AFC 712 April 2011 - Handout 4 Occ Fraud

1AFC 712 April 2011 HO 4Prof. Dr. Syed Noh Syed Ahmad

Master of Forensic Accounting: AFC 712: Accounting Fraud

ExaminationHandout 4

Prof. Dr. Syed Noh Syed Ahmad

Updated: April 2011


Preamble to Handout 5

• It is not possible to discuss all the possible frauds and fraud schemes involving employees. These fraud schemes are aptly named as “fraud against the organisation” – the perpetrators of such fraud illegally took assets from the organisations for their own benefits. These assets include:– Cash: physically or through fraudulent disbursements– Inventory– Other assets: Fixed assets, etc– Corruption, bribery, kickbacks, etc


• In terms of the fraud schemes, the types and methods used are as many as the perpetrators can imagine.

• Thus the focus for this handout is on the red flags for these frauds.

• For details and examples of these frauds, please refer to the text books for the program and internet sites.


Inventory Fraud

• Inventory fraud is one of the most damaging types of fraudulent activity that can go on in a corporation due to the value of the inventory and its far-reaching effects on the financial statements and investors. It has brought down multi-million dollar corporations with ease. Committing inventory fraud does not require unusually high intellect. However, it is usually committed by knowledgeable people who know how to circumvent the system by knowing how to capitalize on the weaknesses in the business. Persons who are involved in this type of fraud are those dealing directly and indirectly with the acquisition, receiving and recording of the inventory processes. (Compare this with Inventory fraud in financial statements.)


What is Inventory Fraud?

• Fictitious Inventory• Misuse of non-cash assets• Misappropriation of non-cash assets

– Larceny– Asset requisitions and transfers– Purchasing and receiving schemes– False shipments

[None cash assets include inventory, and other physical assets.]


FICTITIOUS INVENTORY• Fictitious inventory, could be included as inventory fraud, even

though it does not involved the physical aspect of inventory , i.e. misuse or theft of the inventory. This is because of its impact on the financial statements and thus, the resulting financial statements would be considered as fraudulent. The instances of this type of inventory fraud, as discussed in the session concerning financial statement fraud, is very common.

• A simple example of fictitious inventory is to increase inventory asset value is by creating various records for items that do not exist: unsupported journal entries, inflated inventory count sheets, bogus shipping and receiving reports and fake purchase orders. Since it can be difficult for the investigator to spot such phony documents, the investigator normally uses other means to substantiate the existence and value of inventory.


Examples of Fictitious Inventory Fraud Scheme (These are just a sample of the many possible inventory frauds!! I am sure that you wil

be able to come up with a few more!!):

1. Empty boxes or "hollow squares" in stacked goods, or other containers.

2. Mislabeled boxes containing scrap, obsolete items or lower value materials.

3. Consigned inventory, inventory that is rented, or traded-in items for which credits have not been issued.

4. Diluted inventory so it is less valuable (e.g., adding water to liquid substances).

5. Altering the inventory counts for those items the auditor did not test count.

6. Programming the computer to produce fraudulent physical quantity tabulations or priced inventory listings.

7. Manipulating the inventory counts/compilations for locations not visited by the auditor.

8. Double-counting inventory in transit between locations.

9. Physically moving inventory and counting it at two locations.

10. Including in inventory merchandise recorded as sold but not yet shipped to a customer ("bill and hold sales").


Misuse of Company Assets

• “Borrowing” company assets for personal use:– Company vehicles– Supplies– Computers & office equipment

• Results in lost productivity, increased wear on equipment, etc.


Inventory Larceny

• Strict theft of inventory• Unconcealed on the books• Persons involved are often highly trusted, with

access to secure inventory• Examples:

– After-hours theft from warehouse/storeroom This is very common – with or without ‘inside’ help

– Fake sales scheme


• Fake Sales• Fraudulent Asset

Requisitions• the assets requested

are then classified as damaged or scrap.

