Contents
FRAUD AND CONTROL
15.1 Introduction ............................................................................................................................................ 3
15.2 Learning Objectives ............................................................................................................................... 4
15.3 What is Fraud? ...................................................................................................................................... 4
15.3.1 Types of Intentional Mis-statement ................................................................................................ 5
15.3.2 Fraud Conditions ............................................................................................................................ 6
15.4 Forms of Fraud ...................................................................................................................................... 7
15.4.1 Simple Frauds ................................................................................................................................ 7
15.4.2 Compound and Complex Frauds ................................................................................................... 7
15.4.3 On Book and Off Book Frauds ....................................................................................................... 8
15.5 Types of Fraud ...................................................................................................................................... 9
15.5.1 Fraudulent Financial Reporting ...................................................................................................... 9
15.5.2 Misappropriation of Assets .......................................................................................................... 11
15.5.3 Types of Fraud Not Discussed .................................................................................................... 14
15.6 Fraud Prevention and Detection ......................................................................................................... 15
15.7 Forensic Accounting Investigations ..................................................................................................... 16
15.7.1 Sources of Information ................................................................................................................. 17
15.7.2 Forensic Accounting Techniques ................................................................................................. 18
15.7.3 Business Culture .......................................................................................................................... 18
15.7.4 Warning Signs .............................................................................................................................. 20
15.8 Summary and Review ......................................................................................................................... 23
15.9 Appendix – Activity Solutions .............................................................................................................. 24
©ICAS 2016
ICAS 2016
Notes
FRAUD AND CONTROL
15.1 Introduction
Estimates of the cost of fraud to the UK economy every year range from a few
hundred million pounds to well over a billion pounds. Academics and professionals
alike try to count the cost by looking at the cases reported in the press and by
conducting numerous surveys. However, because most businesses are reluctant to
admit that they have been defrauded, the full extent of the problem is very difficult to
assess, and the reported figures are likely to be a small fraction of the true total.
Fraud affects both the private and public sectors. Through high-profile cases like
Enron, Parmalat, Maxwell, and BCCI, in which thousands of people lost millions of
pounds between them, businesses have been forced to pay more attention to the
problem, if only to allay the fears of both customers and investors.
In the public sector, a desire to ensure better “value for money” has resulted in
increased efforts to reduce the loss to the public purse through fraud.
With all the publicity surrounding these cases and initiatives, you may think that frauds
only happen in large organisations and that when they do, they invariably involve large
sums of money.
In fact, most frauds take place in smaller companies and
organisations, and involve relatively insignificant amounts of money. The perpetrators
are rarely high profile, charismatic individuals. More often than not, they are ordinary
people doing ordinary jobs in ordinary companies, just like the people you are likely to
meet every day on an audit assignment.
In this module, we pull together your previous studies and consider the main types of
fraud you might encounter and what to do if you think you have uncovered one. You
will also explore some of the basic forensic accounting techniques used to investigate
them.
You should revise your knowledge of insolvency by studying the material from TPS
Advanced Finance. This will provide background to this module and also to certain
cases which will be covered in class. As a company can be broken by a fraud, it
would not be surprising to see included in a case study a situation where there was a
fraud, and this lead on to a consideration of insolvency procedures.
You should also revise material from TC Principals of Auditing and Reporting, and
TPS Assurance and Business Systems which covers the responsibility of an external
auditor for the detection and reporting of fraud.
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Notes
15.2 Learning Objectives
On completing this module, you should be able to:
1.
Consider the main types of fraud you may face in a business situation;
2.
Advise on how to prevent fraud;
3.
Evaluate potentially fraudulent situations;
4.
Evaluate accounting systems and identify potential weaknesses; and
5.
Conisder basic forensic accounting techniques.
15.3 What is Fraud?
Before going any further, we must establish what we mean by “fraud”.
Activity 13.3
Without referring to any books or reading any further, write down your definition of
‘fraud’.
In your answer you may have used words like “theft” and “stealing.” You may also
have referred to deception or misrepresentation. These are all different aspects of
fraud. There is no legal definition of fraud but ISA (UK & Ireland) 240 The auditor’s
responsibilities relating to fraud in an audit of financial statements defines fraud as:
An intentional act by one or more individuals among management, those charged with
governance, employees or third parties, involving the use of deception to obtain an
unjust or illegal advantage.(ISA (UK & Ireland) 240, paragraph 11)
The critical issues are:

