’s request is legitimate?

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Without doing some investigation, you don’t really know that your cousin’s friend’s request is legitimate. If you make a contribution without checking, you are placing confidence in both your cousin and her friend, something that is necessary for someone to con you out of your money.

2. Would you make a contribution to help this little girl?

It would be smart to do some background checking first, although medical records are protected in the U.S. and it would be hard to discover whether or not the 4-year old girl really has cancer or not and whether the woman needs financial assistance even if the girl does have cancer.

3. What kind of fraud could your cousin’s friend be committing?

Either your cousin or her friend could be deceiving you into believing the girl has cancer when she really doesn’t or that, even if she does have cancer, money is needed for medical help.

4. How could you make sure the request is legitimate?

As stated in part 2, because of HIPAA (Health privacy) laws, it would be very difficult to know for sure if you are being told the truth. In fact, in this case, it was all a lie. Here are news articles about the fraud with the names and the locations changed..

Formal charges have been filed against a NewTown woman who police say made up a story about her 4-year-old daughter having cancer and solicited more than $3,000 from sympathetic donors. Jane Doe, 30, was charged Tuesday with one count of felony communications fraud and is set to appear in court Sept. 9. NewTown Police said they began investigating Ms. Doe in July after multiple people complained that she duped them into donating. The girl's father told police he had no knowledge of any cancer treatments or any diagnosis of leukemia. Detective Myran Hansen told the NewTown News the little girl herself believed she was sick. After reviewing medical records for the girl and Doe’s two other children, detectives said they found no evidence of a leukemia diagnosis or anything similar. Police said Doe admitted to making up the story in an effort to get her ex-husband's attention, but said "things got out of hand," police wrote. She said she'd used the funds to pay bills. Doe was arrested Aug. 13, and has since posted bail. Authorities said Doe received at least $3,183 from fundraising events and personal donors, including people whose own children had legitimate cancer diagnoses.

•

Another news article a couple of months later stated that friends and family say there's a reason Jane Doe was able to convince everyone around here that her 4year-old daughter had leukemia. She's done it before. "This is her third scam involving cancer," Mary Smith said Wednesday during Doe's sentencing hearing in 6th District Court.

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Internet Assignment 1. a. More than 70,000 professionals. b. An extensive application process and passing the uniform CFE examination. c. The mission of the Association of Certified Fraud Examiners is to reduce the incidence of fraud and white-collar crime and to assist the membership in its detection and deterrence. d. Certified Fraud Examiners (CFEs) come from various professions, including auditors, accountants, fraud investigators, loss prevention specialists, attorneys, educators, and criminologists. CFEs gather evidence, take statements, write reports, and assist in investigating fraud in its varied forms.

Most major corporations and government agencies employ CFEs, and others provide consulting and investigations services. e. Hopefully you do have what it takes. f. Examples might be the “Auditing Accounts Receivable” workbook, “FraudRelated Internal Controls” workbook, and the “Beyond the Numbers: Professional Interviewing Techniques” self-study video. All of these materials and many others offered on the site would help anyone who wants a fraudfighting career. g. The “EthicsLine”—EthicsLine provides a toll-free number used to report anonymous allegations of ethical violations, fraud, waste, and abuse.

EthicsLine is manned 24 hours a day, 365 days a year by contract law enforcement personnel, Certified Fraud Examiners, and trained professionals.

When an employee of a subscriber company calls, he or she will be asked to describe the nature of the suspected problem. From there, the EthicsLine service will promptly relay the information to your company. Your company then decides about what action is necessary.

Debate 1. The purpose of the debate is to help students wrestle with ethical issues before they are actually faced with those issues later in their career. While there is no correct answer to the debate, we strongly encourage students to look at the various options, and consequences to those options, that are available.

Answers to Stop and Think Questions 1. Think about a time in your life when you compromised your own ethical standards. How did the elements of pressure, rationalization, and opportunity affect your decision making? Were the three elements interactive—in other words, did it take less opportunity to make the decision when you were under tremendous pressure?

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a. Answers to this stop and think will vary by person. However, most individuals in the class will have compromised at some time in their life. You shouldn’t let them off the hook too easily.

2. How have individuals you know used power to influence your actions? Have you done something simply because a person(s) had legitimate authority (such as a boss or teacher) over you? Have you ever done anything because a person offered you a reward or benefit for your actions? Have you ever been influenced to participate in something simply because you were asked by a close friend or colleague? Perhaps, in a group project at school you have agreed to do an assignment a certain way because you felt a classmate knew more about the subject matter than you did. Have you ever done anything because you feared possible punishment for not doing it? Chances are that all of us have been influenced to do something based upon power that was exerted by others. These five types of power influence all of our actions everyday. a. Again, the answers will vary by student. Again, you shouldn’t let them off the hook by answering that they haven’t been influenced by the power of others— all of us have.

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Chapter 3 FIGHTING FRAUD: AN OVERVIEW Discussion Questions 1. Fraud prevention is important because it is the most cost-effective way to reduce losses from fraud. Once fraud occurs, there are no winners.

2. Creating a culture of honesty and high ethics helps to reduce fraud in various ways.

Management through its own actions can show that dishonest, questionable, or unethical behavior will not be tolerated. By hiring the right kind of employees, management can select people who are less likely to rationalize their illegal or unethical actions as acceptable. By communicating expectations, management can give fraud awareness training that helps employees understand potential problems they may encounter and how to resolve or report them. And by creating an honestydriven culture, management can help to develop a positive work environment.

Research indicates that fraud occurs less frequently when employees have feelings of ownership toward their organization than when they feel abused, threatened, or ignored.

3. Identifying sources and mitigating risk means that an organization needs a process in place that both defines areas of greatest risk and evaluates and tests controls that minimize those risks. Risks that are inherent in the environment of an organization can often be addressed with an appropriate system of control. Once risks have been assessed, the organization can identify processes, controls, and other procedures that can minimize risks. Appropriate internal systems include well-developed control environments, effective accounting systems, and appropriate control procedures.

4. Because most frauds increase dramatically over time, it is extremely important that when frauds occur they be detected early. Once a fraud has been committed, there are no winners. Perpetrators lose because they suffer humiliation and embarrassment as well as legal punishment. Usually, they must make tax and restitution payments, and there are financial penalties and other adverse consequences. Victims lose because assets are stolen and they incur legal fees, lost time, negative public exposure, and other adverse consequences. The investigation of fraud can be very expensive. Organizations and individuals that have proactive fraud prevention measures usually find that those measures pay big dividends.

5. When fraud is suspected it is important to conduct a thorough review in order to (a) avoid wrongly targeting innocent people; (b) gather sufficient factual evidence about the suspected fraud; and (c) ensure a complete report of all the facts and circumstances, both incriminating and exonerating, is prepared.

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6. The types of evidence produced while investigating fraud can be classified into evidence square. The evidence square includes testimonial evidence, documentary evidence, physical evidence, and personal observation. Testimonial evidence includes evidence gathered from interviews, interrogations, and honesty tests. Documentary evidence includes evidence gathered from paper, computers, and other written or printed sources. Physical evidence includes fingerprints, tire marks, weapons, stolen property, identification numbers or markers on stolen objects, and other tangible evidences that can be associated with theft. Personal observation includes evidence collected by the investigators themselves, including invigilation, surveillance, and covert operations.

7. The evidence square allows us to identify the different types of evidence that can and should be gathered, to identify the evidence gathered, and then to categorize possible evidence so that it is easily understood and correlated with all other sources of evidence in the investigation.

8. a. Surveillance – personal observation b. Tire marks – physical evidence c. Honesty test – testimonial evidence d. Interview – testimonial evidence e. A computer hard drive – physical evidence (Some would classify this as documentary evidence.) f. A financial statement analysis – documentary evidence g. A paper report – documentary evidence h. Identification numbers on vehicles – physical evidence i. Audit of financial statements – personal observation (Some would classify this as documentary evidence.) j. Check stubs – documentary evidence k. Fingerprints – physical evidence l. Background checks – documentary evidence (Some would classify this as personal observation.)

9. One of the major decisions a company or fraud victim must make when fraud is committed is what kind of follow-up actions should be taken. Most organizations and other victims of fraud usually make one of three choices: take no legal action, pursue civil remedies, and/or pursue criminal action against the perpetrators.

10. Civil proceedings seek to reclaim the assets stolen in the fraud. Often, with employee fraud, the employee quickly liquidates and spends the proceeds of the fraud. Thus, there is usually very little to reclaim in a civil suit. However, when fraud involving organizations occurs, civil actions are often useful because those organizations have assets (deep pockets) from which they can pay the damages.

11. Management often avoids taking legal action against fraud perpetrators because of the legal cost and the bad publicity for the company. They justify that the legal costs and

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time spent are more than the value of what was stolen, and what was stolen is less valuable than the company’s good reputation. They fail to recognize that they are destroying the company’s culture of honesty, and opening themselves up for future, potentially larger, frauds.

True/False 1. True 2. False. While a hotline for tips can help detect fraud, there are two fundamental activities that prevent fraud: taking steps to create and maintain a culture of honesty and high ethics, and assessing the risk of fraud and developing concrete responses to mitigate the risks and eliminate opportunities for fraud.

3. False. An important step in creating a culture of honesty involves developing a positive work environment.

4. True 5. True 6. True 7. False. When a perpetrator is not caught, his confidence in the fraud scheme will increase and he will usually become increasingly greedy.

8. True 9. True 10. False. Physical evidence includes fingerprints, tire marks, weapons, stolen property, etc. Paper, computer, and written documents are usually classified as documentary evidence that are part of the concealment scheme.

11. True 12. False. Preventing fraud is generally the most cost-effective way to reduce fraud losses.

13. True 14. True

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15. False. Expectations about punishment must be clearly communicated from top management throughout the organization to effectively implement a fraud prevention program.

16. False. Frauds usually start small and get larger and larger if not detected.

17. True 18. True 19. True 20. True 21. False. Many frauds involve the CEO, so telling only the CEO could be ineffective.

For this reason, Sarbanes-Oxley requires public companies to have independent whistle-blowing systems, so company management is not involved in the whistleblowing system. Sherron Watkins of Enron notified the Chairman of Enron of a brewing scandal, but it was not enough.

22. False. Even though complete prevention is usually not possible, “preventing fraud” is generally the most cost-effective way to reduce losses from fraud.

23. False. Preventing fraud is generally the most cost-effective way to reduce losses from fraud.

24. False. Most fraud perpetrators are first-time offenders who have positive reputations in their work, community, family, and church environments.

Multiple Choice 1. c 2. d 3. b 4. a 5. a 6. b 7. d

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8. c 9. d 10. d 11. d 12. d 13. d 14. a 15. d 16. a 17. a 18. c 19. d 20. d 21. c 22. b Short Cases Case 1 1. There are at least five critical elements in creating an ethical culture: a. Having top management model appropriate behavior. b. Hiring the right kind of employees. c. Communicating expectations throughout the organization and requiring periodic written confirmation of acceptance of those expectations. d. Creating a positive work environment. e. Developing and maintaining an effective policy for handling cases of fraud.

2. Each of the elements listed above would need to be implemented within the company.

In order for management to model appropriate behavior, they would need to accept and understand company policy and choose to model that behavior. To hire good

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employees, the company should perform background checks on potential employees.

Expectations for company employees should be clearly communicated through a corporate code of conduct. Management would need to take the necessary steps to create a positive work environment. When fraud does occur, management must handle the case efficiently and effectively and then perform the necessary steps to ensure that fraud does not occur again. As well, management must communicate to employees that fraud will not be tolerated within the company.

Case 2 Detection and investigation are steps that are taken once fraud has occurred. At this point, much of the damage has already been sustained—victims’ assets are stolen, victims must incur legal fees, lost time, negative public exposure, and other adverse consequences.

Investigation of fraud is typically very expensive. Organizations and individuals that have proactive fraud prevention measures generally find that those measures pay big dividends.

Case 3 Because most frauds increase dramatically over time, it is extremely important that when frauds occur they be detected early. In most cases, the fraud losses that an organization experiences in the final few months of a fraud are higher than the total losses in the first few years of the fraud.

Case 4 1. Research has shown that it is employees and managers, not auditors, who detect most frauds. To effectively prevent and detect fraud, employees and managers must be taught how to watch for and recognize fraud symptoms. By training employees and managers about fraud, the company will save thousands of dollars; many frauds will be prevented, and if a fraud does occur, it will be detected earlier.

2. One of the most effective ways to involve employees in fraud prevention and detection is to provide a formalized protocol for communication that informs employees and others to whom they should report suspected fraud and what form that communication should take. The protocol should assure confidentiality and stress that retribution will not be tolerated. Organizations that are serious about fraud prevention must make it easy for employees and others to come forward and must reward them, not punish them, for doing so. These types of reporting systems (whistle-blowing systems) are now required for public companies under the Sarbanes-Oxley Act. Case 5 1. It would be important to tell your boss that fraud occurs less frequently when employees have positive feelings about the organization or when they feel ownership in the organization. When employees feel abused, threatened, or ignored, the risk for fraud increases.

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2. Factors that have been associated with high levels of fraud and that detract from a positive work environment include a top management that does not care or pay attention to appropriate behavior, negative feedback, and a lack of recognition.

Perceived inequities in an organization, autocratic rather than participative management, low organizational loyalty, unreasonable budget expectations, unrealistically low pay, poor training and promotional opportunities, high turnover and/or absenteeism, lack of clear organizational responsibilities, and poor communication practices within the organization also contribute to a high risk of fraud and detract from a positive work environment.

Case 6 This case should provide the basis for discussing several aspects of ethics in business.

Students will likely have different points of view. The authors believe that ethics can be “taught,” although not in the same way that history or math is taught. A student’s sense of ethics develops over time and is reinforced by dealing with ethical dilemmas. The way people approach and deal with ethical issues seems to be affected by life experiences, including formal education.

There are four levels of ethics: a basic sense of right and wrong; application of that basic sense of right and wrong to business—interpretation of values; ethical courage to make the decision you know is right even when faced with adverse consequences; and ethical leadership—modeling ethical behavior. While the first one—basic sense of right and wrong—may not be effectively taught in school, the other three can.

The authors have tried to expose students to fraud cases where dishonest acts were rationalized because of low ethics. By incorporating ethical issues in several end-of-chapter cases throughout the book, hopefully students will have an increased awareness of ethical dilemmas encountered in business.

Case 7 Fraud investigation is a complex and sensitive matter. If investigations are improperly conducted, the reputations of innocent individuals can be irreparably damaged, guilty parties can go undetected and be free to repeat the act, and the offended entity may not have information to use in preventing and detecting similar incidents or in recovering damages.

Therefore, it is important that fraud investigations not be conducted without predication.

Case 8 There are three follow-up alternatives available to organizations once fraud has occurred: take no legal action, pursue civil remedies, and/or pursue criminal action against the perpetrators.

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Case 9 As is the case in many organizations, the likelihood of fraud increases when employees are hired based on their ability to get the job done rather than being hired for their honesty and integrity. Although Fujimori was successful as a president, his alleged lack of integrity led to a scandal and left a nation without a leader for an extended period of time. The people would probably have been better served by choosing someone with more integrity to lead them.

Case 10 Background checks are a very good way to determine whether people have a past that may be indicative of future fraud. Some fraud perpetrators have deceived even the best interviewers into thinking that they are hard-working, honest people. Especially in the early stages of a business, the individuals hired mold and create a culture at the organization. A culture of honesty or dishonesty, as well as potential losses from fraud, are at stake if the wrong people are hired.

Case 11 Here is a news article about this case. G.M. Missing $436 Million, Accuses L.I. Dealer of Fraud By THOMAS J. LUECK Published: April 09, 1992 Life in this Suffolk County village hasn't been quite the same since sheriff's deputies began removing 700 new cars from John McNamara's sprawling dealership on Friday and General Motors accused him of fraud in obtaining hundreds of millions in loans from the company.

As a car dealer, developer, newspaper publisher, Republican Party insider and philanthropist, there was no one to match Mr. McNamara, the "Mr. Big" of this community and a quintesentially American small-town entrepreneur. For now, all that is clear about Mr. McNamara's problems can be found in papers filed in civil court by the General Motors Acceptance Corporation, which charged him with obtaining loans to finance cars that did not exist, falsifying documents and failing to divulge his business dealings. General Motors said Mr. McNamara owes it $436 million, and it obtained a court order from State Supreme Court in Hauppauge to have his dealership, McNamara Buick-Pontiac, shut down and 700 cars and trucks in his lot, worth $13 million, removed.

Here are the answers to the questions.

1. The amount of revenue needed to make up for the fraud depends on the profit margin or how much net income is made for each dollar of revenues. If the profit margin is 10%, then 10 times the fraud losses would be needed or a total of $4.36 billion. If the profit margin is 5%, then twice that much revenue would be necessary.

2. Reducing future frauds would require the company to embark on a journey to do all of the things mentioned in the chapter, including: (1) taking steps to create and maintain a culture of honesty and high ethics and (2) assessing the risks for fraud and developing concrete responses to mitigate the risks and eliminate the opportunities for fraud.

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3. In a company as big as General Motors, it is certainly not possible to eliminate all frauds, regardless of how good the internal controls and other fraud prevention initiatives are. There will always be some dishonest employee who will perceive an opportunity and be able to commit fraud. However, companies like GM can substantially reduce the occurrences of fraud and, when a fraud occurs, can detect it before it gets huge like this one did.

4. This fraud was probably allowed to occur because of a lack of internal controls or because internal controls that were in place were not being followed or were being overridden. There were probably other factors that allowed the fraud to occur but without being there, it is impossible to know what they were.

Case 12 Prior to the policy change, employee fraud was not seen as a serious issue, and prosecutions were unlikely. The general message was that nothing serious will happen to you if you commit fraud (fraud was acceptable), and so it proliferated. But, creating a policy that would essentially prosecute everyone involved in fraud (minimizing these bad-news reports to the CEO), it was clear that fraud would not tolerated. As a result, fraud within the organization decreased.

Case 13 Jamie needs to understand that most fraud perpetrators have no past history of fraud, and so seemingly “good” people are sometimes involved in fraud. Since fraud requires “confidence,” it is usually those you trust most who are in the best position to commit fraud.

By not taking action Jamie is putting in jeopardy the culture of the organization; this destroys the culture of honesty that could exist if it was well known that all fraud would be handled seriously.

Case 14 1. The management of this company seems too relaxed. They did not provide for an independent check of the accounting records and cash. They created an easy opportunity for Mary to embezzle. a. There was an inadequate segregation of duties in the company. Peter Jones should have been assigned to do some of Mary’s duties so that there was a reduced opportunity for embezzlement.

2. The company should have paid more attention to internal controls, both preventive and detective. Mary had no accountability to anyone, and no one ever checked her work.

Consistent communication could have been one of the effective ways of reducing the fraud. This would have helped identify and remind the employees of what is expected

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of them by the company. They could have also required a written and signed statement that stated the possible punishment for committing fraudulent acts.

Periodically, XYZ’s management should have asked Peter Jones to take care of Miller’s books while she was required to take vacation time. This would have helped detect the fraud at its early stages. Additionally, it might have prevented the fraud, since Mary would have known that someone else would be checking her work.

CASE STUDIES Case Study 1 1. a. The potential pressures for Chris to commit fraud are: 1. The pay that he is receiving relative to the expenses of school, family, and technology widgets was low. While living on a tight budget, the unexpected extra expenses, such as car repairs or medical expenses can put individuals in a pinch and add to the pressure to commit fraud. To get even with his employer for not promoting him or feeling underpaid for the responsibility with which he contends daily. b. The potential opportunities for Chris to commit fraud are: 1. Lack of controls within a growing technology company. The company is integrating software and corrupting accounts and it is easy to disguise fraud in such an environment. Little or no monitoring system on the phony credit card that was provided him.

Failure to experience discipline for past actions.

2. He is the most technologically advanced in the group; therefore, he may be able to devise a way to manipulate systems without the knowledge of his supervisor.

3. He was a trusted employee and was allowed latitude in making decisions. c. The potential rationalizations that Chris could use to justify his actions include: 1. Chris could feel that he deserves higher pay as he has increased the efficiency of the team and holds the responsibility of training those around him. In other words, his responsibilities have increased but his pay has remained the same.

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2. The credit card is a phony credit card that results in no bills and does not charge anyone for services put on the card. In the end, someone will pay for the transactions, but the changes won’t be recognized immediately.

3. The money that Chris could steal would be for a good purpose—to further his education, which would ultimately increase his value to the company; therefore, the company is really benefiting from the fraud.

2. The potential symptoms of fraud include: a. Chris increasing spending on the latest technology (lifestyle symptom). b. Chris moving his monitor into a position where no one could see his screen (behavioral symptom). c. Chris changing his spending habits without a change in salary (lifestyle symptom). d. Chris creating multiple usernames for testing purposes (analytical symptom).

3. Jonathon could have reduced the possibility of fraud by: a. Punishing Chris for his actions in order to create an environment that tells employees that the company does not tolerate or justify dishonesty in any form. b. Creating an internal report that monitors the usage of the phony credit card.

This could be done in conjunction with requiring that employees maintain an activity log of all transactions using the phony credit card. These two reports would be compared every month for accuracy. The company can also require that a manager approve any transaction requiring the use of the credit card. c. Providing a hotline for fellow employees to report suspicious activity. d. Having individuals rotate responsibility and audit each other’s performance. e. Performing random checks on individuals’ computers as part of company policy. f. Establishing tighter controls and monitoring systems for the operations team so that reports are run in order to determine effectiveness and any outliers within a normal distribution.

Case Study 2

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1. The definition of fraud is “… a generic term that embraces all the means which human ingenuity can devise, which are resorted to by one individual, to get an advantage over another by false representation.” Fraud is deception that includes the following elements: • • • • • • •

A representation About a material point That is false, Intentionally or recklessly so, Which is believed And acted upon by the victim To the victim’s damage

Based on the definition of fraud, we can analyze the situation as follows: Derek’s company represented Derek as an SAP expert implying certain training capabilities.

This representation was false and was intentional. The client believed that Derek was an expert because they were told in good faith that he was. The client was billed at an “expert” billing rate. This meant that the client overpaid for Derek’s work since he wasn’t an expert.

This kind of misrepresentation may be standard practice in this type of business situation. Some could argue that if Derek’s firm delivered the system on time and that it worked properly, it doesn’t matter what you call the people that implemented it; they got the job done, so where’s the fraud?

On the other hand, the firm intentionally misrepresented its consultants’ credentials (material point) even though the credentials were false. The client believed the firm and paid the fees (acted upon), believing that Derek was in fact an expert. Even though this practice may be standard in this industry, the authors believe this would still be considered a form of fraud. If the client were to find out about the fraud, the fraud would probably not bring the company down, but it could jeopardize the relationship with the client. If something were to go wrong with the project, both firms could end up in court.

2. Mike, the purchasing manager, exhibited lifestyle characteristics such as certain clothing and the new model BMW that were atypical of someone working in his position at his company, and he enjoyed talking with his colleagues about the clothes and cars. He liked the attention. In addition, his relationship with his suppliers seemed a little suspicious. The amount of time he spent getting to know his suppliers could mean that he was doing an excellent job for his company, but it could also be seen as a symptom that he wasn’t keeping the purchasing transactions at “arm’s length.” He guarded his supplier relationship closely; these relationships could be further evidence that fraud was occurring. His unpredictable behavior could signal fraud, too, as people who commit fraud may feel scared and guilty depending on when they perpetrate their fraud. Finally, the fact that Mike never took vacations is another red

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flag. The fact that he never took vacations coupled with his lengthy term as an employee could have meant that he knew there were flaws in the system and he could work them to his advantage. People in the company thought this is how he saved money for his clothes and car, but it also could have been the opportunity to perpetrate his fraudulent activities. Combining the clothes and car, the close supplier relationships, the personal unpredictability, and the lack of vacations probably gives predication of fraud, and an investigation should take place. These symptoms don’t mean that fraud is happening, but it does look suspicious.

3. Kathy obviously felt work pressure to make her quarterly sales numbers. Whether she realized it or not, the sales she was able to generate by shipping product to customers who didn’t order them was a fraudulent activity; it probably strained relationships with customers, too. This activity misrepresented the actual sales of the company to shareholders.

In this environment, sales should be recognized when they are shipped. By manipulating revenues, the company was able to misrepresent monthly sales. Even though the following month’s sales were proportionately lower, the company used this practice because they believed they could have another month to try to reach sales goals.

This type of fraud is definitely revenue fraud. The company is shipping products without customer orders and recording them as sales, even though many of the products are returned. These “sales” should never be recorded.

Case Study 3 1. Conditions that could contribute to a poor work environment: • High Turnover: The ABC retention department has recently experienced a high level of management turnover, which makes it impossible for a consistent control environment. It is likely that employees do not feel a high sense of loyalty to the current manager.

• Poor Communication/Training: The new manager is so busy catching up on his new responsibilities that he has been unable to hold a training or orientation with his department. This lowers the employees’ commitment to the company and established processes.

• Perceived Inequities: One potential control environment risk is that management drives fancy cars to work, which portrays to employees a lavish and rich lifestyle. This sort of example can cause employees to feel like they also deserve a rich lifestyle and can lead to increased employee fraud as they rationalize their actions.

• Low Pay: Retention agents are paid a lower commission rate than what they consider to be industry standard. This can be a very relevant fraud risk. Employees often commit

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fraud when they do not feel they are being adequately paid for their work. Employees can easily rationalize that they are not stealing, but are simply taking the wages that they rightfully earned.

2. Symptoms the auditor should look for to determine if fraud is occurring within the retention department: There are not adequate controls around the submission and review of retention agents reported account saves. If retention agents were submitting fraudulent accounts you would expect to see decreasing profitability. The decreasing profitability is due to increasing commission expense that is not accompanied by revenue increase. If all retention agents saves were legitimate we would expect profitability to not decrease, as all commissions paid will be accompanied by customer accounts that renew and continue to make monthly payments.

3. Five primary control procedures: • System of Authorizations: Retention agents should not be authorized to update customer contract date information in the CCS. It would be simple for a retention agent to extend a customer contract and take credit for a customer save when in fact the customer never agreed to the extension. If a separate department or person is responsible for updating the customer contract date information in the CCS, they could confirm the legitimacy of the contract extension before authorizing the update to customer contract date information in the CCS. • Segregation of Duties: Retention agents should not be able to update customer contract date information in the CCS. A separate person or department should update the contract date information in the CCS. If the duties of making a contract extension and updating the CCS are not separated it opens up the possibility of a retention agent fraudulently updating the contract date information in the CCS, and thus getting paid on fake retention saves. The duties of updating the CCS and making retention saves should be separated.

• Documents and Records: Proper documents and records allow for an audit trail.

Currently the supervisors do not maintain the record of each agent’s contract saves for the month. This documentation should be maintained so that control effectiveness (the supervisor’s independent check) can be audited and followed up on.

• Independent Checks: Supervisors should be given adequate time to review a statistical sample of each retention agent’s contract saves. The supervisor can verify the legitimacy of the save by listening to the verbal contract that is attached to the customer account. Once the supervisor confirms a sample of the account saves, he/she can process the payroll. Additionally, the department policy should be updated to include a rule that any employee found to have submitted a fraudulent customer account save will be terminated.

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Physical safeguards are more important when cash or physical assets are at risk to be misappropriated, which is not the case in the retention department.

Case Study 4 This is an example of the fraud of corruption and bribery. Corruption in the form of bribery is one of the oldest and most prevalent of all forms of fraud. In certain countries this practice is so prevalent that it has become very difficult for legitimate companies to conduct business without paying bribes. This situation led to the passage of the Foreign Corrupt Practices Act in an attempt to reduce the prevalence of bribes. Fortunately, bribery and corruption are not generally seen as acceptable in the United States, and many companies implement effective policies to prevent such fraud against organizations. In this section we outline several key actions that Biogencyte (as well as other companies) should implement to prevent corruption within their organization.

This kind of fraud could be eliminated by: Having a better Tone-at-the-Top Perhaps the best way to prevent corruption is to have a tone-at-the-top that discourages employees from accepting or paying bribes. The board of directors should carefully select executives that uphold the highest of ethical standards, and instruct those executives to create written policies that discourage bribery and outline the company’s policies regarding the investigation and prevention of such actions. Not only should these policies exist, but they should be frequently discussed within the organization so employees understand expectations. Employees should receive periodic ethics trainings and be required to sign the company code of conduct pertaining to corruption at least annually.

Another way to prevent this type of fraud is to have good Background Searches.

Background searches should be conducted for all employees who handle disbursement/receipt of corporate money. Employees should be required to regularly report any personal relationships they have with vendors or customers. These relationships should be monitored closely to ensure any transactions that take place are arms-length transactions.

In addition, the auditors in our case investigated the personal relationships of the top executives. This investigation revealed potential conflicts of interest. Corruption is frequently associated with top officials and company officers, so external and internal auditors should carefully monitor these relationships to make sure all disclosure requirements are properly met.

Another way to help avoid these kinds of frauds is to insist on complete documentation.

With most bribes and illegal gratuities, a company or employee will try to hide the fact that the transaction occurred by foregoing document creation or falsifying proper documentation.

Biogencyte seemed have documentation policies in place because there was an account related to the bribes made to both the valuation expert and FDA officials. This account and supporting documentation allowed the auditor to gather evidence to support their finding of the fraud occurrence. All companies should ensure that they have the proper documentation policies and controls that prevent employees from overriding these policies.

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Finally, in cases like this, it would be important (in fact, it is now the law) to have a good Whistleblower Hotline in place. Since bribes typically take place “under the table” they can be very difficult (if not impossible) for auditors to detect. Perhaps the best way to detect this type of fraud is internally. In addition to creating a culture that rewards honesty and ethical behavior (tone-at-the-top), companies should provide a way for employees to anonymously report corruption they observe. Fellow employees are much better positioned to observe bribery than top executives or auditors. Management and the board of directors should provide an anonymous hotline for employees to report ethical violations they observe, and information about this hotline should be published so employees know of its existence.

Internet Assignments 1. a. The report states that theft by employee’s accounts for approximately 30 to 50 percent of all business failures. b. The report states that three-quarters of all employees have stolen from their employers and that some employees may engage in theft behavior as a regular part of their lives on the job.

2. The National Fraud Information Center (NFIC) was established in 1992 by the National Consumers’ League to fight the growing menace of telemarketing fraud by improving prevention and enforcement. It is the only nationwide toll-free hotline for consumers to get advice about telephone solicitations and report possible telemarketing fraud to law enforcement agencies. In 1996, the Internet Fraud Watch was created, enabling the NFIC to offer consumers advice about promotions in cyberspace and route reports of suspected online and Internet fraud to the appropriate government agencies.

Consumers can call the NFIC hotline or send their questions to the NFIC Web site.

The NFIC’s trained counselors help consumers identify the danger signs of possible fraud and direct them to the right places for more information, if needed. Consumers can also report suspected telemarketing or Internet fraud through the NFIC hotline or Web site. These reports are relayed to a variety of local, state, and federal law enforcement agencies, alerting them to problems that they may wish to investigate and providing them with the ammunition they need to stop fraud.

Debate We believe Fred should be encouraged to turn himself in. If he does not, you should tell him that for his own good, you are going to report him. If he is not reported, his frauds will probably increase.

Answer to first Stop and Think Questions

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1. Why do you think a fraud perpetrator who is caught would suffer more humiliation and embarrassment than a bank robber or other property offender? a. Fraud perpetrators are usually first-time offenders. In addition, they are usually in positions of trust. They often have families and backgrounds that look exactly like those of honest employees. When they are caught committing a fraud, even telling their families is extremely difficult. On the other hand, bank robbers and similar property offenders are usually repeat criminals with the average bank robber having a rap sheet of 11 previous offenses. To them, getting caught and sent to jail is just another free meal and more of what they are already used to. In addition, they usually don’t hold positions of trust like white-collar criminals do and they usually don’t have family structures like fraud perpetrators. In fact, the research shows that because of the embarrassment factor, white-collar-criminals who are prosecuted have a very low recidivism (repeat offenses) rate while whitecollar criminals who aren’t prosecuted have a very high recidivism rate (why not, nothing serious happened to them.)

2. Do you really believe that having a written code of conduct will reduce fraud and other dishonest acts in an organization? a. Codes of conduct are usually worthless if they are created and then ignored.

Posting a code of conduct on a Web site or even including them in employee handbooks does little good if constant attention isn’t paid to them. That is why companies like Red Hat require annual certification of abiding by the code by every employee and why the company spends large amounts of resources in regular ethics training. To be effective, codes of conduct must be endorsed by management, prominently displayed, and reinforced constantly.

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Chapter 4 PREVENTING FRAUD Discussion Questions 1. Three factors are crucial in creating a culture of honesty, openness, and assistance: hiring honest people and training them in fraud awareness; creating a positive work environment; and providing employee assistance programs (EAPs).

2. Five methods that companies can use to reduce actual or perceived opportunities for fraud are as follows: a. Install good internal controls. b. Discourage collusion, and alert vendors and contractors to company policies. c. Monitor employees, and install tip hotlines. d. Create an expectation of punishment. e. Proactively audit for fraud.

3. Clearly defined codes of ethics delineate between what is acceptable and what is unacceptable. Having employees periodically read and sign the company’s code of ethics not only reinforces their understanding of what constitutes appropriate and inappropriate behavior; it also underscores the fact that their behavior is important to the company. Expectations are clarified, and clear expectations reduce fraud. Clearly specified codes also inhibit rationalizations, and, as previously discussed, rationalization is an important element of nearly every fraud.

4. The most widely recognized way to deter fraud is with a good system of internal controls. Internal controls include a good control environment, a good accounting system, and good control procedures as well as good communication and monitoring.

5. Much collusion can be prevented by simply enforcing mandatory vacations or job transfers, because collusive fraud develops slowly (it takes time to get to know others well enough to trust that they will cooperate and not blow the whistle). When organizations leave one employee in close contact with the same vendors or customers for long periods of time, the risk of individuals deciding to profit personally increases dramatically.

6. Sometimes otherwise innocent vendors and customers are drawn into fraud by perpetrators because they fear that if they do not participate they will lose the business relationship. In most cases, such customers or vendors have only one or two contacts with the firm, and the person who requested illegal gratuities or suggested other types of illegal behavior often intimidates them. A periodic letter to vendors that explains the organization’s policy of no gifts or gratuities helps vendors understand whether company buyers and sellers are acting in accordance with the rules. Such

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letters clarify expectations, something that is very important in preventing fraud.

Many frauds are uncovered when, after receiving such a letter, vendors express concern about their buying or selling relationships.

7. People who commit fraud and hoard their proceeds are virtually nonexistent.

Perpetrators almost always use their stolen money to support expensive habits.

Organizations can monitor their employees by paying close attention to the enhanced lifestyles that result from these expenditures and by listening for verbalized rationalizations.

8. Proactive fraud auditing is conducted by following four steps: identifying risk exposures, identifying the fraud symptoms for each exposure, building audit programs that proactively look for symptoms and exposures, and investigating identified symptoms.

9. Even with advances in technology, fraud is most commonly detected through tips. A good whistle-blowing program is an extremely effective prevention tool. When employees know that colleagues have an easy, anonymous way to report suspected fraud, they are more reluctant to commit fraud.

10. When placed in an environment of low integrity, poor controls, loose accountability, or high pressure, people tend to become increasingly dishonest. While a few people probably will not become dishonest at any point (about 30%), a large portion of the population will be influenced by negative stimuli and eventually cave to dishonesty.

In essence, this phrase means that a lot of people have a point where if the payoff is high enough, they will be dishonest.

11. Along with the standard interviewing, background and reference checks, some institutions are now conducting credit checks, checking employee’s fingerprints against law enforcement records, drug testing, and pen-and-pencil honesty tests.

12. The Pygmalion effect states that when expectations are set below average, results will be substandard. This relates to fraud in that if we expect people to be dishonest, they will often be dishonest. However, if we create a culture of honesty and expect employees to be honest, then employees will often be honest.

True/False 1. False. Under extreme pressure or with the right opportunity, most people would probably steal or embezzle.

2. False. A positive and honest culture helps to prevent fraud.

3. True

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4. False. Although good internal controls help reduce the risk of fraud, they cannot give complete assurance of the absence of fraud.

5. True 6. True 7. False. Not prosecuting perpetrators can be very costly in the long run.

8. True 9. False. The increasingly complex nature of business tends to increase the number of collusive frauds.

10. True 11. False. EAPs are intended to reduce fraud by helping employees with substance abuse, gambling, money management, health, family and personal problems. They are meant to help employees and often serve to prevent fraud.

12. True.

13. False. Creating an expectation of punishment is probably the greatest deterrent to dishonestly, and would only result in lowering the morale of dishonest employees.

Companies must expect honesty, but also must create the expectation of punishment if employees are dishonest.

Multiple Choice 1. e 2. e 3. e 4. b 5. d 6. c 7. a 8. c

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9. b 10. c 11. d 12. b 13. b

Short Cases Case 1 You would probably suggest that Karen implement the following policies and procedures: •

Hiring: A thorough interview should be conducted with each potential candidate. All candidates should supply three personal references, and each reference should be contacted before hiring. In addition, previous employers should be contacted and questioned about the candidate’s performance and reason for leaving.

•

Open-door policy: The manager’s door should always be open. Employees should be encouraged to share new ideas, concerns, pressures, and problems with the management. Conversations between managers and employees should be confidential and should only be shared with others at the employee’s request.

•

Code of Ethics: Each employee should read and sign the company’s Code of Ethics.

The Code of Ethics identifies what behavior is and is not acceptable.

•

Prosecution Policy: The company should have a policy that mandates that any employee who is found to have committed a dishonest act against the company should be released from employment and prosecuted to the fullest extent of the law.

•

Suggestions/Tip/Complaint Box: Employees should be encouraged to write suggestions, tips, and/or complaints and submit them anonymously. Karen should have the only key to this suggestion box and all suggestions/tips/complaints should be seriously considered.

Case 2 Senior management should develop a code of ethics or conduct and communicate it throughout the company. Every employee should be required to read and sign the code each year.

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Case 3 First, the company has no monitoring of controls in place. Jason does not have a manager interviewing him, reviewing company policies, and following up on his activities. The company does not enforce a code of ethics, nor did it inform Jason that a code of ethics existed when he was hired. He only had to sign a document preventing the disclosure of software secrets. Employees do not know that fraudulent behavior is punished; they are left to guess why the employee left.

Case 4 First, Nellie should develop a system to monitor suppliers and buyers associated with the company. A few easy queries can be installed in data and accounting systems to make sure that fake companies are not set up for fraudulent purposes. Nellie needs to set up a system requiring that employees report suspicious activities to her. Nellie also needs to make sure employees understand the proactive stance the company takes in preventing, detecting, and prosecuting fraudulent activities. Nellie can help prevent fraudulent activities by creating an atmosphere of trust and by reviewing the code of ethics the company has with each employee.

Case 5 1. The client has some problematic internal processes, including extremely slow credit memo processing, that can jeopardize the validity of such processes. The company’s credit department had unusually high turnover and an intimidating CFO, resulting in a high-pressure environment. The current credit manager is a friend of the CFO, so there could be a risk of collusion and the fact that they worked together at a previous company may be a red flag that a similar situation may have occurred in the past.

2. The main problem is bad modeling or “tone at the top,” including factors such as integrity, ethical values, and competence of management. If the CFO had integrity and realistic expectations, this fraud would probably have been avoided.

Case 6 1&2 The couple is in charge of handling the cash, recording the cash receipts, and making the deposits at the bank. One of the other part-time employees could make the daily deposits.

The couple is in charge of hiring the part-time personnel; they could easily hire friends or family and collude to steal money or even assets from the restaurants. The owner should hire the part-time personnel himself and have them report daily records of rooms rented, meals served, and payments received. In general, the couple has too much control over the business, and duties need to be segregated. With the part-time employees, segregation of duties could be easily and effectively achieved.

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Case 7 Gant Chevrolet should have created a better work environment. This could have been done using the following steps: 1. Hiring honest people (doing background checks) and providing fraud awareness training.

2. Having an open-door policy.

3. Having a well-understood and respected code of ethics.

4. Providing an EAP that could have helped Danny with his problems.

5. Creating an expectation that dishonesty will be punished.

6. Implementing a tighter set of internal controls.

Case 8 Stronger internal controls would have prevented the fraud. However, internal controls are costly in a small firm. If Mary had taken a more active role in vendor management and required her signature on contract approvals, the fraud could have been prevented. She could have also informed vendors that kickbacks and bribes are not acceptable. Even though this is a small firm, a more active role needed to be taken in monitoring employees. Mary could have established a formal code of ethics and had each employee sign it. There are a few basic things that every small business owner should do, including: signing all checks (this would have allowed her to see payments going to favored vendors), opening the bank statement, depositing all cash, and reviewing periodically all vendors and the amount of services they are providing.

Case 9 There was a serious lack of segregation of duties and independent checks as well as too much supervisory authority in one person in this bank. The bank placed far too much trust and supervisory authority in Robert. If the bank would have had separate supervisors handle dormant accounts and customer complaints, or even if it would have required Robert to take mandatory vacations or rotated him from time to time (so that other employees would periodically deal with customer complaints), the fraud could not have continued for so long or become so substantial.

Case 10 The chapter states that a major factor in preventing fraud is to create a culture of honesty, openness, and assistance. In this case, there was no openness or assistance. No one communicated with this employee. Rather than assisting him, they treated him poorly and talked down to him. Fraud is usually high in this type of environment because employees see the company and its owners as adversaries rather than supporters.

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Case 11 Jorge is a high risk for fraud because he is facing significant financial pressures to repay his student loans and because of his credit card debt. He is depressed, and has an alcohol problem, all of which will add to the desperation that often leads to employee fraud. An EAP could help Jorge deal with his financial, substance abuse and psychological problems and help him lead a financially healthy life. An EAP could help Jorge get medical assistance for his depression, and he could also get drug counseling for his alcohol problem. This assistance would reduce the likelihood that Jorge would succumb to the temptation to commit fraud.

Case 12 First, the program does not allow employees to feel like they are giving anonymous tips. If they are just calling someone in the office who is the fraud liaison, then that person may know the potential whistle-blower, which would obviously discourage employees from making calls. Many of them would fear retaliation from blowing the whistle. Second, if the liaison is involved in the fraud, there would be no one to call. Third, putting a notice in the break room is not sufficient. People must know about the program and be trained about how it works. This lack of training would also create failure in the program. Finally, top management must let employees know that the program is important to them and the company by frequently referring to the program.

Case 13 There are a number of techniques potential employers can use to screen to make sure they are hiring honest employees. Some mentioned in the book are background checks, reference checks, drug tests, criminal records checks, matching potential employees’ fingerprints against fingerprint databases and credit checks. An extensive interview would also be helpful in trying to assess the integrity of the potential employee.

Case 14 1. Hire honest people and provide fraud awareness training: Even in a small business, you can establish hiring procedures that will result in a more honest workforce. You may not be able to perform extensive background checks, but you can at least check references and perform other simple and relatively inexpensive screening processes. Even if you don’t have the resources to conduct lengthy fraudawareness training seminars, discussions at the time of hiring or through the distribution of materials can provide new employees with information about how to handle fraud and the expected results of committing fraudulent behavior.

2. Create a positive work environment: Employees should be aware that either you or another appointed employee is always willing to listen to them with respect to reports of fraudulent activities. No one should be afraid to come forward. You might even create a means of anonymous reporting. This does not necessarily need to include expensive hotlines. It can be something as simple as a locked comment box. As well,

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it is very important that you do not override controls. It may be true that you will never rob your own company, but if your example is one of ignoring controls, you open the door for your employees to do the same.

3. Have a well-understood and respected code of conduct or ethics: You should find a way to inform all employees about what is expected of them with respect to fraudulent activities. This will remove part of their ability to rationalize their actions.

4. Provide an employee assistance program: Fraud usually results (at least in part) from pressures with which the employees are faced. You should attempt to monitor and mitigate these pressures by providing an alternative means for employees to receive assistance.

5. Create an expectation that dishonesty will be punished: You should always prosecute employees who steal from the company. The publicity this causes shouldn’t harm the company as much as the potential long-term effects that may ensue from not punishing dishonesty; most people realize that fraud affects all companies. In fact, your responsible actions against fraud might instill confidence in others that your company is addressing the problem in a healthy manner. Other employees will be less likely to commit fraud if they know they will be punished severely if caught. In the end, the savings will most certainly outweigh the costs.

Case Studies Case Study 1 1. This case is difficult to prevent because it involves “collusion.” That is, an insider was working with outsiders. While internal controls are quite helpful in preventing and detecting fraud committed by single individuals, they are much less effective in preventing collusive frauds. Nevertheless, because of the large size of the transfers, there should have been some secondary approval required. In addition, telephone transfers are usually only authorized to go to certain accounts. The Lord Investments account should not have been an approved transfer account. Banks understand the huge risks involved with wire transfers and generally are very careful to use transfer keys and codes and require secondary approvals on large transfers. They also require the clients to sign transfer agreements in advance and specify into which accounts money can be transferred.