• Employees sometimes falsify asset transfer forms

• Purchasing and Receiving Schemes

• False Shipments of Inventory

• Concealing Inventory Shrinkage


Red Flags for Inventory Fraud

• Inventory increasing faster than sales.• Decreasing inventory turnover.• Shipping costs decreasing as a percentage of

inventory.• Inventory rising faster than total assets move up.• Falling cost of sales as a percentage of sales.• Cost of goods sold on the books not agreeing

with tax returns


ASSESSING THE RISK OF INVENTORY FRAUD

• Statement on Auditing Standards no. 82, Consideration of Fraud in a Financial Statement Audit, (this Statement is included in your reading materials) lists many factors at play in cases of inventory fraud affecting either the financial statements or specifically the inventory. The more “yes” answers, the higher the risk for inventory fraud:


• Is the company attempting to obtain financing

secured by inventory?• Is inventory a significant balance sheet item?• Has the percentage of inventory to total assets

increased over time?• Has the ratio of cost of sales to total sales

decreased over time?• Have shipping costs fallen compared with total

inventory?• Has inventory turnover slowed over time?


• Have there been significant adjusting entries that have increased the inventory balance?

• After the close of an accounting period, have material reversing entries been made to the inventory account?

• Is the company a manufacturer, or does it have a complex system to determine the value of inventory?

• Is the company involved in technology or another volatile or rapidly changing industry?


Chapter 3: Skimming


Skimming Schemes

• Skimming makes up approximately 29% of cash frauds.

• 316 cases of skimming were reported, with a median loss of $50,000.


What is Skimming?

• Definition: theft of cash from victim organization before the cash hits the accounting system

• Off-book fraud

• No direct audit trail

• Books stay balanced

• Most common form of cash fraud


Deterrence Steps for Skimming

• Identify all revenue sources• Determine where they enter the organization• Record accountability immediately• Restrictively endorse all checks “For Deposit

Only” immediately• Include revenue sources in organization’s

budget• Review budget versus actual revenue• Identify and investigate significant variances


Common Skimming Schemes

• Sales skimming

• Receivables skimming

• Refunds and other skimming schemes


Skimming Schemes – Breakdown of Cases

• Of 316 skimming schemes that were studied, 203 involved the theft of sales, as opposed to receivables.

• Sales skimming is easier to conceal because payments are not expected.


Skimming Schemes -Median Losses

$52,000

$44,500

$30,000 $35,000 $40,000 $45,000 $50,000 $55,000

Skimming -Receivables

Skimming -Sales


Sales Skimming Schemes

• Unrecorded sales– Perp makes a sale, pockets money– Never records sale

• Understated sales– Perp pockets a portion of a sale– Either records sale at lower price or smaller

quantity of goods sold


Sales Skimming Schemes

• Register manipulations– Cash register clerk rings “no sale”– Pockets money– Looks like transaction was recorded

• Skimming during off-hours– Perps sell company merchandise on

weekends or after hours


Sales Skimming -Countermeasures

• Surveillance of employees at point of sale

• Maintain secure area for employees to store coats, purses, etc.

• Investigate gaps in transaction sequence/pre-numbered receipts

• Look for excessive non-sale transactions (voids, refunds) at cash registers


Sales Skimming - Countermeasures

• Encourage customers to request receipts (forces employees to ring up sales)

• Rotate employee schedules, measure variances in revenue based on employee

• Use a secret shopper service


Skimming Off-Site Sales

• Remote salespersons largely unsupervised

• Common with insurance salespersons: – Sell a policy, policy never filed

• Property managers:– Lease a property, list it as vacant– Pocket rents


Skimming Off-Site Sales – Countermeasures

• Require external sales staff to maintain activity logs

• Spot-check activity log entries by independent personnel

• Monitor customer complaints independent of sales staff

• Conduct sales trend analysis on external salespersons


Theft in the Mailroom

• Mailroom employees steal incoming checks

• Checks never logged

• Usually occurs when one employee opens mail unsupervised


Theft in the Mailroom - Countermeasures

• Open mail in visible area with supervisory presence or video cameras

• Use two employees to open mail• No purses or briefcases where mail is

opened• Have incoming payments sent to lockbox• Mail marked checks to company, verify

that they are logged


Receivables Skimming

• More difficult to conceal than sales skimming

• Incoming payments “expected”

• Can result in delinquent customer accounts

• Perp must take steps to conceal the fraud


How Skimming is Concealed

• Destroy or alter transaction records

• Lapping

• Steal customer statements

• False account entries

• Inventory padding


Lapping

• Steal customer A’s payment

• Apply customer B’s payment to A’s account, etc.

