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Internal Controls

Internal Controls

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Internal Controls

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  1. Internal Controls

  2. “There is no kind of dishonesty into which otherwise good people more easily and frequently fall than that of defrauding the government.” Benjamin Franklin

  3. How Does Fraud Occur? • Poor internal controls • Lack of proper authorizations • No separation of authorization, custody, and record keeping • No independent checks on performance • Lack of clear lines of authority • Inadequate documentation • Management override of internal controls • Collusion between employees and 3rd parties • Collusion between employees and management • Limited, unclear, or no policies and procedures • Poor or non-existent ethics and/or policy

  4. “We all can learn from audit standards”

  5. Statement on Auditing Standards No. 99 • Exercise professional skepticism • Conduct brainstorming • Identify and assess risks • Communicate

  6. Challenges We Face • 74% of us believe our ethics are higher than those of our peers • 83% of us say that at least one-half of the people we know would list us as one of the most ethical people they know • 92% of us are satisfied with our ethics and character

  7. Would you commit a felony to pay for needed surgery for your child? Yes – 97 percent

  8. Would you commit a felony to pay for needed surgery for your spouse? Yes – 42 percent

  9. “In the real world, successful people do what they have to do to win, even if others consider it cheating.”

  10. We do what we must to win 200 Olympians • Performance enhancing drug, no one will find out, no side affects, and win all races next 5 years 195 2. Performance enhancing drug, win all races next 5 years, then die from side affects, but no one will find out 100

  11. Future Work Force (College) 11% reported cheating in 1963 49% reported cheating in 1993 75% reported cheating in 2003, 2005, 2006, 2007 50% in graduate school in 2006

  12. Trust Is Not A Control Former Director, Federal Emergency Management Agency • Assistant City Manager, Emergency Services Division • Assistant to the City Manager

  13. Trust Is Not A Control Former Deputy Chief Information Officer, U.S. Department of Homeland Security • Bachelor’s Degree (1993), Master’s Degree (1995), and Doctorate (2000) • Hamilton University • Unaccredited fee-for-degree “distance learning” center (“Diploma Mill”) • Bachelor’s Degree (2000), Master’s Degree (2000), and Doctorate (2001)

  14. Reasons We Miss Fraud

  15. Reasons We Miss Fraud • Personalities • Face Value • Avoid Conflict • Checklists • Education • Pressure • Auditor v. Investigator • Business Operations • The “Right” People • Warning Signs

  16. Personalities • Clients’ strong personalities create difficulties • Taken in by friendly personalities • Need to be liked by the client

  17. Personalities • Auditors requested to see a sampling of 400 invoices for ZZZZ Best work. Of those 400, the auditors would select 20. • ZZZZ Best provided 20 fake invoices. • Auditors asked to see 400 original invoices – CFO protested and auditors backed down.

  18. Face Value • Accept answers on face value • Lack of skepticism – never taught and not in personality

  19. Face Value • Crazy Eddie’s – one of the 20th century’s most infamous financial statement frauds • Employees helped auditors with inventory counts • 10 equals 25

  20. Watch What They Say • “The balance sheet is strong.” • “The third quarter is looking great.” • “Our stock is an incredible bargain at current prices.” -- CEO Ken Lay, Enron

  21. Watch What They Say • “We are confident in our marks and the reasonableness of our valuation methods.” • “We have a high degree of certainty in what we have booked to date.” -- CEO Martin Sullivan, AIG

  22. Watch What They Say • “Our liquidity and balance sheet are strong.” • “We don’t see any pressure on our liquidity, let alone a liquidity crisis.” -- CEO Alan Schwartz, Bear Stearns

  23. Watch What They Say • “We are on the right track to put these last two quarters behind us.” -- CEO Richard Fuld, Lehman Brothers • “Our liquidity pool also remains strong at $42 billion.” -- CFO Ian Lowitt, Lehman Brothers

  24. Watch What They Say “In today’s regulatory environment, it’s virtually impossible to violate rules.” -- Bernard Madoff Oct. 20, 2007

  25. Avoid Conflict “People are just too damn lazy.” -- ZZZZ Best’s former CFO Rather than drive out to confirm an address where ZZZZ Best was supposedly doing $45 million in business, the auditors would make a phone call and were satisfied.

  26. Checklists • Use too many checklists – try to get them done versus understanding the questions • Too narrow focused – don’t look to see if things make sense from a broader perspective • Budget & task oriented

  27. Fraudsters Stay One Step Ahead • Electric wheelchair • $5,000 • Billed at least 1,000 times ($5 million) for same wheelchair

  28. Checklists • Do you? • Have you? • Can you? • Are you? • How? • Describe? • What? • Explain?

  29. Education • Fraud and stupid can look just a like • More of a mind-set • Focus on exceptions, oddities, accounting irregularities, and patterns of conduct

  30. Education “No one ever asked.” -- Mark Morze, ZZZZ Best’s former CFO

  31. Education • Does the company possess all of the licenses it needs to conduct the business it does? • How does the company generate the 30%, 40%, 50%, and 60% profit margins that appear on its books? • Why do the company’s bids for complicated, million-dollar projects fit on a single page?

  32. Education • Why is the company constantly in need of additional cash? • Why did the company waste $2 million on equipment it could have rented for 90% less? • Can we (the auditors) speak to at least one satisfied customer?

  33. Education • Why is business conducted only with cashier’s checks? • How can the company’s revenues grow by 400% in 6 months, while the company’s general & administrative costs barely grow at all? • Why aren’t any of the company’s vendors in the Yellow Pages?

  34. Education • Why do the company’s estimates for project costs always equal—to the penny—the supply sheets from the vendors? • Why are there no addresses on the work invoices? • Where are all the government forms regarding permits, licenses, etc.?

  35. Education • Where is all the paperwork on vendor deliveries? • Could the auditors have a tour of one or two of the company’s warehouses or other facilities? • Can the auditors speak with a few of the company’s vendors or subcontractors? If not, why not?

  36. The “Right” People • Too much time on prior year testing & tick marks • Spend too little time talking to the “right” people

  37. The “Right” People • Chairman • Chief Executive Officer • Chief Operating Officer • Chief Financial Officer • Chief Accounting Officer • Chief Compliance Officer • Chief Audit Executive • Chief Legal Officer

  38. The “Right” People • Accounting Manager • A/P Manager • Warehouse Foreman • Billing Manager • Payroll Manager • H/R Manager • Q/A Manager • Contracting Officer

  39. Why Warning Signs are Important? “The average fraud scheme lasted 24 months before it was detected.” -- ACFE 2008 Report to the Nation

  40. Professional Services Contract Effective DateAmountContract Price Contract 09/12/04 $ 85,850 $ 85,850 Mod #1 11/22/04 $ 30,800 $116,650 Mod #2 04/08/05 $ 78,400 $195,050 Mod #3 09/12/05 $ 1,400 $196,450 Mod #4 09/30/05 $148,600 $345,050

  41. Warning Signs • Unexplained employee absences • Refusal to produce records, files or documents • Excessive overtime • Missing documentation

  42. Warning Signs • Payments to a vendor post office box • No original source documents • Lack of competitive bidding • No exceptions or errors