Case Study 2 1. Companies use different approaches in preparing codes of conduct or ethics—some have one code for the entire company. Others have one code for officers and directors, as required by the SEC, and a different one for employees. The risks facing the two groups is different and separate codes can be tailored to those risks. On the other hand, having one code that everyone understands and agrees to is probably the

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best practice. Every year, the board of directors of companies have to review and update the codes for the executives and board and, if there is only one code, it is updated for everyone every year.

2. The Chief Executive Officer, Chief Financial Officer and other financial professionals have agreed to follow the Code. Obviously, this is not broad enough.

While CEOs and CFOs have been involved in many of the financial statement frauds, all key executives of a company, as well as directors, should agree to follow the Code. Furthermore, in many organizations, all employees are expected to agree to follow the Code. We authors recommend that all employees sign and agree to follow the Code.

3. Having a code of conduct sets expectations for the company. The combination of modeling and labeling are important in getting all executives and others to be honest.

A code of conduct is one way to “label” what is appropriate and what is not appropriate.

Internet Assignment 1. The Committee of Sponsoring Organizations (COSO) does not provide a succinct definition of smaller organizations. Rather, it provides characteristics of smaller organizations, including: (1) they have fewer lines of businesses and fewer products within lines than other businesses, (2) they have a concentration of market focus, by channel or geography, (3) they have fewer levels of management with wider spans of control, (4) management usually has significant ownership interest or rights, (5) they have fewer personnel, with wider ranges of duties and (6) they usually have a limited ability to maintain deep resources. As the article goes on to say, however, internal controls are extremely important in these types of smaller businesses, usually because they have higher risks and exposures than larger businesses that can afford to have better segregation of duties, etc.

2. The other ways people are hurt by insurance fraud that are mentioned in the article are: a. People lose their savings. Trusting citizens are bilked out of thousands of dollars, often their entire life savings, by insurance investment schemes. The elderly are especially vulnerable. b. Health is endangered. People’s health and lives are endangered by swindlers who sell nonexistent health policies or perform quack medical care to illegally inflate health insurance claims. c. Premiums stay high. Auto and homeowner insurance prices stay high because insurance companies must pass the large costs of insurance fraud on to policyholders. d. Consumer goods cost more. Prices of goods at your department or grocery store keep rising when businesses pass higher costs of their health and commercial insurance on to customers.

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e. Honest businesses lose money. Businesses lose millions in income annually because fraud increases their costs for employee health coverage and business insurance. f. Innocent people are killed and maimed. People die from insurance schemes such as staged auto accidents and arson — including children and entire families. People and even animals also are murdered for life insurance money. g. Employees lose jobs. People lose jobs, careers and health coverage when insurance companies go bankrupt after being looted by fraud thieves.

Debates 1. a. Employee tips furnish companies with the most common means of detecting fraud. Frequently, companies detect more fraud through employee tips than through auditors. A good whistle-blowing program can be the most effective fraud prevention tool because it makes it much easier for employees to report suspicious behavior, and as employees realize this, the fear of getting caught will act as a deterrent to fraudulent behavior. b. Most people are taught at a young age that we should not “whistle-blow.”

Unfortunately, this idea sticks with many people and leads them to resist turning in their otherwise honest, yet fraud-perpetrating, coworkers. Turning in dishonest employees is ethical; in fact, it is the honest thing to do. If an employee knows about dishonest behavior but does not report it, he/she is essentially an accessory to fraud and is encouraging his coworkers to be dishonest and fraudulent. c. “Whistle-blowing” is ethical, but that doesn’t automatically make people feel comfortable with it. This is why employees should be provided with an anonymous method to report fraud and dishonest behavior. Management should consider giving employees several options to report fraudulent behavior, possibly including a 24/7 toll-free tip line where they can leave tips anonymously, an open-door policy with management, allowing the employee to report to the person overseeing the fraud perpetrator, and an avenue to report suspicious behavior directly to the head of corporate security or internal audit.

2. A major problem in business is that no one takes proactive responsibility to prevent fraud. Top management says it isn’t their responsibility—theirs is a more strategic responsibility. Middle management maintains that it isn’t their responsibility—they have more important things to worry about, like running the business. Internal audit generally maintains that while they are concerned about fraud, they are more concerned about having good internal controls in place and operating efficiency and effectiveness. Internal audit usually maintains that if they come upon “red flags,” they will pursue them, but they are not actually looking for them. Besides, they argue, they

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are not on location enough of the time to know whether something looks problematic or not, especially such symptoms as lifestyle, behavior, and tip symptoms. Corporate security usually argues that they don’t worry about fraud prevention but instead investigate fraud when there is fraud predication. They are concerned about safety, substance abuse, and other things in addition to fraud. Audit committees usually say that while they don’t want any fraud, they don’t have any day-to-day responsibility to prevent it. Theirs is a 50,000-foot altitude view of the company. Finally, legal counsel maintains that they will work with others to help investigate fraud, but proactive fraud prevention is not their responsibility. As a matter of fact, employees and management, who are there every day, are in the best position to detect fraud. This lack of taking responsibility and the turf battles that usually come up when a fraud has occurred are a major deterrent to preventing fraud. In the end, the company should have a formal fraud policy that outlines who is responsible for which elements of fraud, including detection, prevention and investigation. Lack of a fraud policy creates a lack of action and responsibility.

Answers to Stop and Think Questions 1. Do you agree with the statement that most people are capable of committing fraud? Do you believe that you are capable of committing fraud? a. To answer these questions, think about the fraud motivation triangle you learned about in chapter 2. Most people have perceived pressures and will be presented with perceived fraud opportunities sometimes in their lives.

Therefore, the only thing missing from the fraud triangle is the ability to rationalize the dishonest act. Now consider that psychologists tell us that most, if not all of us, judge ourselves by our intentions rather than our actions.

For example, you might intend to eat less, exercise more, get up earlier or be a better husband, wife, father or mother. When people judge themselves by their intentions (as opposed to judging others by their actions), we think we are good people when we have good intentions. So, a potential fraud perpetrator might rationalize that he or she intends to “pay the money back” or “use it for a good purpose.” When our intentions are good, we can act on perceived opportunities and pressures much easier. It is true that very few people would never commit fraud. Assume, for example, that you are a parent and that your children are literally starving and you work in an environment where money is laying around with no controls. Your rationalization might be that you will only “borrow the money” to feed your children and keep them from starving.

Would you commit fraud? Most people would.

2. It is obvious that controls are important in a business organization to get employees and others to act in a manner consistent with management or the owner’s desires. In what other settings would controls be important?

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a. Controls are important in any unit where someone is trying to get other people to act the way they would like them to. Controls are very important in a family, for example. Having a good control environment, including proper modeling and labeling, and good control activities (e.g. proper authorizations) can help insure that children act in ways that are consistent with parents’ hopes and desires. Controls are also important for politicians—to make sure they act the way voters would like them to, for example. That is why we put controls on politicians such as term limits, submitting them for re-election, separation of powers between judicial, legislative and executive branches of government, etc. You can probably think of many other settings in which good controls would be very helpful.

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Chapter 5 RECOGNIZING THE SYMPTOMS OF FRAUD

Discussion Questions 1. With fraud, it is not always apparent that a crime has been committed. Therefore, it is important that observers watch for red flags, or symptoms, in order to detect fraud.

Without fraud symptoms, it would be very difficult to detect fraud.

2. When internal controls are absent or overridden, an opportunity is created, and the risk for fraud increases greatly. By focusing on the internal controls that are absent or overridden, we can identify possible areas and suspects, helping us to detect possible fraud.

3. Accounting symptoms or anomalies involve problems with source documents, faulty journal entries, and inaccuracies in ledgers. These also include any record, electronic or paper, that is unusual.

4. Analytical symptoms or anomalies are procedures or relationships that are unusual or too unrealistic to be believable. They include transactions or events that happen at odd times or places, or that include odd procedures, policies, or practices. They also include transactions and amounts that are too large or too small, that occur too often or too rarely, that are too high or too low, or that result in too much or too little of something. Basically, analytical anomalies are anything out of the ordinary.

5. Most people who commit fraud do so under financial pressure. Sometimes the pressures are real; sometimes they represent simple greed. Once perpetrators meet their financial needs, however, they often continue to steal, using the embezzled funds to improve their lifestyles. They buy new cars. They buy other expensive toys, take vacations, remodel their homes, or move into more expensive houses. Fraud investigators can detect fraud by focusing on these changes in suspected perpetrators’ lifestyles.

6. Research in psychology indicates that when people (especially first-time offenders, as many fraud perpetrators are) commit crimes, they are overwhelmed by fear and guilt.

When perpetrators feel this fear and guilt, they change their behavior. For example, a nice person suddenly becomes mean or angry. Or a person who normally has lots of patience no longer is patient with anyone.

Although no particular behavior signals fraud, it is the changes in behavior that signal possible fraud. By focusing on these changes, we can identify possible perpetrators of fraud.

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7. Tips and complaints are categorized as fraud symptoms rather than actual evidence of fraud because many tips and complaints turn out to be false. It is often difficult to know what motivates a person to complain or provide a tip. Customers, for example, may complain because they think they are being taken advantage of. Employees may phone in tips for reasons of malice, personal problems, or jealousy. Tips from spouses and friends may be motivated by anger, divorce, or blackmail. Therefore, tips and complaints must be treated with care and initially only as symptoms of fraud, not as evidence of it. Individuals must always be considered innocent until proven guilty.

8. Theft is the actual taking of cash, inventory, information, or other assets. Theft can occur manually, by computer, telephone, or other electronic means.

9. Conversion has to do with selling stolen assets or converting them into cash and then spending the cash. If the asset taken is cash, conversion is the spending of the stolen funds.

10. Concealment involves the steps taken by the perpetrator to hide the fraud. In concealment, financial records are altered, cash or inventory is miscounted, or evidence is destroyed.

11. a. If you are an auditor, you are responsible to report internal control weaknesses to the Board of Directors or management. If the company is a public company then you will be required under Sarbanes-Oxley Act, Section 404, to audit the internal controls. The severity of the weakness will determine the extent of your reaction to a control weakness. Auditing concepts such as materiality come to play in this decision but that discussion is beyond the scope of this text. b. If you believe the coworker is exhibiting signs that he or she has been committing fraud you might report this to someone in the organization who can investigate it. Many companies have whistle-blowing systems in place that would allow you to report this activity anonymously. You might also investigate the opportunities for this coworker to commit fraud. Perhaps there is inadequate segregation of duties or other control weaknesses that the company is not aware of. c. If you are in a position to embezzle from the company then you will want to notify someone above you of the control weakness so that you are not tempted to take advantage of the situation. You can present this information to your superior in the spirit of improving the company’s controls and preventing future problems.

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True/False 1. False. Analytical anomalies help to detect fraud, but they do not have to be present for fraud to occur.

2. True 3. True 4. True 5. True 6. False. Analytical fraud symptoms are an excellent way to detect fraud.

7. False. Generally, people who commit fraud use the embezzled funds to improve their lifestyle.

8. True 9. False. When a first-time offender commits fraud, usually he or she becomes engulfed by emotions of fear and guilt. They then change their behavior to cope with the stress.

10. True 11. False. Sometimes you won’t be able to observe that a perpetrator has incentive, opportunity, or rationalization. Rationalization is probably the most difficult element to observe.

12. False. The fraud elements consist of the theft act, concealment, and conversion.

13. False. Auditors can best help detect fraud in concealment.

14. True 15. True 16. False. Employees and coworkers are usually in the best position to detect fraud.

17. True 18. False. The most common control problem when frauds occur is the overriding of existing internal controls.

19. True

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20. True 21. True 22. True 23. True 24. True Multiple Choice 1. b 2. c 3. e 4. a 5. a 6. d 7. d 8. d 9. c 10. d 11. b 12. a 13. b 14. c 15. d 16. d 17. b

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Short Cases Case 1 1. The business is at risk because there is no separation of duties. Cal Smith, Jr. works the night shift alone and then accounts for and deposits the money at the bank in the morning.

2. Possible symptoms: • • • • • •

Cal has never missed a day of work.

Cal feels he is overworked and underpaid.

Numerous doughnuts are thrown away for over baking.

Cal was hired because he was friendly; he is now often angry and frustrated.

Cal has not been getting very much sleep.

Cal recently purchased the car of his dreams.

3. Possible steps to reduce opportunities for fraud: • • • •

Have other employees work at night.

Do not allow Cal to make the deposits or handle cash.

Force Cal to take some time off periodically.

Pay Cal more money so he does not feel overworked and underpaid.

Case 2 1. It is possible that James could be committing fraud. Fraud symptoms include: • • • • • • •

Outstanding bills need to be paid.

Lawsuits are pending from lack of payment.

James drives nice cars.

James has a very expensive home.

James will not update equipment.

James is known for losing his temper.

Many customers are complaining.

2. Most businesses experience customer complaints. While customer complaints are common, they can be possible fraud symptoms, especially if customers do not believe their accounts or charges appear appropriate. Whenever tips or complaints are received, they must be treated with care and considered as possible fraud symptoms but not as actual evidence of fraud.

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Case 3 Several symptoms of fraud exist. The first is the fact that the ranch has a patented new breeding technique that can increase the population from 20 to 100 steers in two years. If this is true, why has it not been chronicled on TV or in newspapers? Next, the business has just started, and companies with a short history are not tried and tested by the business world.

Performance seems suspicious with the immediate growth and phenomenal success. If it seems too good to be true, it probably is. The location in Hawaii is also suspicious, since most people cannot afford to fly to the islands and observe operations. The large growth in assets and revenues, the pressure to invest quickly, and the fact that investors have only 10 days after the initial offering to invest are all possible signs of fraud. Furthermore, the words “double your money,” “sure thing,” and “very exclusive” should tip off any educated person to the possibility of fraud.

Case 4 Tips and complaints are categorized as fraud symptoms rather than actual evidence of fraud because many tips and complaints turn out to be unjustified. It is often difficult to know what motivates a person to complain or provide a tip. Customers, for example, may complain because they feel they are being taken advantage of. Employee tips may be motivated by malice, personal problems, or jealousy. Tips from spouses and friends may be motivated by anger, divorce, or blackmail. Whenever tips or complaints are received, they must be treated with care and considered only as fraud symptoms. Individuals should always be considered innocent until proven guilty and should not be unjustly suspected or indicted.

Case 5 First, vendors with the same address are a symptom in the source documents. Lack of the needed signatures is a sign of weak internal controls or the overriding of controls. The expensive stereo system could be a sign of an extravagant lifestyle, and these symptoms could indicate the existence of fraud.

Case 6 The potential for fraud is high in this situation. When one person is responsible for collecting and depositing cash and adjusting account balances, fraud can easily occur. There is a serious lack of segregation of duties. One solution might be to segregate Joanne’s duties. One employee should open cash receipts and prepare a cash listing. Another employee should update customer balances, and a third, possibly one of the owners, should make bank deposits.

Case 7 Auditors are often criticized for not detecting more frauds. Yet, because of the nature of fraud, auditors are often in the worst position to detect its occurrence. Remember that the

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three elements of every fraud are theft act, concealment, and conversion. Who in an organization is in the best position to recognize fraud in each of these elements? Certainly, with the theft act, it is not the auditors. Auditors are rarely present when funds are stolen or fraud is committed. Rather, they spend one or two weeks on periodic audits, and thefts typically stop during the audit periods. Instead, coworkers, managers, and other employees are usually in the best position to detect fraud in the theft act stage.

In concealment, auditors do have a chance to detect fraud. If audit samples include altered documents, miscounts, or other concealment efforts, auditors may detect fraud. Similarly, they may see internal control weaknesses or analytical relationships that do not make sense.

However, company accountants and even coworkers are probably in a better position to detect fraud in concealment.

At the conversion stage, the auditors are definitely not in the best position to detect fraud.

There is no way, for example, that auditors could recognize certain changes, such as an employee who used to drive a used Ford Focus now drives a new BMW or Lexus. Likewise, auditors will not recognize a perpetrator’s unusual activities, such as wearing designer suits, taking expensive vacations, buying expensive jewelry, or buying a new home with stolen funds. Auditors do not have a reference point from which to see these changes in lifestyle.

Again, it is coworkers, friends, and managers who should detect fraud in conversion.

Case 8 1. There are three elements of every fraud: theft act, concealment, and conversion.

Certainly, during the theft act, it is not the auditors who have the greatest opportunity to detect fraud. Auditors are rarely present when funds are stolen or fraud is committed. Rather, they spend one or two weeks on periodic audits, during which time thefts usually stop. Instead, coworkers, managers, and other employees are usually in the best position to detect fraud in the theft act stage. In concealment, auditors do have a chance to detect fraud. If audit samples include altered documents, miscounts, or other concealment efforts, auditors may detect fraud. Similarly, they may see internal control weaknesses or analytical relationships that do not make sense. However, company accountants and even coworkers are probably in a better position to detect fraud in concealment. At the conversion stage, the auditors are definitely not in the best position to detect fraud. There is no way, for example, that auditors could recognize certain changes, such as an employee who used to drive a used Ford Focus now drives a new BMW or Lexus. Likewise, auditors will not recognize a perpetrator’s unusual activities, such as wearing designer suits, taking expensive vacations, buying expensive jewelry, or buying a new home with stolen funds. Auditors do not have a reference point from which to see these changes in lifestyle. Again, it is coworkers, friends, and managers who should detect fraud in conversion.

2. Not surprisingly, it is the auditors who are absent or nearly absent in each element.

Although most people believe that auditors should detect fraud, they have less opportunity to do so than employees, friends, management, internal audit, and others.

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For this reason, it is crucial that organizations are proactive in combating fraud.

Organizations should have fraud awareness programs, anonymous tip hotlines, and other programs in place to prevent fraud.

Case 9 1. Possible reasons include: • • • • • •

She may have been unsure about the facts of the fraud.

She may have been afraid of the reactions of other employees to “whistleblowers.”

The perpetrator may have intimidated her.

She may not have wanted to be labeled as a “squealer.”

She may have been unsure of how management would react.

The organization may not have a program facilitating the reporting of fraud.

Case 10 Although fraud could be occurring, there is no conclusive proof. Several fraud symptoms do exist, but all of these symptoms could have other possible explanations. You may want to discuss possible symptoms identified in the case and even how the students would proceed in investigating the symptoms. For example, the missing receiving documents may be for goods that were personal items but recorded as inventory or legitimate business expenses. You could investigate this possibility by looking at the other supporting documents for these purchases including vendor invoices and/or cancelled checks. Also, overcharging customers may be a means for John to take funds out of the company. He may be refunding money when the customers complain but keeping it when they don’t notice. You could investigate this possibility by reviewing customer complaints and ensuring that customers are sent monthly statements for amounts due to the store.

Case 11 1. Potential responses may include the following: • • • • •

Attitude/Rationalization Hire honest people Develop a good tone at the top Conduct training or education Establish an ethics policy or codes of conduct

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3. Opportunity • • • • •

Prosecute/punish offenders Actively search for fraud Control activities Whistle-blowing systems Monitoring controls (e.g., internal audit and security)

Case 12 This is definitely a fraud symptom—an analytical fraud symptom. It doesn’t make sense that there were be leins or mortgage loans on properties in one state at banks in another state where the partnership has no properties. As it turns out, the 3 general partners were having hard times on some of their personal investments so they took out loans on some of the limited partnership’s assets at far-away banks where they didn’t think the auditors would find them. This turned out to be a multi-million dollar fraud that resulted in the bankruptcy of the entire limited partnership.

Case Studies Case Study 1 1. The following are four possible symptoms: • • • •

ABC’s revenues increased by 53 percent in 2012, while inventory decreased by 27 percent.

ABC has increased revenues in 2012, while receivables decreased by 23 percent.

ABC has increased revenues in 2012, while accounts payable decreased by 47 percent.

Warehousing costs have increased while inventory balances have decreased.

Case Study 2 1. The following could have been symptoms of Daniel Jones’s fraud: a. Extravagant Lifestyle: Daniel Jones drove expensive vehicles. It is clear from his Web site that Jones enjoyed telling people about his toys. It is likely he showed or talked about his various cars to his fellow employees. A clue to Jones’s fraud is that he began to purchase most of these expensive cars in the last ten months of the fraud, not over the period of time he worked for his company. b. Analytical Anomalies: Jones received large amounts of software free of charge to be used on developmental projects. Someone should have

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discovered that Jones was receiving larger quantities of materials than his colleagues. His company could also require seeing the projects Jones was working on and the reasons why he needed such large amounts of materials. c. Internal Control Weaknesses: His company had no internal control checks for amounts under $1,000. d. Unusual Behaviors: It is not one particular behavior that signals fraud but rather a change in entire behavior. Jones had worked for the company long enough that employees and coworkers would be able to tell if he was experiencing behavioral changes.

2. a. Positive Consequences: Because managers are encouraged to have tighter control over costs, their scrutiny may deter potential fraud perpetrators. Also, managers will take more ownership of their department because they will be in charge of a greater portion of the balance sheet and will likely be more careful with cost and expenses, especially if a bonus is given for keeping costs low. b. Negative Consequences: Managers may be more tempted to commit their own form of financial statement fraud, especially if a bonus is attributed to keeping costs low/revenues high. Controls will need to be in place as deterrents.

3. a. Pressure: Fraud pressures can be divided into four types: financial pressures, vices, work-related pressures, and other pressures. Jones had a perceived pressure to drive nice cars and have other nice luxuries. His desire for luxuries was enough to motivate him to commit fraud. b. Opportunity: His company had a weakness in its controls. It required approval only for software or hardware of more than $1,000. Jones had ordered software in the past for legitimate purposes. He saw that no one really checked up on him, since he was director of a very secret project. c. Rationalization: Although we do not know the exact way he rationalized his acts, we do know that he rationalized his unethical acts in one way or another.

4. It appears that his company tries very hard to create a culture of honesty, openness, and assistance by focusing on hiring honest people. However, his company could benefit from developing a code of ethics. In this situation, there was no overriding of existing controls; rather there were no internal controls in place on purchases of less than $1,000. His company could benefit from having some type of internal control to prevent this type of fraud from occurring in the future. His employer did prosecute Jones in this case, which will help discourage future perpetrators.

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Case Study 3 1. Symptoms of fraud: • • • •

demanding an increased number of contracts by SCI employees; demanding faster processing time for these contracts; some employees are quitting; trying to divert the attention of the federal government.

2. Questions that you might ask: • • • • •

Why are the employees quitting?

Why is contract volume so high?

Does the documentation for the contracts make sense?

Who are the subcontractors?

What is their relationship to SCI?

3. The covert business, staffed by undercover agents, would give investigators the ability to gain the best evidence of fraud through direct contact with those involved in the fraud. Undercover operations are often necessary when massive, collusive fraud is occurring, especially fraud involving kickbacks.

Case Study 4 1. Symptoms of fraud can be divided into six different categories. These categories reveal the following:

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Accounting Anomalies: When searching for fraud, it is helpful to look for sudden changes in account balances. Significant differences in accounts may arise from faulty journal entries and inaccuracies in ledgers.

•

Internal Control Weaknesses: An analysis should be performed to identify areas that have weak or no controls present. This is important because weak controls can be easily overridden when pressure arises to commit fraud.

•

Analytical Anomalies: An analysis of transactions can reveal amounts that are too large or too small for accounts. These accounts should be examined for fraud.

•

Extravagant Lifestyles: Managers should take time to analyze the lifestyles of their employees. Unexpected and unexplained changes in lifestyle may suggest that fraud has taken place. The activities and responsibilities of these employees should be monitored.

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•

Unusual Behaviors: Managers should take time to notice emotional changes of employees. Stress and fear are good indicators that an employee may be committing fraud.

•

Tips and Complaints: Managers should review complaints and tips made by employees. Complaints and tips may provide clues to who is committing fraud.

2. The different types of fraud symptoms that are present in this case are as follows: •

Accounting Anomalies: Hal is concerned that fraud may be occurring as he knows that sales revenue may be higher than normal because the company lost one of its major vendors at the start of the fourth quarter. Hal should check to see if the company acquired new vendors that he is not aware of during the last quarter. Hal should also check to see if sales are significantly higher for a current vendor. It may be possible that vendor fraud is occurring.

•

Internal Control Weaknesses: It is possible that controls have been overridden. Hal noticed that many people around him have been pressured to meet earnings forecasts. An analysis should be performed to determine areas that have weak or no controls present.

•

Unusual Behaviors: Hal noticed that his CEO has been meeting with one of his internal auditors late at night. This is an irregular occurrence and should be investigated.

3. Now that Hal has recognized some fraud symptoms, there are basic analyses that he can perform to determine where fraud may be occurring. Hal can detect signs of fraud through analyzing changes from one period to the next by conducting vertical and horizontal analysis as well as performing ratio analysis. These analyses are useful because they allow one to identify changes with ease because number account balances are converted into percentages. When performing horizontal and ratio analysis it is important to look for sudden changes in account balances from one period to the next, which must be examined in greater detail to determine the reason for the change. Sudden changes may suggest fraud.

Case Study 5 When kickbacks are being accepted from a vendor, the control of the purchasing transactions usually shifts from the buyer to the supplier. As it does, the supplier always wants more business at less cost and at higher profits. Therefore, some of the symptoms you almost always see in vendor kickback-type frauds are : 1. Repeated awards and purchases to the same vendor and fewer purchases from other vendors.

2. Competing biddger complaints and protests.

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3. Complaints about quality and quantity of goods purchased.

4. Multiple contractes awarded below the competitive threshhold.

5. Abnormal bid patterns.

6. Agent fees being paid.

7. Questionable bidders.

8. Awards of contracts to the non-lowest bidder.

9. Contract scope changes after awarding bids.

10. Numberous post-award contract change orders.

11. Urger need for the product or soul sourcing of the product.

12. Questionable ownership of the vendors.

Case Study 6 1. This is an FCPA case. The law that you are concerned that is being violated is the Foreign Corrupt Practices Act (FCPA). This is a major concern of corporations because not only are there potentially large fines but your CEO could be incarcerated.

2. You cannot afford to take this tip lightly, especially because of the specificity of the tip and the potential large penalties. You must follow up immediately and thoroughly. This means that, regardless of the cost, you must hire the best investigative counsel (and maybe forensic accountants) you can to investigate the case. The investigative law firm must confiscate computers (or at least take images of them and company servers.) They must get copies of emails and other correspondence. They must get copies of electronic payments/checks, etc. They must get copies of invoices and other accounting records. They must conduct interviews with individuals who could or would have information about the potential bribes. As audit committee chair, you must have frequent meetings with these investigators and make sure you document the process, including each of the meetings you hold, what was discussed, steps that were taken, decisions that were made, etc. You must also decide when and how to involve the other board members and management, once you are certain they are not involved.

3. If you discover that the allegations are true, you will need to decide whether to disclose the payments voluntarily to the SEC. Some say that disclosing voluntarily is like calling the artillery in on your own position and is therefore a bad idea. They argue that the benefits, if any, are unpredictable and, in any event, are outweighed by

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the risks. However, the SEC enforcement agency has promised to give credit for voluntarily disclosing such payments. Frankly, there is no affirmative obligation to self-report even a serious violation. Unlike other securities laws, there is no FCPA requirement to disclose.

The SEC has promised that companies that do voluntarily disclose will be treated more leniently than those that don’t. Voluntarily disclosing gives the company the opportunity to deal with a violation, remediate, discipline as appropriate and then present the matter in a context that is as favorable as possible. Disclosing is probably consistent with most companies’ codes of ethics and may mitigate shareholder lawsuits or at least help you defend against them.

In deciding whether or not to self-report, some companies weigh the likelihood of whether the violation will become public. Press coverage, whistleblower reports, and complaints by former or disciplined employees can alert agencies and these would increase the likelihood of the violation becoming public. Certainly, disclosure will lead to some kind of government enforcement action and penalties. If the company has not already conducted a thorough and independent investigation, the risk of a government inquiry rises. Unless the government decides not to pursue the matter (which is rare), a period of uncertainty usually follows a self-reporting (uncertainty about whether or not it will be reported especially because of whistleblower rewards also causes uncertainty if it is not self-reported). Some companies that have selfreported have ended up paying substantial financial penalties.

While many directors might disagree, my personal feeling is that even with all the pros and cons of self-reporting, the best thing is always to take the high road: find the truth and then do the right thing. In this case, the right thing would be to thoroughly investigate, all the while staying in touch with the whistle-blower and then self-report what you find to the SEC.

Internet Assignments 1. Many Web site matches can be found that relate to fraud auditing and fraud detection.

For the most part, these sites are from individuals and companies offering their services as fraud examiners.

2. The American Society of Questioned Document Examiners (ASQDE) is an association of professionals qualified in the study and examination of documents, such as disputed handwriting, signatures, typewriting, and the identification of photocopiers, ink, and papers. The purpose of the society is to foster education, sponsor scientific research, establish standards, exchange experience, and provide instruction in the field of questioned document examination.

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Answers to Stop and Think Question 1. What other unusual financial statement relationships may exist in the presence of a fraud? a. Decreased receivables with decreased cash. b. Increased inventory without an increase in payables or a decrease in cash.

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Chapter 6 DATA-DRIVEN FRAUD DETECTION Discussion Questions 1. The North Carolina case at the beginning of the chapter illustrates why proactive fraud detection is important. This type of detection can be done early and without previous indications of fraud, so it is able to catch frauds early. While it can cost more to complete, it can save organizations significant amounts of money if frauds are caught early. It allows an investigator to proactively manage the detection process rather than react to cases as they come in.

2. Anomalies are unintentional errors caused by control weaknesses. When they occur, they are generally spread evenly throughout a data set. Fraud is the intentional circumventing of controls; perpetrators cover their tracks and eliminate indicators. Fraud is often found in very few transactions rather than in an entire data set, similar to a needle in a haystack.

3. Since fraud is often found in very few transactions, sampling at a 5 percent rate guarantees that at a 95 percent level the investigation will miss the fraud. Fraud requires full population analysis whenever possible.

4. Advantages include the following: 1. Software can look at full populations almost as easily as samples.

2. Software can conduct time-intensive analyses quickly.

3. Software contains routines like stratification, summarization, and fuzzy matching that are specifically included for fraud detection purposes.

4. Software allows repeatability: once an algorithm is coded in a macro, it can be improved and reused in future cases.

5. Statistical analyses, such as using Benford’s distribution, can be performed on databases of any size. They are most useful when a particular type of fraud, like phantom vendors, is suspected.

6. The biggest disadvantage of statistical analysis is that without looking for specific types of fraud, it tends to identify large numbers of symptoms. In addition, carefully executed frauds can be lost in the detail when significant amounts of data are involved.

7. Benford’s Law is a mathematical algorithm that accurately predicts, for many data sets, that the first digit of each group of numbers in a random sample will begin with a 1 more than a 2, a 2 more than a 3, a 3 more than a 4, and so on. Benford’s Law predicts the percentage of times that each digit will or should appear in a sequence of numbers.

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8. Data-driven fraud detection determines what kinds of frauds can occur in a particular situation and then uses technology and other methods to determine if those frauds exist. It includes the following six-step processes: 1.

2.

3.

4.

5.

Understanding the business or operation to be studied.

Understanding what kinds of fraud could occur (fraud exposures) in the operation.

Determining the symptoms generated by the most likely frauds.

Using databases and information systems to search for those symptoms.

Following up on symptoms to determine if actual fraud or other factors are causing them.

6. Investigation into symptoms that are deemed representative of fraud.

9. To detect fraud through financial statements, investigators focus on unexplained changes.

They can do this in three ways. First, they can focus on the three primary financial statements: the balance sheet, income statement, and statement of cash flows. Changes in these primary financial statements can be analyzed to determine whether they make sense or represent symptoms that should be investigated. The second method is to convert balance sheet and income statements to change statements by using horizontal and/or vertical analysis. The third is to compute key financial ratios, such as the quick ratio, current ratio, and accounts receivable turnover, and compare these ratios from period to period.

10. By focusing on the unexplained changes in financial statements from period to period, we can identify areas that could possibly contain fraud. We can then focus on these areas and save time and money in fraud prevention and detection.

11. The biggest difficulty in trying to correlate customers, vendors, and employees with known problem people is that many cross-correlations contain formatting inconsistencies.

Finding ways to combine these “nonobvious” relationships is a large problem.

12. A data warehouse can structure data in ways that allow efficient and effective fraud detection. Since data warehouses are directly within the investigator’s control, they can be continually improved to support data-driven fraud detection without affecting production systems.

13. ODBC is the standard way of connecting data analysis applications with databases. It is useful because it provides a live connection and retrieves rich data, including data types, column names, and relationships. Text file import is less effective because it operates in a batch format and requires more preparation upon import.

14. The Soundex algorithm works well for some situations, but its scorings are best suited to English names. It ignores vowels, and scores only consonants. It loses effectiveness with numerical values. N-grams are a more powerful approach because they simply measure the number of matching runs of characters. They work best with larger sequences. Their biggest drawback is that because the number of matches required is exponential, as words become larger, n-gram matching can take significant amounts of time.

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True/False 1. False. Unusual patterns may be caused by non-fraud factors.

2. True 3. False. Data-driven analysis involves using the company’s database to search for unusual or unexpected relationships between numbers.

4. False. The first digit of random data sets begins with a 1 more often than a 2, a 2 more often than a 3, and so on.

5. True 6. False. Understanding the kinds of frauds that can occur is one of the key elements when using data-driven detection techniques.

7. True 8. True 9. False. Unexplained changes are uncommon and often signal that fraud is occurring.

10. True 11. False. Horizontal analysis is a more direct method of focusing on changes.

12. True 13. False. Z-scores are useful in identifying indicators. They are not normally associated with stratification.

14. False. Normally, multiple indicators or red flags are required to determine that a specific scheme is occurring.

Multiple Choice 1. a 2. c 3. d 4. b

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5. b 6. c 7. d 8. a 9. c 10. b 11. c 12. b 13. c 14. d 15. b 16. c 17. d 18. c 19. d Short Cases Case 1 1. Advantages of the data-driven approach: • • • •

Will not alert possible suspects Identifies possible red flags Can find fraud early—before it gets too large and expensive Places control of fraud detection in the investigator’s hands (rather than a reactive approach) • Can be performed on any database • Can analyze full populations of data • Can be tailored to the exact needs and cultures of organizations 2. Disadvantages of the data-driven approach:

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• • • • •

Higher cost than reactive approaches Fraud can be lost in the detail of large data sets and analyses Is general purpose, and it is difficult to refine results May give mis-signals Very difficult to eliminate the mis-signals

3. The reactive approach is still useful and acceptable. This new approach simply provides another technique for finding fraud. Students should offer commentary on the advantages and disadvantages in Case 1.

Case 2 1. Benford’s Law is a rule of data sets. It holds that the first digit of natural data sets will begin with a 1 more often than a 2, a 2 more often than a 3, and so on. Benford’s Law accurately predicts for many kinds of financial data sets that the digits of each group of numbers in a set of naturally occurring numbers will conform to certain distribution patterns.

2. Benford’s Law works with numbers of similar items with no predetermined pattern, but it does not work with numbers such as personal ID numbers or lists where the numbers have a built-in minimum or predetermined pattern.

Case 3 1. Financial statement fraud is best detected by focusing on unexplained changes. To be used as effective fraud detection tools, financial statements (specifically the income statement and the balance sheet) need to be converted into percentage change statements.

You could perform the following procedures to accomplish this conversion: a. Compare balances from one period with another: This might show some significant and unusual changes. b. Calculate key financial statement ratios: For example, quick ratio, accounts receivable turnover, debt-to-equity, profit margin, and others. By examining the changes in these ratios and comparing them with previous periods, it is possible to determine if there are any unexpected or unusual changes that might be indicators of possible fraud. c. Perform vertical analysis: This analysis converts financial statement numbers to percentages, thus making it easy to understand and identify possible fraudulent activities. For example, if sales increased 20 percent, the logical expectation would be that profits should also increase. If profits did not increase, something may be wrong and an investigation should pursue.

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d. Perform horizontal analysis: Which also converts numbers into percentages.

However, horizontal analysis compares the percentage change from period to period, thus making it easier to spot unusual and unexpected changes. e. Analyze the cash flow statement: Based on previous analysis of the income statement and the balance sheet, certain expectations about cash flows can be developed. For example, if sales increased and the accounts receivable turnover decreased, and other things are constant, one would expect that cash inflows should increase. Discrepancies between the balance sheet, the income statement, and the statement of cash flows could be red flags indicating possible fraud.

Case 4 1. Commercial data-mining software. Two of the most popular data-mining packages are Audit Command Language (ACL) and IDEA. Using ACL or IDEA, a fraud examiner can specify queries to use in looking for abnormalities. For example, an examiner could look for fictitious vendors by obtaining a list of vendors with post office box addresses and then investigate to determine if those vendors really exist.

Statistical analysis on client’s databases. Statistical analysis uses predetermined expectations such as Benford’s Law to search the client’s databases for abnormalities or unusual or unexpected relationships between numbers. Benford’s Law predicts the percentages that certain digits in a group of random numbers will appear. If numbers do not conform to these patterns, then further investigation into the cause must be conducted.

Data-driven approach. This approach involves determining the kinds of fraud that can occur and then using technology and other approaches to determine if fraud exists. This method is more extensive and involves the following six-step process: 1.

2.

3.

4.

5.

6.

Understanding the client’s business.

Understanding the types of fraud that can occur.

Listing the symptoms for each type of fraud that can occur.

Using technology to search for those symptoms.

Analyze the search results.

Investigating those symptoms further and determining if they are caused by actual fraud.

Case 5 There are a couple of possibilities available to Bucket Corp.: 1. Commercial data-mining software: By running analyses of Bucket’s purchasing trends with the various buyers, it would quickly come to someone’s attention that Harris Lumber has high prices and high-volume purchases. While this could have something to do with the quality of Harris’s lumber, it merits further investigation.

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2. Statistical analysis: According to Benford’s Law, a higher percentage of invoice totals should start with number 1 (about 30 percent), followed by number 2 (about 17 percent), and so on. The numbers for Harris Lumber clearly do not follow this trend, while the other three companies do follow this trend much more closely. This is a pretty good indication that the invoices for Harris may not be totally genuine. Bucket should look further to see if there are any abnormal relationships between Harris and Bucket’s purchasing agent.

Case 6 1. You can detect fraud in the purchasing department by searching for employees with the same address or telephone numbers as vendors. You can also sort purchases by vendor and purchase volume and observe if the total purchases for any particular vendor increases or decreases at an unexpected rate. Additionally, you could chart price increases of different products over time and the number of each unit that is purchased over time.

Case 7 1. Although fraud could be occurring, one should not jump to conclusions. There may be other reasons why inventory has risen much more than sales, such as poor buying policies, increased prices, obsolete inventory, or stockpiling of inventory.

2. As CEO, there are several different approaches you might take to investigate. Certainly, you would not want to make any accusations, as there could be several nonfraud explanations. You could consider purchasing some software to help analyze the inventory for factors such as dollar amount of purchases by buyer, amount of purchases from each buyer, and inventory turnover. You might also want to consider the possibility of an overstatement of inventory. Examining purchasing records or recounting inventory could help determine if fraud is being perpetrated.

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Case 8 1.

Benford's Law Test 30% 25% 20% 15% 10% 5% 0% 1

2

3

4 Data

5

6

7

8

9

Benford's

2. Based on a comparison of the sample data with Benford’s Law, there could be a possible fraud problem. A much larger sample is required to be certain that the troublesome patterns are persistent, and additional tests such as querying addresses of vendors or analyzing vendor volumes over the past few months should be undertaken.

Case 9 1. The chapter did not go into extensive detail on the steps of time trend analysis, it is really beyond the scope of a fraud textbook. Care should be taken on how much detail to expect on this question. However, it is important because it makes students think through how a time trend analysis should be done. The principles that were discussed in the text include the following: a. Data preparation by standardizing the time axis (a summarization technique). b. Some explanation that the investigator doesn’t need to look at thousands of graphs —summary numbers like regression slopes can be used to get a single number describing the time trend of a specific case. c. Some account must be taken for periods of inactivity (the zeros in the time trend graph shown in the chapter). d. Advanced students may detail the importance of selection of a long enough period to ensure that frauds can be seen starting and/or ending within the investigation time.

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2. Many different types of frauds can be discovered, including rising costs of any product or service, increasing hourly rates for employees, rising equipment usage, and rising charges to accounts.

Case 10 1. Some areas of concern are the rapid growth of receivables without a corresponding increase in inventory. Adding to this concern is the increase in accounts payable.

Normally, as accounts payable increase, inventory should also increase.

2. Possible explanations for these trends exist. The company could have had a change in credit policy, allowing for accounts receivable and accounts payable to increase. Also, the possibility exists that the company has sold or discarded obsolete inventory to reduce the amount it carries on the books.

Case 11 1.

Benford's Law 12 10 8 6 4 2 0 1

2

3

4

5

6

7

8

9

First Digit

Even though the pattern does not exactly follow a normal Benford’s Law shape, it does not differ much from expectations. The only digit that looks out of the ordinary is “4,” and testing could be performed to determine if that is a problem. Most likely, however, fraud is not occurring and no further investigation is necessary.

Case 12 1. Advantages of ODBC: a. Provides a real-time, live connection b. Can connect to almost any database c. Imports not only data but also metadata (column names, types, relationships)

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d. Allows the use of the powerful SQL language 2. Disadvantages of ODBC: a. Can affect runtime systems b. May not be available because of security or privacy concerns c. Not available on older mainframe systems d. The time card data needs to be imported using text file import routines. The columns should be typed correctly (numbers, text, dates), and control totals need to be printed to ensure all records imported correctly.

Case Studies Case Study 1 1. Student answers will vary based on their plan, but each plan should include the six steps to the data-driven approach. Students should identify an investigative team that includes business experts, technology experts, auditors, fraud investigators, and any others that might be useful to performing the process.

2. The chapter lists ACL, IDEA, Picalo, and ActiveData. Students may also decide that Excel or Access is good enough for the investigation. Some students may like ACL or IDEA because they are standard and company-supported. The companies offer training.

Other students may like the open-source and free nature of Picalo.

3. The primary technique useful to this type of analysis is stratification and/or summarization. Stratifying purchases against inventory levels by employee will allow the investigator to see if product levels (having accounted for purchases during the time frame) are decreasing more during any specific employee’s shift.

Case Study 2 1. Use either the Soundex (ACL and IDEA) or Fuzzy Match (Picalo) functions to join the JanitorialPurchases to itself on the Vendor column. In other words, use the software to join two tables, but use the JanitorialPurchases table as both input tables. (If your software does not allow joining a table to itself, copy the JanitorialPurchases table to JanitorialPurchases2 and join with the copy.) Join on the Vendor column. Record ID 1823 shows a purchase from “Master Cleaning Inc.,” a similar name to “Master Cleaning Supply” used in other purchases. This answer should show up with either the Soundex or Fuzzy Match method.

2. One way to do this analysis is to add a column for Benford’s Law expectation for each record (on the price column). Then summarize the records by vendor and calculate the average of the Benford’s column. Most companies show about a 15 percent probability level, but the summarized record from “Master Cleaning Inc.” does not match.

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3. A simple summarization by purchaser and product (calculating the average price paid) will highlight problem combinations. A pivot table will also show this calculation in a nice two-dimensional grid. The analysis doesn’t show any specific problems.

4. Most of the analysis packages have a function for finding gaps in sequence. This shows that record ID 1560 is missing from the list.

5. Use descriptives to get an overview of the dataset. This shows that one record in the quantity column has a zero value. A sort or filter on this column will show that record ID 1677 has a quantity of 0.

6. This part of the problem can be done easily in Picalo, but it is very difficult in ACL and IDEA. It is included in the problem—even though ACL and IDEA don’t support it without scripting—because this type of z-score analysis is an important fraud detection method. You may want to have your students skip this sixth part of the problem and instead have one or two students show the class how it is done in Picalo. If instructors find a nice way of doing it in ACL or IDEA, please share with the authors, and we’ll update it in the next version of the book.

The solution would be easy in any of the programs if only one product was purchased.

But the inclusion of many products, companies, and purchasers in the table makes analysis impossible without stratification and subsequent automated analysis of the subtables.

The solution in Picalo to stratify the data set by product, creates a number of subtables (one for each product). Stratification is required so the means and standard deviations used in the z-score calculation are specific to each product. Then calculate the z-score for each record and sort by this new z-score column (it is important that the stratification occurs first so the averages and standard deviations are done correctly). While the familiar “Master Cleaning Inc.” record comes up, a more subtle trend shows in “Master Cleaning Supply” with Jose. Students may see the potential kickback scheme going on as prices are increasing substantially between Master Cleaning Supply and Jose’s purchases.

Case Study 3 The assignments in this section require that the students use data analysis software to answer the questions. It may be useful to split the class and have some students use ACL, some use Picalo, and so on. Because each software package has its unique strengths, student presentations on the differences may be a useful classroom activity.

