Fraud Detection: An Historical Overview of Auditor Responsibility and Characteristics of Fraud

1. Fraud Detection: An Historical Overview of Auditor Responsibility and Characteristics of Fraud Dr. Donald K. McConnell Jr.

2. Evolution of the Auditor’s Fraud Detection Responsibilities • Circa 1900: fraud detection the auditor’s primary responsibility • The late 1930s: McKesson and Robbins-Did the auditor’s miss something? • The mid-1960s: a “Catch-22”fraud detection scenario • Treadway committee findings led to SAS 53: the first defined responsibilities for detecting “irregularities” • Contemporary responsibilities: SAS 82 (AU 316) –a watershed event

3. Report of the National Commission on Fraudulent Financial Reporting • Commonly referred to as the Treadway Committee Report (1987) • The Committee of Sponsoring Organizations (COSO) • AICPA • AAA • FEI • IIA • IMA • Charge: identify environmental factors present when highest management level fraud occurs

4. The Most Important Findings • A proper “tone at the top” (corporate environment or corporate culture) is the most important factor in combating fraud for the entity • Almost all management level fraud involved three types of schemes: • Improper revenue recognition schemes • Overvalued assets • Improperly capitalized expenditures

5. Improper Revenue Recognition Schemes • Fraudulent sales • Bill and hold arrangements • Improper sales cut off’s • Parking lot transactions • Sales with liberal rights of return • Channel stuffing

6. Overvalued Assets • Assets management knows should be written down • Examples: • Inventories • Accounts receivable • Impaired fixed assets

7. Improperly Capitalized Expenditures • “Creative” asset theory regarding future benefit • Expenditures booked as assets, which should have been expensed • WCOM capitalized ordinary line expenses as fixed assets

8. Other Treadway Committee Report Findings • Perpetrators almost always had complete, accurate audit trails • Highest level management rarely embezzles • Rarely does management fraud involved manipulated financial data or incomplete records • Most management fraud was committed in the area of Accounting estimates • Accounting estimates are: • Hard to develop, and easy to manipulate • Hard to control • Hard to audit

9. What Is the Auditor’s Greatest Nightmare?

10. What is the Auditor’s Fraud Detection Responsibility? • The auditor has a responsibility to plan and perform the audit to obtain REASONABALE ASSURANCE about whether the financial statements are free of MATERIAL misstatement, whether caused by fraud or error. (SAS 99.01) • That responsibility is couched by the terms Reasonable assurance and material

11. Fraud Is a Broad Legal Concept: the Auditor’s Interest Is in Fraudulent Acts Causing Financial Statements to Be Materially Misstated

12. Fraud Schemes Generally Involve: • Pressure or incentive to commit fraud (SAS 99.07) • Perceived opportunity • Attitudes/Rationalization (per ACFE) • These three elements form what CFE’s call “A Fraud Triangle”

13. Misstatements Arising from Fraudulent Financial Reporting [“Fraud for the Entity”]: • Intentional Misstatements or Omissions of Amounts or Disclosures in Financial Statements • Involving Manipulation, Falsification, or Alteration of Accounting Records or Documents, • Misrepresentation or Intentional Omissions, or • Intentional Misapplication of Generally Accepted Accounting Principles. (SAS 99.06)

14. Misstatements Arising from Misappropriation of Assets [“Fraud Against the Entity”] • involves theft of entity assets wherein the effect of the theft causes financial statements not to be in conformity with GAAP. (SAS 99.06) • Examples include: • Embezzlement of cash • Purchasing kick back schemes • Theft of small, valuable, marketable assets (computer chips or small fixed assets)

15. The Auditor is Interested in Fraud Which has the Effect of Causing the Financial Statements to be Materially Misstated; not just in Material Fraud • Doesn’t all material fraud cause the financial statements to materially misstated? An example where this isn’t the case.

16. Fraud Schemes Typically Have Certain Characteristics (Au 316.07) • The schemes typically are concealed • Fraud can involve collusion, which is difficult to detect in an audit • Falsified documentation: Traditional auditors not expected to be experts in ascertaining authenticity

17. Other Characteristics of Fraud • All big frauds started as little ones • Often occur through serendipity • Fraudsters consider it a “borrowing” • Most embezzlers would be truly appalled if accused of being a thief!

18. What Does a Typical Fraudster Look like? • You and me! • They are often intelligent • Almost always well-respected, TRUSTED employees • Often male, over 50, college-educated

19. Glibness or superficial charm Grandiose sense of self worth or egocentric Pathological liar Lack of remorse or guilt Shallow emotions Callousness or lack of empathy Failure to accept responsibility for their actions Profile of a Typical Management Fraudster

20. Motives for “Fraud for The Entity” • Reach or exceed quotas or goals • Meet regulatory requirements • Manipulate stock price/value • Maintain corporate ability to borrow • Personal ambition

21. Lifestyle does not fit income Has access to money or assets Problems at home Problems dealing with pressures Heavily indebted Real or imagined grievances Takes little or no vacation Works odd hours Low morale Drug or gambling problems Personality changes Profile of a Typical Employee Fraudster

22. Motives for “Fraud against the Entity” • Enhance lifestyle • Cure financial problems • Revenge against the company • Cure perceived injustice • Ego-”beat the system” • Personal ambition

23. Various Fraud Issues • Are auditors expected to seek out such indicators of personal financial stress and company/employee conflict? • No, but an awareness of the following should be considered: • Employee layoffs are anticipated • Employees with access to assets susceptible to defalcation exhibit: • Unusual behavioral changes • Lifestyle changes • Appear disgruntled • Known personal financial pressures • Is most fraud detected internally [internal auditors, hot lines] or by external audits?