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OverviewOverview

Understanding Occupational Fraud Understanding Occupational Fraud and Material Misstatementand Material Misstatement

The Current EnvironmentThe Current Environment The Regulators ResponseThe Regulators Response Sarbanes Oxley Section 404Sarbanes Oxley Section 404 Moving Forward Moving Forward

Understanding Understanding Occupational Fraud Occupational Fraud

and Material and Material MisstatementMisstatement

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Defining the TermsDefining the Terms

Occupational Fraud – Occupational Fraud – The use of ones The use of ones occupation for personal enrichment through occupation for personal enrichment through the the deliberate deliberate misuse or misapplication of the misuse or misapplication of the employing organizations resources or assets.employing organizations resources or assets. • Asset Misappropriations Asset Misappropriations

CashCash Theft of inventoryTheft of inventory

• Corruption Corruption Accepting Kickbacks Accepting Kickbacks Engaging in Conflict of interestEngaging in Conflict of interest

• Fraudulent Statements Fraudulent Statements FinancialFinancial Non-FinancialNon-Financial

Source: “2002 Report to the Nation”; ACFE

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Defining the TermsDefining the Terms

Material Misstatement – Material Misstatement – The The omission or distortion of accounting omission or distortion of accounting information that makes it probable that information that makes it probable that the judgment of a the judgment of a reasonable reasonable person person relying on the information would have relying on the information would have been changed or influenced by the been changed or influenced by the omission or distortion.omission or distortion.• Can occur with intent or withoutCan occur with intent or without• Can be monetary or non-monetary Can be monetary or non-monetary

(notes to financial statements)(notes to financial statements)

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Perspectives on FraudPerspectives on Fraud

6%6% of annual revenue of annual revenue

Costs Costs $600 billion$600 billion annually annually

$4,500 for every employee$4,500 for every employee

37%37% of companies worldwide of companies worldwide suffered during previous two yearssuffered during previous two years

Source: “2002 Report to the Nation”; ACFE

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Perspectives on FraudPerspectives on Fraud

The average fraud goes undetected for The average fraud goes undetected for 18 months18 months

The median loss for schemes involving The median loss for schemes involving falsification of an organizations falsification of an organizations financial statements is financial statements is $4.25 million$4.25 million

Management accounts for more than Management accounts for more than 40% of cases40% of cases

Source: “2002 Report to the Nation”; ACFE

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So…whatever happened to……..?So…whatever happened to……..?

WorldcomWorldcom (improper profits, loans, (improper profits, loans, overstated cash flows)overstated cash flows)

Rite AidRite Aid (inflated earnings, improper use of (inflated earnings, improper use of company funds, conspiracy, obstruction)company funds, conspiracy, obstruction)

EnronEnron (hid losses in off balance sheet entities, (hid losses in off balance sheet entities, controls failed)controls failed)

Tyco Tyco (unauthorized pay, deception regarding (unauthorized pay, deception regarding company financial condition)company financial condition)

Many others!!!Many others!!!

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So, Why all the Fraud?So, Why all the Fraud?

Changes in CultureChanges in Culture DownsizingDownsizing Diminished loyaltyDiminished loyalty Bottom-line pressuresBottom-line pressures Executive incentives skyrocketingExecutive incentives skyrocketing

TechnologyTechnology

GlobalizationGlobalization

The Regulators The Regulators ResponseResponse

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SAS 99SAS 99

Professional skepticismProfessional skepticism BrainstormingBrainstorming

• How can fraud occur?How can fraud occur? InquiriesInquiries

• Fraud riskFraud risk• Fraud occurrenceFraud occurrence• Corroborative evidence Corroborative evidence

Management override of I/CManagement override of I/C Revenue recognitionRevenue recognition Unpredictable audit testUnpredictable audit test

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A Proactive ApproachA Proactive Approach

Passage of Sarbanes-Oxley in 2002Passage of Sarbanes-Oxley in 2002• President Bush states the act as, President Bush states the act as, ““...the ...the

most far reaching reforms of American most far reaching reforms of American business practices since the times of business practices since the times of Roosevelt.Roosevelt.””

Formation of PCAOBFormation of PCAOB• Chairman and members appointed by SECChairman and members appointed by SEC

Increased SEC EnforcementIncreased SEC Enforcement• Enforcement actions initiated increased Enforcement actions initiated increased

25% over last five years25% over last five years• Complaints and questions rose 71% over Complaints and questions rose 71% over

last five years (48,169 to 82,337)last five years (48,169 to 82,337)• Increased Enforcement staffIncreased Enforcement staff

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What Does all this Mean?What Does all this Mean?

All of these initiatives put more All of these initiatives put more pressure on company stakeholders to pressure on company stakeholders to focus on the prevention and detection focus on the prevention and detection of fraud and material misstatementof fraud and material misstatement

BUT HOW???BUT HOW???