Because the data sets need to stay small for class purposes, some of the questions can be answered by manually looking through the data set. Be sure to grade students on their process rather than just answers to ensure that their solutions can be used on much larger data sets as well as smaller ones.

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1. The simplest way to perform this analysis in any application (including a database like MS Access) is to do a left join on the two tables by vendor code. This will join the two tables and include all the records from the charges table and any matching records from the approved_vendors table. Those records with an empty approved_vendors column were not approved.

A more straightforward way to do this analysis is to use Picalo’s Find Nonmatching function. This function returns two tables containing nonmatching records from both tables, similar to a filter for records that do not match in the other table.

2. The analysis will show that invoices 2535, 1065, and 922 with vendors AC1 and AC2 do not match. All three purchases were made by Suzie. Follow-up analysis should focus on indicators of phantom vendors or kickback relationships with these vendors.

Again, a left join will work in most applications (with the tables opposite of Question 1).

This type of join will show all records from the approved_vendors table and matching records from the charges table. The records with empty charges columns were not used.

If the student used Picalo’s Find Nonmatching function in Question 1, it also provided the answer to this question.

The analysis will show that four vendors, FPI09, NBV22, PSK34, QMI57 were not used.

This does not indicate fraud, but it highlights vendors that may need to be removed from the approved list because the company no longer purchases from them.

Note that while the primary focus of this problem is on joining, teachers can also assign students to do other analyses to this dataset, including Benford’s Law analysis, duplicate invoice numbers, gaps in invoice number, and trending analysis.

Case Study 4 ABC Company Ratio Analysis As of December 31, 2012 LIQUIDITY RATIOS:

12/31/12

Current ratio current assets/current liabilities Quick ratio (current assets—inventory)/current liabilities Accounts receivable turnover sales/average accounts receivable Days sales in accounts receivable 365/accounts receivable turnover Inventory turnover

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12/31/11

Change

% Change

3.79

2.26

1.53

67.70%

2.57

1.49

1.08

72.48%

4.93

5.19

-0.26

-5.01%

74.04

70.33

3.71

5.28%

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cost of goods sold/average inventory

1.

1.36

-0.18

-13.24%

0.21

0.22

-0.01

-4.55%

0.62

0.61

0.01

1.64%

9.03

11.38

-2.35

-20.65%

0.73

0.70

0.03

4.29%

1.33

1.72

-0.39

-22.67%

18 PROFITABILITY/PERFORMANCE RATIOS: Profit margin net income/net sales Gross profit margin (percent) gross profit/sales Earnings per share net income/number of share of stock Sales/total assets Sales/total assets Sales/working capital Sales/(current assets – current liabilities) EQUITY POSITION RATIOS: Owners’ equity/total assets total stockholders’ equity/total assets Current liabilities/owners’ equity current liabilities/total stockholders’ equity Total liabilities/owners’ equity Total liabilities/total stockholders’ equity

0.61

0.48

0.13

27.08%

.33

.68

-0.35

-51.47%

0.65

1.10

-0.45

-40.91%

ABC Company Balance Sheet As of December 31, 2012 ASSETS Current Assets Cash Accounts receivable Inventory Prepaid expenses Total Current Assets Property, Plant, and Chapter 6

2012

% Total Assets

2011

% Total Assets

2010

% Total Assets

$ 501,992 335,272 515,174 251,874 $1,604,31 2 765,215

23.33%

$ 434,215 302,514 505,321 231,100 $1,473,15 0 735,531

21.58%

$ 375,141 241,764 310,885 136,388 $1,064,17 8 705,132

23.54%

15.59% 23.95% 11.71% 35.57%

15.04% 25.12% 11.49% 36.56%

15.17% 19.50% 8.56% 44.24% 13

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Equipment Accumulated Depreciation TOTAL ASSETS

LIABILITIES Current Liabilities Accounts payable Accrued liabilities Income taxes payable Current portion of LT debt Total Current Liabilities Long-term Liabilities Long-term debt TOTAL LIABILITIES STOCKHOLDERS’ EQUITY Common stock Additional paid-in capital Retained earnings Total Stockholders’ Equity TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

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218,284

10.15%

$2,151,24 3

$ 248,494 122,192 10,645 42,200

196,842

9.78%

$2,011,83 9

11.55% 5.68% 0.49% 1.96%

$ 423,531

$ 366,864 216,533 25,698 42,200

175,400

11.00%

$1,593,91 0

18.24% 10.76% 1.28% 2.10%

$ 651,295

$ 322,156 215,474 22,349 42,200

20.21% 13.52% 1.40% 2.65%

$ 602,179

425,311 $ 848,842

19.77%

400,311 $1,051,60 6

19.90%

375,100 $ 977,279

23.53%

$ 370,124 29,546

17.21%

$ 356,758 24,881

17.73%

$ 320,841 21,910

20.13%

902,731 $1,302,40 1

41.96%

578,594 $ 960,223

28.76%

273,880 $ 273,880

17.18%

$2,151,24 3

1.37%

$2,011,83 9

1.24%

1.37%

$1,593,91 0

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ABC Company Income Statement As of December 31, 2012 Sales Cost of Goods Sold Gross profit

2012 $1,572,134 601,215 $ 970,919

2011 $1,413,581 556,721 $ 856,860

$ Change $158,553 44,494 $114,059

% Change 11.2% 8% 13.3%

EXPENSES Advertising Depreciation Bad debts Legal Miscellaneous Rent Repairs and maintenance Salaries and wages Utilities Total Expenses Net income before income tax Income tax expense NET INCOME

$ 55,153 21,442 20,151 17,261 91,014 148,321 14,315 47,121 $ 15,912 $ 430,690 $ 540,229 216,092 $ 324,137

$ 50,531 21,442 18,934 10,207 31,214 142,078 13,642 45,312 $ 15,643 $ 349,003 $ 507,857 203,143 $ 304,714

$ 4,622 0 1,217 7,054 59,800 6,243 673 1,809 $ 269 $ 81,687 $ 32,372 12,949 $ 19,423

9.1% 0.0% 6.4% 69.1% 191.6% 4.4% 4.9% 4.0% 1.7% 23.4% 6.4% 6.4% 6.4%

Internet Assignments 1. As discussed in the article, performing statistical analysis using Benford’s Law is a good proactive method to detect fraud. The probability of a number beginning with 1 as the first digit is not 1 in 9 as most people think. The law states that the probability of a number beginning with 1 as the first digit is about 30 percent, and the probability of the number beginning with 9 as the first digit is actually 4.6 percent. Armed with this knowledge, a fraud examiner can detect fraud by looking for exceptions to Benford’s Law. Perpetrators of fraud may not understand Benford’s Law and incorrectly assume that the probability is 1 in 9. Benford’s Law helps identify those people that “fake” transactions.

2. a. A neural network is a computer-based model that patterns after the human brain.

It is used to model data, similar to regression in statistics. b. Neural networks can model the normal patterns in the data and find transactional trends that do not match the norm. c. Many industries can benefit from this technology, but in particular, the credit card industry has used it significantly to model consumer behavior and guess when a credit card is being used by a different person. d. Students will name firms that they have found on the Internet.

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e. Students will find different procedures and policies that help identify fraud. One example is a representative calling the card owner to verify large transactions, overseas transactions, or other risky transactions that seem different from that card owner’s (consumer) normal behavior.

Debates 1. The controller might start by telling the CFO that data mining is a great idea and that they should go forward with his suggestion. He should, however, inform the CFO of possible, severe limitations in detecting the fraud that has been committed within the company.

These limitations would include the large size of the company and the immense size of the databases to be analyzed. The controller might also explain the importance of considering implementation of an automated, real-time fraud detection system due to the large number of transactions that are occurring between buyers and hundreds of vendors.

Additionally, he might tell him that by using this method, they could analyze company databases without alerting possible suspects, change and refine the queries as needed, and then automate the queries so they could be run at any time in the future.

2. The debate should center on when sampling is most effective and when full population analysis is required. As a general rule, today’s software packages make full population analysis possible for almost every fraud investigation. Sampling will always be used for things like accounts receivable confirmation letters.

Answers to Stop and Think Questions 1. How are the six steps in the data-driven approach to fraud detection different from the traditional reactive approach? a. The six steps in the data-driven approach are different primarily because they are proactive. They require no predication of fraud to be present. Instead, they provide a hypothesis-testing approach to fraud detection.

2. What are the relative advantages and disadvantages of ODBC compared with text file import? a. ODBC has several advantages over text import, including (1) they are faster and more robust, (2) they include data formats and column names, (3) they automatically handle character encoding, and (4) they provide the powerful SQL language.

3. Ask a friend (who isn’t biased by reading this) to generate 25 numbers between 0 and 100 on a scratch piece of paper. Calculate the distribution of digits in the first position: how many 1s, how many 2s, and so forth? Do the numbers match Benford’s Law? They are likely evenly distributed rather than skewed toward the lower numbers like Benford’s Law.

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a. Since people generally do not generate numbers that follow Benford's Law, the numbers that are generated should give the students a real world example of how to find phantom vendors, false invoices, or other fake numbers. Sometimes people generate numbers that are evenly distributed; other times the numbers favor the 79 range.

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Chapter 7 INVESTIGATING THEFT

Discussion Questions 1. Theft investigation methods help to investigate fraud because they allow the investigator to determine specific facts about the fraud such as how the fraud was perpetrated and how the fraud was concealed. Three main theft act methods are used to investigate theft in suspected frauds. They include surveillance and covert operations, invigilation, and physical evidence. Surveillance and covert operations are used in three ways: stationary or fixed point, moving or tailing, and electronic surveillance. Invigilation is used to determine if fraud is occurring, while physical evidence is used to analyze objects such as inventory, assets, and broken locks.

2. Determining the existence of predication is the most important factor to consider when deciding whether to investigate a case of fraud. Predication is defined as circumstances that would lead a reasonable prudent professional to believe that a fraud has occurred, is occurring, or will occur. Other important factors include: a. Expected strength of evidence. b. Exposure or amount that could have been taken. c. The signal that investigation or non-investigation will send to others in the organization. d. Risks of investigating and not investigating. e. Public exposure or loss of reputation from investigating and not investigating. f. Nature of the possible fraud.

3. A vulnerability chart can be useful when coordinating theories about a suspected fraud. A vulnerability chart coordinates the various elements of the possible fraud, including assets that were taken or are missing, individuals who have opportunities to commit fraud, promising methods to use in the theft investigation, concealment possibilities, conversion possibilities, symptoms observed, pressures on possible perpetrators, potential rationalizations for the fraud, and key internal controls that had to be compromised for the theft to occur.

4. A surveillance log is a detailed record used in an observation. A surveillance log includes the date and time of observation, the name of the observer, the names of corroborating witnesses, the position from which the observation was made, its distance from the scene, and the time the observation began and ended, along with a detailed time log of all the movements and activities of the suspect.

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impossible. Management keeps detailed records before, during, and after the invigilation period. By comparing the activity during the three periods, management can obtain evidence about whether fraud is occurring.

6. Physical evidence, such as paints, stains, fingerprints, and tire marks, can help determine who stole certain assets. For example, by tracing the fingerprints on the safe to a certain employee, we can determine who accessed the safe and if they had authorization to do so.

7. The steps may vary from case to case, depending upon the media being seized.

However, the general pattern is: a. Step 1: After ensuring that you have the legal right to seize, secure the device and perform initial tasks b. Step 2: Clone the device and calculate a CRC checksum c. Step 3: Search the device manually d. Step 4: Search the device using automated procedures 8. If perpetrators suspect they are being investigated for fraud, they could do two things that would affect the outcome of the investigation: destroy or conceal important evidence and completely stop their fraudulent acts so that they cannot be caught in the act.

9. It is important to consult legal counsel to ensure that the suspect’s legal rights will not be violated in the course of the investigation, and that the evidence being obtained will be able to be used in a court of law. It is important to consult with human resources to ensure that company privacy policies are being followed throughout the investigation, and that the investigation will not cause problems with other employees.

10. The Fourth Amendment to the Constitution protects the right of a person against unreasonable searches, and limits the extent to which investigations can be conducted.

11. The fraud triangle plus inquiry approach to investigation includes four things: a. Theft investigative methods b. Concealment investigative methods c. Conversion investigative methods d. Inquiry investigative methods 12.

Potential benefits: a. The CDs are free to download and use. b. The downloaded tools generally include very advanced tools.

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c. The CDs can boot directly into the computer, bypassing Windows passwords. d. Since the tools mount drives in read-only mode, no tracks are left in log files or file timestamps.

Potential drawbacks: a. The tools are based on Linux and can be more difficult to use than more userfriendly, non-open source solutions. b. The tools do not have the precedence in court that EnCase and FTK have. c. The CDs are a combination of many different, stand-alone utilities. EnCase and FTK are all-in-one solutions that do much of the work for you. They are not nearly as user-friendly as non-open source, proprietary solutions.

True/False 1. True 2. True 3. True 4. False. Surveillance is a technique for investigating theft that relies on watching and recording activities of individuals, not studying documents.

5. True 6. False. During invigilation, strict controls are imposed on activities being studied.

7. False. Surveillance logs are recorded during an investigation.

8. False. While legal and valid, undercover operations are extremely expensive.

9. True 10. True 11. False. E-mail, wiretapping, and access to PCs are used in electronic surveillance.

Tailing involves following someone with audio or video recording devices.

12. True 13. False. It should be at least 14 days in length.

14. False. Investigators should focus on the strongest type of evidence in determining which method to use.

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15. False. Under many circumstances, it is completely legal and ethical to seize and search computers.

16. False. Because the data (and even programs) are stored offsite by another company, it is often very difficult to access the data, especially without a search warrant.

17. False. When a file is deleted, the space is only made available for overwriting. The original data remains on the disk until another program uses the freed space to write something new.

18. True Multiple Choice 1. c 2. a 3. c 4. b 5. c 6. b 7. d 8. a 9. c 10. a 11. d 12. b 13. e 14. a 15. c

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16. d 17. b Short Cases Case 1 1. Surveillance and invigilation are two possible investigation methods that could be used. Surveillance could be conducted by setting up a hidden camera above the cash register. The camera would enable the owner to monitor the actions of all employees at the register privately. The owner would want to take into consideration potential privacy issues, however.

Invigilation could be accomplished by providing an excuse to monitor the employee’s actions closely, thus taking away his or her opportunity to commit fraud. The owner would keep close track of the cash flows and coupon redemptions before, during, and after the invigilation period.

Case 2 1. In this case, it may be appropriate to use some form of invigilation. You could begin by identifying possible suspects who have the opportunity to embezzle. Then, after a period of keeping detailed shipping records, you would establish controls that eliminate the possibility of fraud for a period of two to three weeks. After the invigilation period, you would compare shipping records before, during, and after the invigilation. If there are questionable differences, you should consider other investigative methods, such as using the net worth method Case 3 1. Yes, surveillance was the proper method to use in this case. Because this case involves workers’ compensation fraud, it must be shown that he is not disabled. He was lying to the government about his physical condition and making money on the side. To obtain evidence of this type of fraud, surveillance or some other covert method must be used.

2. In conducting surveillance, you must make sure that you do not invade a person’s reasonable expectation of privacy under the Fourth Amendment to the Constitution.

You should probably also consult legal counsel or human resources before surveillance is used.

Case 4 Alternatives ways to investigate and prevent fraud are:

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1. The company could consider a tool checkout program, where tools are assigned to a specific employee, area, or job and marked accordingly. When the tools are discovered missing, the loss could be investigated to see if there is a pattern of loss for certain employees. This may not be an easy plan to carry out because of the size and rotation of employees.

2. Cameras could be installed in places where the company suspects high possibility of theft occurrences. However, the fraud examiners should confirm the use of cameras with legal counsel to ensure that they do not violate applicable laws. The cameras may be hidden or placed in the open, depending on whether the company wants to focus on fraud prevention or fraud detection.

3. The company could implement a strict policy for reprimanding employees who are caught stealing tools and make every employee aware of this policy. Any employees found stealing tools should be rebuked according to the policy, including prosecution and/or being fired. This policy will deter others who might otherwise feel they have the opportunity to steal and would not be punished.

4. The company could embed individuals as undercover employees to watch for other employees stealing tools. Again, careful consultation with legal counsel is necessary to ensure that applicable laws are followed. In addition, if an undercover agent is used, he or she should be a professional, and great care should be taken to ensure that the employees do not know about the undercover employee.

5. Special markings could be placed on tools that would distinguish them from other tools so that they would be hard to sell if found outside of the factory.

6. Electronic markings could be imprinted on the tools. As employees leave the factory with tools, an alarm would sound or some other such device would alert management or security. This approach may not be cost effective, depending on the number of tools being stolen.

There are many other possibilities, each with its own drawbacks and benefits.

Case 5 The purpose of this question is to help students become more familiar with vulnerability charts. Students should prepare a vulnerability chart similar to the one found in the chapter.

Their vulnerability charts will probably vary slightly from each other.

Case 6 1. The order in which Craig conducted his investigation was appropriate because he began from the outside and worked inward toward the prime suspect. He first searched outside sources and narrowed his investigation until finally he confronted the suspect.

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2. It is important to start from the outside and work inward toward a prime suspect because by doing so an investigator can limit the possibility of two things from happening: arousing the suspect’s suspicion and wrongly incriminating innocent people.

Case 7 A vulnerability chart is a chart that helps coordinate the various elements of the possible fraud. It lists missing assets, individuals with theft opportunities, theft investigative methods, concealment possibilities, conversion possibilities, symptoms observed, pressures of possible perpetrators, rationalization of perpetrators, and key internal controls that had to be compromised for the theft to occur. By listing every aspect relating to a specific fraud, examiners can have a more clear understanding of where to begin and how to conduct an investigation.

Case 8 1. The gathering of physical and documentary evidence should be used in this case.

Physical evidence would include fingerprints, etc. Documentary evidence would include the checks.

Case 9 1. Invigilation was effective in the oil theft case. When the employees knew they were being monitored, they shied away from their previous dishonest activity. But when the monitoring was over, these same employees resumed their fraud. By comparing the results of the three time periods (before, during, and after the invigilation period), the investigators were able to see that fraud was occurring.

Case 10 1. The use of a single vendor (with increasing purchases) signals that some kind of kickbacks might be occurring. Collection of documentary evidence is the best method of finding fraud. For example, bid records may show other vendors came in with lower bids, yet the higher-priced vendor was chosen. Alternatively, you might find that the vendor with the increasing purchases was always the low bidder, which may indicate possible collusion with someone inside the company. Record searches focusing on individual purchasers will provide additional evidence.

Case 11 1. A search of the physical records will show whether the increased numbers of customers are purchasing increasing amounts of product. If product purchases are increasing and there is no increase in cash, invigilation (increasing controls) will help

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determine whether cash is truly being taken. Finally (as a last step), surveillance of employees suspected of taking the cash may expose the perpetrator.

Case 12 Students should think critically about the possible side effects of an investigation. Their answers should highlight the methods available to Jim as well as the possible effect on Dan. The following are points to discuss with the class and to expect in answers include: 1. Jim’s concern that he might damage his friendship with Dan, especially if Dan discovers he is investigating him.

2. Jim may not have the legal right to search through all of Dan’s records and office without receiving Dan’s permission or getting a search warrant.

3. Surveillance or covert operations or even public records searches could raise ethical concerns unless there is predication. Jim knows more about his friend’s personal and work life than most employees, but he might not have the right to use his personal knowledge to investigate his friend.

Case 13 1. Students should consider company policies regarding the right to information on work computers. Most businesses have policies that all data on company computers, whether personal or work-related, are company property.

Student should also consider whether to actually seize and clone the computer or to simply investigate the computer as is, after work. Seizure of the computer will be more admissible as evidence, but it would require taking McKnight’s computer for a period of time. A bootable CD would be a less-intrusive way of investigating, but it may not provide sufficient evidence.

2. Depending upon the approach each student takes, he or she should consider EnCase/FTK or bootable CDs. Students might have other software they know about that would provide the correct evidence.

3. With little evidence at this point, it would likely be very difficult to get eBay to disclose any information on a seller. In addition, McKnight may have given eBay bogus information when signing up, so even if you could get a warrant, it may prove fruitless. The involvement of eBay would probably need to happen nearer to the end of the investigation, not at the beginning.

Case 14 You can randomly call on a couple of students to give their slide shows in class, and have all the students turn in printouts of their slides.

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Case Studies Case Study 1 1. Student answers should highlight methods discussed in the chapter, such as physical records searches, public records searches, and Internet searches that can be done without alerting the suspects.

2. A vulnerability chart like the one shown in the chapter is sufficient.

3. Methods discussed should include those that can be done silently or covertly. In order to gain sufficient evidence against the suspects, it is important that the investigation not alter their behavior. This can only be achieved by being discrete throughout the investigation.

4. Physical and documentary evidence collection can be done largely in a covert manner. As an agent of the FBI, you should get subpoenas to look at the records from credit bureaus like Equifax.

Case Study 2 1. The surveillance log does not show the date of the event recorded. It also fails to show the times the surveillance began and was terminated (both at the bank and at the bar).

2. The notes made during surveillance will be used later as evidence against the perpetrator. If these notes are not detailed enough, they will not serve as strong evidence when they are needed.

Case Study 3 This is an actual case that was reported in The Dallas News. Here is the article: Dallas hired tech manager based on phony résumé; now he's charged with theft

By RUDOLPH BUSH (March 16, 2013) Based on his résumé, Antoine Deon Flowers was just the sort of promising young manager the city of Dallas needed to help its information services department recover from a massive hiring scandal. A former Army officer who worked for NASA as a software engineer, Flowers was an education director at a Virginia college. He spoke and wrote Spanish and was working on a master’s degree in math from Southern Methodist University. Today, Flowers, 26, is charged with stealing 12 city-owned iPads, worth nearly $10,000. He was arrested on Feb. 14. According to investigators, he started taking the iPads to pawnshops on Dec. 13 — just three months after he started his $83,000-a-year job with the city. More troubling, a review of Flowers’ résumé by The Dallas Morning News shows that it is largely a work of fiction. It’s clear the city did little to check references on Flowers’ résumé — something called for under the city’s hiring guidelines. On Aug. 30, City Hall extended Flowers an

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offer to become manager of the city’s desktop computer systems, a position that gave him access to critical computer systems, including those used by the Dallas Police Department.

Here are the answers to the specific questions.

1.

Proactively, the city would want to make sure that all the iPads had a passworded finder app that could not be disabled by individuals with access to the iPads.

These apps provide electronic evidence and are often used to track the locality of stolen iPads. You would want to see who had access to the missing iPads, where they were stored, if there were fingerprints on any of the recovered iPads or desks where they were taken from, if there was any pattern to the way they were stolen, etc. You would also want to view video cameras and other devices that might have captured the theft. Once a missing iPad is found, you could then determine who sold the iPads.

2.

Those in the best position to steal the iPads would be the people who had access to them. In this case, it was the manager of the city’s desktop computer systems who had access to all desktop computer devices. In investigations like this, you need to eliminate those who had the greatest opportunity for theft before you look elsewhere for the thieves.

3.

In this case, the iPads were sold to pawnshops. Once you realized how the perpetrator sold or got rid of the iPads, you could then examine the conversion evidence which will be covered in another chapter. Also, once you have a suspicion about who might have taken them, you could start looking at that person’s background file and personal information. Remember that by waiting to interview the primary suspect, you can gather sufficient evidence to conduct a powerful, directed interview without giving your case away prematurely.

Case Study 4 This is an actual case. Here is an article from the NYTimes.com about it.

• G.M. Missing $436 Million, Accuses L.I. Dealer of Fraud •

By THOMAS J. LUECK Published: April 09, 1992 Life in this Suffolk County village hasn't been quite the same since sheriff's deputies began removing 700 new cars from John McNamara's sprawling dealership on Friday and General Motors accused him of fraud in obtaining hundreds of millions in loans from the company. As a car dealer, developer, newspaper publisher, Republican Party insider and philanthropist, there was no one to match Mr. McNamara, the "Mr. Big" of this community and a quintessentially American small-town entrepreneur. For now, all that is clear about Mr. McNamara's problems can be found in papers filed in civil court by the General Motors Acceptance Corporation, which charged him with obtaining loans to finance cars that did not exist, falsifying documents and failing to divulge his business dealings. General Motors said Mr. McNamara owes it $436 million, and it obtained a court order from State Supreme Court in Hauppauge to have his dealership, McNamara Buick-Pontiac, shut down and 700 cars and trucks in his lot, worth $13 million, removed.

Here are the answers to the specific questions:

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1.

Because there were cars that were supposedly being shipped, there should be a significant amount of theft-act type evidence. For example, you could search for the Vehicle Identification Numbers (VIN numbers) on each of the vans and export records for the vans that were assumed to exist. Manufacturing records and physical shipment records for the vans would be additional physical evidence used to investigate the fraud. McNamara also claimed that the vans were being customized at a company called Kay Industries in Indiana, which could also have been confirmed. Because the assets (vans) are large, there would potentially be a lot of physical evidence, if the purchases and shipments were actually taking place.

2.

You can never be certain that these kinds of fraud would not happen again.

However, you can dramatically decrease the probability of a repeat occurrence of this type of fraud by improving the kinds of internal controls in place before loans are made. For example, before loans are made on GM cars, there should be evidence of a VIN number, in addition to identification of a legitimate buyer, and where trucks or boats are involved, some kind of shipping record. There should also be a paper trail for the customization of the vans.

Other controls could include some kind of background check or credit check on the alleged buyers. In this actual case, the internal controls were very substandard. In fact, over the 11 year period of the fraud, loans totaled approximately $6 billion for 17,000 fictitious vans.

Internet Assignments 1. a. The FBI used several different forms of surveillance to gather evidence, including wire tapping, phone recordings, and tailing. b. Yes, the FBI was extremely effective in the surveillance methods used. c. Student answers may vary.

2. (a, b, c and d). Students should provide a one- or two-page write-up on a specific piece of software. This should be useful to you as a teacher because it will keep you updated on new software and the types of functions different applications provide.

Debate a&b The surveillance techniques and covert operations being installed and contemplated can be effective in detecting possible fraud. However, management could be violating Fourth Amendment rights if it is not extremely careful. In addition, the surveillance, when not kept secret, could jeopardize the investigation.

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Another technique that could be employed to detect possible embezzlement would be to use invigilation. This technique can be effective in two ways. First, the perpetrator would not be aware that an investigation is in process. Second, although invigilation can be expensive, with respect to litigation from invasion of privacy issues or possible physical harm to investigators, it is much less risky than a covert operation.

Answers to Stop and Think Boxes 1. Why is it important to conduct activities that do not arouse suspicion first and interview the primary subject near the end of your investigation? What could occur if you fail to do this? a. An investigator who “gives away” his or her case early runs the risk that the suspect or others will destroy evidence, change circumstances, or otherwise cause problems. Secondary interviewees may learn of the case and bottle up or become biased unnecessarily.

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Chapter 8 INVESTIGATING CONCEALMENT Discussion Questions 1. Concealment is generally accomplished by manipulating documentary evidence, such as purchase invoices, sales invoices, credit memos, deposit slips, checks, receiving reports, bills of lading, leases, titles, sales receipts, money orders, cashier's checks, or insurance policies.

2. Primary aspects of documentary evidence include: • • • • •

Chain of custody of documents Marking of evidence Organization of documentary evidence Coordination of evidence Rules concerning original versus copies of documents

3. From the time documentary evidence is received, its chain of custody must be maintained in order for it to be accepted by the courts. Contesting attorneys will make every attempt to introduce the possibility that the document has been altered or tampered with.

4. Programs to help coordinate evidence include CaseMap, CaseCentral, Zantaz, RingTail, and DatiCon. Programs that help in link analysis include the Analyst’s Notebook from i2, Inc. and Xanalys Link Analysis.

5. Documents contain extremely valuable information for conducting fraud investigations. When faced with a choice between an eyewitness and a good document as evidence, most fraud experts would choose the document. Unlike witnesses, documents do not forget, they cannot be cross-examined or confused by attorneys, they cannot commit perjury, and they never tell inconsistent stories.

6. Documentary evidence such as the manipulation of purchase invoices, sales invoices, credit memos, deposit slips, checks, receiving reports, bills of lading, leases, titles, sales receipts, money orders, cashier's checks, or insurance policies provides extremely valuable information when conducting an investigation. It is important to obtain such information because perpetrators, when faced with such information, are much more likely to give a confession. Furthermore, documentary evidence is usually a vital link in proving guilt when a confession is not obtained.

7. Documents contain extremely valuable information for conducting fraud examinations. Documents are some of the best sources of evidence in court, and they provide solid evidence in a case.

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8. Discovery (statistical) sampling allows a fraud examiner to generalize and make inferences from the sample to the population. Many fraud cases involve large databases, and when several examiners are involved in the sampling, the chance for human error increases. However, with computers and technology, examiners can quantify both risk and samples with little or no human error.

9. The three most common ways that investigators can obtain hard-to-get documentary evidence are subpoena, search warrant, and voluntary consent.

True/False 1. True 2. False. Checks are documentary evidence.

3. False. The traditional chain of custody of evidence procedures apply to electronic evidence, along with new procedures like cloning and calculating checksums on the hard drive.

4. False. Original documents are always preferable to photocopies as documentary evidence.

5. False. Graphologists limit their analysis to the study of handwriting, while forensic examiners focus on many more aspects of documents, including date, machine prepared on, etc.

6. True 7. True 8. False. Discovery sampling is one of the easiest of all statistical sampling methods to understand.

9. False. When samples are taken, they are always subject to sampling error, meaning that the sample is not representative of the population.

10. True 11. True 12. False. Random number tables are very effective.

13. True

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14. True 15. True 16. False. The best way to obtain documentary evidence in a computer database is to analyze full populations with queries (data mining).

Multiple Choice 1. a 2. b 3. c 4. d 5. d 6. d 7. a 8. d 9. c 10. b 11. c 12. c 13. a 14. c Short Cases Case 1 The 15 checks selected would have the following numbers: 664, 789, 650, 136, 365, 538, 800, 657, 110, 136, 398, 645, 214, 544, 777.

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Case 2 1. You have found an actual example of fraud. Because fraud is present in the sample, you can conclude that fraud exists in the population from which the sample was taken. Your only question now is how many fraud instances there are in the entire population. At this point, you should terminate sampling and examine the entire population to discover the extent of the fraud.

2. If fraud is not present in the sample, you cannot know for sure whether fraud exists in the population. You would need to examine all checks to be 100 percent sure that fraud does not exist. Based on your sample size, you can state that, at a certain confidence level, the probability of fraud is not more than a certain percent. If you want to be more confident or reduce the probability of fraud, you must take a larger sample.

Case 3 1. Fraud examiners and auditors should never underestimate the value of documents in an investigation, as they can be more valuable to an investigation than eyewitnesses.

If the fraud was suspected or known to have occurred, the auditors should have taken the following steps with respect to the documents: collect, protect, identify, and preserve relevant documents in as good a condition as possible; and make copies of the original documents for use during the investigation so the originals will be available for court.

Case 4 2. Clearly, there appears to be something wrong. First of all, they could only produce photocopies of the invoices, which is not acceptable. The fact that it took them several hours to produce these documents also causes suspicion. Your first step in studying the invoices might be to examine a sample of the invoices given to you. You should stratify the invoices by purchasing agent, then use a random number table or another method of drawing a random sample and select invoices to study. For example, you might start from the top left of the chart, working from left to right and from top to bottom. You could use the last four digits of each five-digit number, skipping the numbers that fall outside of the range. You could verify fifty invoices for each agent. (Obviously, other sampling approaches are also acceptable answers.)

Case Studies Case Study 1 Most fraud examiners prefer documents as evidence instead of witnesses because unlike witnesses, documents do not forget, they cannot be cross-examined or confused by attorneys,

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they cannot commit perjury, and they never tell inconsistent stories. Of course, where possible, documents should be used in conjunction with witnesses.

Once a document is in the custody of John Doe (through a subpoena or other method), he needs to document and maintain its chain of custody. This means that he must keep a record of when he receives a document and what has happened to the document since it came into his possession. Opposing attorneys will attempt to discredit the document’s credibility and authenticity by asking questions about the document’s history.

When John Doe receives a document, he should uniquely mark it so that it can be identified later. He should then put the document in a transparent envelope marked with the date received. A copy of the document should be made for investigative purposes to preserve the original document for trial. It is necessary to protect the original document because photocopies are only admissible in court: • • • •

When the original document has been lost or destroyed without the intent or fault of the party seeking to introduce the secondary evidence.

When the original document is in the possession of an adverse party who fails to produce it after a written notice to do so, or when the party in possession is outside the jurisdiction of the subpoena power of the court.

When the document or record is in the custody of a public office.

When the original documents are too voluminous to permit careful examination, and a summary of their contents is acceptable.

John Doe also needs a consistent organizational scheme for his documents, whether it is by witness, date, or transaction. Such an organized scheme is necessary to accommodate the large amount of documents that can accumulate throughout an investigation process.

Case Study 2 Note that while this case calls for full-population analysis using ACL, Picalo, IDEA, ActiveData, or another software package, it could be easily modified to use discovery sampling as well.

1. The following records use a form of post office box in their address (note the different notation in the addresses): • • • • •

253093: Post Office Box 5122 338127: P.O. Box 25332 530853: PO Box 19877 657378: PO Box 51222 730751: P.O. Box 31

2. There are at least two ways to solve this problem. If your students are using a package that supports stratification via text fields, first stratify the claims file by dentist_id and then check for sequential numbering. If your software does not support advanced

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operations (such as sequential checking) on stratified/classified groups (ACL is in this group), your students can simply sort the file first by dentist id and then by claim id.

Being sorted in this way, the records for each dentist group together. Now check for sequential numbering to locate the problem records. Dentist with id 748218 is sending sequential claim numbers that start at 1000 and continue through about 20 claims sent.

3. Dentist with id 476227 has worked on patient 20372, for a total of 58 times during the three-month period; all of these claims are for cavity fillings.

4. Dentist with id 438439 has a total of five claims for patients that live outside of Maine.

Internet Assignment In the Resources menu, choose Fraud Mall, and then High-Tech Tools. Many different kinds of services and products are offered. The listed packages change often, but the listing should provide a set of examples for the type of software available.

Debates Pro: The obtaining of a search warrant allows the FBI to search the suspect’s residence without violating Fourth Amendment rights. Searching files on a computer is also permissible, according to common law. Thus, it seems that the FBI was fully “warranted” in its search and seizure of incriminating evidence.

Con: Possible Fourth Amendment violations could have occurred because of the use of the Key Logger System (KLS). Had KLS been used solely for the purpose of seizing incriminating evidence, the FBI would be justified. However, KLS also monitored activities of the suspect in normal activities, such as the visitation of non-incriminating Web sites on the Internet. It is possible that the FBI overstepped its rights and infringed Mr. Dayley’s Fourth Amendment rights.

Answers to Stop and Think Boxes 1. Does concealment investigation change when electronic transactions are involved? a. The basic process of concealment investigation does not change when electronic evidence is used. However, some additional steps, such as checksums on documents, may need to be taken.

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2. What types of cases should use link analysis software? Is the cost justified in these cases? a. Generally, very large cases employ link analysis software. When tens or even hundreds of investigators are involved, combining of evidence becomes an issue. In these cases, link analysis software is considered extremely useful.

3. What are the best methods of obtaining documentary evidence? Why? a. The best method of obtaining documentary evidence is the data-driven approach, as discussed in Chapter 6. It allows full-population analysis of large populations of records.

4. When is it appropriate to hire a document expert? When is it not required? a. A document expert is required when the authenticity of a document is in question. An expert can make judgments on whether documents are genuine, counterfeit, fraudulent, or forged.

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Chapter 9 CONVERSION INVESTIGATION METHODS Discussion Questions 1. Most investigations of conversion involve searching public records and other sources to trace purchases of assets, payments of liabilities, and changes in lifestyle and net worth.

2. When people enter into financial transactions, such as buying assets, they leave tracks or “financial footprints.” Trained investigators who know how to follow, study, and interpret these tracks often find valuable evidence that supports allegations of fraud.

3. Understanding how perpetrators convert and spend their stolen funds is important for two reasons: first, to determine the extent of the embezzlement, and second, to gather evidence that can be used in admission-seeking interviews to obtain a confession.

4. Public sources include many federal, state, and local agencies that maintain public records in accordance with various laws. These records include such databases as driver’s license records, marriage records, property tax records, etc. Private sources are comprised of non-governmental records and include gas, electric, water, and other utility records, bank and brokerage records, and other financial institution records.

Private sources include all sources other than federal, state, and local agencies.

5. State, federal, and local public records contain valuable information that is extremely helpful in fraud investigations. Local courts maintain records on past law violators, employment history, personal and physical information, and prior charges. Federal sources, such as FBI records, contain large databases that can be accessed by local law enforcement agencies. State records, such as those of the Secretary of State, contain valuable information, such as UCC filings.

6. The Internet includes many databases, public and private, that can be accessed. By accessing information such as how individuals have spent their money (e.g. purchased boats, real estate, automobiles, etc.), investigators can determine the approximate amounts an individual has spent and the amount of assets he or she has.

This information is helpful both to determine a person’s net worth and also to compare the spending with known sources of income to make a net worth calculation of a possible perpetrator.

7. Net worth calculations are valuable because only assets and reductions in liabilities that can be discovered enter into the calculation. Net worth calculations tend to give a conservative estimate of stolen funds. Because these calculations are conservative, the stolen amounts are usually readily accepted as evidence by courts. Additionally, they often facilitate investigations in the obtaining of confessions from suspects.

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8. Some of the more advanced techniques available when searching for information on Google include searching by phrase, minus search terms, domain restrictions, Google Groups, cached results, and Google News.

9. Because the Internet contains so much information, it is often difficult to conduct effective searches. The advanced techniques help researchers conduct effective searches by allowing them to search entire phrases, to narrow searches and avoid words not associated with the search, and to get cached results as well as search news events.

10. There are four types of information sources available to investigators searching public records. They are government sources, private records, online databases, and Internet searches.

11. The Gramm-Leach-Bliley Act, passed in 1999, prohibits the use of false pretenses to access the personal information of others. It also allows financial institutions to sell customer information unless customers have opted out. This act is both restrictive and helpful to investigations. While preventing false pretenses, it allows the investigator to get information from financial institutions in more accepted ways. This is especially useful since most customers do not opt out.

12. Trash investigation is the discovery of information by looking through a person’s trash. This can be useful since many perpetrators do not shred documents. In addition, software can put shredded documents back together, and many documents are still kept electronically on the computers where they were created.

True/False 1. False. Perpetrators rarely save what they steal; rather, they usually spend their illgotten gains.

2. False. One of the most useful investigation techniques is determining how perpetrators spend their money, not their time.

3. False. Investigations of net worth and lifestyles are usually performed for two reasons: to determine the extent of the embezzlement and spending, and to gather evidence that can be used during admission-seeking interviews to obtain a confession.

4. False. While some federal databases are available only to federal agents, there are databases that the public can access—some online and some by going to the offices of federal agencies.

5. True

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6. False. Counties and other local agencies contain records that are among the most useful in fraud investigations, including property records and records containing personal information.

7. True 8. True 9. False. In recent years, the net worth method has gained prominence among fraud investigators as very useful.

10. True 11. True 12. False. The Gramm-Leach-Bliley Act made it easier for officials and private citizens to access information from financial institutions. While individuals can now “opt out” from having their records sold by financial institutions, the act also made it legal for financial institutions and others that have notified their customers of the “opt out” provision to sell customer databases.

13. True 14. False: State and local agencies usually provide more valuable records than federal agencies do. It really depends on what type of information you are seeking.

15. True 16. True. Unless customers “opt out,” even confidential customer information can be sold.

17. False: The net worth method is very useful in determining the extent of stolen funds.

18. True Multiple Choice 1. c 2. b 3. d 4. d

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5. a 6. b 7. d 8. c 9. d 10. e 11. e 12. d 13. e 14. c 15. a 16. d 17. c 18. c 19. c 20. a

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Short Cases Case 1 Comparative Net Worth-Asset Answer Year 1

Year 2

Year 3

Assets Residence “Baseball cards” Automobiles “Paintings” Cash Total Assets

$100,000 15,000 0 50,000 6,000 $171,000

$100,000 15,000 30,000 150,000 12,000 $307,000

$100,000 25,000 50,000 250,000 14,000 $439,000

Liabilities Mortgage Balance Auto Loan Total Liabilities

$ $100,000 (0) $100,000

$50,000 $30,000 $ 80,000

$0 0 $0

$71,000 $156,000

$227,000 $212,000 30,800 $186,800 40,000 $146,800

$439,000

Net Worth Change in Net Worth Plus Total Expenses Total Income Less Known Income Equals Unknown Income

30,800 $242,800 42,000 $200,800

Based on this information, it appears that there is a likelihood of illegal income. The amount of unknown income, as shown above, is $146,800 in Year 2 and $200,800 in Year 3.

Case 2 1. There are many possible reasons why the employee has exhibited behavioral changes.

There are also many possible reasons why the employee has experienced an increase in unknown income. One reason for the unknown income is that a family member, such as a parent or sibling, could have passed away and given the money to the employee, but there is always the possibility that the employee is committing fraud.

With net worth information, it is impossible to know the reasons for the emotional change and the increase in unknown income. Before jumping to conclusions, the investigator should conduct additional investigations such as preparing a vulnerability chart to help correlate all aspects of the “suspected” fraud, and should search public records such as obituaries or wills to see if a close relative recently died.

2. It is impossible to conclude from these facts that the suspect has been committing fraud. Conversion evidence is circumstantial. Since it is necessary to prove intent to convict someone of fraud, circumstantial evidence is helpful in obtaining confessions

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and other evidence, but it is not sufficient. To prove fraud, you usually need a confession, an obviously fraudulent document, or a series of repeated similar fraudulent actions from which intent can be inferred.

Case 3 1. It is very difficult to draw any conclusions from this analysis. Coworkers of the controller have not noticed significant behavioral or lifestyle changes except for a few “extravagant” vacations. The net worth analysis resulted in a very low estimate of unknown income. However, if the controller embezzled funds to support vacations, those expenses would not be factored into the net worth calculations.

2. Because of the lack of definitive information, an investigator would probably not feel comfortable interviewing the controller at this point. The controller should have no problem explaining the low amounts of unknown income shown in the net worth calculation. Interviewing the suspect at this point may result in unnecessary embarrassment to all parties involved, and possibly even in a “slander” lawsuit against the company.

3. An investigator could determine the location, frequency, and duration of the vacations. With this information, a travel agent could give an estimate of how much money these vacations cost. Additional interviews may provide information as to the travel agency used by the controller or other spending information or patterns. Once additional information is known, another net worth analysis could be performed.

Case 4 All wills become public information upon the death of the testator through a legal process called probate. Therefore, a visit to the county courthouse would provide access to a copy of Uncle Eddie’s will, containing information about beneficiaries and the amount of bequests.

The most difficult challenge may be finding out Uncle Eddie’s full name and the state and county in which he lived. This information could be discovered by interviewing Bill’s known relatives or by searching genealogical databases. You might conduct a death notice or obituary search in a periodicals database, such as LexisNexis, National Automated Accounting Research System (NAARS), etc. The company’s personnel records may also contain information that reveals the names of Bill’s parents. If Eddie were a maternal uncle, Bill’s parents’ marriage license at the county clerk’s office would reveal his mother’s maiden name, which is probably also Eddie’s last name. Finally, Bill claims that all of Eddie’s nephews received a portion of the inheritance. You may find out if Bill’s brothers’ lifestyles have changed as dramatically as his.

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Case 5 1. Unusual behaviors and lifestyle symptoms in this case are decreased sales activity generated by the employee, quick payoff of multiple loans by the employee despite lower sales results, and his poor treatment of customers. The poor treatment of customers may be caused by stress created from trying to cover up fraudulent behavior. The changed behavior could also be caused by difficult personal crises unrelated to the job.

2. This employee could be receiving kickbacks from automobile repair shops. He could also be creating fictitious sales records to increase his personal commissions or just stealing parts or other supplies from the dealership.

Case 6 You should look for changes in spending patterns, changes in banking relationships or patterns, and changes in lifestyle. You should also look for changes in Janet’s attitude.

Finally, you should compute Janet’s net worth and try to determine if there is income from unknown sources.

The Internet and public databases provide many valuable resources for looking up credit histories and even banking activities. You could also request or subpoena Janet’s financial information from her bank or other sources. Using the net worth method will help you discover if Janet is living beyond her means.