• Most common concealment technique

• Perp may keep 2nd set of books to track misapplications


Lapping – Countermeasures

• Watch for employees who put in a lot of time after-hours and on weekends (lapping schemes take a lot of work)

• Enforce mandatory vacations • Spot-check daily deposits to accounts

receivable, verify names on checks match postings

• Compare a/r postings to dates payments were mailed by customers


Stealing Customer Statements

• This is done when skimming causes a customer account to become delinquent

• Usually change customer address in billing system

• Replace real statements with counterfeits showing account current

• Keeps customer from alerting company


Stealing Customer Statements - Countermeasures

• Independent confirmations of aging a/r with customers

• Separate collections department from sales, accounts receivable

• Separate mail function from accounts receivable


False Account Entries to Hide Skimming

• Debit expense account instead of cash

• Debit aging receivables or very large accounts

• Write off accounts as bad debts

• Create fraudulent “discounts”

• Force account balances (add wrong)


False Account Entries – Countermeasures

• Separate duties of receiving cash, posting payments, and reconciling accounts

• Match deposit totals to a/r postings• Investigate shortages in cash account• Require supervisory approval for write-offs• Look for rising trend in write-offs,

discounts• Look for large number of aging accounts


Inventory Padding

• Unrecorded sales cause inventory shrinkage

• Common concealment techniques: – Forced reconciliation of perpetual &

physical inventory– False credits to inventory – Write off as lost, stolen, obsolete


Skimming Controls

• Segregate all cash receipting functions• Supervise employees at all cash collection

points• Supervise employees who open mail• Place restrictive endorsements on all

checks received• Enforce mandatory vacations• Conduct surprise audits/cash counts


Skimming Controls

• Supervisory authority for all price modifications and write-offs

• Independently confirm delinquent customer accts.

• Random customer satisfaction surveys

• Follow up on customer complaints


Cash Larceny


Cash Larceny

• Larceny is the least common of the three major cash misappropriation categories.

• 45 cash larceny cases were reported, with a median loss of $22,000.


What is Cash Larceny?

• Definition:– Intentional taking– Of employer’s cash– Without employer’s consent

• “Cash” includes currency and checks


Cash Larceny v. Skimming

• Skimming is theft of off-book funds

• Cash larceny is theft of on-book funds

• Cash larceny:– Less common than skimming– Less costly than skimming– Direct audit trail


Cash Larceny Schemes

• Theft of cash on hand– From cash register or cash box– Posted customer payments

• Theft from the deposit


How Cash Larceny is Concealed

• Unconcealed

• Personal check in register

• Reversing transactions (voids/refunds)

• Alter cash counts

• Destroy/alter transaction records


Cash Larceny from the Deposit

• Perp usually in charge of daily deposit

• Steal the currency, deposit the checks

• Poor controls are the key– One person prepares/makes deposit,

reconciles bank account– Failure to reconcile deposits/receipts– Deposit left unattended before going to bank


Concealing Larceny from the Deposit

• Deposit lapping– Steal Day 1 deposits– Cover with subsequent receipts

• Deposits in transit– Missing money carried on books as “deposits

in transit”


Cash Larceny - Countermeasures

• Investigate shortages in cash drawers, deposits, etc.

• Investigate missing or altered sales records

• Have two people independently verify deposits on bank statement to postings in general ledger

• Maintain and review daily cash availability amounts


Cash Larceny - Countermeasures

• Have deposits delivered to bank under dual control

• If fraud suspected, verify deposit prior to dispatch without suspect’s knowledge; then contact bank to confirm that deposit was made

• Have deposits made in night drop, verify at beginning of next day

• Make sure deposits in transit are first items to clear on next statement


Register Disbursement Schemes


What Are Register Disbursements?

• Form of fraudulent disbursement

• Cash stolen from cash register

• Perpetrator enters a reversing transaction to justify the disbursement of funds

• Register is balanced


Register Disbursements

Fraudulent Disbursements

Other8.1%

Register2.7%

Payroll16.5%

Check Tamp24.5%

Expense14.9%

Billing33.3%

• Register disbursements made up only 3% of fraudulent disbursement cases.

