Fraud Examination

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Fraud Examination

FOURTH EDITION

W. STEVE ALBRECHT

Brigham Young University

CHAD O. ALBRECHT

Utah State University

CONAN C. ALBRECHT

Brigham Young University

MARK F. ZIMBELMAN

Brigham Young University

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ISBN-13: 978-0-538-47084-1

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Printed in the United States of America

1 2 3 4 5 6 7 15 14 13 12 11

To LeAnn, Jenny, Laurel, and Karen

Brief Contents

About the Authors xii

Foreword xv

Preface xvii

PART 1 Introduction to Fraud 1

1 The Nature of Fraud 3

2 Why People Commit Fraud 31

3 Fighting Fraud: An Overview 69

PART 2 Fraud Prevention 99

4 Preventing Fraud 101

PART 3 Fraud Detection 133

5 Recognizing the Symptoms of Fraud 135

6 Data-Driven Fraud Detection 167

PART 4 Fraud Investigation 207

7 Investigating Theft Acts 209

8 Investigating Concealment 231

9 Conversion Investigation Methods 251

10 Inquiry Methods and Fraud Reports 275

PART 5 Management Fraud 355

11 Financial Statement Fraud 357

12 Revenue- and Inventory-Related Financial Statement Frauds 399

13 Liability, Asset, and Inadequate Disclosure Frauds 445

PART 6 Other Types of Fraud 501

14 Fraud against Organizations 503

15 Consumer Fraud 529

16 Bankruptcy, Divorce, and Tax Fraud 565

17 Fraud in E-Commerce 601

PART 7 Resolution of Fraud 619

18 Legal Follow-Up 621

Appendix Financial Statement Fraud Standards 641

Bibliography 648

Glossary 652

Index 664

Contents

About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xii

Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xvii

PART 1 Introduction to Fraud

CHAPTER 1

The Nature of Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

Seriousness of the Fraud Problem 4

What Is Fraud? 6

Fraud, Greed, Deception, and Confidence 8

Types of Fraud 9

Employee Embezzlement 10

Vendor Fraud 11

Customer Fraud 11

Management Fraud 11

Investment Scams and Other Consumer Frauds 12

Criminal and Civil Prosecution of Fraud 13

Criminal Law 14

Civil Law 15

How to Prepare to Be a Fraud-Fighting Professional 16

Certified Fraud Examiners 17

Academic Requirements 17

Professional Requirements 17

Fraud-Related Careers 17

Review of the Learning Objectives 19

Key Terms 20

Questions 20

Short Cases 23

Case Studies 25

Internet Assignments 28

Debates 28

End Notes 28

CHAPTER 2

Why People Commit Fraud . . . . . . . . . . . . . . . . . . . . 31

Who Commits Fraud 33

The Fraud Triangle 34

The Element of Pressure 36

Financial Pressures 36

Vice Pressures 37

Work-Related Pressures 38

Other Pressures 38

The Element of Opportunity 39

Controls That Prevent and/or Detect Fraudulent

Behavior 39

Summary of the Controls That Prevent or Detect

Fraud 44

Inability to Judge the Quality of Performance 45

Failure to Discipline Fraud Perpetrators 46

Lack of Access to Information 47

Ignorance, Apathy, and Incapacity 47

Lack of an Audit Trail 48

The Element of Rationalization 49

Summary of the Fraud Triangle 51

Fraud Recruitment 53

Power 53

Review of the Learning Objectives 55

Key Terms 56

Questions 56

Short Cases 58

Case Studies 63

Internet Assignment 65

Debate 65

End Notes 65

CHAPTER 3

Fighting Fraud: An Overview . . . . . . . . . . . . . . . . . . 69

Knowing Different Ways That Organizations Fight

Fraud 70

Fraud Prevention 71

Creating a Culture of Honesty and High Ethics 71

Assessing and Mitigating the Risk of Fraud 75

Fraud Detection 77

Fraud Investigation 79

Approaches to Fraud Investigation 80

Conducting a Fraud Investigation 81

Follow-Up Legal Action 82

Civil Action 83

Criminal Action 83

Review of the Learning Objectives 84

Key Terms 85

Questions 85

Short Cases 88

Case Studies 89

Internet Assignments 91

Debates 92

End Notes 92

APPENDIX A: Red Hat Code of Business

Conduct and Ethics 93

PART 2 Fraud Prevention

CHAPTER 4

Preventing Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101

Just About Everyone Can Be Dishonest 103

Creating a Culture of Honesty, Openness,

and Assistance 103

Hiring Honest People and Providing Fraud Awareness

Training 103