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Case 7 Year 1

Year 2

Year 3

Year 4

Year 5

1. Assets Residence Automobile Stocks and Bonds Cash Total Assets

$200,000 50,000 75,000 15,000 $340,000

$200,000 50,000 75,000 16,500 $341,500

$275,000 75,000 100,000 18,150 $468,150

$275,000 75,000 100,000 19,965 $469,965

$275,000 90,000 125,000 21,962 511,962

Liabilities Mortgage Balance Auto Loan Balance Total Liabilities

$175,000 40,000 $215,000

$50,000 20,000 $70,000

$125,000 35,000 $160,000

$107,000 25,000 $132,000

$40,000 10,000 $50,000

Net Worth

$125,000

$271,500

$308,150

$337,965

$461,962

$146,500 49,000 $195,500 (110,000)

$36,650 $29,815 61,000 64,300 $97,650 $94,115 (117,000) (135,000)

$123,997 70,930 $194,927 (143,750)

$85,500

$(19,350) $(40,885)

$51,177

$100,000 10,000 $110,000

$107,000 10,000 $117,000

$125,000 10,000 $135,000

$133,750 10,000 $143,750

$12,000 7,000

$18,000 10,000

$18,000 10,000

$18,000 13,000

30,000 $49,000

33,000 $61,000

36,300 $64,300

39,930 $70,930

Change in Net Worth Plus Total Expenses Total Less Known Income Income from Unknown Sources Income Salary Other Total Income Expenses Mortgage Payments Auto Loan Payments Other Living Expenses Total Expenses

This person could be committing some type of fraud. Income from unknown sources in Year 2 is quite high. Even though years 3 and 4 almost reverse the effects of Year 2, it is not enough. Further, Year 5 shows income from unknown sources again. We might conclude from this that in Year 2, the person committed a large fraud and then decided to wait it out and see what happened. Or he spent his stolen money in years 3 and 4 in assets you could not trace or identify. It is likely that he decided in Year 5 to try his fraud again.

2. Several additional factors are important to consider. First, you should notice some strange trends in this person’s asset and liability accounts that might be worth

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additional investigation. Second, you can see that data from several consecutive years provide a better idea of what might really be occurring.

3. Is this scenario realistic? Perhaps not. Most evidence shows that fraudsters continue to commit their frauds, usually without interruption, and that over time their frauds increase in amount and frequency. It may not be realistic to see a data pattern like this where fraud was possibly committed one year and then not again for several years.

Case 8 1. Red flags appear to exist in the financial data. This person has purchased automobiles, boats, and stocks. The person has also decreased mortgage, auto, and other loans.

2.

Net Worth Increase Expenses Total Income Known Income Unknown Income

Year 1 $102,500

Year 2 $150,000 47,500 47,000 $94,500 90,800 $3,700

Year 3 $272,000 122,000 47,000 $169,000 130,800 $38,200

A possible fraud exists in years 2 and 3. However, one must be careful not to reach immediate conclusions. It is possible that the person has received unknown inheritances that have not been reported to any agencies, has had gambling or other earnings, or has received income from other sources.

Case 9 There are several approaches you could use to investigate possible fraud in Big Time Inc. First, you could check invoices of companies from which there have been increased purchases. Then, you could check publicly available databases to ascertain the legitimacy of all companies that Big Time purchases from, concentrating on the ones with suspicious invoices or increased sales during the past few years. This search could be conducted using Dun & Bradstreet or Dialog. This search would help determine if any of the “suppliers” are fictitious. If you discover fictitious companies, you should check the financial records of Mr. Bezzle, who has sole responsibility for all purchasing decisions. This could be done by contacting banks or other financial institutions or by obtaining a subpoena.

Finally, interviews of unsuccessful vendors, other employers, and even Mr. Bezzle would provide information about Mr. Bezzle’s sources of income, lifestyle, and other relevant factors.

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Case 10 1.

Assets Liabilities Net Worth Prior Year’s Net Worth Net Worth Increase Living Expenses Income Known Income Unknown Income

$120,000 (70,000) $ 50,000 (10,000) $ 40,000 50,000 $90,000 (60,000) $ 30,000

2. An effective interviewer would first ask Tom to list all sources and amounts of income he has without Tom knowing the reasons for the questions. After determining all of Tom’s sources of income and assessing whether it matches the $60,000 of known income, the investigator could reveal to Tom (a little at a time) information about the $30,000 of unknown income. When faced with this unexplainable fact, Tom may confess.

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Case 11 Year 1

Year 2

Year 3

$100,000 20,000 30,000 25,000 $175,000

$100,000 40,000 30,000 30,000 25,000 $225,000

$100,000 90,000 30,000 30,000 50,000 $300,000

Liabilities Mortgage Balance Auto Loan Total Liabilities

$ 90,000 10,000 $100,000

$ 40,000 5,000 $ 45,000

Income Salary Other Total Income

$ 37,000 4,000 $ 41,000

$ 40,000 4,000 $ 44,000

$ 42,000 4,000 $ 46,000

$

6,000 2,000 15,000 $ 23,000

$

6,000 2,500 15,000 $ 23,500

$

$ 75,000

$180,000

$300,000

$105,000 23,500 $128,500 44,000 $ 84,500

$120,000 28,500 $148,500 46,000 $102,500

Assets Personal Residence Automobiles Stocks and Bonds Boat CDs Total Assets

Expenses Mortgage Payments Auto Loan Payments Other Living Expenses Total Expenses Net Worth Change in Net Worth Plus Total Expenses Total Less Known Income Income from Unknown Sources

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6,000 2,500 20,000 $ 28,500

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Case 12 Comparative Net Worth—Asset Method Year 1

Year 2

Year 3

$150,000

$150,000

10,000 18,000 8,000 3,500 $189,500

20,000 35,000 22,000 27,000 7,500 $261,500

$150,000 85,000 35,000 35,000 22,000 50,000 18,000 $395,000

$84,000

$42,000

12,000 $ 96,000

38,000 22,000 $ 102,000

5,0000 $105,000

$ 93,500

$159,500 $ 66,000 46,500 $112,500 54,000

$290,000 $130,500 68,000 $198,500 62,000

$58,500

$136,500

Assets: Residence Residence #2 Stocks and Bonds Automobiles Boat CD Cash Total Assets Liabilities Mortgage Balance #1 Mortgage Balance #2 Auto Loans Boat Loan Total Liabilities Net Worth Change in Net Worth Plus Total Expenses Total Less Known Income Equals Income from Unknown Sources

$15,000 $85,000

It appears that there is a likelihood of fraudulent income. The amounts are $58,500 and $136,500, as calculated above.

Case 13 1. You would probably gather information about the manager’s change in net worth, living expenses, and income so you could make a net-worth calculation. You would search public records, bank records (if you could get them), credit bureau records, real estate and UCC records, and any other records that provide evidence of expenditures.

2. The records that allow you to make a net worth calculation would be most useful— any record that provides evidence of expenditures.

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CASE STUDIES Case Study 1 1. The two most apparent fraud symptoms are the fact that Mark has dramatically increased his standard of living over the last four months, and new customers complaining that their balances are off by $20, $30, and even $50.

2. It is not possible to know from the information given that Mark is committing fraud.

All we know is that Mark has increased his standard of living and that new customers are complaining that their accounts are off. No matter what the situation is, the fact that new customers’ accounts are off definitely signals a red flag that needs investigation.

3. A reasonable action the supervisor could take if he or she suspected that Mark is committing fraud would be to investigate further Mark’s actions while he has been working as a teller. The following are possible actions the supervisor could take to investigate further: • • • •

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Determine if the customers who are complaining that their balances are off have had interactions with Mark.

Perform a net worth calculation to determine the extent of unknown income.

Audit Mark’s account balances over the last four months.

If possible, do a background check to determine if Mark’s grandmother has indeed passed away.

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Financial Data for Mark Assets:

Month 1

Month 2

Month 3

$3,000 600 2,000 2,500

$45,000 $6,000 800 2,000 2,500

$9,100

$56,300

$45,000 $7,000 500 2,0000 2,500 $1,000 $58,000

45,000 $45,000

45,000 $45,000

$11,300

$13,000

Change in Net Worth Plus Total Expenses Total

2,200 2,130 $4,330

1,700 2,230 $3,930

Less Known Income Income from Unknown Source

1,300 $3,030

1,300 $2,630

$1,000 300 $1,300

$1,000 300 $1,300

$1,000 300 $1,300

$700 130

$700 130 600 700 $2,130

$700 130 600 800 $2,230

1992 Geo Prism 2004 Jeep Grand Cherokee Savings Account Checking Account CD Laptop Television Total Assets

$1,000

Liabilities: Auto Loan Total Liabilities Net Worth

$9,100

Income: Salary Other Total Income Expenses: Rent Payments Small Expenditures Auto Loan Payments Other Living Expenses Total Expenses

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400 $1,230

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Case Study 2

Assets Residence Stocks and Bonds Automobiles Cash Total Assets Liabilities Mortgage Balance Auto Loan Student Loans Total Liabilities Net Worth Change in Net Worth Plus Total Expenses Total Less Known Income Equals Income from Unknown Sources

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End Year 1

End Year 2

End Year 3

$50,000 10,000 15,000 5,000 $80,000

$50,000 10,000 15,000 8,000 $83,000

$200,000 10,000 40,000 20,000 $270,000

$40,000 8,000 10,000 $58,000 $22,000

$30,000 5,000 8,000 $43,000 $40,000 $18,000 26,000 $44,000 36,000 $ 8,000

$0 0 0 $0 $270,000 $230,000 23,000 $253,000 41,000 $212,000

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Case Study 3 Assets: Residence Cars Home Shopping Network (furniture) Total Assets Liabilities: Mortgage Balance Car Auto Loan Credit Card Balance Total Liabilities

Year 1 $250,000 90,000 12,000 $352,000 $232,000 78,000 6,000 $316,000

Net Worth

$ 36,000

Expenses: Credit Card Food Cruise Miscellaneous Ring

$ 1,200 9,600 3,500 18,000 3,000 Total Expenses

Total Income Restaurant Salary (Known income) Unknown Income

1500 * 12 (interest free loan) 1000 * 12 500 * 12

$ 35,300 $ 71,300 15,000 $ 56,300

Note: Car and house payments are not included as expenses because the purchase of the house and cards are included above as assets.

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Case Study 4

Assets: Personal Residence Automobiles Houseboat ATVs Total Assets Liabilities: Mortgage Balance Auto Loan Loan on Houseboat Total Liabilities Net Worth Change in Net Worth Plus Total Expenses Total Less Known Income Income from Unknown Sources

Year Before Last

Last Year

This Year

$70,000 15,000

$70,000 45,000 30,000 12,000 $157,000

$200,000 45,000 30,000 12,000 $287,000

$30,500

$100,000

15,000 $45,500

11,000 $111,000

$111,500 64,000 25,700 89,700 61,500 $28,200

$176,000 64,500 30,400 94,900 63,000 $31,900

$85,000 $35,000 2,500 $37,500 $47,500

Internet Assignments 1. a. The U.S. Postal Inspection Service is the law enforcement branch of the U.S. Postal Service, empowered by federal laws and regulations to investigate and enforce over 200 federal statutes related to crimes against the U.S. mail, the Postal Service, and its employees. b. Postal inspectors investigate any crime in which the U.S. mail is used to further a scheme, whether it originated in the mail, by telephone, or on the Internet. c. You can protect yourself against the phony “one-shot” credit card offers by being very careful when you are considering opening a new credit card account. If you have poor credit, be skeptical if you are offered a preapproved card with no credit check. Be sure you know the specific purpose of the card. If you are not satisfied with the information provided by those marketing the cards, do not pay the required fee. You may also wish to check with your local Better Business Bureau, state Attorney General’s office, or Postal Inspection Service office to determine if the company offering the credit card is under investigation.

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d. Characteristics of telemarketing fraud could include the following: • • • • • • • • • •

The offer sounds too good to be true.

High-pressure sales tactics are used.

Insistence on an immediate decision to invest.

You are one of just a few people eligible for the offer.

Your credit card number is requested for verification.

You are urged to provide money quickly.

There is no risk with this investment.

You are given no detailed written information.

You are asked to trust the telemarketer.

You are told you won a prize, but you must pay for something before you can receive it.

2. Some Internet fraud schemes include: a. Auction and Retail Schemes b. Business Opportunity Schemes c. Identity Theft d. Investment Schemes 3. a. Answer: Investigative Professionals, the company that has the Web site “HowToInvestigate.Com,” provides several different types of background checks including basic background checks, extensive background checks, due diligence background checks, criminal records check, employment background checks, tenant background checks, assets searches, business background checks, people finder super searches, and people identifier reports. b. A basic background check provides the following information: i. Personal Information and Identity Verification 1. Identity Verification. Important database searches prove or disprove identity; discover or confirm “identifiers” like DOB, SSN, and addresses 2. Also Know As (aka’s). Discover other names associated with subject 3. Social Security Number (SSN) Search and Verification. Has your subject used other SSN’s in the past? This could be a cause for concern 4. Date and Place that the SSN was Issued Others Associated with Subject’s SSN. Current and Previous Addresses. Database returns important dates of occupancy

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5. Names of Persons at Each Address Subject has Resided. May include spouses, family members, roommates, domestic partners, and common-law spouses 6. Property Owners of Subject’s Residence 7. Neighbors 8. National Death Index ii. Financial Information 1. Nationwide Property Ownership Records 2. Motor Vehicles Registration. Most states. Some restrictions apply 3. Boats and Aircraft Ownership 4. Bankruptcies, Tax Liens, and Judgments iii. Professional Information 1. Occupational License Verification 2. Partnership Affiliations 3. DBA (Doing Business As) iv. Criminal Records 1. Sexual Offender Search: State's lists of sexual offenders 2. Nationwide Criminal Record Search: National Felons Database 3. DUI Check c. The three giant commerical credit bureaus are: •

Equifax: 1-800-685-1111 (general) or 1-800-525-6285 (fraud); PO Box 740241, Atlanta, GA 30374; www.equifax.com

•

Experian: 1-888-397-3742 (general and fraud); PO Box 2002, Allen, TX 75013, www.experian.com

•

TransUnion: 1-800-888-4213 (general) or 1-800-680-7289 (fraud); PO Box 2000, Chester, PA 19022; www.transunion.com

4. a. A complete business background investigation includes: • • • • • •

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Business name Business address Telephone numbers Names of business owners List of products or services Labor, union, or personnel disputes

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• • • • • •

Ratings by Baron’s and Standard & Poor’s Names of key officers, managers, and employees Names of suppliers, buyers, and competitors Profit and loss statement Property owned Litigation

b. To check out a contractor who will be doing work on your house, you can call the county or state department of business regulation to see if the person is licensed to do business in your county or state. You may also want to call the Better Business Bureau or the local Chamber of Commerce to see if there have been complaints against this contractor.

Debates 1. Appears to be committing fraud. The evidence is circumstantial that this person is involved in fraud. He may be jealous because he sees the money the owners are enjoying and wants his piece of the pie. He is likely irritable because he is nervous and doesn’t want to get caught. The early and late hours the employee works also appear to be very strange, and his purchase of the new Porsche makes him a possible suspect of fraudulent behavior.

Not committing fraud. There is insufficient evidence, and the symptoms that are available are circumstantial at best. Fraud could be a possibility; but, due to the circumstantial nature of the evidence in the case, no conclusions can be drawn. To determine if fraud is being committed, you will have to investigate further.

2. Pro: The use of mail is common in the perpetration of many types of fraud, including employee fraud, investment scams, and management frauds. Because of the high use of mail, the most important ally in investigating frauds is the local postal inspector. Armed with a strong understanding of mail fraud statutes, a good relationship with the local postal inspector goes a long way in discovering evidence to support fraud allegations. In addition, if law enforcement is involved, subpoenas and search warrants can be issued and access to government databases, such as National Crime Information Center (NCIC), can be obtained.

Con: There is no need to involve local law enforcement because they are too bureaucratic and too slow. There are plenty of sources available without law enforcement’s help, including records of the Department of Motor Vehicles, the Department of Business Regulation, the County Clerk, the County Land Office and Tax Assessor’s Office, and the Uniform Commercial Code (UCC) filings at the Secretary of State’s office. In addition, without law enforcement, you can access private credit records, utility records, and numerous publicly available databases.

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Answers to Stop and Think Questions 1. Why are state and local sources of information generally more useful than federal sources of information? a. Federal sources of information are generally less specific than state and local sources. b. The inherent nature of the information generally kept by state and local governments (leins, real property, business registrations, local court records, etc.) is generally more useful. c.

2. The Gramm-Leach-Bliley Act protects against the use of false pretenses. In what ways did this act have positive investigative consequences? a. The Gramm-Leach-Bliley Act allows the investigator to get information from financial institutions in legal, straightforward ways because institutions are able to share information under the act unless customers have specifically opted out. This is especially useful since most customers do not opt out.

3. This book lists only a few of the many resources available online. What other sources do you know about or can you find through searching? a. Every time we teach this course, students come up with new and exciting sources of information online. You may want to have a few students present their findings to the class.

4. What is the best time during an investigation to calculate the net worth method on your subject? a. The best time to calculate the net worth method is when you have sufficient information on earnings and expenditures. While an investigator generally won’t use the information until the final suspect interview, it is useful to have the information as early as possible. As more information becomes available, the calculation can be updated to become more reflective of reality as the case progresses.

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Chapter 10 INQUIRY METHODS AND FRAUD REPORTS Discussion Questions 1. An interview is a question-and-answer session designed to elicit information. It differs from an ordinary conversation in that the interview is structured, not free form, and is designed for a specific purpose. It is the systematic questioning of persons who have knowledge of events, people, and evidence involved in a case under investigation.

2. Fraud, like death or serious injury, is a crisis. People who are involved in a crisis generally experience a predictable sequence of reactions to the crisis. Interviewers who understand these reactions are much more effective than interviewers who do not. The predictable sequence of reactions is as follows: • • • • •

Denial Anger Rationalization or bargaining Depression Acceptance

3. The five general types of questions an interviewer can ask are introductory, informational, assessment, closing, and admission-seeking.

4. Whenever two or more human beings are conversing, several types of communication can occur, including expression, persuasion, therapy, ritual, and information exchange.

5. An inhibitor of communication is any sociopsychological barrier that impedes the flow of relevant information by making the respondent unable or unwilling to provide information to the interviewer. The text identifies several inhibitors of communication including competing demands for time, threatened egos, repression, disapproval, and loss of status.

6. Facilitators of communication are those sociopsychological forces that make conversations, including interviews, easier to accomplish. Facilitators of communication include fulfilling expectations, recognition, catharsis, and need for meaning.

7. Informational questions are nonconfrontational and nonthreatening, and are asked for information-gathering purposes.

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8. As a general rule, questioning sequence should proceed from the general to the specific; that is, it is best to seek general information before seeking details.

9. A volatile interview is one that has the potential to bring about strong emotional reactions in the respondent. Typical volatile interviews involve close friends and relatives of a suspect, coconspirators, and similar individuals.

10. Assessment questions seek to establish the credibility of the respondent. They are used only when the interviewer considers previous statements by the respondent to be inconsistent because of possible deception.

11. Norming or calibrating is the process of observing behavior before critical questions are asked as opposed to doing so during questioning. Norming should be a routine part of all interviews. People with truthful attitudes will answer questions one way; those with deceitful attitudes will generally answer them differently. When using norming or calibration techniques, interviewees are asked about something they are comfortable with and then something about the fraud. This process is repeated several times in order to “calibrate” the interviewees’ verbal and nonverbal cues.

12. The three types of honesty testing include pencil-and-paper tests, graphology, and voice stress analysis and polygraphs.

True/False 1. False. Many honesty tests are not used to determine whether someone has committed a crime but rather what their level of honesty is.

2. False. Failure to pass a polygraph test does not mean certain guilt. Polygraphs are deemed to be quite accurate when people pass them but less so when people fail.

3. True 4. True 5. True 6. False. Unless evidence can be obtained, no interview should take place.

7. True 8. True 9. False. The fraud report should not include disciplinary recommendations. It should state facts only.

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10. False. This statement is true with friendly and neutral witnesses, but it is not true if the person being interviewed is an adverse witness or a suspect.

11. False. Fraud reports should list all findings. The goal is to state what happened, regardless of the outcome.

12. True Multiple Choice 1. c 2. d 3. b 4. a 5. c 6. d 7. b 8. e 9. d 10. c 11. b 12. a 13. a 14. d 15. c 16. b 17. a

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Short Cases Case 1 1. Denial 2. Anger 3. Rationalization 4. Depression 5. Acceptance

Judd Disbelief; lets it go Confrontation Jim slipped up Feels sad Friends with Jim

Jim Dumbfounded; denial “What right …”

Just doing his job “The gig is up” Admits guilt

Case 2 Because you may already have enough evidence to support your claims against Damon, the first thing you should do is contact the police and present to them the results of your investigation and audits. You might prearrange a meeting with Damon and record the discussion. You may want to have police officers watch the discussion live. If you decide not to have police involvement, Damon could deny the conversation or say that you fabricated it.

It is important to plan the interview carefully.

1. Introductory Questions: Because you already know Damon through your father-inlaw’s work, Damon should not be alerted by your request for a private talk. Once the discussion has started, you could make small talk initially but should keep it brief.

2. Informational Questions: You could openly bring up the topic of how cheap your father-in-law is and how you wish he would pay more. After a comment like, “I bet it wouldn’t be hard to find a little extra money laying around the office,” you could ask Damon if he can think of any ideas of how to defraud the company. You could ask other questions to gather more information, but if Damon is not willing to open up you could question him directly about the fraud.

3. Closing Questions: To verify the facts he had told you, it is important to ask closing questions. If you want to close the conversation, you could ask, “Do you know anyone else I could talk to? Is there anything else I have forgotten to ask you that would be relevant? If I need to talk to you again, would it be okay?”

4. Assessment Questions: If Damon just does not seem to be opening up to any of your questions, you could specifically bring up some of the things that Damon has done.

You could say that you happened to see him commit fraud and you were just wondering how he happened to pull it off without getting caught. While asking about the frauds, you should bring up each one specifically and watch to try to determine if Damon is telling the truth.

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5. Admission: Seeking Questions: If Damon opens up and feels comfortable with you, you can ask him if he has ever done the things he described or talked about previously. You will likely need to admit to Damon that you have been tracking his frauds and that he has taken a substantial amount of money. You might tell him that you wanted to talk to him directly rather than talking to your father-in-law because you are hopeful that you will find an acceptable way to fix things. You should ask direct questions, encouraging Damon to confess.

Before the interview, you should have prepared a written confession for Damon to sign and it should be accessible in case he admits to what he has done. You might have purposely misprinted the amount taken to read $70,000 so that Damon will notice the difference, change it to $50,000, and initial it. You should be aware, however, that most perpetrators don’t keep track of how much they steal and they always believe it is less than they really took. Putting too large a number for the theft could scare him into not signing.

Case 3 1. Admission-seeking interviews should not normally be conducted until all other investigative procedures have been completed or until there is evidence that can be obtained only from the suspect. The following are some of the steps recommended to be complete before interviewing the suspect: • • • • • • • •

Check personnel records Check company purchasing records Interview former employers Interview unsuccessful vendors Search public records, invigilation, or surveillance Interview other purchasers Interview coworkers Interview suspect

2. If found guilty, Adam will more than likely initially exhibit denial. Later, Adam will likely continue through the sequence of reactions, including anger, rationalization, depression, and acceptance. Fraud, like death or serious injury, is a crisis, and people who are involved in a crisis generally pass through a predictable sequence of reactions to the crisis.

Case 4 1. Typically, fraudsters have an easy time lying when answering “yes” or “no” questions. However, it is more difficult for them to actually come up with substance or details of the lie. In this case, a follow-up question such as “What kind of controls are in place?” would then require the accountant either to lie or expose the lack of controls. By stressing to the perpetrator that someone did, in fact, have the ability to write fraudulent checks, he would then start to show increased signs of stress and

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exhibit more verbal and nonverbal cues of deception. The interview could then continue with the interviewer slowly introducing evidence that shows that the interviewee committed the fraud. This technique would convince the perpetrator that he is already caught, most likely resulting in a confession.

Case 5 1. The reactions are: •

Denial: Mike initially struggled to accept the fact that Bonny dumped him. He frequently thought about her as if she were still his girlfriend.

•

Anger: Mike cut up pictures of Bonny and threw darts at her picture.

•

Rationalization: Mike began listing reasons why he was better off without Bonny.

•

Depression: Mike did not have an interest in any other girls for about six months.

•

Acceptance: Mike realized it was time to move on and ended up meeting Amy and getting married.

2. This example demonstrates how an average person handles a crisis. Investigators of fraud need to understand that people react in similar ways after they have been exposed to a crisis (fraud). By understanding the typical progression of reactions, fraud examiners will be better prepared to interpret information they obtain during interviews and investigations.

Case 6 This is a subjective assignment. Students should follow the principles outlined in the chapter while conducting mock interviews. You may wish to use this scenario and call upon two students to conduct the interview in front of the class. Following the interview, the class should critique interview techniques used.

Case 7 1. A good place to start would be checking personnel records and company records to gather information about Jane. Next, you could examine financial statement accounts to verify that there is erratic activity. During hours when no one is at work, you could examine debit and credit documents to ascertain their purpose. Interviewing Jane’s coworkers and subordinates might come next. Gathering public information about Jane’s spending habits and performing a net worth analysis might be helpful. Finally, you would interview Jane, especially if you have sufficient evidence to confront her

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and obtain a confession. Before you proceed too far, you should obtain the CEO’s and legal counsel’s permissions for the investigation.

2. No. There are several reasons why you would not interview Jane first. First, you would not want to alert Jane to the fact that you are investigating because you would not want her to have a chance to conceal the embezzlement. Second, you would not want to cause any undue hardship or emotional stress for her department or create future legal problems for the company. Finally, in order to eventually seek a confession from Jane, you would want to have as much evidence as possible to convince her that she cannot hide her fraud any longer.

3. You would want to have as much evidence as possible when you interviewed her and you would perform all other investigative procedures before the interview. You would explain to Jane that she should feel free to leave at any time but that you have important information to present to her. You would conduct the interview at a neutral location and make sure that it was a surprise to Jane. You would state the allegations clearly and indicate that Jane was the primary suspect. You would use a direct confrontational style while using statements of sympathy to seek a confession from Jane.

Case 8 1. John went through the predictable sequence of five reactions: denial, anger, rationalization, depression, and acceptance. a. Denial. When John first spoke of the fraud, he mentioned how much he respected his boss. John seemed to screen out reality. He did not respond well to questions, and he seemed emotionally distant from the situation. b. Anger. Later, John became angry. His anger was displayed by his comments about his boss. He also displaced some anger toward his innocent friend. c. Rationalization. John tried to justify why his boss committed the fraud. He cited his boss’s family life, work troubles, and recent traumatic events. John even made the comment that he might have done the same thing. d. Depression. John displayed depression in several ways. He blamed himself for what had happened and felt a sense of embarrassment for what happened before his eyes. e. Acceptance. John finally accepted the fact that the fraud happened. He acknowledged that it occurred and volunteered his assistance with the investigation. At this stage, John wanted to help resolve the situation and move on.

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Case 9 1. Andrew must have found some strong evidence against Paula if he is determined to have her admit her fraud. Using admission-seeking questions will most likely help him get Paula to talk. Admission-seeking questions are generally used when interviewers have grounds to believe an interviewee is guilty. The following outlines a comprehensive interview process, which may lead to an interviewee’s confession: a. Admission: seeking questions have two purposes. The first is to distinguish innocent people from guilty people, and the second is to obtain a valid confession. b. Effective Admission: admission-seeking interviews proceed in an orderly fashion, but the order depends on the circumstances. c. Accuse Directly: the accusation should not be a question, it should be a statement. It should psychologically trap the person. However, words like “steal,” “fraud,” “crime,” “stole,” and “embezzled” should be avoided. The following is an example of a good statement: “Our investigation clearly established that you took company assets without permission.” d. Observe Reaction: after an accusation is made, the interviewer should observe the reaction. Innocent people usually deny the accusation, whereas the guilty respond with silence or grumbling. e. Interrupt: innocent people will not let an interviewer proceed with an accusation. f. Establish Rationalization: this is a pivotal way to get the accused to admit their guilt. The most common rationalization schemes attempt to justify unfair treatment, financial problems, family problems, or revenge. Here is an example of a statement that suggests rationalization: “You’ve worked hard here to get a good reputation. I don’t think the company has paid you what you’re really worth. And that’s the way you feel, isn’t it?” g. Verbal Confession: after an interviewee responds positively to a rationalization scheme, the interviewer needs to push for more details. This is a good time to ask for estimates and amounts. This approach will reveal even more details and will make the interviewee want to tell more: “Was it as many as fifty times?” “No, that’s too much, probably no more than ten.” h. Signed Statements: after a verbal confession is obtained, the interviewer needs to ask the interviewee to sign the statement. One approach that verifies the accusation is intentionally falsifying information on the statement so the accused is tempted to correct it. There should be no more than one statement for each offense.

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2. The answers will often lead an interviewer to consider both verbal and nonverbal clues, physical evidence, and any other relevant documentation.

Case 10 1. Good planning is essential to interviewing. The interview should be conducted in a private setting and ideally should be one-on-one. The physical evidence collected should be brought to the interview and presented to the interviewee so that he or she feels that the best option is to confess. Potential witnesses should have already been interviewed so that their testimony can be presented to rebut any potential alibis.

Finally, prepare a written statement of confession to be signed by the person you suspect of committing fraud. If you let interviewees have time to think after they are ready to confess, they will probably change their minds about confessing.

2. In order for any interview to remain effective and productive, you must show respect and sensitivity. A cooperative environment is created not only if you are professional but also if you are thorough in your questioning. It is not a good idea to “bite back” if the interviewee becomes hostile. Avoid using an accusatory tone as well as harsh terms such as steal and fraud. Be attentive to the answers given, exercise patience, and sympathize by showing that you understand where he or she is coming from (including possible rationalization for committing fraud). All of these steps will aid in receiving a valid confession.

Case Studies Case Study 1 1. Lee and Jackson should not have had to wait for an hour and a half, and Sherman should not have met with both Lee and Jackson at the same time. Sherman should not have tried to intimidate Lee and Jackson by wearing a nice suit and bringing Bruno along, nor should he have made threats or claims that he could not carry out. Sherman should have never have threatened the workers with physical violence, and he should have avoided words like “Dockies.”

2. Sherman should have had the confessions typed prior to the interview so Lee and Jackson would only have to initial each page and sign on the dotted line. Sherman could have met with Lee and Jackson on a one-on-one basis. Meeting with two people at once and then giving them time alone only gives them encouragement and the opportunity to collaborate on their stories. Sherman should have left Bruno out of the entire interview. The intimidation of having Bruno and his nightstick present probably shut down all lines of communication.

3. There were many threats and claims made that Sherman could not prove, at least not right then. Interviewers should never make threats they cannot carry out or make

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claims they cannot prove. Sherman threatened the workers with physical violence, which violates civil and criminal law (not to mention the Geneva Convention) and, if carried out would probably get the case thrown out of court. Sherman mentioned he had surveillance tapes and confessions. If Sherman could not produce the surveillance tapes and confessions or if Lee and Jackson had it on good authority that Sherman’s statement was untrue, Mr. Sherman’s credibility would be destroyed and any future contact with Lee and Jackson would be an exercise in futility.

4. Sherman never should have had Lee and Jackson summoned to an “interrogation” room. To facilitate communication, Sherman should have met with them in a neutral location.

Case Study 2 The following are some of the weaknesses of Brian’s approach: • • • • • • • • • • • • •

To begin with, Brian arranged for the interview to take place in his office. This was probably intimidating and inconvenient for Sue, and she would not have had access to documents that would have been helpful.

He sat far away from Sue, behind a large desk. This is impersonal and intimidating.

He took notes during the interview, making Sue self-conscious regarding what she said.

He used technical jargon. In fact, the language of his opening question sounded more like that of a fraud report.

He talked down to her, asking if she knew what embezzlement was. Her confusion was more likely caused by his use of technical jargon or the fact that she was previously unaware of fraud in her company.

He paced around the room during part of the interview, further intimidating Sue. His questions elicited “yes” and “no” answers and discouraged elaboration.

He dominated the conversation.

The overall tone of the interview was harsh. Sue was not a suspect, and she should have been treated with more courtesy.

Brian expressed no appreciation at the end of the interview. In fact, he was somewhat cold from the start when he did not stand or greet her when she arrived.

He showed no sympathy or respect for the perpetrator. Had Sue known something, she probably would have hesitated to tell him.

It may have been inappropriate for Brian to identify Ralph as a suspect at this point in the investigation.

He did not use a proper opening and closing to the interview.

Case Study 3 1. It would be most important to interview those who worked closely with James.

Management needs to be careful not to arouse suspicion since James may still have contact with many of the employees who continue to work for the company.

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Management should have access to all documents and records, which should help significantly in the investigation as well as preparing for crucial interviews.

2. Management should look for all information that relates to kickback schemes and vendor fraud. Since the investigation has not revealed much information about the companies who were receiving the checks, it is important to try to determine who was receiving the payments and if they were legitimate contractors.

3. Each of the individuals will need to be approached differently depending on the circumstances and whether the individual is hostile, friendly, or neutral.

4. It is important that management discover as much information about the fraud as possible before they approach James. Since James is in such a frail condition, management should be especially sensitive. However, those who interview James would still need to follow the regular guidelines for conducting an interview.

Internet Assignments 1. a. Parts of speech: nouns, pronouns, and verbs are examples of parts of speech.

If usage of these parts of speech deviates from the norm, interviewers should ask why. For example, the use of the first person singular pronoun “I” is indicative of truthful statements and not using it is a deviation from the norm. b. Extraneous information: information that does not answer the question asked can indicate a deviation from the truth because the person is trying to cover up the real facts. c. Lack of conviction: the person giving the statement is avoiding commitment, with phrases such as “I don’t remember,” or “I believe.” d. Balance of the statement: a statement needs to be more than just a series of details; it should be more like an actual account of the event. Statements need to be balanced between three parts: the introduction, which places the event into context; the actual occurrence; and the conclusion, which tells of emotions and reactions and should be as long as the occurrence itself.

It is extremely important to be respectful, professional, and sensitive to the person you are interviewing. Not only is the interviewee more likely to open up to you and be cooperative but also your chances of using the information gathered as evidence are increased if you obtain the information properly. As the quote from the Web site mentioned, if information is obtained by force, threat, or manipulation, most judges will not allow the evidence to be used in court.

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2. There is no correct answer to this question. There are many Web sites that discuss interviewing, and student responses will vary depending on the Web sites they access.

3. Students will have different answers depending upon the advertisement they find.

The answers to this question can make interesting class discussions, especially when you consider how different the courses can be.

4. Student answers will vary based on the tests they take. As with the previous question, the tests the students find and take can make interesting class discussions.

Debates 1. The use of polygraphs has both pros and cons. The benefit of the polygraph test is that, in the hands of a trained expert, it can provide valuable evidence and break an otherwise closed case wide open. Polygraphs are excellent means of obtaining confessions. The drawback of polygraphs is that they are not perfect instruments. An innocent, frightened person may fail the test because he or she demonstrates the characteristics of a guilty person. Also, polygraphs rarely detect psychopathic liars.

Experts agree that while polygraphs provide good evidence for innocence, failure to pass the test does not necessarily mean the person is guilty. Is the risk of convicting an innocent person worth the risk of not performing polygraph tests and not discovering fraud?

2. Legally, it is okay to be deceptive to obtain a confession. Whether it is ethical is another question. Fraud examiners line up on both sides of this issue.

Answers to Stop and Think Questions 1. What are the differences between the three types of interviewees: friendly, neutral, and hostile? a. Neutral interviewees are usually the most helpful because they are the most objective. Friendly interviewees may want to protect or get even with the suspect, or they may have other motives. Hostile interviewees may be associated with the suspect or crime. Suspect interviewees should be questioned without notice. Neutral and friendly interviewees can be interviewed by appointment and at any time.

2. Why is it important to disclose only a portion of the circumstantial evidence you have collected? a. Holding back some information allows the interviewer to maintain the upper hand. If the one being questioned continues to deny a fact, the interviewer can introduce a little more information to show that he or she has more

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information (although the interviewee never knows exactly how much is being held back). It makes the interviewee uncomfortable in lying because he or she might contradict facts known by the interviewer.

3. Paying for information is one type of extrinsic reward. Some professionals may require that you pay them for their interview time or information. What concerns does this raise? How might it jeopardize your case? When might it be appropriate or not appropriate? a. Paying people for information raises immediate concerns about the truthfulness of information. Some people will say anything they are paid to say. It is important to show that those paid for information were not unduly influenced by the payments. One way to mitigate the concern about pay influencing testimony is to show that it is common to pay people for a given type of information (such as a private investigator or an expert witness) and that the qualifications of the person warrant trustworthiness. Generally, expert witnesses are paid for information; fact witnesses are not.

4. How do you choose between traditional tests, graphology, voice stress analysis, and polygraphs? When is each method best used? a. Pencil and paper tests are typically used when you want to screen someone for employment purposes rather than for determining guilt. This makes them less useful for typical fraud investigations but they can be helpful for screening prospective employees based on their likelihood to engage in unethical behavior.

Graphology typically requires an expert to analyze handwriting and, as such, may delay an investigation. As such, graphology may not be very useful for getting a confession from someone in the short-term. It is probably better suited for a court case but is likely to be challenged in court because many fraud investigators do not trust its reliability.

Voice stress analysis and polygraphs should only be used by highly-trained investigators. Investigators need to follow the 11 conditions required for using polygraphs including informing suspects that they don’t have to take the test.

However, a trained investigator who follows the 11 conditions can successfully use a polygraph to help in a high stakes setting where other means are not working.

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Chapter 11 FINANCIAL STATEMENT FRAUD Discussion Questions 1. Below are the most notable abuses that occurred between 2000 and 2002:

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Misstated financial statements and “cooking the books”: Examples include Qwest, Enron, Global Crossing, WorldCom, and Xerox, among others. Some of these frauds involved 20 or more people helping to create fictitious financial results and mislead the public. While not all related to fraud, the number of financial statement restatements were 323 in 2003, 330 in 2002, 270 in 2001, and 233 in 2000.

•

Inappropriate executive loans and corporate looting: Examples include John Rigas (Adelphia), Dennis Kozlowski (Tyco), and Bernie Ebbers (WorldCom).

•

Insider trading scandals: The most notable example was Martha Stewart and Sam Waksal, both of whom have been convicted for selling ImClone stock.

•

Initial Public Offering (IPO) favoritism, including spinning and laddering: Spinning involves giving IPO opportunities to those who arrange quid pro quo opportunities, and laddering involves giving IPO opportunities to those who promise to buy additional shares as prices increase. Examples include Bernie Ebbers of WorldCom and Jeff Skilling of Enron.

•

Excessive CEO retirement perks: Companies including Delta, PepsiCo, AOL Time Warner, Ford, GE, and IBM were highly criticized for endowing huge, costly perks and benefits, such as expensive consulting contracts, use of corporate planes, executive apartments, and house cleaners to retiring executives.

•

Exorbitant compensation (both cash and stock) for executives: Many executives, including Bernie Ebbers of WorldCom and Richard Grasso of the NYSE, received huge cash and equity-based compensation that has since been determined to be excessive.

•

Loans for trading fees and other quid pro quo transactions: Financial institutions such as Citibank and JP Morgan Chase provided favorable loans to companies like Enron in return for the opportunity to make hundreds of millions of dollars in derivatives transactions and other fees.

•

Bankruptcies and excessive debt: Because of the abuse described above and other similar problems, seven of the United States’ ten largest corporate

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bankruptcies in history occurred in 2001 and 2002. These seven bankruptcies were WorldCom (largest ever at $101.9 billion), Enron (second largest ever at $63.4 billion), Global Crossing (fifth largest ever at $25.5 billion), Adelphia (sixth largest ever at $24.4 billion), United Airlines (seventh largest at $22.7 billion), PG&E (eighth largest at $21.5 billion), and Kmart (tenth largest at $17 billion). Four of these seven include some kind of known fraud.

•

Massive fraud by employees: While not in the news nearly as much as financial statement frauds, there has been a large increase in fraud against organizations; some of these frauds are as high as $2 to $3 billion.

2. The fraud triangle provides insight into why recent ethical compromises occurred. We believe there were nine factors that came together to create what we call the “perfect fraud storm.” In explaining this perfect storm, we will use examples from recent frauds.

The first element of the perfect storm was the masking of many existing problems and unethical actions of the prosperous economy in the 1990s and early 2000s. During this time, most businesses appeared to be highly profitable, including many fledgling “dot-com” companies that were testing new (and many times unprofitable) business models. The economy was booming, and investment was high. In this period of perceived success, people made nonsensical investments and other illogical decisions. The advent of “investing over the Internet” for a few dollars per trade brought many new, inexperienced people to the stock market. History has now revealed that several frauds committed since 2002 actually started during the boom years but the apparent booming economy hid the fraudulent behavior. The HealthSouth fraud, for example, began in 1986 and was not caught until 2003.

The booming economy also caused executives to believe that their companies were more successful than they were and that their companies’ success was primarily a result of good management. Academic researchers have found that extended periods of prosperity can reduce a firm’s motivation to comprehend the causes of success, raising the likelihood of faulty attributions. In other words, during boom periods, many firms do not correctly ascribe the reasons behind their successes. Management usually takes credit for good company performance. When company performance degrades, boards often expect results similar to those in the past without new management styles or actions. Since management did not correctly understand past reasons for success, they incorrectly think past methods will continue to work. Once methods that may have worked in the past only because of external factors fail, some CEOs may feel increased pressure. In certain cases, this pressure contributed to fraudulent financial reporting and other dishonest acts.

The second element of the perfect fraud storm was the moral decay that has been occurring in the United States and the rest of the world in recent years. Whatever measure of integrity one uses, dishonesty appears to be increasing. For example, researchers have found that cheating in school, one measure of dishonesty, has increased substantially in recent years.

The following table (which is not given to the students in the text) summarizes some of these studies.

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Ethical Measure High schoolers who said they had cheated on an exam in last twelve months.

Middle school students who said they had cheated on an exam in last twelve months.

College students across the nation admitted to cheating in high school.

High school students admitting to cheating on exam in last year High school students who had cheated in past twelve months Students who had stolen Willing to lie to get a job Number of students self-reporting instances of unpermitted collaboration at nine medium to large state universities Percentage of American high school students who judged cheating to be “common” among their peers The number of high school students who admitted using a cheat sheet on a test Students who admitting to letting others copy their work

Year

%

Year

%

Study Authors

1996

64

1998

70

Josephson Institute of Ethics

1996

N/A

1998

54

1940 s

20%

Now

7598%

1992

61%

2002

74%

2000

71%

2002

74%

2000

35%

2002

38%

2000

28%

2002

39%

Josephson Institute of Ethics Stephen Davis, psychology professor at Emporia State University Josephson Institute of Ethics survey of 12,000 students Josephson Institute of Ethics Josephson Institute of Ethics Josephson Institute of Ethics

1963

11%

1993

49%

1940 s

20%

1997

88%

1969

34%

1989

68%

1969

58%

1989

98%

Donald L. McCabe of Rutgers University Who’s Who among American High School Students survey of 3,210 “high achievers” in 1997 Study by Fred Schab at the University of Georgia Study by Fred Schab at the University of Georgia

The third element of the perfect fraud storm was misplaced executive incentives. Executives of the most fraudulent companies were endowed with hundreds of millions of dollars in stock options and/or restricted stock that made it far more important to keep the stock price rising than to report financial results accurately. In many cases, this stock-based compensation far exceeded executives’ salary-based compensation. For example, in 1997, Bernie Ebbers, the CEO of WorldCom, had a cash-based salary of $935,000. Yet, during that same period, he was able to exercise hundreds of thousands of stock options, making millions in profits and received corporate loans totaling $409 million for purchase of stock and other purposes.1 The attention of many CEOs shifted from managing the firm to managing the stock price. At the Gary Strauss, “Execs Reap Benefits of Cushy Loans,” USATODAY.com, December 2002, < www.usatoday.com/money/companies/management/2002-12-23-ceo-loans_x.htm>.

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cost of countless billions of dollars, managing the stock price all too often turned into fraudulently managing the financials.

The fourth element of the perfect storm, and one closely related to the last, was the oftenunachievable expectations of Wall Street analysts that targeted only short-term behavior.

Company boards and management, generally lacking alternative performance metrics, used comparisons with the stock price of “similar” firms and attainment of analyst expectations as important de facto performance measures. These stock-based incentives compounded the pressure induced by the analyst expectations. Each quarter, the analysts, often coached by companies themselves, forecasted what each company’s earnings per share (EPS) would be.

The forecasts alone drove price movements of the shares, imbedding the expectations in the price of a company’s stock. Executives knew that the penalty for missing the “street’s” estimate was severe; even falling short of expectations by a small amount would drop the company’s stock price by a considerable amount. Consider the following example of one of the frauds that occurred recently.