Intentional: unlike errors, frauds are never accidental

Deception: fraud is always intended to deceive

An unjust or unfair advantage: Fraud is always committed to obtain an
advantage but it may not be a personal advantage. Many major frauds do not
bring direct financial advantage to the perpetrator.
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Notes
15.3.1 Types of Intentional Mis-statement
There are two types of intentional mis-statement that concern auditors – misstatements resulting from fraudulent financial reporting and mis-statements resulting
from misappropriation of assets.
It is important to distinguish these two types of fraud as motivations and methods can
be very different:
Fraudulent financial reporting: This is usually committed by directors and is designed
to deceive shareholders and other financial statement users. These frauds are usually
very large and may involve concealment through manipulation of accounting records,
misrepresentation of material facts or aggressive accounting policies. The motivations
for such frauds include:

To meet market expectations on profit levels or otherwise maintain share price;

To meet banking covenant requirements;

To inflate performance-related bonuses;

To persuade shareholders or lenders to invest in the company; and

To raise the standing of directors in the eyes of the business community.
Misappropriation of assets: This may be committed by staff at any level within the
organisation, including management. These frauds tend to be of a lower value than
fraudulent financial reporting but if they are committed over a long period of time they
can mount up to a considerable amount. They can be motivated by:

Personal greed;

Employees holding grudges against the company;

Employees thinking that they are underpaid or otherwise oppressed;

Adverse personal circumstances;

Lax attitudes to control within the organisation resulting in frequent low level
fraud; and/or

A determination to “beat the system.”
While most people consider themselves to be honest, surveys have shown that:

75% of ordinary people would steal in the right circumstances
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Notes

25% would steal if the opportunity arose, regardless of other considerations

50% would steal if there was little likelihood of getting caught

25% say they would never steal
Activity 15.3.1
Ask yourself if you have ever committed a fraud. If you have, ask yourself why you did
what you did. If you say you have not, ask yourself the following questions:

Have I ever overstated an expense claim?

Have I ever added a quarter-hour that I didn’t work to an overtime claim?

Have I ever billed a client for a quarter-hour I didn’t spend on their affairs?

Have I ever taken stationery home from the office?
Now ask yourself why you did what you did!
The reasons why people commit fraud are many and varied. Fraudsters come from
every conceivable social and economic background. It is virtually impossible to create
a profile of the typical fraudster.
15.3.2 Fraud Conditions
ISA (UK & Ireland) 240 suggests that there is a greater likelihood of fraud if three
conditions are present. These conditions are:
a)
Incentives/pressures to commit fraud, such as:
-
High level of competition within the industry;
-
Falls in profitability, making liquidation or takeover more likely;
-
Pressures on management to meet the expectations of third parties such
as banks, the market, or ultimate parent companies; and
6
-
Personal circumstances of individuals with financial problems.
b)
Opportunities to commit fraud, such as:
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Notes
The existence of related-party transactions with organisations audited by
a different firm;
-
Assets, liabilities, income or expenditure based on subjective estimates
that are hard to verify; and
-
Weak control systems in particular areas – e.g. lack of segregation of
duties, or poor physical controls over stock or cash.
c)
Attitudes that rationalise fraud, such as:
-
A weak ethical environment within the company;
-
Low morale among senior management and other staff members;
-
Management obsession with meeting targets or maintaining share price;
and
-
Perceptions among staff that they are inadequately paid.
Accountants involved with commercial organisations, whether as auditors or as
employees need to be on their guard for the presence of these conditions. If all three
are present, there is a “perfect storm” for fraud, although the presence of any one of
the conditions can create the environment for fraud to take place.
You should now be able to achieve the first learning objective for this module.
15.4 Forms of Fraud
Before looking at specific types of fraud, for example ‘Teeming and Lading’, we need
to understand the main classifications of fraud.
15.4.1 Simple Frauds
About three-quarters of frauds are committed by one person acting alone. These are
often called simple frauds. In a company context, the fraudster may be an insider (an
employee) or an outsider (a customer, a supplier, or an unconnected third party).
Simple frauds are the most common because they are the most secure. Most people
are too scared to ask a colleague to engage in criminal activity and they therefore
devise a scheme that does not require the active participation and/or agreement of
another person.
15.4.2 Compound and Complex Frauds
Two or more persons acting together in collusion commit the other 25% of frauds.
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Notes
If the fraudsters are either all insiders or all outsiders, the fraud is called a
compound fraud. If there are one or more insiders in collusion with one or more
outsiders, the fraud is called a complex fraud.
These are generally easier to detect than simple frauds as the more people involved,
the more clues are likely to be visible. In simple terms, the more conspirators there
are in a scheme, the greater the chance that someone will make a mistake and the
scheme will be discovered.
15.4.3 On Book and Off Book Frauds
Finally, frauds that can be traced through a company’s accounting records are called
on book frauds. They are generally easier to discover because their concealment
involves the manipulation of records which should leave traces that are detectable by
an experienced investigator.
Fraudulent transactions that cannot be traced through an organisation’s accounting
records are called off book frauds and are much harder to detect.
Activity 15.4.3
Listed below are five fraudulent situations, numbered 1 to 5. Match these with the
description (A-E) which best describes their nature.
1.
A purchasing manager takes £1,000 from a salesman for Widget plc in return
for ensuring that his company uses Widget’s products.
2.
An accountant who works for a Big Four firm who does ‘homers’ at the
weekends.
3.
A wages clerk who earns £905 gross a month pays himself an extra £45 gross
per month by entering his wages as £950.
4.
A team of double-glazing installers claim for 3 hours’ overtime on a Wednesday
evening that they actually spent in the pub watching football.
5.
Dodgey Limited is having short-term cash flow difficulties. Its auditor agrees a
stock adjustment with the Finance Director, the effect of which is to understate
the profit and therefore reduce the tax payable by the company in the year
under review. Both know the adjustment is inaccurate.
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a)
Simple/Off Book
b)
Simple/On Book
c)
Compound/On Book
d)
Complex/Off Book
e)
Complex/On Book
Notes
15.5 Types of Fraud
15.5.1 Fraudulent Financial Reporting
There are a number of types of fraud that may be included broadly under the heading
of “earnings management.” This is a difficult area as it can be difficult to tell the point
at which “aggressive accounting policies”
circumstances” crosses the borderline into fraud.
or
“optimistic
interpretation
of
an
to
Techniques used by companies to manipulate earnings include:
Fraud
Warning signs
Deliberate cut off errors: Purchases or

