© 2015 Association of Certified Fraud Examiners, Inc.

Auditing for Internal Fraud

Financial Statement Fraud and Corruption

© 2015 Association of Certified Fraud Examiners, Inc. 2 of 27

Introduction to Financial Statement Fraud

Least common, but most costly, form of

occupational fraud

Almost always involves upper management

Undertaken to:

• Misrepresent the company’s financial health to

outsiders

• Meet compensation-linked performance goals

© 2015 Association of Certified Fraud Examiners, Inc. 3 of 27

Financial Statement Fraud

© 2015 Association of Certified Fraud Examiners, Inc. 4 of 27

Financial Statement Fraud Schemes

Overstated assets or

revenues

Understated

liabilities or

expenses

Improper disclosures

© 2015 Association of Certified Fraud Examiners, Inc. 5 of 27

Overstated Assets or Revenues

Fictitious revenues

Timing differences

• Improper matching of revenues and expenses

• Early revenue recognition

Improper asset valuation

5 of 17

© 2015 Association of Certified Fraud Examiners, Inc. 6 of 27

Understated Liabilities and Expenses

Liability/expense omissions

Recording expenses in the wrong period

Improper capitalizing/expensing

Returns/allowances and warranties

Post-retirement benefits

Operating vs. capital leases

6 of 17

© 2015 Association of Certified Fraud Examiners, Inc. 7 of 27

Improper Disclosures

Related-party

transactions

Liability omissions

Significant events

Management fraud

Accounting changes

© 2015 Association of Certified Fraud Examiners, Inc. 8 of 27

Red Flags of Financial Statement Fraud

Slowdown for previously fast-growing

company

Industry changes

Significant pressure to obtain additional

capital

Unusually high dependence on debt

Significant, unusual, or highly complex

transactions, especially close to year end

Significant estimates involving unusually

subjective judgments or uncertainties

8 of 17

© 2015 Association of Certified Fraud Examiners, Inc. 9 of 27

Red Flags of Financial Statement Fraud

Significant high-risk investments

Management incentives tied to unreasonable

growth or profitability expectations

Lax attitudes about regulatory requirements

History of claims alleging fraud

Lack of established policies or controls

Lack of proper training

Lack of enforcement of procedures

9 of 17

© 2015 Association of Certified Fraud Examiners, Inc. 10 of 27

Detection of Financial Statement Fraud

Vertical analysis

Horizontal analysis

Ratio analysis

© 2015 Association of Certified Fraud Examiners, Inc. 11 of 27

Vertical Analysis

Analyze relationships between items on a

financial statement by expressing

components as percentages of specific line

item.

• On income statement, net sales = 100%

• On balance sheet, total assets/total liabilities and

equity = 100%

© 2015 Association of Certified Fraud Examiners, Inc. 12 of 27

Horizontal Analysis

Analyze percentage

change in individual

financial statement

items from one year to

the next.

© 2015 Association of Certified Fraud Examiners, Inc. 13 of 27

Ratio Analysis

Means of measuring the relationship

between two different amounts

• Accounts receivable turnover

• Sales to total assets

• Related-party sales to total assets

• Working capital to total assets

• Leverage ratios

• Ratios involving nonfinancial data

13 of 17

© 2015 Association of Certified Fraud Examiners, Inc. 14 of 27

Introduction to Corruption

The employee’s use of

his influence in business

transactions in a way

that violates his duty to

the employer for the

purpose of obtaining a

benefit for himself or

someone else

© 2015 Association of Certified Fraud Examiners, Inc. 15 of 27

Types of Corruption Schemes

Bribery and kickbacks

Illegal gratuities

Economic extortion

Conflicts of interest

© 2015 Association of Certified Fraud Examiners, Inc. 16 of 27

Bribery and Kickbacks

Payments, gifts, or gratuities given to

employees from contractors or vendors in

order to influence a business transaction

Involves collusion between employees and

vendors

Usually attacks the purchasing function of

the victim company

Can be very difficult to detect

© 2015 Association of Certified Fraud Examiners, Inc. 17 of 27

Illegal Gratuity

Something of value

given to an employee

to reward a decision

after it has been made

Similar to bribery

schemes, but does not

require proof of intent

to influence

© 2015 Association of Certified Fraud Examiners, Inc. 18 of 27

Economic Extortion

Use of actual or

threatened force or

fear to demand

money or some

other consideration

to make a particular

business decision

Often the other side

of a bribery case

© 2015 Association of Certified Fraud Examiners, Inc. 19 of 27

Conflict of Interest

Employee or agent

of the contracting

company (or a

spouse or close

family member) has

an undisclosed

financial interest in

a contract or

contractor.

© 2015 Association of Certified Fraud Examiners, Inc. 20 of 27

Detection of Corruption Schemes

Typical auditing procedures fall short.

Most often detected through tips from honest

and disgruntled coworkers or vendors.

Strongest indicators:

• Contractor(s) receiving unexplained favorable

treatment from contracting employee

• Continued purchase of high-priced, low-quality

goods or services, without objection or returns

© 2015 Association of Certified Fraud Examiners, Inc. 21 of 27

Detection of Bribery and Kickback Schemes

Compare prices paid for goods and services

to market rates.

Analyze purchase levels by vendor.

Analyze inventory overstocks and shortages.

Identify continued purchases of inferior-

quality goods.

Identify unusual patterns in bidding process.

© 2015 Association of Certified Fraud Examiners, Inc. 22 of 27

Detection of Conflict of Interest Schemes

Identify tips and complaints that might

indicate that a conflict of interest is occurring.

• Typically come from employees who are aware of

a coworker’s self-dealing

Compare vendor and employee addresses

and phone numbers.