Accounting Information Systems - Computer Fraud

8/3/2019 Accounting Information Systems - Computer Fraud

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Chapter 5

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1. Describe fraud and describe the process one follows to

perpetuate a fraud.

2. Discuss why fraud occurs, including the pressures,

opportunities, and rationalizations that are present in

most frauds.

3. Compare and contrast the approaches and techniques

that are used to commit computer fraud.4. Describe how to deter and detect computer fraud.

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Jason Scott finished his tax return.

Everything was in order except his

withholding amount. For some reason, the federal income tax

withholdings on his final paycheck was $5higher than on his W-2 form.

What did he discover?

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Most of the 1,500 company employees had a$5 discrepancy between their reported

withholdings and the actual amountwithheld.

The W-2 ofDon Hawkins, one of the

programmers in charge of the payroll system,showed that thousands of dollars more inwithholding had been reported to the IRSthan had been withheld from his paycheck.

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What constitutes a fraud, and is the

withholding problem a fraud?

If this is indeed a fraud, how was it

perpetrated?

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Why did the company not catch these mistakes

earlier?

Was there a breakdown in controls? What can the company do to detect and prevent

fraud?

Just how vulnerable are computer systems to

fraud?

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This chapter describes the fraud process.

It also explores the reasons that fraud occurs.

The chapter also describes the approaches tocomputer fraud and the specific techniquesused to commit it.

Finally, several methods to deter and detectfraud are analyzed.

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Understand what fraud is

and the process onefollows to perpetuate afraud.

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What is the definition of fraud?

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What is the definition of fraud?

an intentional deception made for personal gain or todamage another individual

Fraud is a crime

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What is computer fraud?

"Conduct which involves the manipulation of a computeror computer data, by whatever method, in order todishonestly obtain money, property or some otheradvantage ofvalue, or to cause loss."

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Since fraudsters dont make journal entries to

record their frauds, we can only estimate the

amount of losses caused by fraudulent acts: Total fraud losses in theU.S. run around 6% of annual

revenues or approximately $660 billion in 2004.

Income tax fraud (the difference between what

taxpayers owe and what they pay to the government)is estimated to be over $200 billion per year.

Fraud in the healthcare industry is estimatedtoexceed $100 billion a year.

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Fraud perpetrators are often referred to as

white-collar criminals.

Distinguishes them from violent criminals,although some white-collar crime can ultimatelyhave violent outcomes, such as:

Perpetrators or their victims committing suicide.

Healthcare patients killed because of alteration ofinformation, etc., that can result in their deaths.

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Three types of occupational fraud: Misappropriation of assets

Corruption

Fraudulent statements

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Employee fraud characteristics: They gain the trust and confidence of the company or

people being defrauded to commit and conceal thefraud. They use weapons of deceit and misinformation. Frauds usually begin from a need then become greed

later on. They grow careless and overconfident over time. Over time, the size of the fraud usually leads to

detection.

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Fraudulent financial reporting

Financial Statements can be falsified to: Deceive investors and creditors Cause a companys stock price to rise Meet cash flow needs

Hide company losses and problems

Example Enron?

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Fraudulent financial reporting is of great

concern to independent auditors, because

undetected frauds lead to half of the lawsuitsagainst auditors.

In the case ofEnron, a financial statement fraud

led to the total elimination of Arthur Andersen,a premiere international public accounting firm.

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Most frauds involve three steps.

The theft of

something

The conversionto cash

Theconcealment

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What is a common way to hide a theft?

What is a payroll example?

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What is a common way to hide a theft?

to charge the stolen item to an expense account

What is a payroll example?

to add a fictitious name to the companys payroll

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What is lapping?

In a lapping scheme, the perpetrator stealscash received from customer A to pay its

accounts receivable.

Funds received at a later date from customer Bare used to pay off customer As balance, etc.

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What is kiting? In a kiting scheme, the perpetrator covers up

a theft by creating cash through the transferof money between banks.

The perpetrator deposits a check from bank A

to bank B and then withdraws the money.

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Since there are insufficient funds in bank A to coverthe check, the perpetrator deposits a check frombank C to bank A before his check to bank B clears.

Since bank C also has insufficient funds, money mustbe deposited to bank C before the check to bank Aclears.

The scheme continues to keep checks from bouncing.