Company
has
incentive
sales around the year end may be
manipulate profit to meet market
recorded in the wrong financial period
expectations – e.g. profits up to
either to increase or decrease the profit
month
to meet market expectations or defraud
forecast.

HMRC.
11
higher/lower
than
Indications that staff are being
pressurised to complete orders or
process sales documentation before
the year end. Weak controls to
ensure
that
transactions
are
processed in the correct accounting
period.
Early revenue recognition:
In cases

Company working in an industry
where there is uncertainty about the
where the exact timing for the
timing of completion of work, revenue
recognition of sales transactions is
may be recognised at too early a stage –
for example interim profits on long term
variable or hard to determine.

A lack of clear accounting policies
contract work may be taken on the basis
to determine the timing of the
of an excessively optimistic interpretation
recognition of sales.
of the future progress of the contract.

The existence of large transactions
around the year end may also be a
warning sign.
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Notes
Inappropriate accruals
or provisions:

Unusual or large journal entries
Senior management may distort the level
around the year end. Accountants
of accruals or provisions either to inflate
need to ensure that provisions are
or reduce profit.
only made when the company has a
legal or constructive liability and to
watch
for
unreasonably
optimistic/pessimistic interpretations
of events.
Overstatement
of
physical
stock

quantities: Profit may be manipulated by
higher
the inclusion of inflated quantities of
stock. Stock sheets may be adjusted
Stock levels and gross margins
than
industry
norms
or
previous years.

after the count to increase profit.
Stock
surpluses
when
physical
counts are compared with stock
records.

Weak controls over stocktaking,
which would permit stock sheets to
be amended at a later stage.
Capitalisation
of
restructuring
costs:

Weak controls over cost allocations.
Where major expenditure is incurred on
Expenditure capitalised should be
restructuring,
really
scrutinised to ensure that it contains
expenses may be capitalised rather than
no expense items. For self-built
charged against the profits of the year.
assets confirm that costs have not
items
that
are
been
inflated
by
inappropriate
overheads or profit (e.g. by charging
labour hours to capital projects at
the normal rates used for outside
contracts.)
Capitalisation
of
research
and

Weak controls over cost allocations
development costs: As with restructuring
and a lack of a clear accounting
costs,
policy
research
and
development
expenditure may be capitalised in error.
Inappropriate
accounting
policies:
for
capitalisation
of
development expenditure.

Accounting policies that are not in
Accounting policies which are too flexible
line with “best practice” for the
or
industry.
optimistic
(“aggressive”)
in
their
application may enable management to

Accounting
policies
which
are
commit fraud – e.g. unusual methods of
vague and permit a variety of
stock valuation or low depreciation rates.
interpretation. The existence of
substantial losses every time fixed
assets are sold may indicate
under-depreciation.
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Notes
15.5.2 Misappropriation of Assets
There are a vast number of frauds that can be included under the heading of
“Misappropriation of assets.” The following table explains some of the more common
frauds and indicates the warning signs that could indicate the presence of fraud.
Fraud
Warning signs
Sales system frauds
Long firm frauds: The fraudster sets up a
new
business,
usually
from

rented
customers and lack of personal
premises. Initially, he buys small amounts
and pays on time. These amounts build
Rapidly increasing sales to new
contact with the customer.