Creating a Positive Work Environment 106

Implementing Employee Assistance Programs

(EAPs) 112

Eliminating Opportunities for Fraud to Occur 113

Having a Good System of Internal Controls 113

Discouraging Collusion between Employees and Others

and Alerting Vendors and Contractors to Company

Policies 116

Monitoring Employees and Having a Whistle-Blowing

System 117

Creating an Expectation of Punishment 119

Conducting Proactive Fraud Auditing 119

Preventing Fraud—A Summary 120

A Comprehensive Approach to Fighting Fraud 120

Organizations and Fraud—The Current Model 121

Review of the Learning Objectives 124

Key Terms 125

Questions 125

Short Cases 126

Case Studies 129

Internet Assignments 130

Debates 131

End Notes 131

PART 3 Fraud Detection

CHAPTER 5

Recognizing the Symptoms of Fraud . . . . . . . . . . .135

Symptoms of Fraud 137

Accounting Anomalies 139

Irregularities in Source Documents 139

Faulty Journal Entries 140

Inaccuracies in Ledgers 141

Internal Control Weaknesses 143

Analytical Fraud Symptoms 144

Extravagant Lifestyles 148

Unusual Behaviors 149

Tips and Complaints 151

Company Employees Are in the Best Position

to Detect Fraud 152

Tips and Complaints Are Fraud Symptoms 152

New Laws Protect Whistle-Blowers and Promote

Fraud Detection 153

Review of the Learning Objectives 158

Key Terms 159

Questions 159

Short Cases 161

Case Studies 163

Internet Assignments 165

End Notes 165

CHAPTER 6

Data-Driven Fraud Detection . . . . . . . . . . . . . . . . . .167

Anomalies and Frauds 168

Audit Sampling and Fraud 169

The Data Analysis Process 169

Step 1: Understand the Business 169

Step 2: Identify Possible Frauds That Could Exist 170

Step 3: Catalog Possible Fraud Symptoms 171

Step 4: Use Technology to Gather Data about

Symptoms 171

Step 5: Analyze Results 172

Step 6: Investigate Symptoms 172

Data Analysis Software 172

Data Access 173

Open Database Connectivity 173

Text Import 174

Hosting a Data Warehouse 174

Data Analysis Techniques 175

Data Preparation 175

Digital Analysis 175

Outlier Investigation 179

Stratification and Summarization 179

Time Trend Analysis 180

Fuzzy Matching 181

Real-Time Analysis 182

Analyzing Financial Statement Reports 183

Review of the Learning Objectives 190

Key Terms 190

vi Contents

Questions 191

Short Cases 193

Case Studies 196

Internet Assignments 202

Debates 202

End Notes 202

APPENDIX A: Examples of the Data-Driven

Approach 203

PART 4 Fraud Investigation

CHAPTER 7

Investigating Theft Acts . . . . . . . . . . . . . . . . . . . . . . .209

When to Investigate 210

Theft Act Investigative Methods 212

Developing a Vulnerability Chart 213

Surveillance and Covert Operations 214

Invigilation 216

Physical Evidence 218

Electronic Evidence 218

Forensic Software Packages 221

E-mail Systems 221

A Comprehensive Example of Using Theft Act

Investigation Methods 222

Review of the Learning Objectives 224

Key Terms 224

Questions 225

Short Cases 226

Case Studies 229

Internet Assignments 230

Debates 230

End Notes 230

CHAPTER 8

Investigating Concealment . . . . . . . . . . . . . . . . . . . . .231

Concealment Investigative Methods 233

Aspects of Documentary Evidence 233

Obtaining Documentary Evidence 237

Audits 237

Document Experts 242

Review of the Learning Objectives 246

Key Terms 246

Questions 246

Short Cases 248

Case Studies 249

Internet Assignments 250

Debates 250

End Notes 250

CHAPTER 9

Conversion Investigation Methods . . . . . . . . . . . . .251

Conversion Searches 253

Government Sources of Information 254

Federal Sources 254

State Sources of Information 255

County and Local Records 256

Private Sources of Information 257

Online Databases 258

Internet Search 260

The Net Worth Method 261

Review of the Learning Objectives 263

Key Terms 264

Questions 264

Short Cases 266

Case Studies 270

Internet Assignments 272

Debates 272

End Notes 273

CHAPTER 10

Inquiry Methods and Fraud Reports. . . . . . . . . . . .275

Interviewing—An Overview 276

Characteristics of a Good Interview 276

Characteristics of a Good Interviewer 277

Understanding Reaction to Crisis 277