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A cashier was stealing money from daily cash receiptsand making up the shortages with the following dayscash receipts.The fraud was discovered during areview of the bank reconciliation when the officemanager noticed that the exact same deposit wasmade on two consecutive days. Suggested controlprocedure that could have prevented this is a simplesegregation of duties the cashier was also preparingthe daily deposit slip, and no one was responsible forreconciling it with the daily cash report.

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During the 1990s, WorldCom was deeply involved inacquisitions and completed several mega-deals

Purchased over 60 firms in 2nd

half of the 90s

WorldCom moved into Internet and data traffic

Handled 50% ofUS Internet traffic

Handled 50% of e-mails worldwide

PurchasedMCI for $37 billion in 1997 By 2001 owned a third of theUS data cables

WasU.S. 2nd largest long-distance operator in 1998 and 2002

Had over 20 million customers in 2002

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From 1998-2000, WorldCom reduced reserve accounts heldto cover liabilities of acquired companies

WorldCom added $2.8 billion to the revenue line from

these reserves

Reserves didnt cut it; An e-mail was sent in December 2000to a division inTexas directing misclassification of expenses.

CFO told key staff members to mark operating costs aslong-term investments.

To the tune of $3.85 billion.

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Operating Expenses to Assets

-CFOs directions affected the income statement:

Revenues xxx (no change)

COGS xxx (no change)

Operating Expenses:

Fees paid to lease other

companies phone networks: xxx (HugeDecrease)

Computer expenses: xxx (HugeDecrease)

NET INCOME xxx (Huge Increase)

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Operating Expenses to Assets

-CFOs directions affected the balance sheet:

Assets:

Computer assets xxx (Huge Increase)

Leasing assets xxx (Huge Increase)

Liabilities xxx (no change)

StockholdersEquity:

Retained Earnings xxx (Huge Increase)

=HAPPY INVESTORS

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Huge losses turned into enormous profits.

$1.38 billion in net income in 2001

Inflated the companys value in its assets

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4. March 7, 2002 - the SEC requests information from WorldCom

How could WorldCom make so much when AT&T is losing money?

5. The Internal audit started digging Found $2 billion company announced for capital expenditures

(Internal Auditors found it was never authorized for capitalexpenditures.)

Found the undocumented $500 million in computer expenses that

were recorded as assets. Searching WorldComs computers,Mr.Morse found $2 billion in

questionable entries

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June 25, 2002 - WorldCom announces it inflated profits by$3.8 billion over the previous five quarters

June 26, 2002 - civil suit filed, stock trading halted

Ultimately, stock was delisted by Nasdaq

July 21, 2002 - WorldCom filed for bankruptcy

17,000 jobs cut to save $1 billion.

WorldCom was renamedMCI in 2004 when it emergedfrom bankruptcy

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Compared to other financial statement frauds,Enron was a very complicated fraud. (WorldCom,for example, was a $7 billion fraud that involved

simply capitalizing expenses (line costs) that shouldhave been expensed (Accounting 200 topic.) Enroninvolved many complex transactions andaccounting issues.

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Enron delivered smoothly growing earnings (but not cash flows.)Wall Street took Enron on its word but didnt understand itsfinancial statements.

It was all about the price of the stock. Enron was a trading

company and Wall Street normally doesnt reward volatileearnings of trading companies. (Goldman Sacks is a tradingcompany. Its stock price was 20 times earnings while Enrons was70 times earnings.)

In its last 5 years, Enron reported 20 straight quarters ofincreasing income.

Enron, that had once made its money from hard assets likepipelines, generated more than 80% of its earnings from avaguer business known as wholesale energy operations and

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Was devoid of any boundary system Enrons core business was losing moneyshifted its focus

from bricks-and-mortar energy business to trading ofderivatives (most derivatives profits were more imagined

than real with many employees lying and misstatingsystematically their profits and losses in order to make theirtrading businesses appear less volatile than they were)

During 2000, Enrons derivatives-related assets increasedfrom $2.2 billion to $12 billion and derivates-relatedliabilities increased from $1.8 billion to $10.5 billion

Enrons top management gave its managers a blank order tojust do it

Deals in unrelated areas such as weather derivatives, waterservices, metals trading, broadband supply and power plantwere all justified.

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Because Enron believed it was leading arevolution, it pushed the rules. Employees

attempted to crush not just outsiders but

each other. Enron was built to maximizevalue by maximizing the individual parts.

Enron traders were afraid to go to the

bathroom because the guy sitting next tothem might use information off their screen

to trade against them.

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Enron took more risk than othersit swung for the fences.


