Ch10 Identifying and preventing fraud

Study guide

Fraud and fraudulent behaviour and their prevention in businessExplain the circumstances under which fraud is likely to ariseIdentify different types of fraud in the organisationExplain the implications of fraud for the organisationExplain the role and duties of individual managers in the fraud detection and prevention processWhere fraud might actually occur and how it can be detected?

1 What is fraud?Fraud is generally defined as deprivation by deceit.In the context of corporation, fraud is:Removal of funds or assets from a businessIntentional misrepresentation of the financial position of the business

Removal of funds or assets Theft of cashTheft of inventoryPayroll fraud(R-57:#3)Members outside payroll dept. to falsify timesheets; members inside payroll dept. to miscalculate payslips; fictitious member of staffTeeming and lading: fraud in the sales ledger area: the theft of cash or cheque, concealed by subsequent receipts against the outstanding debt. (pilot paper #33;R-22:#1)Fictitious customersCollusion with customers

Removal of funds or assets (cont)Bogus supply of goods or servicesPaying for goods not received collusion with suppliersMeeting budgets or target performance measures: pocket profits in excess of the targetManipulation of bank reconciliations and cash booksMisused of pension funds or other assetsDisposal of assets to employees*R-22:#2

Intentional misrepresentation of the financial positionOverstate profitsOver-valuation of inventoryIrrecoverable debt policy may not be enforced (R-22:#3)Fictitious salesManipulation of year end events (cut-off) to window dress the financial statements.Understating expensesManipulation of depreciation figuresUnderstate profits*p565#26

(p334) Reasons for over(under)statingOverstatingEnsure targets to be met; to secure promotion or remunerationsTry to conceal another fraudConvince banks to give loan financeEntice equity investorsUnderstatingFacilitate a private purchase of assets from buz.Defraud Revenue & CustomsTo buy shares below market value

2 Potential for fraud3 Prerequisites for fraud (R-57:#1)Dishonesty: from personality and cultural factors (R-22:#4)Motivation: a calculation of potential rewards and potential sanctionsFinancial needsDesire to exercise negative powerDesire to avoid punishmentOpportunity: a loophole in the control system that allows fraud to be undetected and makes the risk of sanctions acceptable in comparison with rewards available*If one or more of them can be eliminated, the risk of fraud is reduced.

Assessing the risk of fraudIt is starting point to set up internal controls to prevent and detect fraud (Pilot paper#34)External factorsMarket place and general environment: instable environmentThe industry in which the firm operates Internal factors: at company levelChanged, growing or new environment of company*R-22:#5

Indicators of potential fraudBusiness risksProfit levels or profit margins deviating from the industry norm: unusually higher or lowerMarket has a low opinion of the firmComplex organisation structure or vast staff numberStrategy factorsCertain high risk areas such as cash salesPersonnel risks(R-22:#6)Secretive behaviourExpensive lifestyleLong hours or untaken holidaysAutocratic management styleLack of segregation of dutiesLow staff morale

Potential for computer fraudDependency on computers increases exposure to fraudComputer hackersLack of training within the management teamRisk of not having the resources to keep up with the pace of technology developmentNeed for ease of access and flexible systems*R-57:#2

3 Implications of fraud for org.Removal of funds or assets form a businessFewer assets; weakened net asset position; falling returns; ultimate collapse of business may happen (R-23:#7)Intentional misrepresentation of financial positionIf results are overstatedDistribute too much; potential shortfalls in working capital; incorrect decision making affecting managers, investors and suppliers etc. (R-57:#4)If results are understatedReduced return to investors; falling share price; restricted loan finance; legal consequences

4 Systems for detecting and preventing fraudPrevention of fraud must be an integral part of corporate strategy.Prevention should be prioritised before detection and investigation of the fraud.A primary aim of any system of internal controls should be to prevent fraudIt is equally important the control system is designed so as to detect and investigate fraud.* Trend of downsizing increases the difficulty in controlling and preventing fraud

Reasons for poor controlStaff problemsLack of emphasis on compliance or lack of understanding of the reasons for controlEmphasis on the autonomy of operational management may lead to controls being bypassedChanges in senior personnel

General prevention policiesEmphasizing ethicsFormal codes of ethics and good example set by managementPersonnel controls Interview and recruitment procedures to screen for dishonest employeesAppraisal systems to prevent staff demotivationTraining and raising awareness of risks of fraud (fraud awareness education)*R-23:#9

Prevention of fraud in specific business areasSegregation of dutiesAppropriate documentation required for all transactionsLimitation controlsCertain actions that may lead to loopholes should be prohibitedInternal audit should be concentrate on these areas*R-23:#8; p565#27

Internal controls to combat fraudPhysical controlsSegregation of duties: help to minimise the risk of theft and increase the likelihood of detectionAuthorisation policiesCustomer signaturesUsing words rather than numbersDocumentationSequential numberingDates

Internal controls to combat fraudStandard procedures, e.g:Credit investigation for new customersSenior authorisation in all payments wages collected in personEnforcing holiday policyRecruitment policiesComputer security*R-23:#10

Detecting fraudWhistleblower: employees who reveal fraud or malpractice in a workplaceThe likelihood of fraud detection may have been increased by recent legislation in a number of countries that provides employment protection rights to whistleblowers.

Detecting fraudAvailability of informationCost and management accounting informationPersonnel proceduresLines of reporting

Investigation of fraudThere should be a fraud response plan, a strategy for investigating and dealing with the consequences of fraudsInvestigation procedures:Establish the extent of lossEstablish how the fraud occurredConsider who implicated in the fraudAssess the existing controls Certain actions such as ensuring the security of the records, securing of assets, suspending staff, changing password should be taken*R-57:#5

Fraud officerResponsible for initiating and overseeing fraud investigations, implementing the fraud response plan and follow-up actions (in large organisations)Can talk to staff confidentially without consulting senior management.

5 Responsibility for detecting and preventing fraudIt is the responsibility of the directors to prevent and detect fraud (R-23:#11;R-57:#6)Ensure honest activities, safeguard assetsDeter and detect fraudEnsure reliable financial informationThe responsibility of external auditor is only to express an opinion upon whether the financial statements give a true and fair view of the company.Has a reasonable expectation of detecting fraudDocument his findings of fraud and report them to managementMay make the report to an appropriate authorityMay qualify his audit report accordingly

Managers and staff have responsibility to help in detecting fraudOperational managers should be alert for signs of petty fraudFinance staff should be alert for unusual items in accounting dataPersonnel staff should be alert for signs of low moraleNon-executive directors should act on signs of dishonesty by senior executive managementInternal audit staffs have responsibility for ensuring systems and controls are thoroughly reviewed.Audit committee should review the org.s performance in fraud prevention and report to the board.