For this company, the “street” made the following EPS estimates for three consecutive quarters2: Firm Morgan Stanley Smith Barney Robertson Stephens Cowen & Co. Alex Brown Paine Webber Goldman Sachs Furman Selz Hambrecht & Quist

1st Qtr ($) 0.23 0.17 0.17 0.18 0.18 0.21 0.17 0.17 0.17

2nd Qtr ($) 0.17 0.21 0.25 0.21 0.25 0.28

3rd Qtr ($)

0.21 0.21

0.23 0.23

0.23 0.24

Based on these estimates, the consensus estimate was that the company would have EPS of $0.17 in the first quarter, $0.22 in the second quarter, and $0.23 in the third quarter. As has now been shown, the company’s actual earnings during the three quarters were $0.08, $0.13, and $0.16, respectively. In order not to miss the “street’s” estimates, management committed a fraud of $62 million or $.09 per share in the first quarter, a fraud of $.09 in the second quarter, and a fraud of $0.07 in the third quarter.

The complaint in this case read (in part) as follows: “The goal of this scheme was to ensure that [the company] always met Wall Street’s growing earnings expectations for the company. [The company’s] management knew that meeting or exceeding these estimates was a key factor for the stock price of all publicly traded companies and therefore set out to ensure that the company met Wall Street’s targets every quarter regardless of the company’s actual earnings. During 2

The data relating to this case are real but proprietary. Because litigation is still ongoing, the source and name of the company have not been revealed.

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the period 1998 to 1999 alone, management improperly inflated the company’s operating income by more than $500 million before taxes, which represents more than one-third of the total operating income reported by [the company].”

The fifth element in the perfect storm was the large amounts of debt and leverage each of these fraudulent companies had. This debt placed tremendous financial pressure on executives not only to have high earnings to offset high interest costs but also to report high earnings to meet debt and other covenants. For example, during 2000, Enron’s derivativesrelated liabilities increased from $1.8 billion to $10.5 billion. Similarly, WorldCom had over $100 billion in debt when it filed history’s largest bankruptcy. During 2002 alone, 186 public companies, including WorldCom, Enron, Adelphia, and Global Crossing, filed for bankruptcy in the United States with $368 billion in debt.3 The sixth element of the perfect storm was the nature of U.S. accounting rules. In contrast to accounting practices in other countries such as the U.K. and Australia, U.S. generally accepted accounting principles (GAAP) are much more rule based than principles based.4 One perspective on having rules-based standards is that if a client chooses a particular questionable method of accounting that is not specifically prohibited by GAAP, it is hard for auditors or others to argue that the client cannot use that method of accounting. The existing general principles already contained within GAAP notwithstanding, when auditors and other advisors sought to create competitive advantages by identifying and exploiting possible loopholes, it became harder to make a convincing case that a particular accounting treatment is prohibited when it “isn’t against the rules.” Professional judgment lapsed as the general principles already contained within GAAP and SEC regulations were ignored or minimized.

The result was that rather than deferring to existing, more general rules, specific rules (or the lack of specific rules) were exploited for new, often complex financial arrangements as justification to decide what was or was not an acceptable accounting practice.

As an example, consider the case of Enron. Even if Arthur Andersen had argued that Enron’s Special Purpose Entities (SPEs) were not appropriate, it would have been impossible for them to make the case that they were against any specific rules. Some have suggested that one of the reasons it took so long to get plea bargains or indictments in the Enron case was because it was not immediately clear whether GAAP or any laws had actually been broken.

A seventh element of the perfect fraud storm was the opportunistic behavior of some CPA firms. In some cases, accounting firms used audits as loss leaders to establish relationships with companies so they could sell more lucrative consulting services. The rapid growth of the consulting practices of the “Big 5” accounting firms, which was much higher than the growth of other consulting firms, attested to the fact that it is much easier to sell consulting services to existing audit clients than to new clients. In many cases, audit fees were much smaller than consulting fees for the same clients, and accounting firms felt little conflict “Bankruptcy Filings Reach All-Time High in 2002,” The Business Journal, January 2002, <http://www.bizjournals.com/portland/stories/2002/12/30/daily17.html>.

4 In 2003, the SEC acknowledged that U.S. GAAP may be too “rule-based” and wrote a position paper arguing for more “principles” or “objectives-based” accounting standards.

3

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between independence and opportunities for increased profits. In particular, these alternative services allowed some auditors to lose their focus and become business advisors rather than auditors. This is especially true of Arthur Andersen, which had spent considerable energy building its consulting practice only to see that practice split off into a separate firm.

Privately, several Andersen partners have admitted that the surviving Andersen firm and some of its partners had vowed to “out consult” the firm that separated from them and became preoccupied with that goal.

The eighth element of the perfect storm was greed by executives, investment banks, commercial banks, and investors. Each of these groups benefited from the strong economy, the high level of lucrative transactions, and the apparently high profits of companies. None of them wanted to accept bad news. As a result, they sometimes ignored negative news and entered into bad transactions.5 For example, in the Enron case, various commercial and investment banks made hundreds of millions from Enron’s lucrative investment banking transactions on top of the tens of millions in loan interest and fees. None of these firms alerted investors about derivative or other underwriting problems at Enron. Similarly, in October 2001, after several executives had abandoned Enron and negative news was reaching the public, 16 of 17 security analysts covering Enron still rated the company a “strong buy” or “buy.”6 Enron’s outside law firms were making high profits from Enron’s transactions as well. These firms also failed to correct or disclose any problems related to the derivatives and special purpose entities but in fact helped draft the requisite associated legal documentation. Finally, the three major credit rating agencies, Moody’s, Standard & Poor’s, and Fitch/IBC—who all received substantial fees from Enron—did nothing to alert investors of pending problems. Amazingly, just weeks prior to Enron’s bankruptcy filing, after most of the negative news was out and Enron’s stock was trading for $3 per share, all three agencies still gave investment grade ratings to Enron’s debt.7 Finally, the ninth element of the perfect storm was three types of educator failures. First, educators had not provided sufficient ethics training to students. By not forcing students to face realistic ethical dilemmas in the classroom, graduates were ill equipped to deal with the real ethical dilemmas they faced in the business world. In one allegedly fraudulent scheme, for example, participants included virtually the entire senior management of the company, including but not limited to its former chairman and chief executive officer, its former president, two former chief financial officers and various other senior accounting and business personnel. In total, it is likely that there were over twenty individuals involved in the earnings overstatement schemes. Such a large number of participants points to a generally failed ethical compass for this group. Consider another case of a chief accountant.

A March 5, 2001 Fortune article included the following warning about Enron: “To skeptics, the lack of clarity raises a red flag about Enron’s pricey stock…the inability to get behind the numbers combined with ever higher expectations for the company may increase the chance of a nasty surprise. Enron is an earnings-at-risk story…”

Bethany McLean, “Is Enron Overpriced,” Fortune.com, 5 March, 2001, <http://www.fortune.com/fortune/print/0,15935,369278,00.html>. Even with this bad news, firms kept investing heavily in Enron and partnering or facilitating Enron’s risky transactions.

6 Peter G. Fitzgerald, “Stock Analyst Disclosure,” Peter G. Fitzgerald, U.S. Senator, Illinois, <http://fitzgerald.senate.gov/legislation/stkanalyst/analystmain.htm>.

7 Ben White, “Do Rating Agencies Make the Grade? Enron Case Revives Some Old Issues,” Council of Development Finance Agencies, 31 January 2002, <http://www.cdfa.net/cdfa/press.nsf/pages/275> 5

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A CFO instructed the chief accountant to increase earnings by an amount somewhat over $100 million. The chief accountant was skeptical about the purpose of these instructions but did not challenge them. Instead, the chief accountant followed directions and allegedly created a spreadsheet containing seven pages of improper journal entries—105 in total—that he determined were necessary to carry out the CFO’s instructions. Such fraud was not unusual. In many of the cases, the individuals involved had no prior records of dishonesty, and yet when they were asked to participate in fraudulent accounting, they did so quietly and of free will.

A second educator failure was not teaching students about fraud. One of the authors has taught a fraud course to business students for several years. It is his experience that most business school graduates would not recognize a fraud if it hit them between the eyes. The large majority of business students do not understand the elements of fraud, perceived pressures and opportunities, the process of rationalization, or red flags that indicate the possible presence of dishonest behavior. And, when they see something that does not look right, their first reaction is to deny a colleague could be committing dishonest acts.

A third educator failure is the way we have taught accountants and business students in the past. Effective accounting education must focus less on teaching content as an end unto itself and instead use content as a context for helping students develop analytical skills. As an expert witness, one of the authors has seen too many cases where accountants applied what they thought was appropriate content knowledge to unstructured or different situations only to find out later that the underlying issues were different than they had thought and that they totally missed the major risks inherent in the circumstances.

Because of these financial statement and other problems that caused such a decline in the market value of stocks and a loss of investor confidence, a number of new laws and corporate governance changes have been implemented by the SEC, PCAOB, NYSE, NASDAQ, FASB, and others.

3. Financial statements are important to the efficiency of America’s capital markets because they provide meaningful disclosures of where a company has been, where it is currently, and where it is going. For the markets to work efficiently, accurate information about the companies whose stocks are listed must be publicly available. Information makes the markets operate efficiently, and financial information is some of the most important information to help investors and creditors make investment and credit decisions.

4. Financial statement fraud is intentional misstatements or misrepresentations about the financial position or financial results of an organization in an organization’s financial statements. Financial statement fraud can result from manipulation, falsification, or alteration of accounting records or from omitting critical information from the financial statements. For misrepresentations in the financial statements to represent financial statement fraud, the misrepresentations must be intentional. Unintentional misrepresentations are called errors and are different than financial statement fraud.

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5. Top executives and officers of an organization most often commit financial statement fraud.

The most common person involved, according to empirical research, is the CEO, but CFOs and other executives are often involved as well.

6. CEOs are often perpetrators of financial statement fraud because they have ultimate responsibility for the success of an organization. In that position, they often perceive and personalize the kinds of fraud pressures and opportunities that were discussed in the chapter (e.g., the need to meet Wall Street earnings expectations.)

7. Creating fictitious journal entries, fictitious documentation, and altering the numbers in the financial statements often conceal financial statement frauds. The most common financial statement frauds are misstatements of revenues and receivables followed by misstatements of inventory and cost of goods sold.

8. An audit committee provides a third-party view to the financial situation of a company. The audit committee has an intimate knowledge of the company that is not matched by outsiders.

An audit committee should ensure that appropriate controls are in place and provide a check and balance to the major decisions of management. Management generally has a tougher time hiding fraud from an actively involved audit committee.

9. Some examples of motives/pressure to commit financial statement fraud are: • • • • •

To meet analyst’s expectations CEO bonuses are often tied to performance High stock prices may need to be supported by high income CEOs typically have stock option packages or hold large amounts of company stock, tying their personal net worth to the success of the company Debt covenants may require certain levels of financial performance

10. The four different areas that must be examined when trying to detect financial statement fraud are management and directors, relationships with others, organization and industry, and financial results and operating characteristics. For each of these, there are several elements that must be examined as discussed in the chapter.

11. Some of the ways that financial statement fraud schemes can be identified are by looking for related-party transactions, using various means such as horizontal and vertical analysis to look for unusual relationships or balances in the financial statements, investigating the backgrounds and motivations of executives and officers, and looking for organization structures that do not make sense.

12. The reason members of management and the board of directors must be examined when searching for financial statement fraud exposures is because it is people, specifically management and board members, who commit financial statement fraud. Without such individuals manipulating the financial statements, there would be no financial statement fraud. To determine if management or board members are involved in financial statement

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fraud, it is important to examine their motivations, backgrounds, and decision-making ability and power within the organization.

13. Relationships with others are important areas to look at when searching for financial statement fraud. Hiding the truth in related companies (such as the related-party partnerships (SPEs) in the Enron case) or using sham or unrealistic transactions with related parties to overstate revenues, inventories, or other financial statement accounts often are ways of committing financial statement fraud. One of the easiest ways to commit financial statement fraud is to enter into transactions with fictitious organizations that appear to be independent but are really related parties. In addition, relationships with financial institutions, auditors, or lawyers that appear unusual or problematic can often signal that something is not right.

14. It is always important to evaluate the relationship between a company and its auditors when considering financial statement fraud. Fraud can occur much more easily if auditors lack independence. Auditors also have a difficult time detecting fraud if their access to a company and its records is unreasonably limited. Another factor impacting an auditor’s ability to uncover fraud is unreasonable time constraints. Disputes with auditors about accounting issues can also be indicative of fraud. It is especially important to evaluate the company/auditor relationship when there has been a change in auditors. Companies rarely change auditors without a major motivation to do so. As a result, auditor changes can often signal underlying fraud problems.

True/False 1. False. Like other frauds, financial statement fraud is rarely seen and may be concealed through collusion among management, employees, third parties, or in other ways.

2. True 3. True 4. False. The most common methods used involve improper revenue recognition, the overstatement of assets, and the understatement of expenses and liabilities, in that order.

5. True 6. True 7. False. The Fraud Exposure Rectangle is used in identifying management fraud exposures. In addition to the three corners mentioned above, the rectangle includes Financial Results and Operating Characteristics.

8. False. Financial statement fraud is usually committed by the highest individuals in an organization and most often on behalf of the organization as opposed to against it.

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9. True 10. False. Relationships with others (e.g., related parties) should be examined because unrealistic and non–“arm’s length” transactions are some of the easiest ways to perpetrate financial statement fraud.

11. True 12. False. While CFOs are often involved, the CEO (Chief Executive Officer) of an organization is the person that commits, motivates and instigates most financial statement fraud.

13. False. On behalf of an organization, top management almost always commits financial statement fraud.

14. False. Most people who commit management fraud are first-time offenders.

15. False. Most financial statement fraud occurs in smaller organizations where one or two individuals have almost total decision-making ability.

16. False. A person engaged in zero-order reasoning only considers conditions that directly affect himself or herself and not other people.

17. True 18. True 19. True Multiple Choice 1. e 2. d 3. e 4. c 5. d 6. d 7. a

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8. c 9. a 10. d 11. c 12. a 13. b Short Cases Case 1 Most of the fraud symptoms in this case relate to management, the board of directors, and relationships with others.

Management and the board of directors: The senior officers were friends. They had a lot of power in the new company, which allowed them to collude if needed. Their positions in the company allowed them to influence decisions and override internal controls as they wished. They owned a large percentage of the common stock, so they had a personal motivation for the stock price to be as high as possible. They comprised a large percentage of the board of directors, so they were insiders.

Relationships with others: The fact that the president of the local bank was appointed to the board of directors not only represented a “grey” member in the board (because he had loaned the company money), but it could also represent a concern about how valid the transactions are between the company and the bank. Is the bank giving the company extremely lax credit terms or an unreasonably low interest rate? Are the transactions with the bank arm’s length? One might also be concerned about the company’s relationship with city officials, who feel a strong motivation to keep this company in town because it boosts the city’s economy, provides jobs, etc.

Case 2 1. In determining whether or not a good system of internal controls would have prevented fraudulent backdating practices, it is important to understand who the perpetrators were.

Internal controls are most effective in preventing or detecting employees who commit fraud when acting alone. When collusion (two or more people are involved), internal controls are less effective. When top management and the directors are involved, as was the case with option backdating, they can often “override” internal controls. Internal control activities (procedures) such as segregation of duties, proper authorizations, and so forth, wouldn’t be nearly as effective in preventing this type of fraud as would a good control environment (tone at the top.) While a few of these firms’ backdating practices were caught by auditors or

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outsiders, most backdating revelations have come from companies themselves after thoroughly examining all options granted in the past.

2. The question of why executives and directors would have allowed this fraudulent practice is a tough one. Hopefully, in most cases, the option backdating was known by only a few people. Those individuals probably engaged in the practice because of the elements of the fraud triangle: (1) they felt a pressure to increase their compensation—greed, (2) they perceived an opportunity to backdate without getting caught—no one had been paying attention to option dating in the past, and (3) they rationalized that it was okay—everyone else was doing it. With respect to the rationalization, they were correct. While everyone wasn’t doing it, lots of companies were. The fact that many others are acting illegal doesn’t make it right.

3. A whistle-blower system allows individuals to call in anonymously to report suspected violations. A whistle-blower system would probably be the most effective way to catch this kind of fraud because individuals who saw the dishonest acts could report violations by company executives without fear of reprisal because no one knows who the anonymous caller is. Whistle-blower systems are most important where internal controls can be overridden. The fact that a whistle-blower system is in place helps prevent or deters dishonest acts. Providing a way for everyone who could see fraud to easily report that fraud significantly increases the likelihood that dishonest acts will be reported.

Case 3 Below are some of the red flags that fraud may be occurring: • • • • • • • • • •

Success since beginning operations Rapid growth in revenues Pressure to perform well for the IPO Increased commissions as a way to increase revenue Personal relationships between executives Change in auditors Dispute with auditor over revenue recognition accounting Infrequent board of director and audit committee meetings Close relationships between the board and management High level of stock options held by management

Case 4 Financial statement fraud is very different than embezzlement and misappropriation. Perpetrators of financial statement fraud are usually members of top management who manipulate financial statements in order to boost earnings and increase stock prices. On the other hand, embezzlement and misappropriation take place when employees steal from the organizations for which they are working. Top management benefits from financial statement fraud whereas the benefactors of embezzlement and misappropriation are the middle management, frontline workers, and others who engage in the misappropriation and embezzlement.

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Case 5 1.

2.

3.

4.

5.

6.

7.

Management and directors Organization and industry Organization and industry Relationships with others Financial results and operating characteristics Relationships with others Management and directors

Case Studies Case Study 1 1.

The Chipmunk Company Ratio Analysis LIQUIDITY RATIOS Current ratio: current assets/current liabilities Quick ratio: (current assets— inventory–prepaid expenses)/current liabilities Sales/receivables: net sales/net ending receivables Number of days sales in A/R: net ending receivables/(net sales/365) Inventory turnover: cost of sales/average inventory

12/31/10

12/31/09

CHANGE

PERCENT CHANGE

INDUSTRY AVERAGE

2.310

2.491

−0.181

−7.27%

1.21

0.416

0.402

0.014

3.46%

0.35

16.05

17.78

−1.73

−9.73%

23.42

22.74

20.53

2.21

10.76%

15.58

1.48

1.39

0.09

6.37%

1.29

2. ANALYSIS: The current ratio has declined by more than 7 percent during the year, which raises a few questions. There might be a possibility of fraud in cash or near cash (current assets). The collection period of accounts receivable is also questionable. There is almost an 11 percent increase in days sales in accounts receivable, and the company is taking much longer than the industry average to collect its receivables. This also could indicate that fraud is occurring as the company may be channel stuffing or creating fictitious sales and accounts receivable.

Case Study 2 1.

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a. Although this information is not in the case for students to learn, a financial analyst would have greatly benefited by investigating management and directors, because the major players in Bre-X had histories of fraud, unethical, and illegal acts. Chances are that if they were unethical in the past, they would continue that behavior. By investigating management and directors, an analyst would have identified an immediate red flag of fraud. b. Although investigating the company’s relationship with other entities may not have signaled any immediate red flags, an analyst could have understood more about the company, its affiliates, and the risks involved. c. Although this information is not in the case for students to learn, an analyst who would have investigated the organization and its industry would have realized that mining in Canada has a long history of scandals and fraud. Penny stock scandals and other such scandals are often perpetrated via the Canadian stock exchanges. An analyst who would have investigated the industry would realize the inherent risk that is associated with mining. d. By investigating the financial results and operating characteristics of Bre-X Minerals, an analyst may have realized that the financial results were especially high for pure speculation. The company was brand new and had no history of financial results. The quantity of gold that they were supposed to have discovered had never in fact been mined in large quantities. The only gold that had actually been taken was small samples, which could easily have been tampered with.

2. At Bre-X Minerals’ height, the price of gold on the open market dropped because of the anticipation of the new gold supply. When the entire operation proved to be a scam, many investors lost money. Furthermore, the Canadian stock market lost credibility and reputation.

As a result of the scam and the chaos that followed, the entire Canadian stock market was forced to shut down for a period of time.

3. Greed by executives, investment banks, commercial banks, and investors; educator failure; unachievable expectations of investors and others; unrealistic compensation for executives; moral decay; and the good economy of the 1990s all contributed to both the perfect fraud storm as well as the Bre-X Minerals scandal.

4. The major motivation to commit fraud was the greed and moral decay of the executives. This was not the first time that these individuals had been convicted of fraud. The executives loved to live a lavish lifestyle and would do just about anything to maintain their desired lifestyle.

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Case Study 3 1. a. If zero-order reasoning were employed, an independent auditor would not consider conditions that affect the auditee. The independent auditor would only be interested in conditions that directly affect him or her. The audit plan often takes into account costs and benefits associated with specific assurance levels in the audit. Therefore, zeroorder reasoning would most likely be that the auditor simply follows the already established audit plan. b. If first-order reasoning were employed, the auditor would consider conditions affecting the auditee when planning the audit. The auditor should notice that the level of returned product was quite high for the previous year. Also, because allowances for future returns were too low on the books compared to the actual returns from the prior year, the auditors should consider altering the audit plan. The auditor should have tried to observe the location where the actual returned goods were stored. The auditor should also try to trace the steps of several returns through the accounting process to determine if all appropriate recordings are made. The auditor could also do more extensive analytical and substantive testing to make sure that allowances for returns and sales of product are at appropriate levels. In performing these procedures, the auditor would likely rely heavily on typical procedures performed in prior audits and not consider that the client may be concealing a fraud in a manner that the typical procedures won’t detect. c. If higher-order reasoning were employed, the auditor considers additional layers of complexity, including how management may anticipate the auditor’s behavior. The auditor may adjust the audit plan by introducing unexpected audit procedures in response to what the auditor believes management may be doing to conceal a fraud based on management’s strategic reasoning. Thus, the auditor may perform an unexpected inspection of the location of where returned goods are held. The auditor would realize that management would steer the auditor away from storage locations of returned goods because management realized that the auditor would want to perform physical inspection of inventory. Realizing that management was applying strategic reasoning to conceal a fraud, the auditor would interview employees who worked where these goods may be stored and perform unexpected inspections of these goods to get an accurate count of the magnitude of returned goods and attempt to unveil a fraud.

The auditor could also use technology such as ACL or Picalo to look for transactions that are abnormal in nature or that have abnormal timing. The auditor could also interview other personnel regarding their job functions, performance of tasks, and the recording of non-routine accounting entries in order to determine if discrepancies exist between stories. This may provide the auditors with further insight into which areas of the audit to alter in their attempt to uncover the concealment of a fraud.

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Internet Assignments 1. The first part of the assignment has no prescribed answer because student searchers will go several different directions, depending on word combinations used. Some of the key points of the CFO.com article are as follows: •

While auditors do not mention fraud in their standard audit report, investors expect auditors to detect fraud. The profession has tried to minimize their responsibility for fraud but the public has held them responsible. This is known as the “expectation gap.”

•

The PCAOB is trying to close this expectations gap by requiring the standard audit report to mention auditors’ responsibility for detecting fraud.

•

PCAOB rules require auditors to provide reasonable assurance that the financial statements are not materially misstated due to fraud but the standard audit report does not tell investors they are responsible for material misstatements due to fraud.

•

Users are asking auditors to identify their clients’ key risk areas but auditors are reluctant due to liability reasons.

•

The PCAOB is working to establish a financial reporting fraud center for collecting information on preventing and detecting fraud.

Debates 1. a. Pro: Yes, this is true. Just ask an average person on the street what they think about the accounting industry, and they will likely give you a derogatory response. Even informed users will argue that there is no good way to account for intangibles such as goodwill, which make up much of certain companies’ financial statements these days.

Proof that companies are playing the earnings game with financial statements is all around us. How else would companies meet earnings forecasts set by analysts such a high percentage of the time? a. Con: It is a complex world and a complex business environment in which we find ourselves. There are no easy answers as to how we can represent the true financial position of a company. The accounting profession has done an amazing job at capturing this information and at holding companies to strict standards; however, this is not to say that everything is perfect. Accounting standards will have to continually evolve to match the business environment. Companies will have to be held to higher standards, since they are the ones who are trying to play the earnings game and not necessarily the auditors. In addition, it is the companies themselves who guide Wall Street’s forecasts.

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2. a. Earnings management is acceptable for the reasons below: • • • • •

Increased stock value for meeting forecasted earnings.

Giving management a chance to correct a bad quarter (period).

Less pressure on management for missed earnings.

GAAP providing legitimate ways to manage earnings.

GAAP is not that precise and there are lots of acceptable accounting alternatives.

b. With earnings management: • • • • •

Financial statements are not accurate.

Stockholders are misled.

Earnings management is a precursor to fraud, especially if results do not improve.

Some earnings management is fraud and other types of earnings management are precursors to fraud.

Based on the evidence and the definition of financial statement fraud, earnings management may or may not be financial statement fraud. The most problematic part of earnings management is that it often leads to management fraud because management gets in the habit of changing numbers to meet expectations (as in the PharMor case).

Answers to Stop & Think Questions 1. Had Finn not complied with Monus’s expense manipulation requests early on, would the Phar-Mor fraud have progressed to the extent it did? Also, how would Finn’s career have been different? a. Had Finn not complied with Monus’ expense manipulation requests early on, then the Phar-Mor fraud may have not happened or at least continued for very long. Had Finn reported Monus’ actions early on to the proper people, then the perpetuated fraud may not have happened. Finn may have prevented the eventual downfall of Phar-Mor and retained his position. Conversely, Finn may have been fired by Monus because he would not agree to participate in the fraudulent financial reporting. The outcome of how Finn’s career would have ended up is uncertain, but he probably would not have had to face the consequences, such as prison time, for participating in fraudulent activities.

2. If auditors and investigators modified their typical procedures and regularly used a few unexpected procedures to look for fraud, how would this affect a potential perpetrator’s opportunity to conceal a fraud?

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a. If auditors and investigators modified the typical procedures used to look for fraud and regularly used a few unexpected procedures to look for fraud, it would be more difficult for fraud to be perpetrated. Potential fraud perpetrators would need to be more creative and need to engage in strategic reasoning themselves to prevent getting caught. This limits the perpetrators opportunity to commit fraud.

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Chapter 12 REVENUE AND INVENTORYRELATED FINANCIAL STATEMENT FRAUDS Discussion Questions 1. Some of the most common revenue fraud schemes are recording fictitious sales, recognizing revenues too early, overstating real sales, understating the allowance for doubtful accounts, not recording returned goods from customers, not writing off uncollectible receivables, writing off uncollectible receivables in later periods, recording bank transfers as cash received from customers, and not recording discounts given to customers.

2. Some of the most common ways to search proactively for revenue frauds are to analyze financial balances and relationships within the financial statements, compare financial statement amounts and relationships with nonfinancial statement amounts, compare balances and relationships with those of similar firms in the same industries, and proactively search for scheme-specific symptoms such as analytical or control symptoms.

3. It is very important to follow up on revenue (and all) financial statement fraud symptoms because we will never know for sure if fraud is occurring without additional follow-up. At best, analyzing financial statements for fraud only provides circumstantial evidence. It takes much more than the financial statement fraud symptoms identified to prove that fraud is occurring because the symptoms may be caused by other nonfraud factors.

4. Some of the most common inventory fraud schemes are underrecording purchases, recording purchases too late, not recording purchases, overstating purchase returns, recording purchase returns in an earlier period than when actually returned, overstating purchase discounts, not writing off or writing down obsolete inventory, over-counting inventory, and not recording cost of goods sold when recording sales transactions.

5. There are many ways to proactively search for inventory frauds. As with other types of financial fraud, you can look for different symptoms in various ways. However, you can specifically examine the inventory balances in the financial statements by looking for unusual changes in the inventory and cost of goods sold account balances from period to period, looking for unusual changes in inventory and cost of goods sold relationships from period to period, comparing financial results and trends of the company with those of similar firms in the same industry, and comparing recorded amounts in the financial statements with nonfinancial statement amounts.

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6. Common-size financial statements are balance sheets and income statements converted to percentages. Balance sheet numbers are usually converted by changing each number to a percentage of total assets. Income statement balances are usually converted to percentages by calculating each number as a percentage of total revenues.

7. Revenue frauds are probably most common because they are the easiest to perpetrate; they simply require recording a journal entry debiting Accounts Receivable and crediting Revenues and you have increased assets, revenues, and income. Even better, if the fraud is not caught in the current period, the fictitious revenues are closed out and do not appear in the next period. Inventory and cost of goods sold frauds are also common because they are also easy to perpetrate. All a fraud perpetrator has to do is overstate ending inventory and both assets and income are overstated. The problem, however, is that because the overstated ending inventory becomes the beginning inventory of the next period, the fraud perpetrator has an even bigger concealment headache the next period.

8. If sales returns are not recorded, total revenues and net income are overstated.

9. If ending inventory is overstated, cost of goods sold is understated, with gross margin and net income becoming overstated.

10. When we compare financial statement amounts with actual amounts, it usually makes the numbers become much more real. One company, for example, stated on their financial statements that they had $38,000,000 in metallic alloy that cost about 50 cents per pound. When the auditors compared this amount to realistic numbers, they discovered that it would take nearly 12 times the warehouse space the company currently had for all of its operations. After a more thorough investigation, it became evident that financial statement fraud was present.

True/False 1. False. Overstated revenues and overstated net income are among the most common types of financial statement fraud. One would only understate revenues and income to minimize taxes, but doing so results in less attractive financial statements.

2. True 3. False. The statement of cash flows is already a “change” statement, and horizontal analysis only makes sense with the balance sheet and income statement.

4. True 5. True

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6. True 7. False. Comparing financial results of a company with similar firms is an effective way to look for fraud symptoms.

8. True 9. True 10. False. The gross profit margin is calculated by dividing gross profit by net sales, not by cost of goods sold.

11. False. The working capital turnover ratio is calculated by dividing sales by average working capital (current assets – current liabilities).

12. True 13. True

Multiple Choice 1. c 2. d 3. a 4. b 5. d 6. a 7. c 8. b 9. d 10. a 11. d 12. b

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13. c 14. d 15. c 16. c 17. d 18. b 19. c 20. a 21. d 22. b

Short Cases Case 1 You could take several steps. For example, you could examine the analytical relationships on the financial statements. You could use horizontal and vertical analysis to verify that Accounts Receivable, Cost of Goods Sold, and Bad Debt Expense are growing proportionally with sales. You could examine the nature of the business to see if year-end sales make sense.

You could compare financial results with firms in the same industry. You could inspect internal controls to see whether controls are being overridden. Finally, you could analyze the documents to verify that revenue was recognized in the correct period.

Case 2 The easiest way to increase earnings is to overstate revenues or inventory. When revenues are overstated, receivables and income are overstated. When inventory is overstated, cost of goods sold is understated and income increases. The problem with overstating inventory is that the misstatement will never go away, since the ending inventory balance one period becomes the beginning balance next period. Additional methods of increasing earnings might be to overstate other assets, understate bad debt expense or liabilities, or not record discounts given to customers.

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Case 3 After performing the analysis, the accounts that raise questions are Accounts Receivable and Retained Earnings. The percentage changes are shown in the following table:

Cash A/R Inventory PP&E (net) Notes Rec. Tot. Assets

2007 $1,000 250 600 1,500 500 $3,850

2008 $1,200 375 700 1,700 500 $4,475

Percent Change 20.0% 50.0% 16.7% 13.3% 0.0% 16.2%

2009 $1,400 600 825 1,800 500 $5,125

Percent Change 16.7% 60.0% 17.9% 5.9% 0.0% 14.5%

2010 $1,500 900 975 1,950 500 $5,825

Percent Change 7.1% 50.0% 18.2% 8.3% 0.0% 13.7%

A/P Other Liab.

Notes Pay. Tot. Liab.

$ 700 200 1,200 $2,100

$ 900 300 1,400 $2,600

28.6% 50.0% 16.7% 23.8%

$1,000 350 1,500 $2,850

11.1% 16.7% 7.1% 9.6%

$1,100 425 1,750 $3,275

10.0% 21.4% 16.7% 14.9%

Stock Out. Ret. Earn.

Total Share.

Equity

$1,000 750

$1,000 875

0.0% 16.7%

$1,000 1,275

0.0% 45.7%

$1,000 1,550

0.0% 21.6%

$1,750

$1,875

7.1%

$2,275

21.3%

$2,550

12.1%

$3,850

$4,475

16.2%

$5,125

14.5%

$5,825

13.7%

Total Liab./ Share. Equ.

The Accounts Receivables balances are most questionable because of the huge jump from year to year. Those balances would be even more suspicious if there had been a drop in business incurred by most companies in the technology sector.

Case 4 Using percentage changes in sales from year to year to see if there are any trends [(Salest+1 – Salest)/Salest], the results are as follows: Horizontal Analysis % Change in Sales

Year 1 to 2 5%

Year 2 to 3 5%

Year 3 to 4 25%

Year 4 to 5 50%

The calculations indicate that the percentage increase from years 3 to 4 and 4 to 5 are larger than the past years and are very large on an absolute basis. This large and sudden increase is a possible red flag of revenue overstatement.

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Case 5 Comparing the ratio of Cost of Goods Sold to Sales for all five years to indicate trends, the calculations are as follows: Vertical Analysis COGS/Sales

Year 1 75%

Year 2 75%

Year 3 75%

Year 4 48%

Year 5 29%

Cost of Goods Sold as a percent of Sales declined considerably in years 4 and 5. This is an alarming trend and a possible red flag of cost of goods sold understatement.

Case 6 The following are symptoms and schemes used in this case: 1. Funneling bank loans through third parties to make it look as though customers had paid when they had not.

2. Deliberately providing “false or incomplete information” to auditors and conspiring to obstruct the firm’s audits.

3. Factoring unpaid receivables to banks to obtain up-front cash. Side letters that were concealed from the auditors gave the banks the right to take the money back if they could not collect from the company’s customers.

4. The bulk of the company’s sales came from contracts signed at the end of quarters, so managers could meet ambitious quarterly sales targets and receive multimillion-dollar bonuses.

One of the first questions that needs to be examined is how the company explained the sudden growth in sales from hundreds to millions. The auditors should have investigated this increase. Also, the fact that most sales were recorded in the last days of the quarter should have been investigated. The auditors should have concluded that management had strong motivation to commit fraud because executives were being paid high bonuses based on sales volume.

As discussed in this chapter, the analytical symptoms and the accounting or documentary symptoms, if understood and analyzed by auditors, could have lead to earlier fraud discovery.

Case 7 1. One way to search for possible red flags of fraud would be to determine if the market value of inventories is higher or lower than reported inventory amounts. Doing this reveals the following:

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Reported 2010 $1,654,500

Market Value $2,400,000 (300 million × $.08)

$2,625,000

$2,832,000 (5.9 million × $.48)

$ 224,500

$ 132,000 (1.1 million × $.12)

Finished goods inventory (Approx. 300 million feet—2010) Copper rod inventory (Approx. 5.9 million lbs.—2010) Plastics inventory (Approx. 1.1 million lbs.—2010) Market price of insulated wire (per foot) Market price of copper rod (per lb.)

Market price of plastics (per lb.)

$ $ $

0.008 0.480 0.120

$ $ $

0.009 0.480 0.190

2. From this table, if you multiply the market prices by the actual quantities of inventories in 2010, you can see that for two of the three inventories, the amounts reported in the balance sheet are much lower than what the market prices show.

Because inventory should be carried on the balance sheet at the lower of cost of market, these amounts may be fine. However, changes in percentages from year to year should be examined. Since the market value is significantly less than the carrying amount of plastics inventory, this difference should be investigated, as it represents a possible fraud symptom.

Using vertical analysis results in the following:

Sales Cost of goods sold Finished goods inventory (Approx. 300 million ft.—2010) Copper rod inventory (Approx. 5.9 million lbs.—2010) Plastics inventory (Approx. 1.1 million lbs.—2010) Accounts payable (for inv. purchases)

2010 $8,450,000 6,242,500 1,654,500

100.00% 73.88% 19.58%

2009 $8,150,000 100.00% 6,080,000 74.60% 1,175,500 14.42%

2,625,000

31.07%

1,650,000

20.25%

224,500

2.66%

182,000

2.23%

450,000

5.33%

425,000

5.21%

We can see that even though Cost of Goods Sold has stayed relatively constant as a percentage of sales, finished goods inventory has increased as a percentage of sales. Copper Rod Inventory increased dramatically as a percentage of sales as well, but what is interesting is that Accounts Payable also maintained the relatively constant percentage with sales. You would expect to see an increase in Accounts Payable as inventory levels increase, but that is not the case here. This possible red flag demands further investigation.

Case 8 Sales discounts appear too high—No.

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Accounts receivable increases as a percentage of revenues—Yes. Bad debt allowance increases by the same percentage as Accounts Receivable—No. Sales returns increase—No if recorded properly; fraud would involve not reporting returns.

Large percent of revenues are recorded in the fourth quarter—Yes. Unexplained reconciling items on the bank statement—Yes. In answering part 2, some possible answers are: •

Accounts Receivable increases as a percentage of sales: Compare your client’s percentage with other firms in the same industry, query accounts receivable balances and rank order them according to size or age to determine which ones increased, match accounts receivable balances with new customers, and vendor approvals, and so on.

•

Large percentage of revenues are recorded in the fourth quarter: Compare with previous years, compare with other firms in the same industry to see if an industry norm, query sales by customers, and so on.

Case 9 •

Management and Board of Directors: The fact that brothers manage the company may indicate the possibility of collusion. Also, they own a good portion of stock, meaning that their scope of influence and control is quite large.

•

Relationship with others: The last audit is something you should investigate. Were there disputes? Did the auditor suspect fraud? If so, this is a big red flag that fraud is being committed.

•

Organization and Industry: The off-book ventures seem complicated and may provide opportunity to hide liabilities like Enron did with its SPEs.

•

Financial Results: No symptoms provided here—yet!

Case 10 1. The most obvious symptom would be an increase in returns. Because a sale was voided, there will be a decrease in revenue. In addition, the inventory will go up at the time of the return. However, when inventory is accounted for later in the day or week, it will be lower than originally expected.

2. The owner can run a query to determine when the majority of returns have taken place. Chances are that the majority of the returns will take place when the manager was working. Based on these calculations, the owner can speculate on the extent of the fraud.

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3. No, you still do not have enough evidence to prove that she is guilty. However, armed with this information, as well as the other employee’s witness, it should be relatively easy to obtain a confession.

4. The owner could perform an invigilation operation, calculate a net worth analysis, or install a hidden camera to see if it is possible to catch the manager in the act of stealing.

5. The owner could have required that all returns be made to someone other than the person who originally conducted the transaction. Employee training and fraud awareness problems might have prevented the fraud from ever occurring.

Case 11 1. The main reason that the addresses might match is if the company was doing business with a related party owned by the controller.

2. Students should list the different symptoms that would be present in each of the scenarios listed in the previous question.

3. If the company is engaging in related-party transactions and is a public company, then they will need to disclose those transactions in the financial statements. If a private company and a bank or other institution relies on the financial statements, they should still disclose them.

4. Sue should contact the company’s internal auditor or audit committee to ensure that they are aware of this information. If the company has a whistle-blower hotline she may use that to report the situation. She should be careful to simply report facts but not make allegations since she may not be aware of the entire circumstances.

5. She should gather evidence to test and document her beliefs. She should contact an attorney to gain advice on the proper course of action.

Case 12 Students could list any of the following or others: • • • • • •

Not disclosing transactions with related parties.

Failing to disclose contingent liabilities that are possible or probable and that would create a loss for the company.

Failing to disclose contractual obligations, including restrictions on specific assets or liabilities.

Incorrectly disclosing contingent gains that are probably not going to occur.

Failing to disclose information regarding loans to creditors.

Inadequately disclosing significant accounting policies.

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• • •

Inadequately disclosing information about market value declines of assets, including marketable securities.

Inadequately disclosing information about pension or other long-term liabilities.

Lack of disclosure of significant events.

Case 13 Compare balances in the statements from one period to the next to see if there are any unexpected changes. High increases or decreases in balances or amounts might be red flags of financial statement manipulation.

Use of key ratios involves computing key financial statement ratios and comparing the changes in these ratios from period to period. If changes in ratios do not make sense, there is a possibility of fraud.

Performance of vertical analysis for balance sheet is where total assets are set to 100 percent and all other balance amounts are a percentage of gross total assets.

Performance of horizontal analysis examines the percentage change in amounts on the financial statements from one period to the next.

Case 14 A—Nancy Temple B—Andrew Fastow C—David Duncan D—Kenneth Lay E—Jeff Skilling F—Michael Kooper G—Michael Odom All of these individuals were associated with the Enron fraud; all of them except Nancy Temple, David Duncan, and Michael Odom worked for Enron. Nancy Temple was an attorney with Arthur Andersen; David Duncan and Michael Odom were Andersen partners.

Those working for Enron were in the best positions to participate in the frauds.

Case 15 1. The auditor should have several concerns about the company’s situation, including: •

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Management Style: The hands-off approach by Jeff, the owner, creates many opportunities for the executives and employees to commit fraud. It is unlikely that he would ever catch it because he is never around and rarely looks at the books. The case does not discuss educational background, but it is unlikely

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that he possesses a great understanding of financial statements. If he relies on his brother to explain them to him, Chucky could easily lie about the numbers.

•

Executives: People who have a propensity to gamble have a perceived pressure to commit fraud in order to support their habit. The fact that Chucky had ownership in a company that is facing bankruptcy is a second financial pressure.

•

Employees: The employees have pressure to commit fraud based upon their compensation. They are rewarded for pushing sales, which may cause them to falsify sales or set up a kickback scheme in which they could sell the product to straw buyers who would subsequently sell them back and get reimbursed.

This would allow the employee to earn his or her commission.

•

Internal Controls: The two areas of concern here are the lack of segregation of duties and the blank checks. Chucky has control over the custodial and reporting functions of cash disbursement and can easily commit fraud.

Presigned, blank checks are never a good idea.

2. List of possible suggestions include: •

Management style: Jeff needs to take a more active role in the company. He should also hire an outside firm to audit his company. It would be beneficial for him to question all the company executives periodically about their activities.

•

Executives: More members of management need to be hired so the important authorization, custodial, and recording duties can be segregated. Currently, Chucky has too much control and can easily manipulate the books.

•

Employees: A different reward system needs to be established so that commissions are paid only on those sales that are not subsequently reversed.

•

Internal Controls: Jeff needs to authorize all payments and sign checks only at the time of payment. He also needs to mail the checks himself in order to ensure they are properly mailed.

3. Lock-It-Up has many internal control weaknesses and the books cannot be relied upon. Without making the necessary changes listed earlier, it would be too risky to audit Home Safety after they had acquired Lock-It-Up. There is just too much risk of fraud; a subsequent audit would need to be performed.

4. Some factors that can make it more difficult for the auditor to detect fraud include: •

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Former auditors of the audit firm now work for the company.

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•

The company has a good understanding of the audit approach used by the firm and can use that knowledge to their advantage.

•

The audit firm performs other high revenue-generating activities for the company (cross-selling), which are needed by the audit firm.

•

Weak internal controls.

Case 16 1. Accounts affected include Inventory, Revenue, Cost of Goods Sold, and Accounts Receivable. Revenue, Accounts Receivable, and Inventory would all be overstated and Cost of Goods Sold would be understated.

2. To discover the relationship between the company and its distributor regarding this transaction, the auditors could potentially do the following: •

Read the details of the contract regarding the timing and nature of the sale.

•

Inquire of the distributor the details of the transaction.

•

Interview employees working in the shipping or storage areas to find out about their normal course of work and about the products in the facility.

•

Corroborate information gathered from the employees with that of management and look for any discrepancies.

•

Do analytics on quarterly revenue or related figures to see if any irregularities appear.

•

Interview sales people and inquire about unusual terms or agreements.

Case Studies Case Study 1 1. Enron ignored two important internal controls when it created the LJM1 SPE. First, Enron’s board of directors waived the company’s own Code of Conduct, which prohibited the existence of LJM1, and approved the SPE’s creation. Also, by appointing Andrew Fastow to run the SPE, Enron broke the SEC’s rule that company executives are not allowed to control separate entities if those entities are directly related to the company. If they had heeded the protective internal controls established by the company and the SEC, Enron executives may have been able to avoid the fraud that led to its eventual bankruptcy.

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2. The Performance Review Committee created a sense of fear and intimidation among the employees at Enron. Employees were afraid to express any concerns they had with how top executives were managing the business because by doing so their very careers were at stake. Therefore, the scandal at Enron was able to continue for a long time without the interruptions of whistle-blowers.

3. Possible factors that explain the occurrence of financial statement fraud may include (but are not limited to) the following: a. Moral decay in society b. Performance incentives to executives c. Pressure to meet Wall Street performance expectations and to be rewarded for short-term behavior d. Increasingly large amounts of company debt and leverage e. Nature of accounting rules—they can sometimes be interpreted or manipulated to the benefit of an individual or institution f. Behavior of CPA firms g. Greed by company executives, investment banks, commercial banks, and investors h. Failure to educate students in integrity and business ethics 4. Yes, unclear financial reporting is a clear signal that either fraud or negligence is occurring within a company. If it is impossible to work behind the numbers and figure out where they are coming from, then it is possible that they are coming directly from the minds of the CFO or the internal audit department. Confusing accounting practices always act as a possible red flag for fraud.