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Jeff Skilling left in Augustgave no reason for his departure. By mid-August 2001, the stock price began falling Former CEO, Kenneth Lay, came back in August O

ct.1

6announced $618

million loss but not that it hadwritten down equity by $1.2 billion OctoberMoodys downgraded Enrons debt Nov.8Told investors they were restating earnings for the

past 4 and years Dec.2Filed bankruptcy

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In early 2001, Jim Chanos, who runs KynikosAssociates, a highly regarded firm specializing inshort selling said publicly that no one could explainhow Enron actually made money. He noted thatEnron had completed transactions with relatedparties that were run by a senior officer ofEnronand assumed it was a conflict of interest. (Enronwouldnt answer questions about LJM and otherpartnerships.)

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Was paid $52 million in 2000, the majority of which was fornon-audit related consulting services.

Failed to spot many ofEnrons losses Should have assessed Enron managements internal controls

on derivates tradingexpressed approval of internal controlsduring 1998 through 2000

Kept a whole floor of auditors assigned at Enron year around Enron was Andersens second largest client Did both external and internal audits CFOs and controllers were former Andersen executives

Accused of document destructionwas criminally indicted Went out of business My partner friend I had $4 million in my retirement account

and I lost it all. Some partners who transferred to other firmsnow have two equity loans and no retirement savings.

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1.Denmark

2.Finland 3. Sweden

4. New Zealand

5.Iceland

6.Canada

7.Singapore 8. Netherlands, Norway

16. Hong Kong 17. United States

Austria 25. Japan

29. Taiwan 43. South Korea 52. China 81. Nigeria 84. Paraguay

85. Cameroon

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Good economy was masking many problems Moral decay in society Executive incentives

Wall Street expectationsrewards for short-termbehavior Nature of accounting rules Behavior of CPA firms Greed by investment banks, commercial banks, and

investors Educator failures

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Meeting Wall Streets Expectations

Stock prices are tied to meeting Wall Streets earningsforecasts

Focus is on short-term performance only

Companies are heavily punished for not meeting forecasts

Executives have been endowed with hundreds of millionsof dollars worth of stock optionsfar exceeds

compensation (tied to stock price)

Performance is based on earnings & stock price

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Discuss why fraud occurs,

including the pressures,

opportunities, andrationalizations that are

present in most frauds.

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Researchers have compared the psychological and

demographic characteristics of three groups of people:

White-collarcriminals

Violentcriminals

General

public

Few differencesSignificant

differences

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What are some common characteristics offraud perpetrators?

Most spend their illegal income rather than investor save it.

Once they begin the fraud, it is very hard for them

to stop. They usually begin to rely on the extra income.

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Perpetrators of computer fraud tend to be youngerand possess more computer knowledge,experience, and skills.

Some computer fraud perpetrators are moremotivated by curiosity and the challenge ofbeating the system.

Others commit fraud to gain stature among othersin the computer community.

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Three conditions are necessary for fraud to

occur:

1 A pressure or motive2 An opportunity

3 A rationalization

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The FraudTriangle

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What are somefinancialpressures?

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What are somefinancialpressures?

living beyond means

high personal debt inadequate income

poor credit ratings

heavy financial losses

large gambling debts

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What are somefinancial statementpressures?

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What are somefinancial statementpressures?

Prop up earnings or stock priceOR to reduce

earnings Cover the inability to generate cash flow

Obtain financing

Appear to comply with bond covenants or other

agreements

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What are some work-relatedpressures?

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What are some work-relatedpressures?

low salary

nonrecognition of performance job dissatisfaction

fear of losing job

overaggressive bonus plans

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What are otherpressures?

challenge

family/peer pressure emotional instability

need for power or control

excessive pride or ambition

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An opportunity is the condition or situationthat allows a person to commit and conceal adishonest act.

What are the ways fraud can be concealedthat we discussed?

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Opportunities often stem from a lack ofinternal controls.

However, the most prevalent opportunity forfraud results from a companys failure toenforce its system of internal controls.

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Most perpetrators have an excuse or a

rationalization that allows them to justify theirillegal behavior.

What are some rationalizations?

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Most perpetrators have an excuse or arationalization that allows them to justify theirillegal behavior.

What are some rationalizations? The perpetrator is just borrowing the stolen assets.

The perpetrator is not hurting a real person, just a

computer system.

No one will ever know.

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Fraud occurs when: People have perceived, non-shareablepressures;

The opportunitygateway is left open; and

They can rationalize their actions to reduce themoral impact in their minds (i.e., they have lowintegrity).