One way...One way...strengthenstrengthen and and monitormonitor the internal control environmentthe internal control environment

That is the mandate of That is the mandate of Sarbanes-Sarbanes-Oxley Section 404Oxley Section 404

Sarbanes-Oxley Section Sarbanes-Oxley Section 404404

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Understanding the Understanding the RequirementsRequirements

•Management

•Independent Auditors

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Management of W Company, Inc. (the Company) is responsible for establishing and maintaining adequate internal control over financial reporting. This internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.

Management assessed the Company’s internal control over financial reporting as of December 31, 200X. Based on this assessment, management believes that, as of December 31, 200X, the Company maintained effective internal control over financial reporting, including maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company, and policies and procedures that provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company, based on the criteria for effective internal control over financial reporting established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Management Assertion Management Assertion (Not SEC (Not SEC Approved)Approved)

SAMPLE

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We have examined management’s assertion included in the accompanying [title of management’s report] that W Company, Inc. maintained effective internal control over financial reporting as of December 31, 200X, including maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company, and policies and procedures that provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company, based on the criteria for effective internal control over financial reporting established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. W Company’s management is responsible for maintaining effective internal control over financial reporting. Our responsibility is to express an opinion on management’s assertion based on our examination.

In our opinion, management’s assertion that W Company, Inc. maintained effective internal control over financial reporting as of December 31, 200X, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework, of the Committee of Sponsoring Organizations of the Treadway Commission.

Auditor Attestation Auditor Attestation (Not SEC Approved)(Not SEC Approved)

SAMPLE

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Timing of 404 ImplementationTiming of 404 Implementation

WASWAS NOWNOW

All CompaniesAll Companies

FY on or afterFY on or afterApril 15, April 15, 20052005

July 15, July 15, 20052005

Accelerated Accelerated FilersFilers

FY on or afterFY on or after

June 15, June 15, 20042004

November November 15, 200415, 2004

Foreign FilersForeign Filers

FY on or afterFY on or afterApril 15, April 15, 20052005

July 15, July 15, 20052005

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Considerations for ManagementConsiderations for Management

Management’s ResponsibilitiesManagement’s Responsibilities

Assess effectiveness of controls Assess effectiveness of controls over financial reportingover financial reporting

Provide auditor with assertionsProvide auditor with assertions Submit control report with annual Submit control report with annual

reportreport

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Considerations for ManagementConsiderations for Management

Develop an Internal Control Self Develop an Internal Control Self Assessment MethodologyAssessment Methodology

Identify ObjectivesIdentify Objectives Develop Project PlanDevelop Project Plan Develop the Self-Assessment Develop the Self-Assessment ModelModel Populate the Model for EvaluationPopulate the Model for Evaluation

2020

Section 404 reinforces the Section 404 reinforces the Sarbanes-Oxley Act’s requirement Sarbanes-Oxley Act’s requirement for the audit committee to for the audit committee to oversee the company’s internal oversee the company’s internal control over financial reportingcontrol over financial reporting

Key ActionsKey Actions Understand Increased Independent Understand Increased Independent

Auditor involvementAuditor involvement Monitor progressMonitor progress Hold management accountableHold management accountable Self-assessSelf-assess

Considerations for Audit Considerations for Audit CommitteesCommittees

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Considerations for Independent Considerations for Independent AuditorAuditor

Key Elements of an Internal Key Elements of an Internal Control AuditControl Audit

Audit and render an opinion on Audit and render an opinion on management’s assessment of management’s assessment of internal controls over financial internal controls over financial reportingreporting

Communicate significant Communicate significant deficiencies and material deficiencies and material weaknessesweaknesses

Evaluate management’s report for Evaluate management’s report for appropriatenessappropriateness

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Sounds Involved...What’s in it for Sounds Involved...What’s in it for me?me?

Strong Internal Strong Internal ControlControl

Reduce potential for Reduce potential for fraudfraud

Gain (or regain) Gain (or regain) investor trust investor trust

Comply with laws and Comply with laws and regulationsregulations

Gain visibility into Gain visibility into operating operating inefficienciesinefficiencies

Minimize Minimize whistleblower actionswhistleblower actions

Set the “tone at the Set the “tone at the top”top”

Weak Internal Weak Internal ControlControl

Increased exposure Increased exposure to fraudto fraud

Misstated financial Misstated financial statementsstatements

Unfavorable publicityUnfavorable publicity Negative impact on Negative impact on

shareholder valueshareholder value SEC sanctionsSEC sanctions Lawsuits or other Lawsuits or other

legal actionslegal actions

The Business Case for a Strong Internal Control Program

Moving ForwardMoving Forward

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Outlook for the FutureOutlook for the Future

Accept that the environment has Accept that the environment has profoundly changedprofoundly changed

Promote understanding of internal Promote understanding of internal control within the organizationcontrol within the organization

Factor into your business model the cost Factor into your business model the cost of developing an internal control programof developing an internal control program

Monitor developments and refinements in Monitor developments and refinements in the Regulators standardsthe Regulators standards

Understand the limits of internal controlUnderstand the limits of internal control