Failure to make adequate credit
up over time and he gradually acquires a
checks for new customers or follow
credit record. Then he orders goods to
up credit references can make a
the full extent of his credit limit, sells them
company more susceptible to this
and disappears without paying.
kind of fraud.
Falsified credit applications: False names

Incomplete
or
inconsistent
and addresses and financial data on
applications. Weak controls such
credit application forms.
as
failure
to
take
up
credit
references and lack of training for
credit controllers in interpreting
replies (e.g. from banks).

Using credit reference agencies
and having Trade Credit Circles
whereby suppliers exchange credit
information
on
customers,
can
reduce the threat.
Teeming
and
lading:
Stealing

Weak controls such as a lack of
cash/cheques received from debtors and
segregation of duties between cash
covering this by using cash/cheques
and sales ledger, coupled with a
subsequently
lack of independent credit control
received
from
other
customers.
and
follow
up
of
customer
complaints.
False and early invoicing: Salesmen may

try to inflate commission/hit targets by
overcharging
customers,
persuading
Large volumes of credit notes or
other adjustments.

Weak controls such as lack of
them to accept higher prices in return for
contact
between
senior
a “kickback”, or to buy more than they
management and customers, or a
need with the option of returning what
high level of autonomy given to
they cannot use at a later date. Salesmen
salesmen.
could also raise invoices for fictitious
sales and cancel them later.
Defrauding of debt factor: Raising false
As companies increasingly use factors to
invoices or invoicing before the sale is
improve their cash flows, this fraud may
actually made, or failing to pass on credit
become more common.
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It is usually
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Notes
notes to the factor for processing. This
perpetrated by senior management.
can gain cash flow benefits at the factor’s

expense.
Warning
signs
include
an
increased number of adjustments
to amounts received from factors
and weak controls over the timing
of the raising of invoices.
Under-recording of cash sales: In a retail

Excessive
stock
margins
shortages;
setting, individual sales are not processed
declining
at
particular
through the till and the employee pockets
shops; excessive number of “over-
the cash.
rings” in the cash registers. Weak
controls over bar code documents
Setting up in competition: Doing “homers”
usually
for
employer.
cash,
This
undercutting
may
also

the
Orders being cancelled; declines in
the volume of orders generated by
involve
particular
salesmen.
Can
be
submitting orders late to the employer so
detected by checking the list of
that the customer will go elsewhere.
directors
at
the
Registrar
of
Companies to see if employees
have interests in other companies.
Writing
off
“bad
debts”:
Customers

Weak controls such as lack of
inducing a credit controller to write off bad
senior management authorisation
debts in return for a kickback.
and legal follow up for all bad debt
write offs.
Purchase system frauds
Bogus goods or services: Often Internet-

Weak
controls
over
vetting of
based. Customers order using credit card
sources from which purchases are
details or paying cash up front. By the
made.
time they realise the goods are not going
to arrive the fraudster has disappeared.
Bribery: Paying a “kickback” to someone
It can be hard to draw the line between
in the purchasing company to ensure that
legitimate promotional/business gifts and
goods are purchased from a particular
bribes, especially in organisations with
supplier, or that unnecessarily large
large promotional budgets.
quantities of items are purchased.

Warning
signs
include
weak
controls over the acceptance of
gifts
and
entertainment
from
suppliers. The easiest approach is
to have a total ban on accepting
gifts.
Goods for own use: Ordering goods or
Particularly prevalent in industries where
services for personal use
staff have readily marketable skills that
can be used to do “homers” such as
building or plumbing companies.

12
Weak
controls
over
the
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authorisation of purchase orders,
checking of stock delivered to
purchase orders and authorising of
invoices. Delivery addresses on
delivery notes should be checked
to make sure that they are not
private addresses.
Dummy suppliers: If an employee is able

Weak control over approval of
to set up a bogus company and add it to
suppliers and lack of segregation in
the purchase ledger he/she may be able
approving invoices with orders,
to submit their own invoices and have
delivery notes etc. Signs of this
them paid by the company.
fraud
include
instances
where
addresses or telephone numbers
for suppliers are the same as those
for employees on the payroll.
Stock frauds
Theft of stock: Some companies are more

Gross
margins
vulnerable to theft because their stocks
averages
are more easily transportable or more
when
readily marketable
compared
and
stock
below
industry
shortfalls
is
with
noted
counted
stock
and
records.
Weak controls over the physical
security of stock or lack of rigorous
documentation in support of the
issuing of stock.
Payroll frauds
Unauthorised
salary
increases:

Weak controls over access to the
Employees with access to the payroll
payroll master file and lack of
master
verification of changes made to
file
may
give
unauthorised
increases to themselves or friends.
Inflated
bonuses/commission
overtime:
An
easier
way
to
rates of pay.
and

Lower
margins
on
jobs
than
obtain
expected or higher payroll costs
additional remuneration is to submit
than budget. Weak controls over
inflated claims for bonuses or overtime.
the approval of overtime, bonuses
This could be done in collusion with the
or commission can create the
line manager who authorises the claim,
environment for this kind of fraud.
although it can be done without such
collusion if the line manager is not
vigilant.
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Notes
Ghost employees: False employees are
Companies operating in industries where
entered in the payroll, or employees who
there is a high turnover of staff or where
leave the company are kept on the
staff are geographically remote.
payroll.