5. SAS 99, which is the fraud audit standard, states that it is possible that an audit governed by Generally Accepted Auditing Standards (i.e. GAAS) can be performed and that major fraud not be caught, especially if forgery and collusion are involved.

To determine whether or not Arthur Andersen should have caught this fraud, an investigation would have to be conducted. Certainly, there will be experts who will line up on both sides and make their cases. When auditing Enron, Andersen was performing a GAAS audit, not a forensic one, and GAAS audit procedures do not always detect frauds, even major financial statement frauds.

According to one of the best-selling auditing textbooks, auditing is “a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those

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assertions and established criteria and communicating the results to interested users” (emphasis added).

(Source: Auditing Concepts Committee, “Report of the Committee on Basic Auditing Concepts,” The Accounting Review, 47, Supp. (1972), 18. Quoted in Rittenberg, Larry E. and Bradley J. Schwieger, Auditing: Concepts for a Changing Environment. Thomson/South-Western: Cincinnati, Ohio, 2005.)

There are many types of audits and auditors. Using the earlier definition of auditing, the following chart summarizes some of the common types of auditors and what they do: Type of Audit 1. Financial statement (GAAS) audit

2. Fraud (forensic) audit

3. Compliance audits, such as tax audits

4. Operational audit

Quantifiable Info.

Financial statements Records, testimonials, personal observation, and physical evidence

Tax returns, procedures followed Any part of an organization’s operating procedures or methods

Established Criteria General Accepted Accounting Principles (GAAP)

Standards of Performance Generally Accepted Accounting Standards (GAAS)

Criminal or civil law, statutory regulations Specified procedures, rules, or regulations (e.g., tax laws and regulations)

Rules of evidence Criteria specified in agreements, laws or regulations, procedures for tax examiners

Effectiveness and efficiency

None specified

A financial statement auditor is governed by GAAS and is concerned with determining whether recorded information properly reflects the economic events that occurred during the accounting period. Since Generally Accepted Accounting Principles (GAAP) are the criteria for evaluating whether the accounting information is properly recorded, any auditor involved with these data must understand GAAP. In addition to understanding GAAP and accounting, the auditor must possess expertise in the accumulation and interpretation of audit evidence. It is this expertise that distinguishes financial statement auditors from accountants.

An example of a compliance auditor is an IRS agent. In this role, the agents conduct examinations of individuals’ and businesses’ tax returns to determine the extent to which their filed tax returns comply with the technical requirements of the tax law as imposed by the Internal Revenue Code and whether or not they have paid the right amount of taxes. In this role, the agents are determining compliance with the laws, hence the use of the term compliance audit. Another example of a compliance audit

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would be an audit demanded by a bank of a company’s financial records to determine if the bank requirements for a loan continuation have been met.

A fraud or forensic audit, on the other hand, is quite different. A fraud audit involves investigating predication of fraud once fraud is suspected or predication is present.

The purpose of a fraud audit is to find the truth: to determine whether or not fraud really occurred, how much fraud existed, who committed the fraud, what the perpetrators motivations were, and so forth. A fraud auditor gathers evidence that can be used to make decisions about whether or not to pursue legal remedies and what should happen to the suspected perpetrators. Fraud audits can provide evidence that helps to exonerate and convict suspected perpetrators.

In the case of Enron, the audit performed by Arthur Andersen was an audit as governed by GAAS. As such, Andersen’s objective was to obtain sufficient competent evidential matter to provide the firm with a reasonable basis for forming an opinion. The amount and kinds of evidential matter required to support an informed opinion are matters for the auditor to determine in the exercise of professional judgment after a careful study of the circumstances in the particular case.

In the great majority of cases, the auditor finds it necessary to rely on evidence that is persuasive rather than convincing. Both the individual assertions in financial statements and the overall proposition that the financial statements as a whole present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles, are of such a nature that even an experienced auditor is seldom convinced beyond all doubt with respect to all aspects of the statements being audited. An auditor typically works within economic limits; his opinion, to be economically useful, must be formed within a reasonable length of time and at reasonable cost. The auditor must decide, again exercising professional judgment, whether the evidential matter available to him within the limits of time and cost is sufficient to justify expression of an opinion. (AU 326, pp.20–21.)

An auditor cannot obtain absolute assurance that material misstatements in the financial statements will be detected. Because of the concealment aspects of fraudulent activity, including the fact that fraud often involves collusion or falsified documentation, and the need to apply professional judgment in the identification and evaluation of fraud risk factors and other conditions, even a properly planned and performed audit may not detect a material misstatement resulting from fraud.

Accordingly, because of the previously discussed characteristics of fraud and the nature of fraud evidence, the auditor is able to obtain only reasonable assurance that material misstatements in the financial statements, including misstatements resulting from fraud, are detected. (AU 316, p. 10.)

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As these standards state, even a properly planned and conducted financial statement audit may not detect a material misstatement resulting from fraud. The following table outlines some of the differences between a financial statement audit and a fraud audit: Characteristic of Audit

Purpose of the audit Motivation for the audit Training and background of auditors

Focus of work Reason for examining internal controls

Reliance on management representations

Extent of testing Timing of work

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Financial Statement (GAAS) Audit

Forensic (Fraud) Audit

To detect and investigate suspected fraud. A fraud auditor To determine the “fairness” of the financial determines the who, when, how, statements. and how much of a fraud.

Predication (specific allegation Required by regulators as part of SEC or suspicion) of fraud already filings or annual reports. exists.

Forgery, conspiracy, lying, deceit, fraud schemes, detection Generally accepted accounting principles and investigation methods, and generally accepted auditing standards. criminal profiles, laws, etc.

Specific accounts, procedures, or activities (where predication Overall financial statements. exists).

To see where specific fraud opportunities exist so it can be determined if they have been To establish the scope of and plan the audit. abused.

Must rely on management representations Knows that representations because it is both economically and cannot be relied upon; thus, inherently impossible to place no reliance— demands proof through physical a GAAS auditor neither assumes guilt nor inspection and corroboration of innocence of management. evidence.

Much more extensive. Fraud auditors examine entire populations where fraud is suspected. In this case, the fraud auditors (Andersen) spent 3,700 man-days over a 16-week period at a cost of $19 million to conduct their fraud audit.

Sampling and selective testing based on a (And that was after the risk approach. coconspirators had confessed.)

At year end, therefore somewhat predictable Whenever there is an allegation; and easier to conceal fraud. usually by surprise.

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Access to information

GAAS auditors have to request information from the management of the client. There are many “prepared by client (PBC)” schedules used in a GAAS audit.

Participants in audits

GAAS auditors.

Time perspective

Past transactions, estimates, future occurrences, management’s plans, etc.

GAAS types of audit procedures (reperformance, analytical tests, documentation, confirmation, observation, physical examination, and inquiry).

GAAS auditors rarely see fraud.

Procedures used

Exposure to fraud

Fraud auditors can use the power of subpoena and court orders to get information. Since they are often working for an audit committee, as in this case, they can demand whatever information they want or need.

GAAS auditors, forensic accountants, lawyers, and investigators.

Always looking at the past with 20/20 hindsight.

Surveillance, interrogation, invigilation, confessions, confiscation of computers and other evidence, etc.

(Any method needed.)

Fraud auditors spend their time studying and investigating fraud.

One of the major differences between a financial statement and a fraud audit is the focus of the work. As stated earlier, financial statement audits look at the entire financial statements. Fraud audits, on the other hand, focus extensively on selected accounts where there are suspicions and questions.

Another major difference is the time perspective of fraud and GAAS audits. Fraud audits have the benefit of hindsight whereas GAAS audits do not. Unfortunately, hindsight allows us to revise our judgments of events after the fact. Knowing that a fraud existed creates a growing sense that, in retrospect, what has happened was actually inevitable. Hindsight turns unexpected events into expected events and makes it less surprising than it would have been without the benefit of hindsight. The problem with a priori audits is that there is always noise. In fact, with respect to finding fraud, nonfraud-related information is vastly more plentiful than fraud-related information.

Information about someone’s fraudulent intentions tends to be short on detail. With fraud, there rarely is a clear story—at least, not until afterward when, after a thorough investigation, hindsight allows one to be written. Further, hindsight bias is inevitable when there is knowledge of an adverse outcome. Reviewers who know of an adverse outcome are more likely to trivialize the a priori dilemma facing auditors. For the auditor to detect the fraud, he or she would have had to connect the few dots that

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related to the fraud from among the thousands of records and dots that were irrelevant.

With hindsight, people with knowledge of the outcome have a tendency to believe falsely that they would have found the fraud and to exaggerate the likelihood that the fraud should have been discovered. Unfortunately, with hindsight bias, people tend to believe that the fraud would have been equally predictable and detectible using foresight.

While auditing standards provide that a GAAS audit be planned and performed to provide reasonable assurance of detecting frauds that are material to the financial statements, they do not require auditors to be fraud experts.

Internet Assignments 1. Here is an example of a possible solution using the assets of Oracle Corporation.

Oracle Corporation ASSETS (in millions) Current assets: Cash and cash equivalents Marketable securities Trade receivables Other receivables Deferred tax assets Prepaid expenses and other current assets Total current assets Non-current assets: Property, net Intangible assets, net Goodwill Other assets Total non-current assets Total assets

2005

Vertical Analysis

Vertical Analysis

2006

Horizontal Analysis

3,894 877 2,570 330 486

18.82% 4.24% 12.42% 1.60% 2.35%

6,659 946 3,022 398 714

22.94% 3.26% 10.41% 1.37% 2.46%

71.01% 7.87% 17.59% 20.61% 46.91%

291 8,448

1.41% 40.84%

235 11,974

0.81% 41.25%

-19.24% 41.74%

1,442

6.97%

1,391

4.79%

-3.54%

3,373 7,003 421

16.30% 33.85% 2.04%

4,528 9,809 1,327

15.60% 33.79% 4.57%

34.24% 40.07% 215.20%

12,239

59.16%

17,055

58.75%

39.35%

20,687

100.00%

29,029

100.00%

40.32%

2. The answer to this question will depend on which year of IBM’s financial statements are searched. The answer might be something like the following, which is an analysis of a recent year of IBM’s footnotes. Using the annual report, the revenue policies seem legitimate. However, there may be some concerns about the use of contracts for

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services and software licenses. The note concerning inventory provides a table separating finished goods from work in process. The amount in finished goods has increased over the year, while work in process decreased. This may signal that sales are dropping, causing more goods to wait before being shipped out. Total revenues for the period have only increased 0.97 percent since last year, and revenues increased 7.2 percent over the previous year. The largest component of revenues, hardware, actually decreased by 0.29 percent. In the management discussion, it concludes that the decrease in hardware is due to decreasing prices in memory chips and less reliance on servers to generate revenues. These changes seem consistent with what would be expected. Total inventory decreased by 2.1 percent during the year, which seems to remain consistent with the decreasing sales in hardware.

Debate This case provides a setting in which students can think about ethical issues and professional issues. As such, there is no correct answer to this case. However, here are some things a student might think about: 1. Ethical principles require professionals to consider the impact of their actions.

2. The basic issue is not whether a decision is legal or illegal, as legal issues may be unethical in some cases. Therefore, a student must look beyond the standard of “legal/illegal.” In this case, even though IBM did what is legal, were their actions unethical?

Is it misleading the investment community if growth is not from a company’s core operations but from accounting adjustments, which are unlikely to continue?

Answers to Stop and Think Questions 1. What are some potential problems with using anonymous whistle-blowing systems? a. Anonymous whistle-blowing systems are useful in helping people overcome certain fears of reporting the possibilities of fraudulent activities. However, a few possible problems with these anonymous whistle-blowing systems can include, but are not limited to the following:

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Tips or complaints can be made on particular people for unsubstantiated reasons. Complaints can be made out of spite, jealousy, or for other reasons.

•

Unsubstantiated complaints can cost companies a great deal of money to investigate.

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•

Because complaints are anonymous, it is difficult to follow-up with those who complained to see if complaints are resolved or to obtain further information if the initial report lacked critical information.

2. What are some potentially legitimate reasons a company may have high inventory balances? a. Many potentially legitimate reasons exist for why a company could have high inventory balances. These include, but are not limited to the following:

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Costs associated with holding inventory are lower than that of obtaining the inventory (i.e., shipping costs, ordering costs, etc.)

•

A company may be stocking up for expected large-volume sales (i.e., seasonal sales, introduction of a new, popular product, etc.)

•

Inventory may not be selling as well as expected.

•

The operating nature of a business is such that inventory is generally held for longer periods of time or is quite expensive (i.e., luxury car sales, luxury jewelry, etc.)

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Chapter 13 LIABILITY, ASSET, AND INADEQUATE DISCLOSURE FRAUDS

Discussion Questions 1. Understatement of liability frauds are difficult to discover because often no recorded amounts exist to determine whether amounts are appropriate. In most cases, liability understatements involve leaving the liabilities completely off the books.

2.

Four methods used to search for financial statement fraud symptoms are: •

Look for unusual changes or trends in liability balances from period to period.

•

Look for unusual changes in liability relationships from period to period.

•

Compare financial results and trends of the company to similar firms within the industry.

•

Compare recorded amounts in the financial statements with the assets they are supposed to represent or with amounts outside the financial statements.

Examples for each of the above methods are as follows:

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To study changes in individual liability balances, examine the changes in liabilities presented on the statement of cash flows, or preferably use horizontal analysis to examine the percentage change in each liability account quickly to determine if it is unusual.

•

Relationships can be examined by looking at changes in ratios, including the acid test, current, accounts payable/purchases, accounts payable/total liabilities, and interest expense/notes payable ratios, among others.

•

Comparisons with other firms might include comparing warranty expense and liability as a percentage of sales with competitor firms.

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•

Comparing liabilities with assets they are supposed to represent might include examining the increases in mortgages payable with the new buildings purchased or constructed during the year.

3. Cutoff problems relate to the inclusion of all accounts payable (or other assets or liabilities) that should be reported in the current period and exclusion of all that should be reported in past and future periods. Cutoff means properly including or not including end-of-period items. For example, including accounts payable incurred on December 30 as a liability in January but not December would represent a cutoff problem and possible financial statement fraud.

4. If proper adjusting entries are not made, accrued liabilities would not be recorded.

These types of liabilities are only recorded with adjusting entries. Leaving them off the financial statements could constitute financial statement fraud if it were done intentionally.

5. Unearned revenues (or liabilities) are amounts received from customers that have not yet been earned and that should be recorded as liabilities; earned revenues are amounts received or due from customers, which have been earned and should be reported as revenues. Improperly recognizing unearned revenues as earned could constitute financial statement fraud if done intentionally.

6. Financial statement readers deserve to know about contingent or possible liabilities that may have to be paid in the future. Accounting rules require contingent liabilities whose likelihood of payment is “reasonably possible” to be disclosed in the footnotes and contingent liabilities whose likelihood of payment is “probable” to be recorded as liabilities in the financial statements. Failure to record or disclose contingent liabilities properly could constitute financial statement fraud if done intentionally.

7. Documentary symptoms of underrecording contingent liabilities could include the following: • • • • • • •

Identification of lawsuits by attorneys Payments made to attorneys without acknowledged litigation Mention of litigation in corporate minutes Correspondence with governmental agencies, such as the Environmental Protection Agency (EPA), or the Securities and Exchange Commission (SEC) Significant payments to plaintiffs and others Withdrawal or issuance of an other-than-clean audit opinion by predecessor auditors Correspondence from previous auditors, banks, regulators, or others.

8. Capitalization means recording something (such as start-up costs) as an asset rather than as an expense. Improper capitalization would result in the overstatement of assets and the understatement of expenses and could constitute financial statement fraud if done intentionally.

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9. Although cash is the most common asset stolen in employee frauds, it is not an asset that is frequently overstated when committing financial statement fraud. The reason is because, by confirming bank balances and using other audit procedures, it is quite easy to determine if cash is overstated.

10. When two firms merge, there are specific accounting rules that dictate at what amounts acquired assets should be recorded. Sometimes, merged companies manipulate these rules to overstate the assets of the combined company and thus commit financial statement fraud. Another type of merger-related fraud is to overstate merger reserves (a one-time, nonoperating charge) and then reverse those charges into income or to hide operating expenses in the merger reserve.

11. If all statement amounts are presented appropriately, financial statement fraud could still be occurring because of omissions of required or informative disclosures that should have been made. This type of fraud is labeled disclosure fraud.

12. The four kinds of analysis that can be used in searching for analytical fraud symptoms are: • • • •

Comparing changes and trends in financial statement account balances.

Comparing changes and trends in financial statement relationships.

Comparing financial statement balances with nonfinancial statement information or things, such as the assets they represent.

Comparing financial statement balances and policies with those used by other similar companies.

13. Some possible explanations for the differences in the amount of fixed assets compared to sales could include the following: • • • •

The first company is much more efficient.

The second company may have just spent millions renovating its facilities.

The second company's fixed assets are newer and less depreciated.

The second company is overstating its assets and committing fraud.

All of these explanations are alternatives that you should consider when finding differences between companies in the same industry.

14. Disclosure fraud can be categorized into the following three groups: • •

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Overall misrepresentations about the nature of the company or its products, usually made through news reports, interviews, annual reports, and elsewhere.

Misrepresentations in the Management Discussions and Analysis (MD&A), such as Edison Schools Inc., or in other nonfinancial statement sections of annual reports, 10-Ks, 10-Qs, and other reports.

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•

Misrepresentations and omissions in the footnotes to the financial statements, such as the failure to disclose related-party transactions.

True/False 1. False. Management generally has incentives to understate liabilities to make earnings and financial statements look better. However, there are times when management may overstate liabilities such as merger reserves in order to smooth income at a later date. Even so, the bigger concern is to understate liabilities.

2. True 3. False. Confirmations are an effective way of finding understated liabilities with banks and other creditors with which a company does regular business. However, if the management of a company wanted to hide debt from auditors or others, they would usually not include the hidden creditors on a list provided to the auditors.

4. True 5. False. Since there are usually no reported amounts for contingent liabilities, there are no ratios that would indicate whether unrecorded liabilities are being recorded or not.

In general, you would need to look for documentation or receive confirmation from third parties or attorneys to find contingent liabilities.

6. True 7. True 8. True 9. False. Intangible assets are assets most often improperly capitalized.

10. True 11. True 12. False. Most financial statement frauds occur in smaller, less-established companies; however, CPAs must be alert to the symptoms of financial statement fraud when auditing large, well-established companies as well.

13. True 14. False. Comparing this type of financial statement information is often very helpful in identifying fraud symptoms of underrecorded liabilities. For example, if recorded interest expense is high relative to the interest rate on the debt and the recorded

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balance of the debt, then either interest expense is overstated or the liability is understated.

15. True 16. False. Comparing cash and marketable security balances with those of similar companies is usually not very helpful. Even similar companies often have significantly different amounts of cash and marketable securities because they have different plans and different spending patterns.

Multiple Choice 1. e: Selling purchased goods can create warranty liabilities.

2. b 3. f 4. c 5. c 6. a 7. d 8. d 9. a 10. c 11. d 12. a 13. b 14. d 15. d 16. a 17. d

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18. e (both b and c are correct) 19. b 20. d 21. d 22. e Short Cases Case 1 1. Possible fraud symptoms include the following: a. John’s revenues have increased dramatically, but his warranty costs have not.

This could be a sign of understatement of expenses and warranty liabilities to show higher profits and lower liabilities. Usually, with additional sales, inventory increases as well. With the growth of a company comes increases in loans or outside funding, but John’s financial statements do not reflect any such funding.

2. John’s increased sales at lower costs could be the result of better products requiring less service than in years past. The revenue increase and lower inventory balance could also be caused by industry improvements and decreases in product costs.

Case 2 Finding these off-balance-sheet liabilities could be difficult. Some evidence of the creation of these partnerships [special purpose entities—SPEs—now called variable interest entities (VIEs)] should be included in board minutes. In addition, communications with banks and other financing sources may have revealed Enron had guaranteed the debt related to these entities with its stock. Interviews with executives about unrecorded liabilities might have revealed the liabilities. Interviews with non-executives may have even been more effective as some employees (such as Sharon Watkins) were unhappy with the way Enron was structuring these transactions. A search for related parties could have revealed the existence of the partnerships. Investigators could have questioned how the company grew so fast and had the high level of assets it had with the small amount of debt it was reporting. Lien searches in states where Enron’s funding sources reside might have disclosed unrecorded liabilities.

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Case 3 When expenses are recorded, assets are either decreased or liabilities are recorded. Not recording expenses means the company is either overstating its assets or understating its liabilities, both of which are types of fraud as discussed in this chapter. If significant, the nonrecording of expenses could result in material financial statement fraud, causing investors to be misled. Since the SEC’s role is to protect investors, the understatement of expenses should be of major concern to the SEC. Case 4 1. Because at the time, it was unclear how much would ultimately have to be paid to creditors, if any, and because there was uncertainty regarding the protection offered partners in a CPA firm by “LLC” status, these litigation claims represented a contingent liability. The way this contingent liability should have been reported depended on the likelihood of payment. If you had determined payment was probable and the amount was reasonably estimable, the estimated amount of claims to be paid should have been recorded as a liability in the financial statements.

2. If payment were reasonably possible or not reasonably estimable, footnote disclosure should have been included. Failure to disclose or report these contingent liabilities would probably constitute financial statement fraud. Since Arthur Andersen is now out of business, it will be interesting to see how much legal protection the LLC form of business offers its former partners.

Case 5 There are four reasons why the market value of the stock dropped so dramatically. First, the existence of these loans was a complete surprise to investors. Second, these were loans to a related party (the CEO’s company) and signal that the company’s CEO has the ability to use company funds in any way he desired. The presence of these guarantees represented an internal control environment that was problematic. Third, the company will be liable to repay these loans if the related entity defaults. If the related entity were strong enough on its own, it would not have needed Adelphia’s guarantees to secure the loans. Fourth, if surprises such as this occur, investors have to be wondering what the next surprise will be and if the financial reports are accurate or whether financial statement fraud is occurring. As we know now, there was significant corporate looting and financial statement fraud at Adelphia.

Case 6 Auditing fraud standards state that it is very difficult to detect fraud that involves forgery and/or collusion. In fact, auditing standards (SAS 99) state that the existence of an undetected fraud does not mean a negligent audit was performed. However, the auditors could have questioned why they were being shown photocopies rather than original records. In addition, cut-off tests of inventory and accounts payable, together with confirmations to vendors, would probably have disclosed the fraud. It is not always clear whether or not a negligent

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audit was performed in cases like this. That is why auditors and plaintiffs are willing to spend millions of dollars defending or supporting their cases (as they did in this case) because they both think they are right. Ultimately, this auditor negligence case was settled out of court for an undisclosed amount.

Case 7 Acid-test ratio (Quick assets/Current liabilities) Current ratio (Current assets/Current liabilities) Accounts payable/Cost of goods sold Accounts payable/Total liabilities Accounts payable/Inventory

20x1 1.12 1.49 0.31 0.23 3.68

20x2 1.07 1.37 0.23 0.19 3.70

20x3 0.73 1.00 0.31 0.19 5.29

Possible fraud Possible fraud Possible fraud

All ratios focus on the reasonableness of the accounts payable balance relative to related account balances. Increases in the acid-test and current ratios and decreases in the accounts payable to inventory ratios are indicative of accounts payable fraud.

Case 8 There are several ways a company might try to understate liabilities, including the following: •

Not recording loans incurred,

•

Borrowing but not disclosing debt incurred on existing lines of credit,

•

Underrecording or not reporting debt (notes, mortgages, etc.) of related parties, and

•

Claiming that debt on a company’s books is personal debt of the owners or principals rather than debt of the business.

Case 9 1. There are three main red flags of financial statement fraud. a. Sales may be overstated, because sales increased 304 percent from 2007 to 2015. However, sales only increased 152 percent from 2014 to 2015. b. Allowance for doubtful accounts may be understated because in 2016, allowance for doubtful accounts is only 1.2 percent of A/R before net.

However, in 2015, it accounted for 3.5 percent of A/R before net. c. Cost of goods sold may be understated. The COGS as a percentage of sales in 2016 is 42 percent. In 2015 and 2014, the COGS as a percentage of sales is 54.9 percent and 55 percent, respectively.

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2014

2015

2x16

Allowable for doubtful accounts as % of A/R

148,300—1.16%

139,200—3.42%

Sales and % of increase

37,847,681—304%

12,445,015—152%

8,213,236

COGS and % of sales

15,895,741—42%

6,832,927—54.9%

4,523,186—55%

2. The company may be involved in several different types of financial statement fraud including, but not limited to: a. Inflated Sales b. Understatement of allowance for doubtful accounts, or c. Understatement of cost of goods sold.

It is also very unusual that the amount of Inventories is exactly equal to Other Current Assets in both 2016 and 2015.

Case 10 1. Revenue recognition—Cutter and Buck improperly recognized as revenue $5.7 million in shipments to distributors functioning as company warehouses and later concealed the improper transactions from the auditors, board of directors, and shareholders. Improper revenue recognition is the most common type of financial statement fraud.

2. These shipments were evidently made on a consignment basis, since distributors had no obligation to pay for the goods. Thus, shipments should not have been recorded as sales until the distributors had resold the merchandise.

3. Some of the pressures that may have led to this fraud are declining sales, tough competition, slow economy, shareholders who demand a higher stock return, and threat to management of being fired or demoted.

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Case 11 1&2 FASB Statement 5 requires the recording of contingent liabilities on the balance sheet if they are probable and estimable. This means that the liability will probably be incurred and that it can be reasonably valued. If there is only a reasonable possibility that the liability will be incurred, then it should be disclosed in the financial statement notes.

3&4 At this point, the value of the liability can be reasonably estimated at the full amount of the loan received by No Certainty, and it is reasonably possible that the contingent liability will occur. Consequently, the appropriate accounting treatment is to disclose the liability in the financial statement notes. Recording the full amount of the loan as a liability would not accurately reflect the financial status of Wehav Funds; bear in mind, accounting is conservative and should encourage transparency, but financial statements should not be the “worst-case scenario.”

Case 12 1. This case provides an example of how an acquisition provides opportunities for fraud perpetrators to manipulate their financial reports to make them look more favorable.

2. The fraud in this case results from inappropriately using acquisition accounting to inflate assets. Companies involved in mergers and acquisitions have wrongly taken an opportunity to use inappropriate market values (instead of book values), by assigning higher book values to assets that will be amortized or depreciated, or by assigning worthless assets to goodwill.

3. Several controls may have helped prevent this type of fraud. However, because it involves management fraud, a very effective and vigilant Board of Directors is likely the only effective control within the organization. The Board would need to be very involved and understand what management is doing in order to prevent such practices. Another approach to preventing this fraud may involve changing the accounting regulation for acquisition accounting. Under current accounting standards, companies are not required to report the portion of their earnings that result from acquisitions. As such, regulators could help prevent this type of fraud by requiring companies to reveal, in detail, the amount of profit from acquisitions. Requiring such disclosures would make these types of manipulations more transparent to investors and may help prevent instances of merger/acquisition fraud.

Case 13 1. There are a couple of valid reasons for the increase in inventory cost. First, if the company reports its inventory at cost, it is possible that the company has recently

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purchased inventory at a much higher cost than in prior periods. Second, although you have just finished a comprehensive audit of all physical controls, you may have missed something that is contributing to the increase in inventory. It is important that students realize that although red flags exist, we still do not know for certain that fraud is occurring.

2. It is easy for a perpetrator to commit this type of fraud. The perpetrator need only change the amount of inventory in order to manipulate the financial statements.

Micky Monus, CEO of Phar-Mor, perpetrated one of the largest inventory-related financial statement schemes by simply moving excess inventory to warehouses or store locations where he knew the auditors were going to verify numbers.

3. One of the best and easiest ways to prevent this type of fraud is to check inventory numbers with actual physical amounts. By overstating inventory, management lowers the cost of goods sold, which improves gross profit and net income. Since management need only make adjusting entries to inventory to get a quick boost to the financial statements, it is important that auditors and fraud examiners check inventory accounts regularly.

Case 14 Investors entrusted millions of dollars to Bayou Funds despite several red flags that some research on the Internet or a bit of asking around might have uncovered. Investors could have done the following to discover fraudulent behavior and prevent their monetary losses: •

Research the authenticity of the sham “independent” audit firm. When an unknown firm is the one that audits the financial statements, this should raise red flags and encourage investors to investigate further. (Through investigation, one would find out that Marino was the registered agent for the accounting firm).

•

Investors could have researched whether any lawsuits against the company or reports were made to regulatory agencies regarding behavior by the company. (An estranged partner in the business sued Bayou in federal court in Louisiana, alleging $7 million was missing from a trading account and that he’d seen evidence of potential securities-law violations).

•

Prospective investors should have thoroughly inquired of management about the funds—terms of the contracts governing the funds, investment strategies, investment instruments used in the funds, etc. Any oddities or discoveries out of the ordinary would raise red flags for investors.

•

Investors should have looked into companies which did business with the funds. For example, they could have investigated the broker firm and inquired of any odd events or behavior by managers of the firm. By doing this they would find that the broker was a related firm, Bayou Securities LLC, which was fined by regulators for

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incomplete records. Discovering these things would indicate inadequate disclosure and raise red flags.

•

Investors could compare the performance of Bayou Funds with other similar funds in the industry. Any significant differences should raise red flags.

Additional articles can be found at the following sites: • • •

www.post-gazette.com/pg/05241/562008.stm www.usatoday.com/money/industries/brokerage/2005-08-30-bayou-usat_x.htm www.allbusiness.com/accounting-reporting/fraud/613459-1.html

Case Studies Case Study 1 1. The SEC is responsible for creating and enforcing laws that prevent fraud and punish perpetrators. One such law requires that all publicly traded companies submit their public reports and financial statements to the SEC on an annual basis for review.

Knowing that they are under constant scrutiny by the SEC will discourage most companies from engaging in security fraud. Other regulations enforced by the SEC bring similar results.

2. Each year, the executives at Waste Management set earnings targets for the upcoming year. By meeting these annual targets, the executives could qualify for promotions and large bonuses. In addition, as the company consistently met annual earnings targets, the value of the company’s stock also increased. The rise in stock price brought huge benefits to the company executives, who were compensated primarily with enormous stock option plans. Therefore, by fraudulently altering its reported numbers, Waste Management appeared to reach its targeted goals and its executives were able to “enrich themselves” with increased income and status.

3. Answers will vary, although we hope your students will provide an ethical, high-road answer. This is the kind of pressure that sometimes motivates managers to commit fraud. There are a number of actual cases very similar to these. You should be able to have a good class discussion based on this requirement.

Article found at www.sec.gov/news/headlines/wastemgmt6.htm.

Case Study 2 1. Answers will vary, although we hope your students will provide an ethical, high-road answer. This situation really happened at WorldCom and at some other companies that committed financial statement fraud. This requirement should provide you with

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an opportunity to discuss ethical dilemmas that your students will face after they graduate.

2. Altering the reported financial statements will usually cause more harm to a company than would employee embezzlement or any other form of fraud. This is true because of one simple fact: the success of a company depends on the amount of trust that shareholders, customers, and employees have in it. When it is discovered that a company has compromised its integrity by falsifying financial statements, the company immediately loses the trust of its stakeholders. And without that trust, stock prices drop and the company often crumbles. As the company falls, customers lose confidence in its products and employees ultimately lose their jobs. Hence, through the domino effect, a company can quickly be reduced from a multibillion-dollar revenue-making machine to bankruptcy. It has been reported that financial statement fraud often causes a drop in the market value of a stock by about 500 to 1,000 times the amount of the fraud. WorldCom is a good example of how expensive financial statement fraud can be. As a result of an alleged $11 billion fraud, the company quickly declared the largest bankruptcy in the history of the United States—some $101.9 billion. Shareholders lost more than $180 billion of invested funds, leaving them with virtually nothing. Furthermore, tens of thousands of employees lost their jobs and could no longer claim their hard-earned retirement savings. Clearly, everybody lost due to fraud schemes that could and should have been avoided.

3. By requiring auditors to examine and report on the effectiveness of a company’s internal control structure, the U.S. government hopes to decrease the amount of financial statement fraud that occurs in the future. When management is forced to include its auditor’s evaluations of company internal controls in its annual public reports, it will be more concerned about improving the company’s internal controls.

And, as the company’s internal controls improve, there will be less opportunity to commit fraud. Therefore, the new policies set forth by the Sarbanes-Oxley Act will help to prevent financial statement fraud from occurring.

Internet Assignment 1. a. Conferences, employee meetings, conference calls, press releases, interviews, SEC filings, and statements to members of the media are the seven forums through which the defendants are accused of disseminating false and misleading statements. b. 16 c. 14 d. Enron reported that it would restate its financial statements over the past several years, and that previously issued reports for those years should not be

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relied on. Enron announced the organization of the Special Committee to review their recent accounting practices, and it explained the illicit nature of its LJM partnerships. This form 8-K seemed to be Enron’s way of coming clean about its illegal activity.

Debate While many off-balance-sheet liabilities are perfectly acceptable under GAAP, many people believe that Lehman’s use of off-balance-sheet activities was unethical. The bankruptcy examiner, wrote in his report that these repo 105 and 108 transactions may ultimately lead to a lawsuit against Lehman’s auditor, Ernst and Young. Currently, the SEC is investigating these transactions and some lawsuits alleging fraud have been filed. Whether the courts or the SEC will determine that Lehman’s repo 105 and 108 transactions constituted financial statement fraud depends on whether GAAP was followed and whether it was management’s intent to deceive investors and creditors. This bankruptcy report makes a strong case that these conditions did exist and, therefore, fraud charges may prevail. However, the incentive of the bankruptcy examiner is to recover as many assets as possible so he may be motivated to show fraud in this situation so that the firm can recover assets from Lehman’s auditor. In any case, the transactions are certainly far from transparent which should lead us to conclude that the firm was not very ethical.

Answers to Stop and Think Questions 1. Why would so many people invest in a company like AFCO? What could investors have done to have prevented themselves from falling into investment schemes such as this? e. People are often interested in profitable ventures; they often follow the actions of reputable people; and they are sometimes too trusting in others. Many people are attracted to investments that promise to provide great returns, while blind-sighted by the prospect of quick, easy money. In addition, in the case of AFCO, people may have invested because of the reputation of other investors.

When a potential investor sees that someone they know and respect is investing, then they become more likely to follow and invest themselves.

When a fraud is perpetrated through a culture because of acquaintances such as this, the fraud is referred to as “affinity fraud.”

Investors could have prevented their losses by performing proper research.

Investors should have asked if an outside auditor had audited the financial statements of the company and what was the auditor’s opinion of the company. When investors were asked to take out second mortgages on their homes, or when excessive return rates were promised without much assurance, red flags should have risen in the minds of many investors to do

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further research into AFCO. The old saying that “if it looks too good to be true, it probably is” is very applicable here!

2. How often do investors review the nonfinancial section of annual reports? Why is it important to read the nonfinancial sections of annual reports or the footnotes to the financial statements? a. It is important to look at the nonfinancial section of the annual report or the footnotes to the financial statements because they can indicate symptoms of possible fraud. In these parts of the annual report, one can find symptoms related to the nature of the company, its assets and organization, its management, and its operating characteristics. Descriptions about or explanations of various aspects of the business or its people may help to raise red flags when examined carefully.

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Chapter 14 Fraud Against Organizations Discussion Questions 1.

Employees, vendors, and customers of organizations have three opportunities to steal assets: they can steal cash and other assets as they are coming into an organization (receipt fraud), they can steal cash and other assets that are on hand, or they can commit disbursement fraud by having the organization pay for something it shouldn’t pay for or pay too much for something it purchases. With each of these three types of fraud, the perpetrators can act alone or they can work in collusion with others.

2.

With larceny, employees or others steal cash after it has already been recorded in the company’s accounting system. Larcenies can take place in any circumstance in which an employee has access to cash. Common larceny schemes involve the theft of cash or currency on hand (in a cash register or cash box, for example) or from bank deposits. Cash larcenies are most successful when they involve relatively small amounts over extended periods of time. With such thefts, businesses often write the small missing amounts off as “shorts” or “miscounts,” rather than as thefts.

3.

The most basic skimming scheme is taking money from the sale of goods or services but making no record of the sale. More complicated skimming schemes occur when employees understate sales and collections by recording false or larger-than-reality sales discounts, misappropriate customer payments and write the receivable off as “uncollectible,” embezzle a first customer’s payment and then credit that customer’s account when a second customer pays (this sort of delayed recognition of payment is called lapping), or works together with customers to allow them to pay later than required or less than required.

4.

The research studies of the ACFE found that fraudulent disbursements comprised the highest percentage of asset misappropriations by far. In fact, based on the number of cases studied, fraudulent disbursements more than doubled the total of skimming and larceny. The ACFE divides fraudulent disbursements into six major types: check tampering, register disbursement schemes, billing schemes, expense schemes, payroll schemes, and other fraudulent disbursements.

5.

Check tampering is a type of fraudulent disbursement scheme in which an employee either prepares a fraudulent check for his or her own benefit or intercepts a check intended for a third party and converts the check to his own benefit. Check tampering is unique among the disbursement frauds because it is the one group of schemes in which the perpetrator physically prepares the fraudulent check. In most fraudulent disbursement schemes, the culprit generates

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a payment to him or herself by submitting some false document to the victim company, such as an invoice or a time card. The false document represents a claim for payment and causes the victim company to issue a check, which the perpetrator then converts. These frauds essentially amount to trickery; the perpetrator fools the company into handing over its money. Check tampering schemes are fundamentally different. With check tampering, the fraud perpetrator takes physical control of a check and makes it payable to himself or herself by either forging the maker (signing the check), forging endorsements, or altering payees.

6.

Register disbursement schemes are among the least costly of all disbursement schemes.. There are two basic fraudulent disbursement schemes that take place at the register: false refunds and false voids. With false refunds, a fraud perpetrator processes a transaction as if a customer were returning merchandise, even though there is no actual return. The fraud perpetrator then takes money from the cash register in the amount of the false return. Since the register tape shows that a merchandise return has been made, it appears that the disbursement is legitimate.

The concealment problem for perpetrators is that with false refunds, a debit is made to the inventory system, showing that merchandise has been returned.

Since no inventory was returned, the recorded inventory amount is overstated and an inventory count may reveal the “missing” inventory. A similar and more difficult fraud to detect is the overstating of refunds. In these cases, merchandise is actually returned, but the value of the return is overstated.

7.

With billing schemes, the perpetrator does not have to undergo the risk of taking company cash or merchandise. In a billing scheme, the perpetrator submits or alters an invoice that causes his employer to issue a check willingly. Although the support for the check is fraudulent, the disbursement itself is facially valid.

Billing schemes are extremely common and quite expensive. The median cost of billing schemes in the ACFE study was the highest of all asset misappropriation classifications. Since the majority of most businesses’ disbursements are made in the purchasing cycle, larger thefts can be hidden through false billing schemes easier than through other kinds of fraudulent disbursements. Employees who utilize billing schemes are just going where the money is. The three most common types of billing schemes are setting up dummy companies (shell companies) to submit invoices to the victim organization, altering or doublepaying nonaccomplice vendors’ statements, and making personal purchases with company funds.

8.

Expense and payroll schemes are similar to billing schemes. The perpetrators of these frauds produce false documentation that causes the victim company to make a fraudulent disbursement unknowingly. With expense and payroll schemes, the false documentation includes items like time cards, sales orders, and expense reports. Expense schemes involve over billing the company for travel and other related business expenses, such as business lunches, hotel bills, air travel, and so forth. There are four common types of expense disbursement

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schemes: mischaracterizing expenses, overstating expenses, submitting fictitious expenses, and submitting the same expense multiple times. The first type of expense disbursement fraud involves mischaracterizing a personal expense to make it look like a business expense.

9.

One of the most common ways in which executives loot their companies is with disbursement frauds. Executives do this through low-interest or interest-free loans. In some cases, companies will forgive repayment of loans. When executives illegally loot their companies, in one form or another, they use corporate funds for personal use.

10. While payroll schemes are common examples used when discussing fraud, in reality they account for only a very small percentage of all frauds. Payroll fraud schemes fall into four major categories: ghost employees, falsified hours and salary, commission schemes, and false workers’ compensation claims. Of all payroll fraud schemes, ghost employee schemes tend to generate the largest losses. According to the ACFE, their average loss per occurrence is very high and can be quite costly to organizations. Ghost employee frauds involve putting someone on the payroll who does not actually work for the victim company or keeping someone on the payroll who no longer works for the company. Through the falsification of personnel or payroll records, fraud perpetrators cause paychecks to be generated to a ghost. Fraud perpetrators or their accomplices then cash these paychecks. Use of a ghost employee scheme by a fraud perpetrator is like adding a second income to his/her household. In order for ghost employee fraud schemes to work, four things must happen: the ghost must be added to the payroll, timekeeping and wage rate information must be collected, a paycheck must be issued to the ghost (unless direct deposits are used), and the check must be delivered to the perpetrator or an accomplice.

11. Corruption can be broken down into the following four scheme types: bribery schemes, conflicts of interest schemes, economic extortion schemes, and illegal gratuity schemes. By far, the largest of these is bribery, followed by conflict of interest schemes, economic extortion schemes and illegal gratuity schemes.

12. Bribery involves the offering, giving, receiving, or soliciting of anything of value to influence an official act. The term “official act” means that traditional bribery statutes only proscribe payments made to influence the decisions of government agents or employees. Many occupational fraud schemes, however, involve commercial bribery, which is similar to the traditional definition of bribery except that something of value is offered to influence a business decision rather than an official act of government. In a commercial bribery scheme, and employee receives payment without the employer’s consent. In other words, commercial bribery cases deal with the acceptance of under-the-table payments in return for the exercise of influence over a business transaction.

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13. Kickbacks are undisclosed payments made by vendors to employees of purchasing companies. The purpose of a kickback is usually to enlist the corrupt employee in an over-billing scheme. Sometimes, vendors pay kickbacks simply to get extra business from the purchasing company. Since all vendor information is contained in the financial databases of a company, fraud examiners can proactively search databases for red flags. It is usually easy to identify kickbacks and similar types of frauds.

14. A conflict of interest occurs when an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the company. As with other corruption schemes, conflicts of interest involve the exertion of an employee’s influence to the detriment of his/her company.

Conflicts usually involve self-dealing by an employee. In some cases, an employee acts in a manner detrimental to his/her company in order to provide a benefit to a friend or relative, even though the fraud perpetrator receives no financial benefit from the transaction. In order to be classified as a conflict of interest scheme, the employee’s interest in a transaction must be undisclosed.

The essential element in a conflict case is that the fraud perpetrator takes advantage of his/her employer; the victim company is unaware that its employee has divided loyalties. If an employer knows of the employee’s interest in a business deal or negotiation, there can be no conflict of interest, no matter how favorable the arrangement is for the employee.

15. The six kinds of fraudulent disbursements include (1) check tampering, (2) register disbursement schemes, (3) billing schemes, (4) payroll schemes, (5) expense schemes, and (6) other fraudulent disbursements.

16. The four types of corruption are (1) bribery schemes, (2) conflicts of interest schemes, (3) economic extortion schemes and (4) illegal gratuity schemes.

17. While both involve the theft of cash, larceny schemes involve stealing cash that has already been recorded in the company’s accounting system. With the cash already accounted for, it is easier to determine when the cash is missing.

Skimming schemes involve stealing cash before it has been recorded in the records of the company.

True/False 1. False: The association has approximately 70,000 members.

2. False: Management and owners who commit fraud constitute a greater percentage than frauds committed by employees.

3. False: Fraud losses are not proportionate to age or education.

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4. True 5. False: Larceny schemes are less common than skimming schemes.

6. False: Billing schemes do not have the highest median loss per incident of all frauds.

7. False: Kickback schemes do not always involve the purchasing function of the victim company. In the chapter, an example of an accounts receivable kickback was presented.

8. True 9. False: Commercial bribery and traditional bribery can both be used to influence official government.

10. True 11. True 12. False: Skimming is the stealing of cash by employees before cash is recorded in the company’s accounting system.

13. True 14. True 15. True 16. True 17. False: Kickbacks are undisclosed payments made by vendors to employees for special benefits.

18. True 19. False: Illegal gratuities are made after deals are approved and before payment is accepted.

20. True 21. False Bid-rigging schemes involve an employee fraudulently assisting a vendor in winning a contract that is supposed to involve a competitive bidding process.

22. False False refunds involve processing a transaction as if a customer were returning merchandise, even though no actual return takes place.

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Multiple Choice 1.

a

2.

c

3.

b

4.

b

5.

b

6.

b

7.

c

8.

d

9.

b

10.

a

11.

b

12.

b

13.

d

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Short Cases Case 1.

1. What Regina is doing is called “false refunds.” It is one of several different “register disbursement schemes,” which are among the least costly of all disbursement schemes.

2. There are several ways to detect this kind of fraud. The employer should compare returns by different cashiers to see if one has unusually high returns. The employer could also employ “secret employees” to make returns, or could periodically check register tapes for returns. Cameras would also help in detecting this fraud.