Fraud is much less likely to occur when There is low pressure, low opportunity, and high

integrity.

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Compare and contrast the

approaches and techniquesthat are used to commitcomputer fraud.

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TheU.S.Department ofJustice defines

computer fraud as any illegal act for which

knowledge of computer technology is essentialfor its perpetration, investigation, or

prosecution.

What are examples of computer fraud? unauthorized use, access, modification, copying, and

destruction of software or data

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theft of money by altering computer records or thetheft of computer time

theft or destruction of computer hardware

use or the conspiracy to use computer resources tocommit a felony

intent to illegally obtain information or tangibleproperty through the use of computers

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Organizations that track computer fraud

estimate that 80% ofU.S. businesses have

been victimized by at least one incident ofcomputer fraud.

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No one knows for sure exactly how muchcompanies lose to computer fraud.Why?

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No one knows for sure exactly how muchcompanies lose to computer fraud.Why?There is disagreement on what computer fraud is.

Many computer frauds go undetected, or unreported.

Most networks have a low level of security.

Many Internet pages give instructions on how to perpetrate

computer crimes. Law enforcement is unable to keep up with fraud.

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Computerinstruction fraud

Processor fraud

Data fraud

Inputfraud

Outputfraud

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Processor Fraud Involves unauthorized system use

Includes theft of computer time and services.

Computer Instructions Fraud Involves tampering with software that processes

company data

May include:Modifying the software

Making illegal copies

Using it in an unauthorized manner

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Data Fraud

Involves: Altering or damaging a companys data files; or

Copying, using, or searching the data files withoutauthorization.

Sale of stolen data

Output Fraud Stealing or misusing system output.

Use computers and peripheral devices to createcounterfeit outputs

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What are some of the more common

techniques to commit computer fraud?

Cracking Data diddling

Data leakage

Denial of service attack

Eavesdropping

E-mail forgery and threats

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Hacking

Internet misinformation and terrorism

Logic time bomb Masquerading or impersonation

Password cracking

Piggybacking

Round-down

Salami technique

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Software piracy

Scavenging

Social engineering Superzapping

Trap door

Trojan horse

Virus

Worm

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Describe how to deter anddetect computer fraud.

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What are some measures that can decreasethe potential of fraud?

1 Make fraud less likely to occur.

2 Increase the difficulty of committing fraud.

3 Improve detection methods.

4 Reduce fraud losses.5 Prosecute and incarcerate fraud perpetrators.

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1 Make fraud less likely to occur.

Use proper hiring and firing practices.

Manage disgruntled employees.

Train employees in security and fraud prevention.

Manage and track software licenses.

Require signed confidentiality agreements.

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2 Increase the difficulty of committing fraud. Develop a strong system of internal controls.

Segregate duties.

Require vacations and rotate duties.

Restrict access to computer equipment and datafiles.

Encrypt data and programs.

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3 Improve detection methods.

Protect telephone lines and the system fromviruses.

Control sensitive data.

Control laptop computers.

Monitor hacker information.

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4 Reduce fraud losses.

Maintain adequate insurance.

Store backup copies of programs and data files ina secure, off-site location.

Develop a contingency plan for fraud occurrences.

Use software to monitor system activity and

recover from fraud.

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5 Prosecute and incarcerate fraud perpetrators.

Most fraud cases go unreported andunprosecuted.Why?

Many cases of computer fraud are as yet undetected.

Companies are reluctant to report computer crimes.

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Law enforcement officials and the courts are so busywith violent crimes that they have little time for fraudcases.

It is difficult, costly, and time consuming toinvestigate.

Many law enforcement officials, lawyers, and judgeslack the computer skills needed to investigate,prosecute, and evaluate computer crimes.

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What did Jason present to the president?

A copy of his own withholding report filed withthe IRS and a printout of withholdings from thepayroll records.

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How did Jason believe the fraud was

perpetrated? The payroll system had undergone some minor

modifications.

The payroll project had been completed without theusual review by other systems personnel.

An unusual code subtracted $5 from most employees

withholdings and added it to Dons.

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What guidelines should Jason suggest toprevent this from happening again?

Strictly enforce existing controls.

New controls should be put into place todetect fraud.

Employees should be trained in fraudawareness, security measures, and ethical

issues. Jason also urged the president to prosecute

the case.

Documents

Accounting Information Systems - Computer Fraud