Weak controls over new starts and
leavers.

Lack of comparison between the
payroll master file and the HR
department master file.
15.5.3 Types of Fraud Not Discussed
While these notes highlight the main areas in which frauds are likely to occur in an
average business, you should bear in mind that every business is unique. Each will
have its own particular accounting peculiarities and, depending on the industry sector
in which it operates, will be more susceptible to one type of fraud than another. The
notes do not cover frauds in specialist sectors such as banking, financial services,
insurance, and have concentrated more on ‘day to day’ frauds rather than the more
complicated accounting frauds which are likely to be perpetrated by the management
of a business.
It is easy to see that rigorous control of cheque signatories, cash floats and incoming
mail might all contribute to the prevention of fraud within an organisation.
Furthermore, the notes do not cover in detail ‘gratuitous alienations’ and ‘unfair
preferences’ and other offences under the Insolvency Act 1986 which could be
considered fraudulent in nature.
A gratuitous alienation is a transaction by individuals where they transfer an asset at
less than full value in prejudice of the creditors’ interests.
Transfer may be to family
or friends in order to return at a later date. In cases of personal bankruptcy, it can be
challenged under s34 of the Bankruptcy (Scotland) Act 1985.
An unfair preference is where one creditor is paid off in preference to others who have
rights in a winding-up. Unfair preferences often arise where the debtor wishes to
ensure retention of a creditor’s goodwill should the debtor start trading again or it may
involve repayment of directors’ loans.
In terms of sections 242 and 243 of the Insolvency Act 1986, certain specific
transactions entered into by businesses may subsequently be challenged if it
becomes insolvent.
You should ensure that you are familiar with the provisions of these sections so that
you can identify potentially challengeable transactions. You should also be aware that
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section 212 of the Insolvency Act makes provision for the recovery from delinquent
directors of funds misappropriated prior to insolvency.
You should now be able to achieve the second learning objective for this module.
15.6 Fraud Prevention and Detection
It is important to note that the responsibility for detecting and preventing fraud rests
with the management of a business. Auditors and accountants can and should, of
course, advise management on any weaknesses that exist in their accounting and
internal control systems.
As previously discussed, internal controls play a major part in preventing and
detecting fraud. These must be appropriate to the size and nature of the business.
The lack or inadequacy of controls could provide an opportunity for fraud.
You should remember from TC PAR / TPS ABS that there are 5 categories of control
activities commonly used to help prevent / detect fraud:

