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Chapter 5: RECOGNIZING THE SYMPTOMS OF FRAUD
-Symptoms are not full evidence if you discover symptoms, it doesn’t mean that fraud is for sure will happen. -Symptoms are not actual proof it just shows that something might happening. -Frauds are different from other criminals: Fraud is a crime that is seldomly observed (nothing to see) it is done is secret (not lots of people see that) With fraud it is not usually obvious that a crime has been committed. (ex – murder, robbery) Only fraud symptoms, red flags, or indicators are observed. Symptoms of fraud can be separated into six groups: Accounting anomalies : unusual processes or procedures in the accounting system Internal control weaknesses : vulnerabilities in a company’s system of controls Analytical anomalies : relationships in financial or nonfinancial data that do not make sense, such as an unreasonable change in a volume, mix, or price Extravagant lifestyle : indications a person may be committing fraud, such as suddenly buying an expensive house, driving luxury cars, and wearing expensive clothes and jewelry Unusual behavior : personality signs that a person may be committing fraud, such as a sudden “Jekyll and Hyde” personality or exhibiting dramatic highs and lows Tips and complaints These factors are only symptoms rather than conclusive proof of fraud; there may be other explanations for the existence of these symptoms.
1. Accounting anomalies
Common accounting anomaly fraud symptoms involve problems with: Source documents Faulty journal entries Inaccuracies in ledgers Most financial statement auditors match documents to see whether support exists and is adequate. Auditors and examiners who detect fraud go beyond just looking at the existence of documents to determine whether the documents are authentic or fraudulent,
whether the expenditures make sense, and whether all aspects of the documentation are in order. Common accounting anomaly fraud symptoms involve problems with source documents, faulty journal entries, and inaccuracies in ledgers. a) Irregularities in Source Documents Common fraud symptoms involving source documents a. Missing documents b. Stale items on bank reconciliations c. Excessive voids or credits d. Common names or addresses of payees or customers e. Increased past-due accounts f. Increased reconciling items g. Alterations on documents h. Duplicate payments i. Second endorsements on checks j. Document sequences that do not make sense k. Questionable handwriting on documents l. Photocopied documents +external auditor: look at documents if they exist, support for F/S +examiner: look beyond the F/S, going further b) Faulty Journal Entries Accounting is a language, just as English and Japanese are. For example, consider the following journal entry: Legal Expense 5, Cash 5, In the English language, this entry says, “An attorney was paid $5,000 in cash.” In the language of accounting, this entry says, “Debit Legal Expense; credit Cash.” A person who speaks both accounting and English will realize that these statements say exactly the same thing. The problem with the language of accounting is that it can be manipulated to tell a lie, just as can English or Japanese or any other language. Common journal entry fraud symptoms o Journal entries without documentary support o Unexplained adjustments to receivables, payables, revenues, or expenses o Journal entries that do not balance
2. Internal Control Weaknesses
Common internal control fraud symptoms Lack of segregation of duties Lack of physical safeguards Lack of independent checks Lack of proper authorization Lack of proper documents and records Overriding of existing controls Inadequate accounting system Many studies have found that the element most common in frauds is the overriding of existing internal controls. There are three simple procedures that small business owners should do personally when they can’t afford sufficient employees to guarantee effective segregation of duties. always open the bank statement themselves and, if possible, reconcile the bank statement pay everything by check or with a specific credit card so there is a record or they should be the only person able to make electronic bank transfers if they use checks, they should sign every check themselves and not delegate the signing to anyone else. These simple procedures, if done on a timely basis, will prevent many frauds.
3. Analytical Fraud Symptoms
Analytical fraud symptoms are procedures or relationships that are unusual or too unrealistic to be believable. Common examples of analytical symptoms Unexplained inventory shortages or adjustments Deviations from specifications Increased scrap Excess purchases Too many debit or credit memos Significant increases or decreases in account balances, ratios, or relationships Physical abnormalities Cash shortages or overages Excessive late charges Unreasonable expenses or reimbursements Excessive turnover of executives Strange financial statement relationships Relationships between financial statement numbers are also predictable.