Case 2.

1. The kind of fraud being committed is cash theft through fraudulent disbursements; check tampering.

2. Approximately 25% of frauds are of this type.

3. Safeguards in programs to prevent employees from changing vendor information are • Requiring two signatures on checks and • Segregation of duties; those who create checks should have no authorization power.

Case 3.

1.

The fact that the goods would generally be worthless if it were not for the buyer is irrelevant, since there is a buyer. The courts will be interested in every detail of every asset when it comes to liquidation and settlement with creditors. You should make every effort to record accurately and honestly the true value of all inventory items.

2.

It is a crime to falsify knowingly and fraudulently any documents, records, or statements during a bankruptcy. This situation, which creates an excellent opportunity for fraud, could easily result in inventory larceny.

Case 4.

Ed’s fraud scheme falls into the broad category of corruption. Specifically, Ed is involved in a conflict of interest purchasing scheme. Conflicts of interest occur when Chapter 14

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an employee has an undisclosed economic or personal interest in a transaction that adversely affects the company. Ed is committing the most common type of conflict purchasing scheme: Ed (the purchasing agent) has a personal interest in buying from Sarah’s line of products. In this case, Ed has divided loyalties. He wants to help his fiancée and is not considering that his actions will adversely affect his employer.

Although at first glance his actions do not look so bad, because Style high-fashion sales have decreased, the store will probably end up heavily discounting Sarah’s products and losing money.

Case 5.

Due to the nature of this question, answers will vary. However, each student should identify the following.

1.

2.

3.

4.

Whether the perpetrators were employees, management, owners, or customers.

The dollar amounts of the fraud.

The gender, age, marital status, and education level of the perpetrator.

The size of the company by number of employees.

Case 6.

Students should show proof that they have completed the quiz. The purpose of this quiz is to reinforce the chapter’s principles regarding fraud in the workplace.

Case 7.

1.

The type of fraud Ken committed was asset misappropriation, specifically stealing receipts.

2.

Ken could be prosecuted both civilly and criminally. The development company should try to regain as much of its losses as possible.

3.

To prevent this fraud, the owner could have been more involved in the accounting function; specifically, he should have reviewed the receipts more frequently in order to check for theft and/or customers who have not been paying.

Case 8.

1.

Jill is committing theft of cash through fraudulent disbursements (registerdisbursement scheme/fictitious voids).

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2.

The florist should improve the process for voids. The florist should require that a receipt is attached and information about the sale/void be collected, including the name of the salesperson, the reason for the void, and possibly a customer signature. The florist might also want to consider limiting who can complete voids rather than allowing any employee to do so. By collecting more information about voids, the florist can track who is completing voids, how often, and possibly detect any patterns or inappropriate voids.

In addition, the florist should work on a more efficient way of managing inventory. Instead of allowing the designers to use whatever inventory they would like, the florist could consider requiring their designers to document what inventory they use. They should also document how much inventory is lost to spoilage.

Case 9.

1.

Billing schemes and kickbacks are the types of fraud Jake Rosen committed.

2.

As discussed throughout the book, it is always less costly to prevent fraud than to detect and investigate fraud after it has already occurred. The hospital may have been able to do a better job of creating a culture of honesty and openness. A better open-door policy in the hospital may have allowed Mr. Rosen to speak with someone about his concerns before he felt pressure to commit fraud. A powerful code of ethics is always essential to create a positive work environment.

To help prevent the fraud, the hospital could have installed better controls. To prevent kickbacks and billing schemes, the hospital could have monitored its employees better. The company should have required mandatory vacations.

Hospital administration should have noted the increase in Mr. Rosen’s standard of living. Simple analytical procedures should have revealed some important red flags such as the unreasonable increase in maintenance expenses, unreasonable billing rates, and increase in volume of work.

Case 10.

The most possible explanation is that John Johnson is giving the work to his cousin, Johnson Cleaning. Although we do not know that fraud is occurring, several red flags are present. In a best -case scenario, a conflict of interest exists. Before accusing anyone, it is important that we investigate further so as not to falsely incriminate anyone.

Case 11.

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1.

Hank is committing corruption, and more specifically a conflict of interest sales scheme. He is selling items below market value to friends, resulting in a lower profit margin for the company. Hank is also receiving kickbacks.

2.

There are many ways that a company could find out about such a simple fraud.

First, the company could require management approval of all overrides. Second, it could require a detailed description for the reason of each override. Third, since the company has all the records of sales transactions, the company can periodically run a query on the volume of overrides attributed to each employee to see which employees are initiating overrides. If suspicious, the company could then monitor the employee’s actions or look back on previous video surveillance tapes to obtain further understanding.

Case 12.

1. Billing scheme – 4 2. Asset misappropriation – 7 3. Check tampering – 3 4. Disbursement fraud – 9 5. Expense scheme – 1 6. Investment scam – 10 7. Illegal gratuities – 6 8. Lapping – 2 9. Payroll fraud scheme – 5 10. Skimming – 8

Case 13.

Answer: At the time this book went to press, some of the most corrupt countries were Belarus, Cambodia, Côte d'Ivoire, Equatorial Guinea, Uzbekistan, Democratic Republic of the Congo, Chad, Bangladesh and Sudan. Some of the least corrupt countries are Iceland, Finland, New Zealand, Denmark, Singapore, Sweden and Switzerland. More corrupt countries seem to be smaller and more impoverished, while less corrupt countries for the most part seem to be economically strong, first world countries. There appears to be a strong correlation between per capita GDP and corruption.

Case 14.

John is committing a theft of cash through skimming by taking cash before it is entered into the accounting system.

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Case 15.

1.

This is a difficult ethical question that many business owners who do business abroad face, and one that must be decided on an individual basis. Bribes are ethically wrong and are illegal in the United States. In fact, the Foreign Corrupt Practices Act was passed in the U.S. to prevent such bribes and punish U.S. corporations that engage in bribes.

2.

Many people believe, however, that in some countries business will not function without small bribes that are often referred to as “grease payments.” Regardless of what individuals decide to do in these instances, countries where bribery is prevalent usually suffer economically as their economy has the added friction of bribes that impedes economic growth, disincentivizes foreign investment, and keeps the country in perpetual poverty.

Extensive Cases Extensive Case 1.

This fraud involves two different types of corruption: bribery schemes and conflict of interest schemes. Bribery involves the offering, giving, or receiving of anything of value to influence an official act. “Hart promised to help Bell Company win county business in exchange for thousands of dollars in cash or in-kind payments from Eaves. Eaves accepted this exchange.” This shows the payment made to influence the decision of government. In addition, $256,000 in kickbacks from Hernandez Trucking was shared among Max, Eaves, and Hart. This usually results in higher delivery prices and lower service quality. A conflict of interest occurred when Hart and Eaves had undisclosed economic and personal interests in a transaction that adversely affected Mavis County and the company. For example, Hart approved a contract with Bell to operate all the county’s landfills, and Hart, his friends, and other county officials were given free lodging, meals, fishing, and golf, the costs of which were covered by Eaves. In addition, Hart signed a promissory note for $90,000 that he received from Eaves.

Extensive Case 2.

1.

Yes, fraud is probably occurring. The following is a possible solution to the case: After examining the financial data, Mikos noticed that the hotel had recently changed a number of its usual vendors. He found that when Jim Smoot took over the kitchen, the food supplier contract was switched to Supreme Meats, a company he discovered was owned by Jim’s brother-in-law, Steve. In just a few

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weeks, payments to Supreme Meats increased sharply. While looking over the restaurant’s payment records, Tony glanced at some of the other departments and noticed something else unusual: all linens were now being cleaned by Supreme Laundry, supplies to the gift shop were being delivered by Supreme Gifts, and the cars were being parked by Supreme Valets. All had been switched from other vendors in the past few months and all had quickly increased their billing by 15 to 30%.

Running a quick business check, Mikos found all these “supreme” companies were run by Jim’s brother-in-law, Steve. When confronted with the evidence, Jim confessed he helped Steve get all of these accounts in return for a cut of the ever-increasing profits to compensate for his low wage.1 2.

The number of ways in which employees can misappropriate assets is limitless.

Some examples are theft of cash through skimming, theft of cash through fraudulent disbursements, theft of cash through larceny, bribery, conflicts of interest, and vendor kickbacks.

Internet Assignments 1. a.

Mr. Wells graduated with honors from the University of Oklahoma with a Bachelor’s degree in Business Administration, and he spent two years on the audit staff of Coopers & Lybrand. In 1972, he was appointed a special agent of the FBI, specializing in the investigation of white-collar crime.

Over the next ten years, he assisted in nearly 200 criminal convictions. In 1981, Mr. Wells left the FBI to form Wells & Associates, a consulting group of criminologists dealing with fraud detection and deterrence. Mr. Wells’s background and experience has contributed to his success as a CFE.

b.

Mr. Wells has written The Fraud Examiners Manual—first, second, and third Editions; Fraud Examination: A Guide to Investigative and Audit Procedures; Occupational Fraud & Abuse; and The Accountant’s Handbook of Fraud and Commercial Crime.

c.

Mr. Wells is a member of the American Institute of Certified Public Accountants, the Institute of Internal Auditors, the National Criminal Justice Association, and the American Society of Industrial Security. He has served on the Practice Advisory Council of the American Accounting Association and the Ethics Committee of the Texas Society of CPAs. He has also served on the Board of Directors for CrimeStoppers.

Case and solution loosely based on a problem found in the AICPA’s “Catch Me if You Can” online fraud detection game.

1

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2. The eight tips for preventing employee fraud, as identified on this website as authored by Larry Cook, are: 1.

Create a positive work environment. A positive work environment encourages employees to follow established policies and procedures, and act in the best interests of the organization. Fair employment practices, written job descriptions, clear organizational structure, comprehensive policies and procedures, open lines of communication between management and employees, and positive employee recognition will all help reduce the likelihood of internal fraud and theft.

2.

Implement internal controls. These measures are designed to ensure the effectiveness and efficiencies of operations, compliance with laws and regulations, safeguarding of assets, and accurate financial reporting. The controls for safeguarding assets and financial reporting require policies and procedures addressing:

•

Separation of duties. No employee should be responsible for both recording and processing a transaction.

•

Access controls. Access to physical and financial assets and information, as well as accounting systems, should be restricted to authorized employees.

•

Authorization controls. Develop and implement policies to determine how financial transactions are initiated, authorized, recorded, and reviewed. Internal controls will reduce opportunities for fraud.

3.

Hire honest people. Of course, this is the goal of every company, and is easier said than done. But if you have weak (or nonexistent) internal fraud controls, it's even more important to make sure your employees are honest. Dishonest employees will ignore your attempts to provide a positive work environment, and search for ways to defeat even the most comprehensive internal controls. Learn more about Ethics and People Management.

Preemployment background checks are an excellent way to cut down on hiring dishonest employees. A thorough preemployment background check should include:

4.

•

Criminal history for crimes involving violence, theft, and fraud;

•

Civil history for lawsuits involving collections, restraining orders, and fraud;

•

Driver's license check for numerous or serious violations;

•

Education verification for degrees from accredited institutions;

•

Employment verification of positions, length of employment, and reasons for leaving.

Educate your employees. You need to inform your employees about your policies and procedures related to fraud, the internal controls in place to prevent fraud, the organization's code of conduct and ethics policies, and how violations

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of these policies will be disciplined. Every employee should sign a form to verify receipt of this material. Employees should receive annual training on these topics and on the definition of what's considered fraudulent behavior, and sign an acknowledgement each time. Read more about Preventing Crime and Violence in the Workplace.

5.

Implement an anonymous reporting system. Every organization should provide a confidential reporting system for employees, vendors, and customers to anonymously report any violations of policies and procedures. Promote and encourage the use of the reporting system whenever possible.

6.

Perform regular - and irregular - audits. Every company should have regular assessments, but random, unannounced financial audits and fraud assessments can help identify new vulnerabilities, and measure the effectiveness of existing controls. It also lets employees know that fraud prevention is a high priority for the organization.

7.

Investigate every incident. A thorough and prompt investigation of policy and procedure violations, allegations of fraud, or warning signs of fraud will give you the facts you need to make informed decisions and reduce losses.

8.

Lead by example. Senior management and business owners set the example for the organization's employees. A cavalier attitude toward rules and regulations by management will soon be reflected in the attitude of employees. Every employee - regardless of position - should be held accountable for their actions.

Implementing these recommendations can dramatically reduce the opportunity for employee theft and protect the assets of your business. If you suspect fraudulent activity by an employee, seek professional assistance to conduct the investigation. Determine what's necessary to protect your business and prevent a reoccurrence.

Debate According to the chapter, the ideal fraud perpetrator would have the following characteristics: • • • •

Is an older employee, probably in a management position Is a married male Has a postgraduate degree Works in a larger corporation

The rationale for the previous characteristics is that an older employee generally has been working for the company longer and has grown into a position where considerable trust is put on him or her. This allows for many more opportunities to commit fraud. The statistics show that men perform larger frauds than women, and Chapter 14

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that married perpetrators commit more than any other marital status category. This could be part of the perceived pressure to provide for their families. A postgraduate degree not only makes you more eligible for management positions, as mentioned before, but will usually give you a better understanding of business or operations, which will better facilitate the perceived opportunity to commit fraud. Finally, there is more opportunity for more people and more resources to commit fraud in a large corporation. This may lead to additional disgruntled employees upset with wages or other circumstances in a profitable organization, which can lead to rationalization of committing fraud. This is the third and final part of the fraud triangle. It is for these reasons and the way they contribute to the fraud triangle that the previously stated characteristics describe the most likely perpetrator of a large fraud.

Stop and Think 1.

Besides the frauds introduced in the above paragraphs, what other types of frauds against corporations can individuals perpetrate?

When individuals perpetrate frauds against organizations, they either steal assets that come into the business (e.g. cash from revenues), steal assets on hand (e.g. supplies, cash, equipment, etc.) or they have the company pay for something it shouldn’t or too much for something it is buying (disbursement fraud.) Each of these types of fraud can be committed by an employee alone, by a customer or vendor alone, or collusively by an employee and a customer and/or vendor working together.

2.

The federal government gives huge rewards for taking action to expose fraud against itself. Under federal law, if you have personal knowledge that an individual, business, city, county, or town has provided false information to obtain money from the federal government or to avoid paying money to the federal government, you may file a claim to recover more than triple the amount of monies defrauded from the government. Federal law protects you against any retaliation. Why do you think the federal government offers rewards for whistle-blowing about government fraud?

The federal government is a very large organization that relies on many people to carry out its transactions. Because of the large amounts involved, there are often tremendous opportunities for people to commit fraud. Rewards for whistle blowing represent both a deterrent (people will be less likely to commit fraud if they know others can benefit financially from turning them in) and a way for people to report incidents and make money.

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Chapter 15 CONSUMER FRAUD Discussion Questions 1. It is important to study consumer fraud because practically all of us at one time or another will face some type of consumer fraud. It is important that we learn to be skeptical so that we don’t become victims.

2. Identity theft is the assumption of one person’s identity by another person. Identity theft occurs when someone uses information to pose as another person in order to obtain personal gains.

3. It is very easy for perpetrators to steal a person’s identity. Common methods include filling out a preapproved credit card application, searching through a victim’s trash, stealing from a victim’s mailbox, and gaining a victim’s personal information via the Internet.

4. Consumers can take many steps to minimize their risk of identity theft, including shredding important documents, depositing valuable mail information directly at an official post office drop box, opting out of preapproved credit cards, and registering on the national do-not-call register.

5. Examples of foreign advance-fee scams are any offers obtained via mail, Internet, phone, or fax that invite individuals to participate in transferring money from an individual’s domestic country to a foreign country.

6. A Nigerian money offer is any kind of letter or e-mail that invites you to share in the transfer of wealth from Nigeria or some other (usually) African country to the United States or elsewhere. Such letters usually offer the receiver the opportunity to make a large sum of money for participating in some fraudulent transaction.

7. There are many differences between fraudulent multilevel marketing organizations and legitimate multilevel marketing organizations. One of the main differences is legitimate organizations focus on selling a product while fraudulent multilevel marketing schemes usually do not involve the selling of a product.

8. When economies are involved in consumer fraud, foreign investors are hesitant to invest in the country; citizens are defrauded out of savings; and havoc and chaos can result. Fraud of any type cripples economics and slows down their growth.

9. Perpetrators focus on the elderly and uneducated because these individuals are less likely to suspect fraud. The elderly and uneducated are less informed and much more likely to have confidence in fraudulent scams than others.

Albrecht: Fraud Examination, 5e

10. Investments scams involve worthless investments being sold to unsuspecting investors. Examples include worthless stock, worthless real estate, or other sham investment opportunities.

11. Many consumer frauds are centered around deals that seem too good to be true; they promise a good deal, high returns with no risk, or something that is not ordinarily available to the public. This is what causes many to fall for the fraud—they think what they are getting into is too good to pass up and they will get rich quickly.

12. Many businesses lose billions of dollars a year to fraud of all kinds of consumer fraud, many having to do with stolen checks and credit cards. These businesses pass on the loss of fraud to consumers. They also spend a great deal of money on fraud prevention, which is also a cost passed on to consumers. Further, many transactions are made more difficult because of fraud prevention measures. Everyone is affected in a very real way by consumer fraud, even if they are not directly affected.

13. Quickly call your credit card companies and cancel your credit cards, cancel any debit cards and put a stop on any checks you had in your wallet. The sooner you act, the less risk you face. These are the first and most simple steps you will need to do to avoid risk, but depending upon what you carry in your wallet, you may need to take additional measures.

True/False 1. True 2. True 3. False. The best way to prevent this type of fraud is to contact the issuing agencies and opt out of receiving any preapproved credit card applications.

4. True 5. False. The Gramm-Leach-Bliley Act gives organizations the right to share your information with other entities for profit; however, it also gives you the right to opt out of having your information shared.

6. True 7. True 8. False. The elderly are more susceptible to telemarketing fraud than any other type of fraud.

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9. False. The larger the amount requested, the easier it is to detect the possibility of a scam.

10. False. Under the Gramm-Leach-Bliley Act, organizations have the right to sell individuals’ personal information unless that individual decides to proactively opt out of having their information sold.

11. False. While the FTC will provide valuable information to victims of consumer fraud, they will not contact the FBI, Secret Service, or local police to coordinate the investigation; that is the responsibility of the victim.

12. False. The National Processing Company was not given responsibility by the FTC to preregister consumers for the national do-not-call registry.

13. True 14. False. While Congress has outlawed fraudulent pyramid schemes in the United States (fraudulent pyramid organizations with no product or service), legitimate pyramid organizations are ethical and legal.

15. False. Consumer fraud affects everyone.

16. False. Everyone is a victim of consumer fraud, even those who never experience it firsthand. Because of consumer fraud, prices are higher to cover losses that result from the frauds. However, even very intelligent and careful people can become the direct victims of consumer fraud as things are stolen from them or databases where their information is “securely” contained are hacked into. Everyone is indirectly affected by consumer fraud, and everyone is a direct potential victim.

17. False. While many MLMs are fraudulent, there are many that are not. Some companies that employ a MLM format are publicly traded, well known, and respected.

18. True. A person’s tax return has his or her name, SSN, birth date, and names of spouses and children. This is more than enough information to steal a person’s identity.

19. False. With someone’s name and SSN, along with other publicly available information like addresses and phone numbers, someone’s identity can easily be stolen.

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Multiple Choice 1. a 2. b 3. b 4. e 5. c 6. e 7. c 8. a 9. c 10. a 11. d 12. c 13. c 14. b 15. a Short Cases Case 1 Students’ answers will vary. Instructors should verify that the student has reported on at least two of the 12 available statistics. Student reports should identify the exact statistic, page number, and one or two paragraphs detailing why they find the statistic interesting, important, or applicable.

Case 2 Students should turn in their completed affidavit. In addition, here are the answers to the T/F questions:

Albrecht: Fraud Examination, 5e

1. F 2. F 3. A victim might send a completed affidavit to each creditor, bank, or company that provided the thief with the unauthorized credit, goods, or services described.

4. Victims should not send an affidavit to the FTC or any other government agency.

Case 3 Students should turn in a copy of the letter they wrote to opt out of preapproved credit card mailings.

Case 4 1. The most obvious red flag was that Miguel did not receive his bank statement at the beginning of the month. Documents such as bank statements, credit card statements, insurance information, and other financial information should follow a regular pattern; if this pattern is altered, it should be an obvious red flag. The second red flag was the phone call that Miguel received during dinner. Had he addressed the problem instead of hanging up the phone, he could have minimized his losses.

2. Miguel, like the majority of consumers, ignored the initial red flags. He could have minimized his losses simply by investigating the red flags when they first appeared.

3. Miguel should contact the FTC and local law enforcement as well as credit bureaus and other agencies to repair his credit and reputation. Miguel should contact the bank, credit card companies, and all those organizations with which fraudulent transactions took place.

Case 5 1. As discussed in the chapter, Jenny should be very careful about approaching her grandfather with respect to fraud. Jenny should be sensitive and approach the matter indirectly and patiently. However, because her grandfather has already been a victim, Jenny should take action before her grandfather is taken advantage of again.

Remember, once a fraudster has had success, the fraudster will continue to swindle larger and larger amounts of money from the victim. Jenny could contact the Better Business Bureau and try to find out more information about the organization. If Jenny approaches her grandfather in a sensitive and respectful way, her grandfather’s dignity should not be offended.

2. When approaching a possible victim of telemarketing fraud, it is important to avoid words such as defrauded, victimized, duped, swindled, or any other word that the

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victim can possibly interpret as confrontational or judgmental. Family members should approach the matter indirectly and patiently.

3. The elderly are susceptible to fraud for several reasons. First, many older individuals are extremely lonely, and fraudsters use this loneliness to build a relationship of trust.

Second, when elderly people are conned out of money, they rarely tell family and friends or even report the incident. Third, the elderly are extremely trusting, and many do not believe that someone would actually take advantage of them. Once defrauded, these gullible victims often go into a state of denial. Fourth, because fraudsters are able to build such strong ties between themselves and the victim, fraudsters will con elderly victims out of money as many as seven or eight times before the victim refuses to pay more money.

4. In general, the elderly are much more emotional than other types of people.

Fraudsters use this emotion to their own financial benefit. By manipulating victims’ emotions, fraudsters are able to swindle money out of their victims.

Case 6 Students should turn in a one-page paper describing the potential fraud schemes that can occur with the transaction they decide to pick. The paper should include the red flags as well as the preventive measures one should take to avoid being a victim of the type of fraud they choose.

Case 7 This is a common example of a cashier check scam. The best way to deal with this situation is to ignore the e-mail and have nothing to do with “David.” You would receive a validlooking check and be able to cash the check, receiving cash from your bank. You would wire the $4,000, but no one would show up for the car, the check would bounce within several weeks once it was determined it was a forgery, and you would be out $4,000.

Case 8 This is an example of a recent scam that targeted job seekers. In this scam, money would be sent and then no other correspondence from the potential employer would be received. A reasonable reply to the e-mail would be to either decide from the contents of the e-mail and the awkward request that the request is fraudulent and to ignore the e-mail, or request to speak to someone on the phone and then purchase your own tickets. It is important to remember that anyone can post ads on an online job-posting forum, and that despite the official-sounding names, the companies may be fraudulent.

Case 9 You will find many different examples on this Web site. Have fun, and look for interesting ones.

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Case Studies Case Study 1 1. Gardiah Mfana is probably a fictional person and his proposition is not real. In almost every case, when something seems too good to be true, it is.

2. The proposition made by Gardiah Mfana seems too easy and too promising to be real.

3. Elements of fraud present in this letter: a. Author’s Request: The purpose of the letter is to obtain specific information from the recipient. If we take a step back and realize exactly what the author is asking for, we can see some obvious red flags for fraud. He asks the recipient to give him four pieces of information: the recipient’s full name, the recipient’s address, the recipient’s private telephone and fax number, and all details of the recipient’s bank account (name of institution, account number, routing number, etc.). b. Author’s False Identity: The author of the letter directly states his name as Gardiah Mfana and his occupation as a consulting bank auditor in South Africa. Why would he state his name and occupation if he were about to commit large-scale fraud? Would he not take better precaution to avoid being caught? Either he is a very careless con artist or a cautious one who has advertently provided false identification. c. Apparent Simplicity of the Deal: The fraudulent deal is written to seem simple and foolproof to the recipient. The author uses phrases such as “this is simple,” “there is no risk at all,” and “rest assured” to convince the recipient that participating in the deal will bring no negative consequences. d. Lure: The author uses language to lure the recipient to provide the “needed” information. He promises to compensate the recipient with 25 percent of the proceeds of the fraudulent transaction, which equals $12,550,000. He also uses language that assures the recipient of his trust and confidentiality. In short, he promises that “this transaction will be most profitable” for both the recipient and himself. e. E-mail Address: The e-mail address from which the author sent the message is different than the address to which he asks the recipient to reply (initial address = inquiriesgm4@yahoo.com; reply address = inquiriesgm5@yahoo.com). It is possible that the author provides a different reply address to prevent being tracked down and eventually caught.

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4. Almost all of these kinds of scams promise huge amounts of money in return for participating in some kind of transaction. In this case, the participant will get 25 percent of the proceeds or about $12.5 million. A second common element of these kinds of scams is that the letter asks for urgent help . A third element is that they almost always come from a third-world country—usually Nigeria. And fourth, they all make promises that are too good to be true.

5. The society we live in places the acquisition of money and wealth as one of its highest priorities. Greed has become the driving motivation in many people’s lives.

But at the same time, people are often unwilling to pay the price of dedicated work and sacrifice to reach financial independence. They think, “How much better would life be if we could be rich without having to do anything to earn our wealth?”

Therefore, when faced with an opportunity to get free money (lottery, gambling, or scams), people often forget to think about the possibility of losing money in the process. They then become the victims of fraud. In many ways, participating in these schemes is a gamble, just like going to Las Vegas. Participants are “rolling the dice,” hoping that they hit the jackpot.

6. Answers will vary but may include the following: •

Make the decision that money will not be the most important priority in your life.

•

Realize that financial stability can only come through hard work; money is never free.

•

Learn to distinguish fraud and acknowledge that it is real and that it exists all around us.

•

Never participate in a business deal that seems too good to be true, because it usually is.

Case Study 2 1. This was a real scheme that was detected by the dean of a business school. The obvious tip that this was a fraud was the unbelievably high rate of return. Every investment is a trade-off between risk and return, and the return in this case is unreasonable. The old adage that “if it sounds too good to be true, it probably is” was true in this case.

2. The return in this case, when compounded annually was 5.6 million percent. It wouldn’t take long until a $6,000 investment was greater than the total GDP of the United States.

3. This scheme, like many others, was successful because too many investors are naïve and greedy. There were people who were making money in this scheme and they

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were telling their friends about it. We know of two instances where people even told their friends about this in church sermons they were giving and Sunday school lessons they were teaching. And, when the scheme was highlighted on the news, several people, who were investors, called and/or wrote the dean telling him he was an idiot for thinking this was a fraud. In the end, he was right, and some of those people who complained so loudly about his actions thanked him for being bold.

4. The actions taken by this faculty member (who was a business school dean) were absolutely appropriate. No legitimate investment pays this kind of a return and a professor at a business school would know this. His actions saved many potential future investors a lot of money.

Internet Assignment The purpose of this exercise is to familiarize students with actual telemarketing scams.

Students should turn in answers to the four questions for the scheme they describe.

Debate 1. The purpose of this activity is to help students understand the different aspects of the Gramm-Leach-Bliley Act. Students’ opinions will differ.

2. Students’ opinions will differ. The authors, however, believe that consumers should be aware that organizations are selling their information.

3. Students’ opinions will differ. The authors, however, feel that just because something is legal does not mean that it is ethical.

Answers to Stop and Think Questions 1. Do you think it is possible to completely eliminate identity fraud risks from your life? a. Because we use credit cards and other personal identifying information in so many settings (e.g., eating out, making purchases, traveling, etc.), it is probably never possible to completely eliminate all identity theft fraud risk.

For example, a waiter in a restaurant can purchase a small scanner (two inches by three inches) and scan your credit card. With identity theft, we should practice the “porcupine principle,” meaning that we should make it harder to get us than to get others. Fraudsters always go after the easiest targets. For example, an individual who leaves his or her purse or wallet on the seat of a car where it can easily be seen through the windows will be at greater risk for identity theft than others.

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2. How could a fraudster use your SSN only to perpetrate a fraud against you? a. Unlike credit cards with which purchases can be made, SSNs are only identifiers. Identity thieves use your SSN to access other information, such as credit card numbers which they can then use. For example, armed with your credit card information, the thieves can call the bank, pretend to be you, have your personal SSN, and ask for the last credit card transaction. If the last transaction was to pay a telephone bill, for example, they can then call the telephone company and give them information about your last transaction (the amount, date, etc.) and your social security information. They now have enough personal information about you that the telephone company will probably give them your credit card number. Then, armed with your credit card number and SSN, they can purchase items over the Internet where they don’t have to physically show your card but only need the number and expiration date. There are many other ways thieves could use your SSN to commit identity theft.

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Chapter 16 BANKRUPTCY, DIVORCE, AND TAX FRAUD Discussion Questions 1. The reason that fraud is so common in bankruptcies and divorces is because in both situations, assets are taken away from someone or an organization and given to someone else. In bankruptcy cases, the assets taken are given to creditors. In divorces, assets taken are given to spouses and attorneys representing spouses. To keep assets from being taken, individuals often attempt to hide or transfer assets fraudulently so that they cannot be known or discovered. Transfers of assets to offshore bank accounts, relatives, friends, and other hiding places are all too common in both bankruptcy and divorce.

2. Bankruptcy is the legal process that allows a debtor to work out an orderly plan to either settle debts or liquidate assets and distribute them to creditors. Bankruptcies have several purposes, including giving a debtor relief from creditor collection and foreclosure actions and protecting creditors from unfair collection efforts by other creditors. A bankruptcy filing allows the debtor to work out an orderly plan to settle debts or liquidate assets and distribute the proceeds to creditors in a way that treats creditors with the same equal status.

The most common types of bankruptcy are chapters 7, 11, and 13. Chapters 7 and 11 may be used by corporations or individuals. Under Chapter 7, the bankruptcy is a complete liquidation or “shutting down of the business,” and all assets are liquidated and used to pay creditors, usually for some percentage of actual debts owed. In contrast, under Chapter 11, the creditors are told to “back off” or to give the bankrupt entity some space or breathing room and time until it can reorganize its operational and financial affairs, settle its debts, and continue to operate in a reorganized fashion.

Chapter 13 bankruptcies are reorganizations (similar to Chapter 11) that can be used by individuals meeting certain tests (individuals with regular income and with debts of $1 million or less). Debtors make regular payments to creditors over a specified number of years under Chapter 13. If reorganization does not work in chapters 11 or 13 bankruptcies, judges often order a complete adjudication or Chapter 7 bankruptcy.

3. As stated above, the most relevant sections of the bankruptcy code are chapters 7, 11, and 13. Under Chapter 7, the bankruptcy includes a complete liquidation of the business. All liquidated assets are used to pay creditors. Under Chapter 11, creditors must give the organization more time until it can reorganize its operational and financial affairs. Under Chapter 13, individuals are allowed to make payments to creditors over a specified number of years.

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4. Tax fraud is the intentional underpaying of taxes. For example, tax fraud would include actions such as not reporting income that should be taxed or deliberately overstating (without basis) tax deductions and exemptions.

5. The major participants involved in a bankruptcy are the trustees, the examiners, the debtors, the creditors, and the adjusters. The trustees are used to administer bankruptcy cases, appoint other trustees, review employees, and review fee applications. The examiners are appointed by bankruptcy judges to investigate allegations of fraud or misconduct. The debtor is the “person” who is the subject of the filing. The creditor is defined as one who holds a valid claim against a debtor. The adjusters are known as operation or field agents. They assist the trustee by performing duties such as securing business facilities and assets, locating assets, and locating business records.

6. The most common bankruptcy fraud schemes are petition mills, multiple filing, false statements, trustee fraud, attorney fraud, forged filings, embezzlement, credit card fraud, and bust-outs. After the concealment-of-assets fraud schemes, petition mills and multiple filings are the most prominent bankruptcy fraud schemes.

7. Fraudulent concealment of assets or income is the most common type of divorce fraud scheme. These involve any type of transaction where one of the parties is deliberately and intentionally hiding assets from the other party.

8. Some of the most common tax fraud schemes are not reporting income that should be taxed and deliberately overstating (without basis) tax deductions and exemptions.

Examples of these types of fraud include using a false Social Security number, keeping two sets of financial books, hiding income, and claiming a blind spouse as a dependent when you are single.

9. The concealment and transfer of assets encompasses the majority of bankrupty and divorce fraud. Perpetrators conceal and transfer assets to keep assets from being taken. To this end, individuals often attempt to hide or transfer assets fraudulently so that they cannot be known or discovered. Transfers of assets to offshore bank accounts, relatives, friends, and other hiding places are very common.

10. Court-appointed or panel trustees are usually individuals or firms, such as accountants or lawyers, who identify and collect a debtor’s assets and then allocate those assets to creditors in an orderly manner.

11. The affidavit is a legal document that allows a CFE, CPA, or other professional independent of the court to investigate allegations of bankruptcy fraud. The affidavit is sworn under oath and notorized. The exact content and extent of detail required in the affidavit vary by jurisdiction. The affidavit is addressed to the court and is submitted by the attorney for the person who engaged the investigator (such as the trustee, examiner, or creditors’ committee) as part of the application for retention. A complete example is found in Appendix A.

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12. Creditors initiate the filing of an application for retention of investigator.

13. It is important that investigators involved in bankruptcy or divorce cases are especially careful about what they put in their reports because once the reports are submitted they become legal documents of the court and can be used by any party.

Unsupported conclusions could expose the investigator to charges of false accusations, which could result in costly civil liability.

14. The arm of the IRS that investigates tax fraud is known as Criminal Investigation Division, or CI. CI is directed at the portion of U.S. taxpayers who willfully and intentionally violate their known legal duty of voluntarily filing income tax returns or paying the correct amount of income, employment, or excise taxes.

15. Illegal income, such as income from fraud gains, must be reported on an individual’s income tax return. Using tools such as the net worth method, the IRS and others can prosecute individuals for not paying taxes on income when they are unable to prove that fraud actually did occur. In the last few years, perpetrators of employee embezzlement, dishonest executives, and other fraudsters have been prosecuted for underpaying taxes on illegal income.

16. Money laundering is the process by which one conceals the existence, illegal source, or illegal application of income and then disguises that income to make it appear legitimate. In other words, it is a way that criminals “clean” money that is obtained by illegal means.

17. Money laundering is almost always accompanied by other illegal activities. Money that is generated through illegal means such as drug trafficking, organized crime, tax evasion, or any other type of fraud must be successfully “laundered” so that it can be reintroduced into the economy.

True/False 1. False. The FBI and other law enforcement agencies usually investigate criminal bankruptcy cases.

2. True 3. False. Fraudulent transfers usually occur within one year of bankruptcy.

4. True 5. False. Concealment of assets occurs on a larger scale for businesses than it does for individuals.

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6. True 7. False. Chapter 7 bankruptcies involve complete liquidation; Chapter 11 bankruptcies are intended to give the company or individual time to work out their problem—such a bankruptcy is intended to get the creditors to back off demanding payments for a time.

8. True 9. True 10. False. The purpose of criminal laws is to “right a wrong” or send someone to jail or have them pay fines, whereas the purpose of civil laws is to seek monetary remedies or recover stolen funds. (The two ideas are switched in the question.)

11. False. While this is true of any investigator paid by the debtor’s estate, individual creditors can hire an investigator anytime they want.

12. True 13. True 14. True 15. True 16. False. The Internal Revenue Service is a branch of the U.S. Department of Treasury.

The U.S. Department of Treasury is not a branch of the Internal Revenue Service.

17. True 18. False. You must not be older than thirty-seven years of age.

Multiple Choice 1. b 2. b 3. a 4. a 5. c

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6. a 7. a 8. d 9. d 10. c 11. d 12. c 13. a 14. c 15. d 16. d Short Cases Case 1 This is a “planned bankruptcy” or a “bust-out.” Probably the best indicator that something was amiss was the change in management in a rather shady buyout. Selling large amounts to one customer, Billy, and borrowing increasingly large amounts are also warning signals.

Case 2 An important fact not disclosed is who is going to pay for the services. Without the judge’s pre-approval, the investigator will not be paid by the debtor’s estate and will need to be paid by whoever engaged him, in this case, the credit union. Most of the time, investigators are paid by the debtor’s estate, but in the rare case that the credit union has contracted to pay for services, there should be no problem in proceeding with the investigation. If the judge has approved the investigator, there will be an “Affidavit of Proposed Investigator” and the corresponding “Application for Retention of Investigator.” Both of these documents are official court documents and will contain the rate and scope of services of the investigator.

Case 3 Possible red flags are:

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1. Unusual reduction in assets. This company may be concealing inventory. Comparing last year’s financial statements to the current period will indicate possible decreases.

Also, with access to the warehouse, a physical count will indicate whether inventory is missing.

2. Examination of bank account activity will show signs of unusual activity in recent months. Particularly, transfers between the shareholders’ personal accounts and the company’s accounts could show signs of concealment.

3. Reviewing recent travel of shareholders could reveal possible connections to tax havens or secret bank account locations. If key shareholders or officers have traveled to such locations, it is possible they are concealing assets in secret bank accounts.

Case 4 1. Yes, Colleen does have a responsibility to report the apparent fraud.

2. Assuming Colleen has sufficient evidence that the fraud is taking place, she should feel obligated to report the fraud through one or more channels that are available. For example, if the company is a publicly traded company, then Colleen should report the fraud to the audit committee of the Board of Directors. Also, publicly traded companies are required to have whistle-blower hotlines. Colleen could report the fraud on the hotline as well. If the company is private, then the fraud is still illegal especially if taxes are not being paid on the illegal income. Colleen should discuss her responsibilities with an attorney to ensure she is not implicated in the fraud and that all laws are complied with.

3. Once the fraud is discovered, the executives will owe back taxes and will be assessed interest, fines and penalties on the taxes. In addition, the executives will likely be charged with tax evasion and could face prison sentences as a result.

4. As discussed in the chapter, individuals are required to pay taxes on all income, including illegal income.

5. By simply subtracting the known income of the executives from the change in the executives’ net worth and spending, prosecutors can determine the amount of illegal income.

Case 5 As a corporation, Trek, Inc., has two options: Chapter 7 bankruptcy, where all assets will be liquidated to pay off creditors, or Chapter 13 bankruptcy, where Trek will be given some time by the judge to work out a solution to pay creditors and get its “house in order.” With Chapter 13, Trek, Inc., would continue to operate, but it would implement a plan for reorganization and paying off the debt.

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Case 6 1. Below are all laws that apply to fraud.

Title 26 USC § 7201 Attempt to evade or defeat tax Title 26 USC § 7202 Title 26 USC § 7203

Willful failure to collect or pay owed tax Willful failure to file return, supply information, or pay tax

Title 26 USC § 7206(1)

Fraud and false statements

Title 26 USC § 7206(2)

Fraud and false statements Attempts to interfere with administration of Internal Revenue laws Conspiracy to commit offense or to defraud the United States

Title 26 USC § 7212(A) Title 18 USC § 371

2. Students should show how each of the laws in the above chart relate to the prosecution of fraud.

3. When prosecuting fraud, some of the laws listed in the chapter are more applicable than others. It all depends on the type of violation. For example, Title 26 USC § 7206(2) is extremely helpful when prosecuting perpetrators of financial statement fraud. All of the laws listed in the chapter are not necessarily broken when tax fraud occurs. However, all of the laws can be broken, depending on the type and situation of the tax fraud.

Case 7 Most people would argue that Enron was a bankruptcy that resulted from fraud. At least, there were numerous allegations of fraud, including hiding liabilities and losses in offbalance-sheet partnerships, and several executives either entered guilty pleas or were convicted of fraud. Many people believe that Enron’s financial statements were misleading because they showed huge profits, when in actuality most of the corporation’s losses and liabilities were reported in small, unaudited partnerships.

Case 8 1. The mission of Criminal Investigation Division is to serve the American public by investigating potential criminal violations of the Internal Revenue Code and related financial crimes in a manner that fosters confidence in the tax system and compliance with the law. In other words, the mission of the IRS is to investigate and prosecute taxpayers who willfully and intentionally violate their known legal duty of voluntarily filing income tax returns or paying the correct amount of income, employment, or excise taxes.

2. The criminal investigation division works closely with the Department of Justice, U.S. Attorneys, the FBI, U.S. Customs, the Drug Enforcement Administration, U.S.

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Postal Inspection Service, Inspector General of all federal agencies, and the U.S. Marshal Service.

3. To work as an entry-level CI special agent, you must be a U.S. citizen and not be older than thirty-seven years of age. You must have completed a four-year course of study or Bachelor’s degree in any field of study that included or was supplemented by at least fifteen semester hours in accounting, plus an additional nine semester hours from among the following or closely related fields: finance, economics, business law, tax law, or money and banking, or you must have a combination of education and experience that together meet the total qualification requirements, such as being a CPA. Case 9 It appears that John is concealing assets as part of a divorce fraud. John has most likely transferred significant assets to off-shore locations where he hopes they will not be detected so that he won’t be required to share the assets with his wife as settlement in the divorce.

Case 10 The objective of this problem is to make students aware of the different types of people who are often involved in bankruptcy fraud. Students should turn in a paper listing some of the individuals the U.S. Attorney’s office accuses as well as their roles in the bankruptcy proceedings and the fraudulent behavior of which they are accused.

Case 11 1. A trustee is a neutral party that litigates issues and provides administrative and regulatory supervision of bankruptcy cases.

2. The functions of the trustee program are to: identify fraud and abuse; identify and refer federal crimes to the U.S. Attorney; supervise case administration; and appoint and supervise private trustees who administer bankruptcy estates.

3. The U.S. Trustee Program routinely hires CPAs and CFEs as bankruptcy analysts.

4. The goal of the National Civil Enforcement Initiative is to focus its resources more specifically on combating fraud and abuse in the bankruptcy system.

5. The specific actions that the program can take under the National Civil Enforcement Initiative are: to dismiss abusive filings; to deny discharges sought by dishonest and ineligible debtors; to limit improper refiling by debtors; to deter identity fraud in bankruptcy; to curb unfair practices by attorneys and creditors; and to sanction unscrupulous bankruptcy petition preparers and scam operators.

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6. According to the report, bankruptcy fraud is often connected to credit card fraud, tax fraud, identity fraud, federal benefits fraud, and money laundering.

7. Six categories of referrals to the district attorney’s office include: concealment of assets by debtors and officers of debtor companies; identity fraud and/or Social Security fraud; credit card “bust-outs;” crimes by bankruptcy professionals; mortgage foreclosure scams; and various other crimes including tax fraud, bank fraud, mail fraud, and perjury.

8. Ten duties of a U.S. Trustee include: reviewing first day orders; conducting initial debtor interviews; appointing official committees; conducting meetings of creditors; appointing Chapter 11 trustees and examiners; monitoring employment and compensation of professionals; reviewing reorganization plans and disclosure statements; ensuring compliance; preventing delay and preserving assets; and combating fraud.

Case 12 Section 153 of the bankruptcy code makes Mark’s activities of embezzlement against a debtor’s estate illegal.

Case 13 In order for criminal prosecution of the father, the transfer of money would have had to occur within one year prior to the bankruptcy petition’s filing date.

Case 14 1. The company does not seem to have acted as a going concern for the past three years.

There have been no R&D expenses, and profit margins are drastically lower.

Company executives have sought to increase credit terms and inventory during this time, yet sales are decreasing, and reported inventory is decreasing on the balance sheet. These are symptoms that there may be concealment of assets. This behavior also suggests that management may have tried to secure loans for nonbusiness use.

2. No. The Bankruptcy Code provides for the revocation of debt discharge obtained through fraudulent actions.

Case 15 In Liz’s case, if she would have known the names of current band members, she could have compared these names to the checks that Flash wrote within the past year. She should have been more skeptical and less trusting.

Although the following is not in the text, you might review the list below of other steps that a spouse can take to prevent hidden assets during a divorce.

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1. If you suspect that your spouse may attempt to hide assets, it is best to start investigating your household and business finances before initiating divorce proceedings.

2. Make copies of important documents such as tax returns from the past several years, bank account statements, pay stubs, and any other documents that reflect joints assets or debts.

3. Keep copies of these documents outside the home if you are still living with your spouse or partner.

4. Also, as a precautionary measure, you might want to open a separate savings account in your name only. If your spouse hides assets, you may find yourself in need of a small nest egg. Down the line, however, you may have to relinquish some of your savings to your spouse.1 Case 16 1. Bill committed divorce fraud; Bill hid assets from his wife and from the court.