Authorisation

Performance Reviews

Information Processing

Physical

Segregation of Duties
Activity 15.6
List in brief the internal controls that would help prevent and detect fraud in a small
manufacturing company with 50 employees spread over two factory sites and a head
office. Use the five categories listed above to help you.
In considering how best to prevent fraud, managers should look in detail at each
activity undertaken by the business and assess the risk of fraud in each area. In doing
so, thought should be given to the experiences of other companies in the same
industry.
Management should frequently ask questions such as “What if this
happened?” and “Why do we do that?” Existing controls should then be evaluated to
ascertain if they adequately address the dangers identified.
If necessary, other
controls should be put in place and existing ones strengthened. Finally, steps should
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Notes
be taken to ensure that all employees understand the controls in place and that the
controls are properly implemented.
However, focusing solely on accounting systems is unlikely to be a successful strategy
in identifying and preventing potential fraud.
While the effect of fraud is almost
invariably an accounting issue in that the loss to the victim can be quantified in pounds
and pence, the books and records alone will rarely tell the whole story. A much
broader look at the environment in which the business operates is needed.
One inescapable fact is that all frauds are committed by people! As a result of this,
the fraud investigator or adviser should always look closely at the human dynamics in
any business.
A particularly important part of this is ensuring that the personnel
function of a business is effective. It does not matter whether the personnel function is
formalised or not. What is important is that sufficient information is known about the
background of each existing employee and that adequate checks are made on
potential employees before an offer of employment is made.
In this regard,
professional qualifications and references from former employers should always be
checked and taken up.
If you are asked to advise a client on how to prevent fraud, you would essentially
adopt the approach outlined above. However, you should take great care to ensure
that the management is closely involved at all stages of the work and that they ‘own’
the measures and controls that you propose.
Finally, if you think you have uncovered a fraud in the course of your normal work, the
last thing you should do is speak to someone in the business! Initially, discreetly
gather together the information which gave rise to your suspicions and discuss them
with your immediate superior. Only after the evidence has been thoroughly assessed
should consideration be given to the best way to advise your client. Particular thought
should be given to who within the business should be informed, so that the perpetrator
is not warned of any potential investigation and given the chance to destroy any
further evidence.
As auditors and accountants we must also give consideration to the requirements of
the money laundering regulations and be mindful not to ‘tip off’ our client should we
come across fraudulent activity.
You should now be able to achieve the third learning objective for this module.
15.7 Forensic Accounting Investigations
A forensic accountant uses many of the basic skills that an auditor employs.
In
investigating a fraud, he must be observant, analytical, methodical and patient. He
must also be able to listen to people and, on occasions, be extremely diplomatic.
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Most important of all, he must be discreet as often his enquiries will have to be
conducted without causing the perpetrator (or someone close to him) to be suspicious.
A forensic accountant often approaches a suspected fraud from several different
angles. He will generally, as you would expect, look at the financial data available, but
he will also be interested in the ‘business culture’ of the company he is dealing with.
He will also be on the look out for a number of warning signs of fraud. These are
discussed in greater detail below.
15.7.1 Sources of Information
There is no checklist of information that an investigator must use in gathering
information. The nature of the suspected fraud will dictate, to a significant degree,
what evidence is required.
Activity 15.7.1
You have been asked by a client to establish whether the purchase ledger clerk has
been taking bribes from a supplier to ensure the client company buys more from the
supplier. What sources of information would you use?
A fraud investigator may use any legitimate source of information, financial or
otherwise, to (a) establish if a fraud has been committed, (b) ascertain the extent and
value of the fraud and (c) put together a picture of the suspected fraudster.
In
obtaining information, the investigator must always be sure that the methods are legal.
In many cases, he should bear in mind that the documents he obtains may be used as
evidence and he should therefore take care to carefully note where and when they
were obtained.
In some case, the original documents which might assist the investigator may have
been lost or destroyed, either accidentally or deliberately.
The investigator may
therefore have to reconstruct the information using records obtained from other parties
such as banks, suppliers, customers etc. In some circumstances, forensic computer
specialists may be able to recover lost records. If records are reconstructed, it is even
more important that the source of the material and the method used is properly
recorded.
Once the investigator has gathered and analysed all the information and concluded
that a particular individual may have committed a fraud, then, and only then, is he
likely to be in a position to confront the suspect. Interviewing suspects is a specialised
part of the investigator’s job and involves particular skills that are too complex to deal
with in these notes. Suffice to say that the legal considerations governing the conduct
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Notes
of such interviews are crucial and a forensic accountant should be careful not to
prejudice the work that has gone before by overstepping his remit.
15.7.2 Forensic Accounting Techniques
There are a number of techniques which are common to those used in general
auditing which may be used to specifically identify potential frauds. The following is a
brief outline of certain methods which may throw up evidence of fraud.
Trend Analysis
By comparing accounting information for several trading periods the investigator can
identify discrepancies.
In general this method can be done by simply looking at
percentage changes year on year between accounting categories or with greater
sophistication, index numbers can be estimated in order to benchmark actual
performance against expected performance.
Proportional Analysis
This is performed to ensure an increase in activity is matched by commensurate
change in the costs of the company.
This can also be performed on the physical
quantities of materials moving through manufacturing processes identifying unusual
wastage or abnormal losses.
Circularisations
Positive circularisation of debtors and creditors done on a random basis can detect
errors in specific sales and purchase accounts ledgers.
Identification of receipts
Positive identification of cheques received on a given day and the tracing of these
payments through the accounts and bank statements can detect teaming and lading.
Stock counts
Independent observer attendance at the stock count and examination of count
procedures can identify whether there is unusual activity. As stock is such a complex
area it has often been used as an area for fraud.
Unusual items
Any transactions recorded through non-standard accounting systems or journal entries
for year-end adjustments should be carefully scrutinised as these can fall outside the
normal internal control systems of the business.
15.7.3 Business Culture
As part of the information-gathering process, a fraud investigator will often be
interested in the ‘environment’ in which the business operates. He will want to learn
as much as he can about the culture of the business as this will assist him in
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interpreting much of the information he collects. He will therefore discreetly consider
matters such as the internal controls in place and how they are used, the
management’s leadership style, how employees are motivated and the general level
of morale within the company.
Weak internal controls
By now, it should be readily apparent that the single most important and effective