To individuals who really understand accounting, financial statements tell a story. The elements of the story must be internally consistent. Analytical fraud symptoms are anything out of the ordinary. When using analytical procedures to look for signs of fraud, make sure you develop an independent expectation of what the analytical relationships should be based on your understanding of the economics affecting the company.
4. Extravagant Lifestyles
Most people who commit fraud are under financial pressure—real or perceived. Once perpetrators meet their financial needs, they usually continue to steal, using the embezzled funds to improve their lifestyles. Examples of lifestyle improvements Buy new cars Buy expensive toys such as boats or recreation vehicles Take vacations Remodel homes Move into more expensive houses Buy expensive jewelry or clothes Spend more money on food and other day-to-day living expenses Very few save the money they steal. As they become more and more confident in their fraud schemes, they steal and spend larger amounts. Soon they are living lifestyles far beyond what they can afford.
5. Unusual Behaviors
Research in psychology reveals that when a person (especially a first-time fraud perpetrator) commits a crime, he or she becomes engulfed by emotions of fear and guilt. These emotions express themselves as stress. The individual often exhibits unusual and recognizable behavior patterns to cope with the stress No particular behavior signals fraud; rather, changes in behavior are signals. People who are normally nice may become intimidating and belligerent. People who are normally belligerent may suddenly become nice. Once in a while, someone commits a fraud or another crime and does not feel stress. Such people are called sociopaths or psychopaths. They feel no guilt because they have no conscience. Behavior signals of Fraud perpetrators:
First, in the theft act, someone can witness the perpetrator taking cash or other assets. Second, in concealment, altered records or miscounts of cash or inventory can be recognized. Third, in conversion, the lifestyle changes that perpetrators almost inevitably make when they convert their embezzled funds are visible. Company employees are in the best position to detect fraud: Although co-workers and managers are in the best position to detect fraud, they are usually the least trained to recognize fraud or even be aware that it can exist. Even so, many frauds are detected when an employee, a friend, a manager, a customer, or another person untrained in fraud provides a tip or complaint that something is wrong. Tips and Complaints are Fraud symptoms: Complaints and tips are categorized as fraud symptoms because many tips and complaints turn out to be unjustified. Examples of motivations behind complaints and tips: Customers may complain because they feel they are being taken advantage of Vendors may provide a false tip because they are disgruntled because of a lost contract Employee tips may be motivated by malice, personal problems, or jealousy Tips from spouses and friends may be motivated by anger, divorce, or blackmail Whenever tips or complaints are received, they must be treated with care and considered only as fraud symptoms. Unreported knowledge of suspicious of Fraud: In some situations, people are hesitant to come forward with knowledge or suspicions of fraud. Reasons include: Some uncertainty that a fraud is taking place Fear reprisal for being a whistle-blower Intimidation by the perpetrator Belief that squealing on someone is wrong Not easy to come forward within many organizations New laws protect Whistle-blowers and Promote Fraud Detection: Sarbanes-Oxley Act (2002) o Mandated that every public company have a whistle-blower system in place and that it be promoted among employees and others
Dodd-Frank Act (2010) o Authorized the payment of financial rewards to whistle-blowers o Under this legislation, whistle-blowers can receive from 10 to 30 percent of the money that the government collects when a Securities and Exchange Commission (SEC) enforcement action leads to a sanction exceeding $1 million o In October 2013, the SEC reported that the largest award to date under that program was an award that exceeded $14 million Whistle-blowing systems should not be considered substitutes for maintaining an open environment in which employees feel comfortable about reporting known or suspected fraudulent activities. o Employees should be encouraged to first consider reporting such activities to someone in their management chain, to an internal auditor, to corporate security, or to legal counsel. They should, however, be kept aware of the hotline option and encouraged to use it if they are not comfortable with other options.