2. If Sue suspects that Bill might be hiding assets, she could present the evidence in court to obtain a more favorable divorce settlement. If she felt particularly harmed by Bill’s fraud, she could ask law enforcement officials to investigate in order to possibly file criminal charges against him.

Case 17 1. They are colluding in order to conceal assets from the divorce judge.

2. Sally could verify that the assets were actually sold by having the court request documentation of the sale. Once the evidence is presented showing that the assets were sold to Sam for below the market prices, Sally could request that she be compensated for the losses.

3. Because John and Sam are such good friends, John could be selling the assets at below market prices so that he will still have access or part ownership of the assets after the divorce is finalized. Or, they could have an agreement that Sam will sell them back to John at the same low prices after the divorce.

Case 18 1. The Southern District of Florida had the largest number of money laundering matters referred with a total of 106 referrals.

1

Accessed in November 2003: www.mylawyer.com

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2. The investigative agencies mentioned that look into money laundering mentioned in the report include the following: a. U.S. Customs b. Internal Revenue Service (IRS) c. Bureau of Alcohol, Tabacco and Firearms d. Secret Service e. Federal Bureau of Investigation (FBI) f. Drug Enforcement Administration (DEA) g. Immigration and Naturalization Service h. U.S. Marshals Service 3. The main federal legislation acts related to money laundering in the United States are the following: a. Bank Secrecy Act (1970) b. The Money Laundering Control Act (1986) c. The Anti-Drug Abuse Act (1988) d. The Money Laundering Suppression Act (1994) e. The Money Laundering and Financial Crimes Strategy Act (1998) f. USA PATRIOT Act (2001) 4. A total of 1,420 cases were adjudicated in U.S. district court, with money laundering as the most serious offense in 2001. Of these cases, 87.5% lead to the conviction of a criminal.

The average prison sentence imposed for defendants convicted of money laundering was 48 months.

Case Studies Case Study 1 1. The opportunities to commit fraud include difficulty of detection, lack of controls, and segregation of parties. Almost all appraisal frauds involve collusion between some type of broker or investor and an appraiser. The appraiser is promised future jobs or given some type of kickback above the standard fee to inflate the value of a home artificially. The lack of regulation between brokers and appraisers is causing a fraud-friendly environment.

2. In both instances, appraisal fraud was not suspected until the victims tried to refinance their homes, requiring a second appraisal. A second appraisal would also be necessary if a homeowner decides to sell. The problem is that refinancing and selling of homes usually does not occur until well after the original faulty appraisal. Possible appraisal fraud is not detected until well after the crime and often many economic factors have changed since the original appraisal that make proving the “intent” to

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commit fraud extremely difficult. Valuing properties involves judgment, and different people sometimes value things differently. As we saw in the case, “Appraisals are opinions. Value, like beauty, is in the eye of the beholder.”

3. Because appraisers are picked independently and are paid per transaction, they fear that if they do not go along with the higher valuations sought by brokers, they will lose business. The perceived pressure is that if an appraiser disagrees that a property is worth enough to support a loan, a broker will never call back with new business.

They also feel that if they say no to the deal, the broker will just find some less honest appraiser with whom to work.

4. Appraisers rationalize that everyone else in the business is doing the same thing. If they do not go along with a broker valuation, the broker will just find another appraiser who will. Besides, appraising properties requires so much judgment that it will be virtually impossible to prove that someone did it incorrectly. “Property values are like stocks, they go up—they go down.”

5. The sluggish economy around this time period (September 11, stock market decline, corporate fraud and failures) caused sales-tax revenues and state income-tax revenues to slide, meaning local governments needed to count on property taxes all the more.

Without the revenue generated from increasing property taxes, county government programs fail and budgets run large deficits.

6. Because appraisal fraud is usually detected when a second appraisal is done years later, a good control would require two appraisers from independent entities to value the same property and compare results. If the values differ significantly, further investigation may be required. The negative is that doing two appraisals for each property is time consuming and costly—virtually doubling the price.

7. Homeowners naturally have counterbalancing incentives that act as controls. On the one hand, a homeowner would like the appraised value of the home to be lower than it actually is to reduce the property tax burden. On the other hand, the homeowner would like the appraised value to be higher than it actually is because the homeowner can then take out a larger mortgage on the home to buy other assets.

Internet Assignments 1. a. Industry experts estimate that 10 percent of all bankruptcy petitions contain some elements of fraud. b. The goals of IRS Criminal Investigation’s Bankruptcy Fraud Program are: i. Increase voluntary compliance with federal tax laws through the prosecution of those committing significant crimes in the bankruptcy arena.

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ii. Enhance IRS presence among bankruptcy professionals and practitioners for the dual purpose of increasing compliance and providing contact points to report allegations of fraud. iii. Foster enhanced cooperation between the IRS Operating Divisions and Criminal Investigation in attaining mutual compliance goals. c. Students should bring two or three examples of bankruptcy fraud to class.

Answers to Stop and Think Questions 2. Why do you think the hiding of assets is so common in bankruptcy and divorce fraud cases? a. When an individual or business commits tax, bankruptcy, or divorce fraud, assets are generally hidden from the government, creditors, or spouses. The reason these assets are hidden is to prevent the loss of these assets from perpetrators. Committing fraud by hiding assets is so common in bankruptcy and divorce fraud cases because perpetrators want to prevent these assets from being taken away from them. In bankruptcy cases, fraud perpetrators hope to maintain their assets instead of giving them away to creditors. In divorce cases, the perpetrators hope to maintain assets instead of giving them to a spouse or attorneys representing a spouse. If tax, bankruptcy, or divorce fraud investigations fail to discover these hidden assets, the individuals or businesses must make them appear to be generated from legitimate sources before they can use the assets. This is where money laundering comes into play. Money laundering is the method by which these illegally hidden assets may be reintroduced by criminals back into the economy without drawing attention.

3. Most illegal transactions such as drug deals and terrorist activities are conducted in cash. Why is it important for criminals to get their cash deposited into financial institutions? a. Whenever a large amount of cash is deposited in a financial institution or used to purchase anything including goods or securities, U.S. companies are required to report the details of the transaction. Currently, details of all suspicious cash transactions including all cash transactions over $10,000 must be reported to the federal government. As such, criminals may have enormous cash on hand but they are limited in their ability to use the funds without being reported unless they can get the funds into a financial institution where they will be able to use it in another form.

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Chapter 17 FRAUD IN E-COMMERCE Discussion Questions 1. Below are some of the reasons that e-business transactions pose unique or heightened risks. a. Many e-business firms have unproven business models. b. Many e-business firms have innovative technologies for which security developments lag behind transactions developments. c. E-business transactions often involve the transfer of confidential information to unseen parties. d. Personal contact is absent in e-business transactions. e. With e-business transactions, it is often difficult to determine if you are dealing with a large, successful company, a small start-up company struggling to survive, or even a fraudulent company.

2. Some of the common ways in which e-business fraud is perpetrated are data theft, spoofing, stealing passwords, sniffing, falsified identity, customer impersonation, false Web site, and e-mail or Web-visit hijacking.

3. Authenticity of an e-business partner can never be known absolutely. Digital signatures are the de facto standard for authentication in digital transactions. A message hash that can be successfully decrypted with the sender’s public key is statistically guaranteed to have been encrypted by the sender. Other methods include encrypted data, biometrics, and secret codes or passwords.

4. Sniffing involves the viewing of information as it passes along a network communications channel, using specialized hardware attached to a network to monitor or record the network traffic.

5. Spoofing is a significant risk because fraud perpetrators can hide their true identities by supplying changing information on e-mail headers, thus allowing unauthorized access. Spoofing can be used to enable users to change their passwords while those passwords changes are being recorded.

6. A password is an authorization control. Passwords authorize only those who know the password to access systems.

7. Biometrics is a promising fraud prevention tool because each individual has unique biological characteristics, such as retina or fingerprint patterns, that cannot be duplicated. Biometrics offers significantly more security than passwords, for example.

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8. The data-driven, six-step approach to detecting fraud includes understanding the business or operation, understanding fraud exposures, determining the kinds of symptoms frauds generate, proactively searching for those symptoms, analyzing the results, and investigating. This approach is very relevant to detecting e-business fraud because of the amount of data involved in analyzing transactions and log files.

9. While many business organizations contend that providing confidential information such as credit card numbers over the Internet is secure, every once in a while we read of a major breach of confidential information and unauthorized access to the information. The risk is more toward the storage of your personal data on the corporation’s servers (and subsequent access by hackers) than in the transfer across the Internet. Because of problems such as sniffing, spoofing, Web hijacking, there continues to be some risk in providing confidential information over the Internet. Of course, risks are also present when you provide your credit card to cashiers at a restaurant, for example. Nothing prevents that cashier from making a photocopy of your credit card, scanning your card into a small pocket card reader, and then abusing your card in other ways.

10. No fraud risks, including e-business risks, can ever be completely eliminated. Just as we think we have foolproof prevention systems, fraud perpetrators will devise new ways to perpetrate fraud. In addition, the reason we often rely on detective controls is that it is impossible to prevent, or even know of, all frauds.

11. Answers will be specific to each school. Security through obscurity is the practice of making security measures so complex that would-be attackers are confused and cannot breach the system. This method of security is commonly used, but most security experts have little faith in it. Making security complex, rather than using tried-and-true methods of security, simply heightens the challenge to hackers.

12. Third-party providers are able to focus on a single business goal: keeping a company’s data secure and accessible to those authorized. They provide 24-hour monitoring and security and effective password and encryption management. They are located in “safe” geographic locations.

True/False 1. True 2. True 3. False. Spoofing is changing information in an e-mail header or IP address.

4. True

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5. True 6. False. Web sites are similar to bust-out frauds.

7. True 8. False. Biometrics is the use of human features to provide controls.

9. True 10. True 11. False. Intrusion detection is the activity of trying to break into your own networks. It is illegal to break into competitors’ networks!

12. True

Multiple Choice 1. b 2. b 3. d 4. c 5. a 6. a 7. c 8. a 9. d 10. d 11. d 12. c

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Short Cases Case 1 Students should be encouraged to use their creativity and learning to find fraud opportunities where EDI and e-commerce are present. Following are several internal and external opportunities identified in this chapter.

Internal Opportunities • New systems, especially electronic systems, often present control weaknesses. The securing of controls will likely lag behind the implementation of the system.

• Programmer access and backdoors to installed systems (left over from the programming and testing stages of development).

• Improper user passwords that can be easily guessed.

• Lack of encryption or use of poor encryption methods when data are sent between internal computers (often, encryption is used for the order coming in, but plain text is used internally between systems).

• Employees stealing customer and order data from internal systems using USB keys or portable external hard drives.

• Vandalism of systems, deletion of files, and virus attacks internally.

External Opportunities • Orders placed by false clients impersonating real clients.

• Poorly implemented firewalls to prevent outside hackers and attacks.

• Hackers stealing credit card and other client information from internal systems.

• Computer viruses entering systems from external sources, such as e-mail messages.

• Improperly secured software (or not updating systems with critical updates from vendors) that leaves holes open to outside hackers.

• Social engineering of external attackers, for example, impersonating technical support on the phone to gather user passwords to systems.

• Spoofing IP addresses to impersonate vendors in electronic funds transfers.

• SQL injections and/or cross-site scripting that crashes customer portals or, even worse, that publishes secret customer information to hackers.

Case 2 Students should search popular search engines to find stories. Successful queries on Google are “credit card stolen,” “credit card database hacked,” and “e-commerce stolen.” At the time of this writing, these queries show a host of results detailing stories of electronic fraud.

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Case 3 1. Passwords should be changed frequently, such as once a month or once every three months.

2. Best practices normally dictate the following policies.

•

Systems should enforce that passwords include mixed-case letters and at least one number.

•

Regular checks on passwords should be done. Programs like “John the Ripper” use brute-force attacks with dictionary words and common word forms to discover passwords. When passwords are successfully cracked, users should be notified and encouraged to select better passwords.

•

A common method of selecting a robust password is to use the first letter of each word in a phrase. For example, “I love to eat 10 pickles on Monday” becomes “Ilte10poM”—a very difficult password to crack.

•

Users should be encouraged to use a password on critical systems that is different than passwords used on Web sites or noncritical systems.

3. Several alternatives to passwords exist.

• • •

Biometrics (eye or fingerprint scans) Access cards and readers Cryptographic keys using public and private key algorithms. For logins to systems, keys are generally considered much more secure than passwords. In addition, they are much more convenient!

A second goal of this case is to teach students how to write effective e-mail messages.

E-mail messages are different from traditional letters and memos in several ways. A Google search for “how to write an e-mail” provides many sites with advice on e-mail composition. The following are several points suggested by http://www.webfoot.com: •

Use a useful subject line to help people mentally shift to the propert context of the email.

•

Most e-mail users prefer plain-text e-mail to formatted-text e-mail. In other words, the use of bolding, font sizes, etc., is often discouraged—especially when sending email to a person at another organization. Word highlighting in plain text can be done with stars: *highlighted words*.

•

Use short, to-the-point paragraphs. Get to the point immediately and end quickly. Emails longer than a few paragraphs are often skimmed or simply ignored by users.

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•

Since this e-mail is between friends (as e-mail most often is), it should be casual in its tone.

Case 4 1. This question allows students to explore a subject that is only mentioned in the chapter text. Virtual private networks (VPNs) are beyond the scope of most fraud investigations, but they are vital to controls and security. A good place to find information on VPNs is http://en.wikipedia.org/wiki/VPN. According to the Wikipedia, a VPN is “a private communications network usually used within a company, or by several different companies or organizations, communicating over a public network.”

2. A VPN sets up an encrypted tunnel within a public network. In other words, VPNs give the security and feel of a private line even though they work over the general, public Internet lines.

3. IPSEC is the primary standard that makes VPNs possible because it provides the cryptographic tunnel at the network level. IPSEC-based VPNs are considered secure by today’s standards (at least, as secure as anything we have to date).

4. Be sure to coach students to focus on the management and security issues rather than on the technical issues. Students can quickly become lost in the technical features of VPNs, Internet protocol security (IPSEC), point-to-point tunneling protocol (PPTP), OpenVPN, and other protocols. The point of this case is to learn about VPNs and their use generally. The critical question to answer is how VPNs provide control and limit fraud opportunities within organizations.

Case 5 This is an important case for students because it describes exactly what they do each day with their own laptops. Virus protection, especially in the Windows operating system, is critical on today’s Internet. Ask the class what antivirus programs they use, how often they update their virus definitions, and how else they protect their computers.

The issue becomes significant because laptops essentially bypass firewalls and regular corporate control measures. Whereas normal e-mail and other traffic are inspected by most corporate control environments, individual laptops plug directly into internal networks. Any viruses or worms laptops pick up when on public networks (such as when employees take their laptops home or on trips) are able to transfer directly to internal networks.

There is no easy solution to this problem. Since antivirus software must be run on client laptops (rather than on servers), IT personnel have a very difficult problem keeping hundreds or thousands of employee computers up to date and free from viruses. Some organizations standardize on a single configuration and do not allow any other software to be loaded on to

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corporate machines. Other organizations try to minimize the risk by pushing virus updates to laptops.

Case 6 1. E-mail encryption is available with most clients, such as MS Outlook, Eudora, and Apple Mail. However, very few users use it. Discuss with the class why e-mail encryption is not used more widely. One of the primary reasons is a lack of understanding of it.

Both systems are based on public/private key pairs. Text encrypted with a person’s public key can be decrypted only by his or her private key. Stated alternatively, text encrypted with a public key cannot be decrypted by the same public key. It is like a safe with one key that locks it and another, private key, that unlocks it. Anyone can lock a message in the safe, but only the intended recipient can unlock it. Therefore, it is permissible to distribute one’s public key widely to friends and correspondants. If they want to send the person e-mail, they encrypt the message with the recipient’s public key and send the message. If the message is intercepted by a third party, it is unreadable. E-mail clients automatically encrypt and decrypt; all that is required is the generation of a key pair and dissemination of the public key.

The public key is also good to verify the authenticity of the sender. Talk with the class about the lack of wisdom people have when they send scanned pictures of their written signature. In effect, the senders have given all recipients a printable, usable version of their signature! Instead, e-mail systems use key pairs for digital signatures.

Digital signatures are beyond the scope of this text, but some teachers may want to include supplemental material about them.

2. The two primary standards for e-mail security are S/MIME and PGP. S/MIME is a multicorporate standard that is supported by Microsoft, IBM, and many others. PGP is supported by the open source community. Both standards provide secure encryption and authentication. The following are some differences between the two systems.

S/MIME Centralized system run by corporations Supported by most corporate e-mail systems, such as MS Outlook Considered secure

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PGP Decentralized system using a collection of friends and manually disseminated keys Supported by open source e-mail clients and plugins to MS Outlook Considered secure

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Case 7 1, 2 & 3 Answers will vary depending on the firm researched. It is more likely that such a firm would be hired in a large company where there are larger numbers of employees, more passwords, and more risk.

Case 8 1. It can open the students’ eyes to security problems when they see how easy it is to sniff traffic on networks. Since Ethernet, the primary communications mechanism for local networks, uses a broadcast technique for transmission, traffic from any computer on a network can be picked up by any other computer. For Windows-based computers, Wireshark is an excellent program for sniffing network traffic.

If your school has wireless for laptops or a computer lab, student computers are already connected to one another. Download the Wireshark application from www.wireshark.org/ and start it on one computer. Have a student on another computer check their POP-based e-mail account or go to a Web site. Their traffic should show up on the Wireshark application.

2. Applications like Wireshark are used by network personnel to troubleshoot networks and by programmers to troubleshoot applications they are developing.

3. There is an ongoing debate in the security community whether these applications increase or decrease security. The first group argues that there are thousands of “good” hackers to every “bad” hacker. Wide distribution of these applications allows the good hackers to find and patch holes in security. The group further argues that “bad” hackers will always have these applications regardless of the distribution method or applicable laws. The opposing group argues that many “bad” hackers would not be as organized or as well tooled if these applications did not exist or were not distributed widely. Discuss these two positions with your class.

Case 9 Answer will vary depending on the type of security used. An extra key under the doormat at home or hidden beneath your car. While this method is certainly security through obscurity, do students feel comfortable with it? Perhaps in this case, it works well because the risks are minimal as compared with the advantage of being able to unlock your car when needed. Does context matter?

As additional insights, you could inform your students of the following: Some organizations use nonstandard ports to hide Web servers and other services. For example, a corporation might put its intranet Web server on port 84 rather than the standard port 80. While this might seem secure at first, most hackers run a port scan on all available

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ports as their first attack. Port scans will immediately show the Web server on port 84 and circumvent the security. It might be useful to introduce the students to Bugtraq, the premier security hole tracking e-mail list. Note that Bugtraq is an e-mail list rather than a Web site you can visit. Most security holes are announced over this list regardless of the vendor or operating system involved.

Case 10 A simple web search for “common eBay scams” will reveal a number of frauds that occur on eBay. Some of these include the following: •

Shill Bidding: This is where a seller is not happy with the current bid price of his or her item. To increase the price, he or she uses a second account to bid up the price.

•

Item for picture only: This occurs with technology items, where a small font sentence at the bottom of the screen says that the auction is for a picture of the item, not the real item.

•

Second chance bidding: Suppose you lost an auction because you were outbid. Just after the auction ends, the “seller” sends you another e-mail asking if you want to bid because either he or she has two of the items or the winning bidder defaulted. The email actually comes from a third party who will simply take your money.

Case 11 There are essentially three types of services for payment processing: 1. Services like Google and Yahoo! checkout. These services manage the entire process. A Web site simply needs to turn control over to them during checkout. The user generally moves to the service’s computers rather than staying at the ecommerce site. The advantage is that these sites are programmed with best practices and robust security. The drawback is that the Web site owner loses control of how the process occurs (you have to do it their way), so customization is very difficult.

2. Out-of-the-box e-commerce software. These products are bought and implemented on the Web site’s servers. They usually control more than just the payment process— they are entire solutions that include shopping carts, product catalogs, and payment processing. The advantage is that these products are all-in-one solutions. The disadvantage is that the e-commerce provider must adopt the entire package to get the payment functionality.

3. Custom services like Authorize.net. These services generally provide only a programming interface for the e-commerce system to connect to for credit card processing. The advantage of these sites is that they allow full customization and ecommerce sites built from the ground up. They allow total flexibility. The

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disadvantage is that they can be more expensive than the other solutions, and they require more programming and customization to make work (work effectively?).

Case Studies Case Study 1 This case can be as small as a one-page write-up or as large as a semester project. You may want to consider grouping students into teams of three to four people to spread the work out.

You may further ask students to prepare 15-minute presentations around which to structure class discussion.

Case Study 2 This case helps students understand the impact of customer attitudes on e-commerce fraud. It also gives them a chance to evaluate their own feelings and attitudes toward personal information on the Internet. You may consider grouping the students into teams to survey their peers and present their findings.

Case Study 3 This case gives students the opportunity to apply the proactive fraud examination method to e-commerce situations. You will likely need to help students find companies that specialize in e-business, as these organizations can be difficult to find. Grade the students on the professionalism of their interviews, the quality of their analysis, and the correctness of their reports.

Case Study 4 The following table describes several frauds about which Scott should be concerned.

1. Fraud Scheme Use of stolen credit cards

SQL injections to steal customer data and/or order products at incorrect prices Falsified Web sites impersonating Scott’s new site Programmer access to data after implementation

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2. Prevention and Detection Steps Credit card address verification, card verification numbers, Visa/MasterCard/other authentication programs Check programming code to ensure it circumvents SQL injections and cross-site scripting Monthly checking of competitor sites Checking for common names and URLs Use of Google’s “find similar sites” link on search results containing his site Explicitly change passwords and control access points during implementation

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Sniffing of credit card and other information by hackers during legitimate orders

Use of industry standard protocols for encryption like SSL

Answers to Stop and Think Questions 1. How has the Internet changed your day-to-day life? What security precautions do you take each time you use the Internet? a. Answers to this will vary by student. Common answers include (1) password protection, (2) ensuring HTTPS when accessing secure Web sites like banks, (3) protection against spyware, viruses, and identity theft on sites, and (4) protection when purchasing online, especially at auction sites like eBay. 2. How can the data-driven fraud detection approach be used to detect e-business fraud? What data sources can be used to discover potential frauds? a. Since all e-business transactions use technology, they generate significant amounts of log traffic and database records. These can be queried to both prevent and detect fraud.

1. Skills are required to detect and investigate e-business fraud? What other classes might help you learn these skills? a. Skills include (1) traditional fraud detection skills, (2) database knowledge, including relationships, SQL, and scripting, (3) programming knowledge to automate behavior, (4) how fraud schemes show up in database transactions, (5) forensics skills to test and investigate hacking and intrusion, and (6) privacy knowledge.

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Chapter 18 LEGAL FOLLOW-UP Discussion Questions 1. State courts are organized with a series of lower trial courts that hear misdemeanors and small felonies (such as housing courts, small claims courts, probate courts, criminal courts, traffic courts, county or municipal courts, juvenile courts, and domestic relation courts); higher trial courts for larger felonies (circuit courts or superior courts); intermediate appellate or reviewing courts; and the highest level appellate or supreme courts.

2. Federal courts are organized with a series of initial courts, including U.S. Administrative Agency Courts, U.S. District Courts, U.S. Tax Courts, U.S. Bankruptcy Courts, and U.S. Magistrates; an intermediate series of appellate courts, including the 12 Circuit Courts and the U.S. Court of Appeals for International Trade and Claims Court issues; and the highest level appellate or U.S. Supreme Court.

3. The difference between civil and criminal trials is that a criminal trial is held for the purpose of righting a public wrong or offenses against society and usually involves the defendant paying fines or serving jail time, while civil trials are held for the purpose of righting a private wrong. Civil trials are usually held to recover monetary damages suffered because of the actions of another party, and they usually result in monetary judgments being paid, but no one pays fines or serves jail time.

4. There are four identifiable stages in civil litigation: investigation and pleadings, including contacting an attorney and filing a complaint; discovery, where evidence is searched for; motion practice and negotiation, where parties file motions with judges to obtain additional information, seek to get the complaint dismissed, and even negotiate a settlement; and the trial and appeal.

5. An interrogatory is a series of written questions that specifically identifies information needed from the opposing party. The interrogatory is filed with the court, and, normally, the other side must answer within 30 days. Interrogatories usually ask questions about personnel, documents, and the nature of the organization, although any questions can be asked.

6. A deposition is testimony taken under oath before the trial begins. In a deposition, the opposing side’s attorney asks fact and expert witnesses questions.

7. Depositions help attorneys see how witnesses react to questioning, obtain admissions, or provide information that can perjure a witness.

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8. A fraud investigator may benefit by attending the depositions of opposing experts because their depositions may reveal information and opinions that are not accurately reflected in the expert’s written report or work papers. A fraud investigator’s technical knowledge of the areas of testimony can help ensure that the deposition reveals all of the opposing expert’s opinions and the methodologies and supporting information used in reaching those opinions.

9. The criminal litigation process involves filing criminal charges, arresting and charging the defendant, arraignment, discovery, pretrial motions, and the trial and appeals.

10. Discovery is the legal process by which each party’s attorneys try to find all information about the other side’s case before the trial begins. Discovery is the most time-consuming and expensive part of litigation and can include production requests, interrogatories, requests for admission, subpoenas, and depositions.

11. Fraud examiners are used as expert witnesses in many ways. Most often, they are used to discuss elements of the fraud, identify and discuss fraud symptoms, and provide evidence about fraud motivations.

12. The purpose of having a fraud investigator or other expert witness testify in a trial is to aid the jury in understanding technical issues involved.

13. The chapter provided a lengthy list of do’s and don’ts about being an expert witness.

The most important of these are probably being independent and honest, being well prepared, and listening carefully to all questions asked of you at trials and depositions. A good expert has only his or her reputation to sell, and anything that enhances that reputation is a good thing to do.

14. An expert witness can testify about the nature of the fraud, the damages suffered in the fraud, the negligence of the victim in allowing the fraud to happen, and standards that were violated.

15. During deposition, the expert should take a defensive posture. Answer only those questions that are asked; never volunteer anything beyond what is asked. Before answering, give time to the attorneys on your side to object to the questions on the basis of relevance, foundation, or some other reasonable basis of objection.

True/False 1. False. Most fraud cases are tried in state courts.

2. False. Bankruptcy cases are heard in federal bankruptcy courts.

3. True

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4. True 5. True 6. True 7. False. To be successful, the plaintiff in a civil case must only prove his or her case by the preponderance of the evidence.

8. False: Discovery is the legal process by which each party’s attorneys try to find all information about the other side’s case before the trial begins.

9. True 10. True 11. False. A request for admission asks the opposing party to admit designated facts relevant to litigation.

12. True 13. True 14. True 15. False. The defendant cannot choose. Lower courts are for misdemeanors and smaller cases, usually below $10,000. Higher courts try felonies and more serious cases, usually above $10,000.

16. False. An individual can be prosecuted both civilly and criminally.

17. True Multiple Choice 1. b 2. d 3. d 4. d 5. c

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6. d 7. e 8. c 9. d 10. b 11. a 12. d 13. a Short Cases Case 1 The two main reasons why Mr. Pringles is probably not worried are as follows: 1. Mr. Bill did not follow correct legal procedure—it is important first to approach an attorney in a situation like this. Also, Mr. Bill should have legally gathered careful evidence at work that would better explain and tie Mr. Pringles to the fraud.

2. Mr. Bill has violated the “breaking and entering” law and has violated the Fourth Amendment—it was illegal for Mr. Bill to enter Mr. Pringles’ personal residence without having government approval, and to gain government approval, there must be sufficient evidence to suspect that the person is guilty of a crime. Even then, the government is subject to “reasonable” searches and seizures.

Case 2 1. You would seek criminal action against this employee because securities fraud deals with a public offense. A public offense deals with offenses against society as a whole.

You may seek civil remedies as well.

2. This case would be assigned to a U.S. district court because securities fraud is a federal offense, and fraud cases involving federal laws or statutes are usually tried in a U.S. district court. However, the New York Stock Exchange tries many of its cases before arbitration panels. Therefore, this case may not be heard in a U.S. district court after all.

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Case 3 This case is either at the “Discovery” phase or “Motion Practice and Negotiation” phase.

Because allegations have been made, we can assume that the initial pleading has been filed.

Now both parties are trying to gather as much information as they can to make their case.

Each party might also be trying to file a motion for summary judgment or negotiating the case without going to trial. We know that the case has not been settled, so it is not in the “Settlement Negotiations” phase yet.

As a postscript to this problem, both the COO and the CEO (in a second trial) were convicted of fraud. Most of the others plea bargained with prosecutors and assisted the prosecutors.

Case 4 Some of the services that a fraud expert can provide in most fraud investigations include: 1. Investigation: When allegations of fraud are initially made, many things are unknown and must be determined. Often the Board of Directors will hire a law firm and the law firm will hire fraud examiners to help discover facts related to the fraud.

A fraud investigator will help ascertain the facts and gain an understanding of what has happened and who is at fault.

2. Legal follow-up: In a fraud case both the defendant and the prosecution will likely involve fraud examiners in the legal action that takes place. They both will probably use fraud experts in the trial, helping in the depositions of witnesses, explaining complicated ideas, and giving their expert opinions.

3. Implementation of controls: The victim of a fraud will generally want to put controls in place to prevent a similar event from happening again. A fraud expert can help identify control weaknesses and problems and suggest ways to prevent the problem from reoccurring.

Case 5 In order for Mr. Simpson to be convicted in a criminal case, he had to be determined guilty beyond a reasonable doubt. The jury in the criminal case determined that a reasonable doubt existed as to Mr. Simpson’s commission of the murder. In the civil case, however, the jury felt that Nicole’s family had a better case than Mr. Simpson’s, thereby awarding them the compensation. This case shows that it is much more difficult to convict someone in a criminal case than it is to win a judgment against someone in a civil trial.

Case 6 One alternative would be to allow the clerk to go unpunished or merely to transfer him to another department. The advantages to this action are that the cost, hassle, and potential negative publicity of prosecution would be avoided, especially since it is unlikely that the

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store will recover all of its losses from the fraud. The disadvantages of this option are that the clerk would go essentially unpunished and would be free to steal again. This action would also do nothing to discourage other employees from committing fraud and might even cause other employees to believe that “nothing serious happens when you are dishonest.”

A second option would be to prosecute the fraud civilly or criminally. While it is unlikely that all of the losses associated with the fraud would be recovered, the long-term benefits could outweigh the costs. Prosecution would discourage both the clerk and other employees from committing fraud in the future and establish a precedent that dishonesty is not tolerated.

Among the disadvantages to this option are that the store’s relationship with the uncle who is a manager might be damaged, and other problems could be incurred.

A third, less dramatic option might be simply to terminate the clerk. While probably not as effective as prosecution for deterring future fraud, termination would establish an acceptable precedent and probably maintain a cordial relationship with the uncle.

Case 7 1. XYZ’s next course of action would probably be to appeal the decision handed down by the court. With a judgment of this magnitude, the chances of the appeals court upholding such a large decision are quite slim.

2. If you suspect that the bank statements have been altered, you can issue a request for admission to question the other party, or you can subpoena the actual bank statements from the bank. Usually, however, you only get copies, not original documents.

Case 8 Most important, as an expert witness you will study the facts of the case as discovered during the discovery period. You will study relevant documents, perhaps even suggesting that the prosecution gather further documentation and information that will assist you in preparing your opinions. For example, you will want to be certain that all documents pertaining to the questioned accounts are in order. You will probably read all depositions of fact witnesses.

You will also likely look for other evidence about top management’s lifestyles, work habits, and attitudes. Your goal is to understand as much about the case as possible and then to support the case with your relevant experience and knowledge of similar frauds. After studying the facts, you should form your opinions about the fraud. These opinions must agree with the facts and with your relevant experience, because during the deposition and trial, the defense will try hard to discredit your opinions and expertise. You can further assist the prosecution by helping them to guide their case and their questions to focus on the most important facts.

Case 9

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The first stage of the civil litigation is investigation and pleadings. ABC will file an initial pleading that explains the alleged violation of the law and the monetary expenses or damages sought. Bobby Jones will then file a motion or a response to the pleading.

After these are filed, they will enter into the discovery stage, where each side’s attorneys will try to find out information about the other side’s case. This is usually the most difficult and longest stage of litigation. During discovery, attorneys will obtain information through subpoenas, interrogatories, requests for admission, and depositions.

The next stage is motion practice and negotiation. This occurs during discovery, when both parties seek rulings from the trial judge. The parties may also seek a settlement out of court, and the case is resolved.

The final stage is the trial and appeal. If, up to this point, the case is not closed by motion or settlement, it will go to trial. Before the trial, both parties involved will agree on terms and rules of the trial. Usually, a jury trial will be held, where a judge will determine issues of the law. Both parties will present their case, and the judge will charge the jury to apply the law in reaching its verdict. After a judgment is issued, there is a time period where either party may appeal part or all of the judgment. Appeals generally relate to matters of the law, not facts of the case.

Case 10 1&2 No, John probably does not have grounds for an appeal. In this case, John is hoping to appeal the verdict because there was inappropriate evidence introduced into the case. But John’s rights were not violated, and the search on John’s computer that produced the evidence was legal. Searches of business by employers or investigators hired by employers do not violate the Fourth Amendment rights and do not require “probable cause.” If an employer turns over evidence to the government, they can use the evidence to prosecute defendants without obtaining a search warrant.

Case 11 OHS may be in violation of the Fourth Amendment for two reasons. First, OHS does not have a written policy allowing searches of lockers and does not have a history of searching lockers. Second, OHS is acting at the request of the government. For an employee to sue an employer for the violation of a constitutional right, there must be some form of state action involved. State action is involved during any investigation by a state or federal entity, including investigations of their own employees. There are no bright-line rules regarding when an investigation can be considered to involve state action. However, the following examples could be considered to involve state action: •

Investigations conducted by a private company but at the suggestion of the state or federal authorities (as in the earlier case).

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•

Investigation started by a private company that is later taken over by or expanded by state or federal authorities.

•

Joint investigations with or aided by state or federal authorities.

•

Investigations conducted by a private company are required by state or federal law.

•

Searches or interrogations conducted by outside investigators who are off-duty state, local, or federal authorities.

Case 12 1. Mr. Oaks might confess and repay all the money without having to go to court. But even if he does not confess, trials are expensive. If the fraud is large, the media will cover the proceedings, which will often show negative publicity about the company.

Also, the damages committed by Mr. Oaks might be impossible to recover by Turley Bank, leaving the case with the only purpose of punishing Mr. Oaks.

2. Court is very expensive and time consuming. Before the trial begins, the bank knows how much evidence it has, and it knows how much of a settlement it can receive from Mr. Oaks. By settling out of court, the bank will probably still recover much of the settlement without going through the expenses of court.

3. At this point, Mr. Oaks knows how much evidence the bank has and what will be the likely settlement. In order to avoid publicity, time, and the expense of the trial, Mr. Oaks may plea bargain before the trial begins.

Case 13 1. Some of the things the expert witness did well include: a. Maintained composure and confidence. b. Asked for a break when he realized he was getting tired. c. Was not concerned when the opposing counsel scored points.

2. Some of the things the expert witness did not do so well include: a. Argued with opposing counsel. b. Lost his temper. c. Did not answer with simple “yes” or “no” answers.

Case 14 1. Possible answers include:

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a. Is a body of 16 to 23 people. b. Selected from the community. c. Listen to evidence presented by witnesses and prosecutors. d. Can consider any evidence, even that which would not be admissible at trial. e. At least 12 grand jurors must agree for an indictment to be issued.

2. Possible answers include: a. Do not lose your temper or become angry or antagonistic; recognize that it is opposing counsel’s job to attempt to discredit you. b. Do not be concerned if opposing counsel scores points. c. Do not quibble unduly or become argumentative with opposing counsel. d. Do not respond evasively or ambiguously to questions, no matter how difficult that might be. e. Be extra careful if opposing counsel takes on a friendly air. f. Do not become hostile if opposing counsel tries to bully you. g. Resist responding with simple “yes” or “no” answers that may be misleading without some qualification. h. Do your best to recognize signals, such as careless answers, that you may be getting tired or losing your competitive edge. i. Do not allow opposing counsel to entice you into coming up with answers to questions addressing matters outside your area of expertise. j. Maintain the position you took in your direct testimony. k. Do not allow opposing counsel to con you into an advocacy role 3. a. A deposition is a testimony taken before trial begins. b. A deposition can be a powerful tool in the hands of a skilled attorney because they can see how a witness reacts to questions, and they can get a witness to commit to a particular position at deposition that can prevent him or her from suddenly “recalling” a matter favorably during the trial. c. The other three stages of the civil litigation process that cases usually go through are: • • •

Investigation and Pleadings.

Motion and Negotiation.

Trials and Appeals.

Case Studies Case Study 1 1. All fraud perpetrators have rationalizations that help to convince them that their dishonest acts are tolerable. In the case of John Rigas, the following two explanations may have been his rationalizations.

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a. First, Rigas gave a lot of service to the community. He used his (or his company’s) money to help those in need. Rigas gave millions in charitable contributions, bought homes for those who could not afford them, and flew people on his private planes to receive medical treatment. He probably rationalized his actions by concluding that it was acceptable to misuse company funds if he was using it to benefit others. The textbook states that “we rationalize dishonesty by our desire to make other people feel good.” b. Adelphia was a family-owned business. Rigas was its founder and nursed it as it grew to become a publicly traded communications giant. No doubt he felt that the company’s revenue was a product of his own hard work and sacrifice and that he was entitled to its use. To him and his family, their efforts deserved greater compensation 2. The following are common rationalizations made by perpetrators of fraud: a. “The organization owes it to me.” b. “I am only borrowing the money—I will pay it back.” c. “Nobody will get hurt.” d. “I deserve more.” e. “It’s for a good purpose.” f. “We’ll fix the books as soon as we get over this financial difficulty.” g. “My reputation is more important than my integrity 3. In family businesses there is a tendency to consider company money as a personal asset. Also, employees (family members) are so familiar with and trusting of each other that fraudulent activity can often go unsuspected.

4. This case was prosecuted criminally and in 2005, John Rigas and his son, Timothy Rigas, were sentenced to 15 and 20 years in prison, respectively. John was 80 at the time and Timothy was 49. The two were ordered to report to prison in August 2007.

Given John’s ailing health (he had heart surgery in 1999 and was reported to have bladder cancer in 2007), this prison term is effectively a death sentence. John Rigas got a reduced sentence from 15 years down to 12 years in an earlier appeal, which means he’ll be able to get out in January 2018, or when he’s 94 years old.

Additionally, Rigas’ lawyer(s) found out on October 4, 2010, that their request for a new trial and reduced sentence for Rigas was rejected by the Supreme Court. Over the last few years, the SEC has tried to set the standard that fraud will not be tolerated in public companies.

The Adelphia fraud has also led to numerous civil cases. For example, John Rigas claims he never intended to defraud Adelphia and the cash advances were loans he would repay. He said he relied on auditors at Deloitte & Touche and lawyers at the Pittsburgh firm Buchanan Ingersoll, now Buchanan Ingersoll & Rooney. Deloitte agreed to pay $50 million to settle a civil lawsuit by the U.S. Securities and Exchange Commission and $210 million to settle with Adelphia investors. Deloitte, Adelphia,

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and the Rigases sued each other in 2007 in state court in Philadelphia over who bears responsibility for the fraud. Investors are also suing Buchanan.

5. You would pay attention to the majority of presence on the board of directors, family dominance, the cash management system, that the company used $4 million of company funds to buy personal shares of Adelphia stock for the family, the standard of living of the Rigas, the Rigas entities, the off-sheet balance loans, as well as the violations of RICO act, fiduciary duties, etc.

Internet Assignment 1. This deposition was conducted in the Securities and Exchange Commission, Los Angeles Office.

2. The three individuals representing the SEC are Andrew J. Dunbar, Nicolas Morgan, and Martin J. Murphy.

3. These three most likely are lawyers. The chapter reads, “only attorneys can ask questions at depositions” 4. This statement means that the witness has been subpoenaed, or commanded to appear before the court.

5. The two exhibits presented in this deposition are Exhibit 29: List of Banks and Brokerage Firms and Exhibit 30: Position Statement.

6. Clearly the deposition turned to the particulars of Mr. Slatkin’s banking activities (copies of checks, wire transfers, etc.), which is why the SEC employed more exhibits in the second part of the deposition than the first.

7. The examiners are being particular in their questions because it is possible that defendants might alter documents before submitting them, as the chapter points out.

The SEC lawyers are trying to determine the validity of the documents produced.

8. According to Mr. Dunbar, “This is an investigation…to determine if there have been any violations of certain provisions of the federal securities laws” (pp. 3–18).

9. Mr. Boltz asks Mr. Slatkin clarifying questions and makes clarifying statements that prompt Mr. Slatkin’s answers. His intention is to make sure that not only is the witness answering truthfully but also that his answers are being correctly understood.

10. Mr. Boltz seems to believe his client is under investigation for illegally accepting compensation from clients.

11. Mr. Boltz is extremely confident (p. 10).

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a. When asked how he can be certain that NAA Financial is “good for the money,” he responds with, “Oh well, he’s been dealing with them for (a very, very long time).” b. Mr. Boltz’s method of verification is absolutely not legitimate. c. Yes, he acts as though he has made personal contact. d. Mitchell Axiall is Mr. Boltz’s principal NAA contact.

12. From this Web site, we learn that NAA Financial never existed. We also learn that Michel (Mitchell) Axiall is a ficticious character whose role Jacobs assumed.

Debates 1. a. Position 1 (Civil Court Remedies)—A typical response may include: i. When companies pursue remedies in civil court, usually the fraud cases are settled before the case goes to trial. The purpose of a civil lawsuit is to compensate for harm done to the organization. To be successful, the company only has to prove its case by the “preponderance of the evidence,” which means they only have to tilt the judge or jury toward their side in order to win. If the company wins, monetary restitution will be awarded. Civil complaints can be filed against both the employee and the payer of the kickbacks. b. Position 2 (Criminal Prosecution) – A typical response may include: i. The criminal prosecution system is the only way to put the fraud perpetrator in jail. The criminal justice system includes more protections for the rights of the defendant, including the protections that arise from the Fourth, Fifth, and Sixth Amendments. Officers of the court and local law enforcement must be involved in order to prosecute the perpetrator criminally. It is much more difficult to prove a fraud case criminally because the case must be proven “beyond a reasonable doubt.” Law enforcement and officers of the court must follow proper procedures as they gather evidence, or else the evidence may become inadmissible in court. Criminal prosecution, however, is the best way to deter future fraudulent activity by this perpetrator and by other employees who will be watching to see what happens to this dishonest employee.

2. Daren could decide that the information represents only possible fraudulent activity, and not consider it something worth testifying to the court about. He could also think

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that he has been brought to this case in order to protect the defendant; thus, he might think he is not responsible for bringing forth incriminating data. Daren could approach the defendant’s attorney and share the information he has discovered. The attorney will likely not call him as a witness in this case, but Daren faces the issue of reporting his findings to the prosecution. Daren also faces the issue of not reporting his discovery to the attorney and simply reporting his findings on the witness stand during examination. The main issue Daren faces is whether to reveal the new information. If Daren believes the information is serious enough, at a minimum he should resign from the case. You could have the class debate whether he should reveal the new information or even resign from the case.

Answers to Stop and Think Questions 1. Why is it good for a witness to be “defensive” in depositions and “offensive” in court? a. Because depositions are often taken in an atmosphere a little more informal than in a courtroom, witnesses may naturally tend toward being informal in their deposition comments. This can be a mistake. A deposition is a powerful tool in the hands of a skilled attorney. If a witness is not prepared for the deposition, the attorney may be able to obtain admissions or errors not possible at trial. The attorney may also get a witness to commit to a particular position at deposition that can prevent him or her from suddenly recalling a favorable matter at trial. Because of this, “defensive” witnesses are very cautious of comments they make in a deposition so as to not have it hurt them during a trial. They often answer with simple “yes” or “no” answers so they don’t say anything that they are not certain of or that may be misunderstood.

Also, by not elaborating, the witness does not reveal to the opposing party what he or she thinks the key points are in the trial. During a trial, witnesses still must prepare adequately and think about comments they make, but they may speak more freely or “offensively.” At this point, the witness will attempt to make key points to the trial even if the question is only tangentially related to the point. The position a witness takes during a trial will not be used after the trial is over.

2. During the discovery stage in the legal process, why would opposing sides be cooperative in providing information about evidence they intend to introduce during the trial? a. Several reasons exist why opposing sides would cooperate during the discovery stage of the legal process. First, to some extent, parties must comply with certain motions that require them to provide documents or other information to the opposing party which requests the information. Second, having a common understanding of the evidence and information that will be brought to trial will not only allow the separate parties to prepare accordingly,

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but it also allows for a smoother legal process in the sense that major surprises will not be concealed that may delay or overly complicate the trial proceedings. Obviously, information regarding the entire case of a party is not disclosed, but by cooperating with each other about information regarding major issues, both parties can adequately prepare for the trial.

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