• 20 register disbursement cases were reported, with a median loss of $22,500.


Fraudulent Register Disbursements

Two Principle Schemes:

• False refunds

• False voids


Register Disbursements – Breakdown of Cases

Only 20 register disbursement cases were reported in the 1993 study. They were almost evenly split between fraudulent voids and refunds.


Register Disbursements -Median Losses

$50,000

$20,000

$0 $10,000 $20,000 $30,000 $40,000 $50,000

FaudulentVoids

FraudulentRefunds

• The median cost for fraudulent voids was more than twice that of fraudulent refund schemes.

• Overall, the median cost of a register disbursement scheme was $22,500.


False Refunds

• Fictitious refunds– No merchandise actually returned– Results in overstated inventory

• Overstated refunds– Overstate a legitimate refund, skim excess


False Refunds

Credit card refunds

• Credit refunds to accomplice account– Accomplice kicks back portion of the refund

• Perp credits refund to his own account


False Voids

• Perp makes sale, keeps customer’s receipt

• After customer gone, uses receipt to process false void– May need manager approval– Forge signature– Manager “rubber stamps” voids

• Perp pockets money


Concealing Register Disbursements

• Multiple disbursements below review level

• Destroy transaction records

• Rely on company: nobody looking for fraud


Register Disbursements – Countermeasures

• Periodically run trend analysis, look for employees who process too many reversals

• Look for refunds/voids in recurring amounts, especially round numbers

• Look for excessive refunds/voids just below review levels

• Encourage customers to examine their receipts – if you don’t get one, it’s free!


Register Disbursements – Countermeasures

• Verify transactions by making random “customer satisfaction” calls to customers who have returned merchandise

• Be alert for multiple refunds for the same merchandise

• Look for refunds/voids with no corresponding sale


Register Disbursement Controls

• Require management approval for all refunds/voids

• Maintain management presence at cash registers

• Restrict access to control key that authorizes reversing entries

• Cashiers should not be allowed to reverse their own sales



• Maintain file on all voids/refunds

• Require separate log-in code for every cashier

• Require copy of customer receipt with all reversals

• Someone independent of cashiers should prepare register count sheets



• Observe Inventory

• Run perpetual inventory if possible


Initial Action In The Event Of Fraud- As Recommended By KPMG

• When fraud occurs or is suspected, management is sometimes tempted to resolve the matter internally. This may expose the organization to significant risk. When you become aware of incidents or suspicions of fraud in your organization, we recommend that you consider the following:



• Do not:– Respond emotionally or act hastily.– Immediately confront the suspects.– Damage or mark any evidence or potential

evidence.– Limit the scope of your concerns to a specific

issue.



• Do– Be objective in your assessment.– Limit the number of people whom you discuss

your suspicions.– Carefully preserve any evidence by removing

access to documents and electronic media.– Call in the professionals.


General investigation rules• Preserve the evidence - documents, computers,

personal laptops, voicemails, emails, phone logs, security camera tapes.

• Focus on the facts. Be objective. Avoid communicating judgments / conclusions and making accusations unless evidence has been obtained.

• Guard against legal exposures to defamation, libel and slander, and also wrongful invasion of privacy (through improper searches of desk, lockers, personal storage), violations of law on audio / videotaping of conversations and the use of threats, promises, inducements, offers to waive reporting to the authorities or to waive prosecution in return for co-operation.


General investigation rules

• Act professionally. Guard against other actions likely to be inconsistent with the corporate image or damaging to the corporate reputation.

• Ensure that disciplinary action does not precede the completion of the investigation to avoid the risk of making a wrongful termination, losing the suspect's cooperation and creating a perception of a lack of objectivity.


General investigation rules

• Always consider how the investigation will be perceived not only the subject but also by others, both during and after. Consider how it will reflect on the company's reputation for being ethical, against fraud / illegal acts and for treating its employees with respect. Inappropriate actions or a poorly conducted investigation can severely damage employee relations and set back the company's attempts to promote a law-abiding workplace.


Documents

AFC 712 April 2011 - Handout 4 Occ Fraud