counter-fraud measure is the existence and operation of appropriate internal controls.
These will not only help protect an organisation from fraud by insiders by ensuring that
employees cannot exceed their authority, but should also ensure that attempts to
defraud the business from the outside are identified before they have an effect.
The extent to which these controls are formalised will depend to a great extent on the
size of the business.
For example, a structured system requiring the written
authorisation of every purchase by a manager would not be appropriate or necessary
in a small business, but may be in a larger one. Likewise, the segregation of duties
found in a large organisation would not be cost-effective in a smaller business.
However, internal controls of some nature will exist in every business.
What is important is whether or not the controls are properly and consistently
operated.
If the controls exist, but they are not operated, then the message to all is
loud and clear – “We are not serious about combating fraud”. In this regard, the
management of a business must take the lead in ensuring that internal controls exist,
are implemented and adequately monitored.
Leadership
As discussed above, the attitude of management in any business is crucial. A strict
but fair management style can dictate the manner in which a company does business.
Strong leadership is important in the fight against fraud.
However, too strong a
leadership can also be dangerous.
It would be wrong to say that every chairman or manager who takes a hands-on
approach to managing his business is a likely fraudster.
Sometimes it takes a
dynamic and domineering leader to drive a business forward and make it successful.
However, inappropriate or excessive involvement by senior management in mundane
matters or the existence of ‘secret projects’ known only to a few members of staff may
be indicators of a potential problem.
If there have been redundancies or dismissals, checking who has left and why can
also be revealing. Sometimes, employees who have discovered frauds or other
irregularities by those above them are removed to protect their superiors’ position.
Achievement driven staff
Money and success are important motivators.
Achievement, whether in terms of
earnings or position, can be a driving force for a lot of people. The danger comes
when achievement becomes of paramount importance and integrity takes second
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place. If a company’s philosophy is “success whatever the price” then there is a
danger that corners will be cut and that staff will get the message that “anything goes”
as long as the targets are met. Such an environment is extremely “fraud friendly”.
Particular attention should be paid to employees whose remuneration package is
heavily dependent on bonuses and meeting targets. The temptation to commit fraud
to maintain or increase one’s earnings is much greater in those circumstances.
Low morale
As discussed earlier, one of the reasons people commit fraud is a feeling of being
badly treated by someone. An environment in which staff feel insecure, underpaid, or
unappreciated is more at risk from fraud than one in which everyone is contented.
Another common reason for fraud is boredom. Again, if staff feel challenged and
motivated, they are less likely to turn to crime to amuse themselves. The balance
between challenging staff and over-working them is hard to strike. Nevertheless, the
general morale of a workforce is worth considering when assessing the likelihood of a
company falling victim to an internal fraud.
15.7.4 Warning Signs
In addition to considering the more general points discussed above, there are also a
number of warning signs for which an investigator will be looking out. These include
unusual behaviour or events, breaches of internal or external rules, individuals with
extravagant lifestyles or those who take few holidays. In addition, he will consider the
financial position of the business itself.
Unusual Behaviour
In looking for possible fraud, a good technique is to ‘Establish the norm, look for the
abnormal’. This is applicable to both the behaviour of individuals and what happens
within the company.
For example, managers are employed to manage. If a person in a position of seniority
insists on doing work that should be more appropriately delegated to a subordinate, it
may be that he is trying to hide something. On the other hand, it may be that he is just
a bad manager!
From a paper-trail perspective, most companies do not have to issue more than a few
copy invoices in a year. If there are numerous duplicate invoices, it may be indicative
of a greater problem. However, it could equally point to a computer error which
generates too many pieces of paper.
Very often warning signs can be misinterpreted and it is therefore essential to
establish as many facts as possible before reaching conclusions.
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Notes
Breaches of law/internal rules
Without people who live by the maxim “Rules are made to be broken”, the world would
be a poorer place. Progress is often made by those who refuse to be tied down by
perceived wisdom. However, in a business context, mavericks can be dangerous.
Those who are risk takers, and those who are prepared to break internal rules and
even the law, are more likely to have less compunction about small instances of deceit
than the risk averse.
Extravagant lifestyles
If a purchase ledger clerk earning £15,000 a year wears designer suits, an expensive
watch, eats in all the best restaurants, drives a Mercedes sports car, and holidays
twice a year in the Bahamas, there are several possible explanations. He (or she)
could be married to a wealthy and successful partner who is generous to him. He
could be a man of independent means who works to avoid getting bored rather than
because he needs the money. Or he could be augmenting his income by perpetrating
one of the many frauds we have discussed.
Anyone who is apparently living beyond their means is worthy of attention by fraud
investigators.
However, because there are genuine reasons why someone may
appear to be better off than their salary suggests, enquiries into their personal
circumstances should always be made discreetly and suspicions never voiced until the
possibility of other legitimate sources of finance have been ruled out.
observe this rule could be very embarrassing and costly.
Failure to
Untaken holidays
In most cases, frauds will be discovered unless the concealment by the perpetrator is
maintained. It is very difficult to manipulate accounting records and deflect queries
about discrepancies unless you are physically present to undertake the task. For this
reason, many fraudsters are reluctant to take annual leave and therefore appear to
their colleagues and bosses to be either ‘workaholics’ or ‘very loyal and
conscientious’. A recent fraud at an insurance company was discovered only when an
employee went on holiday and was replaced by a temporary worker.
From a fraud investigators point of view, anyone who does not take regular annual
leave or is never absent from the office for more than a week, is worthy of further
attention.
conclusions.
workaholic!
However as with expensive lifestyles, you should never jump to
The person who only takes a few holidays may indeed just be a
For both fraud prevention and health reasons, employers should always insist that
their employees take their holiday entitlement and that they take at least two weeks off
together.
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Notes
Business Indicators
Having looked at the personal factors that may persuade an individual to commit a
fraud, we must bear in mind that the state of a company’s finance may also have an
influence on someone to commit a fraud. For example, a company with severe cashflow problems may be tempted to over-invoice in an attempt to improve its bank
position. A company with a weak balance sheet may attempt to suppress known
liabilities in order to make it look more stable than it really is. Analytical review of a
company’s recent accounts can often help the fraud investigator in identifying potential
motives or areas of interest.
Do not underestimate the effect that desperation to survive will have on
management’s judgement and attitude to risk-taking. Attempts to keep going and
maintain trade regularly result in transactions which are not in the normal course of
trade. Often, subsequent to insolvency, these can be challenged by the receiver or
liquidator.
You should now be able to achieve the fourth and fifth learning objectives for this
module.
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Notes
15.8 Summary and Review
In this module we have looked at how to identify a fraud by looking for its three main
elements:

Loss to someone

Caused by a deliberate act or omission by another and

Involving some form of deception.
We went on to look at why people commit fraudulent acts, and learned that the
reasons are many and varied.
We learned how to classify frauds and examined a number of specific fraudulent
schemes. We then briefly considered fraud prevention and detection.
Finally we covered some of the techniques used by forensic accountants in
investigating suspected frauds.
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15.9 Appendix – Activity Solutions
Notes
Solution 15.4.3
1.
D – There are two people involved, one inside the company and one outside. It
is therefore a complex fraud.
However, the bribe will not show up in the
purchasing company’s books so it is an off book fraud.
2.
A – There is only one person involved – the accountant. The client is not
involved, as he will think the accountant is the individual, not the firm the
accountant works for during the day. The scheme is therefore simple. As the
‘homers’ will never show up in the firm’s books, it is an off book fraud.
3.
B – There is only one person involved – the payroll clerk. The fraud is therefore
simple.
However, the employer’s accounting records should include an
authorised rate of pay sheet with the correct rate of pay and the rate actually
paid will be recorded in the payroll records. The alteration of the authorisation
and the different amount actually paid should be detectable through the
accounting records and the fraud is therefore on book.
4.
C – The installation team would have to agree the false story and there is
therefore collusion between employees. This is a good example of a compound
fraud. The unnecessary excess time spent should be identifiable from the job
sheets and the overtime would be recorded in the payroll.
The fraud is
therefore on book.
5.
E – The journal for the stock adjustment will be recorded through the nominal
ledger.
The auditor and the Finance Director are outsiders and insiders
respectively. The scheme is therefore on book and complex.
Solution 15.6
Your answer may have included:
24

Authorisation of transactions by an appropriate level of management

Matching of purchase orders/goods received notes/purchase invoices

Matching of sales orders/goods despatched notes/sales invoices

Authorisation of credit notes by senior management

Authorisation of discounts allowed by senior management
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Notes

Appropriate credit control procedures

Regular performance and review of stock takes and reconciliations to stock
records

Regular performance and review of sales and purchase ledger reconciliations

Regular performance and review of bank reconciliations

Authorisation of additions to payroll by senior management

Authorisation of overtime payments by senior management
Solution 15.7.1
Your answer should include:

A review of your client’s accounting records, and in particular the purchase
ledger, to determine if there is any evidence that one supplier has been
preferred over another or if the amount of business placed with any one supplier
is significantly higher than previously.

Discreet enquiries into the purchase ledger clerk’s personal affairs to put
together a ‘financial profile’. This may include performing a credit check to see
if he (or she) is in debt and therefore under financial pressure, and obtaining
property searches to identify any significant borrowings (or lack of them).

You might also go to see his house and find out what make of car he drives and
how many he and his family own, with a view to getting a feel for whether or not
he is living within his known means.

You might discreetly interview work colleagues to find out if he has any
expensive hobbies, where he goes on holiday and whether he has extravagant
tastes in clothes, food etc.

You would wish to ascertain what the ordering systems are and whether the
goods have historically been purchased elsewhere.

You would wish to form a view as to the suitability of the suppliers used – the
fraud might include an inflated price or over-billing.
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