Stage 1. Denial 279

Stage 2. Anger 279

Stage 3. Bargaining and Rationalization 280

Stage 4. Depression 280

Stage 5. Acceptance 280

Planning an Interview 280

The Interviewer’s Demeanor 281

The Language of Interviews 281

Question Typology 281

Elements of Conversation 282

Inhibitors of Communication 283

Facilitators of Communication 284

Mechanics of the Interview 285

Introductory Questions 285

Methodology 286

Informational Questions 288

Question Sequence 289

Informational Question Techniques 289

Note-Taking 289

Observing Respondent Reactions 290

Theme Development 291

Transition Methodology 291

Dealing with Resistance 292

Difficult People 292

Volatile Interviews 293

Contents vii

Assessment Questions 294

Detecting Deception 294

Methodology of Assessment Questions 296

Closing Questions 298

Admission-Seeking Questions 299

Steps in the Admission-Seeking Interview 300

Refute Alibis 303

Motive for the Fraud 305

Others Involved 306

Physical Evidence 306

Specifics of Each Offense 307

Signed Statements 307

Key Points in Signed Statements 308

Honesty Testing 308

Pencil-and-Paper Test 309

Graphology 309

Voice Stress Analysis and Polygraphs 309

The Fraud Report 309

Review of the Learning Objectives 310

Key Terms 311

Questions 311

Short Cases 313

Case Studies 316

Internet Assignments 318

Debates 318

End Notes 318

APPENDIX A: Sample Signed Statement 319

APPENDIX B: An Example Fraud Report 320

PART 5 Management Fraud

CHAPTER 11

Financial Statement Fraud . . . . . . . . . . . . . . . . . . . . .357

The Problem of Financial Statement Fraud 359

Financial Statement Fraud in Recent Years 359

Why These Problems Occurred 360

Element 1: A Booming Economy 361

Element 2: Decay of Moral Values 361

Element 3: Misplaced Incentives 361

Element 4: High Analysts’ Expectations 361

Element 5: High Debt Levels 362

Element 6: Focus on Accounting Rules Rather Than

Principles 362

Element 7: Lack of Auditor Independence 362

Element 8: Greed 363

Element 9: Educator Failures 363

Nature of Financial Statement Fraud 364

Financial Statement Fraud Statistics 364

Phar-Mor: An Example of Financial Statement

Fraud 366

Motivations for Financial Statement Fraud 367

A Framework for Detecting Financial Statement

Fraud 368

Management and the Board of Directors 370

Managements’ Backgrounds 370

Managements’ Motivations 371

Managements’ Influence in Making Decisions for the

Organization 371

Relationships with Others 372

Relationship with Financial Institutions 373

Relationship with Related Organizations and

Individuals 373

Relationship with Auditors 373

Relationship with Lawyers 374

Relationship with Investors 374

Relationship with Regulatory Bodies 374

Organization and Industry 376

Financial Results and Operating Characteristics 377

Review of the Learning Objectives 379

Key Terms 379

Questions 380

Short Cases 382

Case Studies 383

Internet Assignments 387

Debates 387

End Notes 388

APPENDIX A: Recent Laws and Corporate Governance

Changes Following the Sarbanes-Oxley Act 389

CHAPTER 12

Revenue- and Inventory-Related Financial

Statement Frauds. . . . . . . . . . . . . . . . . . . . . . . . . . .399

Revenue-Related Fraud 400

Acceptable Alternatives 401

Ease of Manipulating Net Income Using Revenues and

Receivables 401

Identifying Revenue-Related Fraud Exposures 402

Identifying Revenue-Related Fraud Symptoms 404

Actively Searching for Revenue-Related Fraud

Symptoms 406

Actively Searching for Revenue-Related Analytical

Symptoms 407

Actively Searching for Accounting or Documentary

Symptoms 410

Actively Searching for Control Symptoms 411

Actively Searching for Behavioral or Verbal and Lifestyle

Symptoms 412

Actively Searching for Tips and Complaints 413

Following Up on Revenue-Related Fraud Symptoms 413

viii Contents

Inventory and Cost of Goods Sold Frauds 414

Identifying Inventory-Related Fraud Exposures 415

Identifying Inventory-Related Fraud Symptoms 416

Proactively Looking for Inventory-Related Fraud

Symptoms 418

Searching for Inventory and Cost of Goods Sold

Analytical Symptoms 419

Actively Searching for Accounting or Documentary

Symptoms 422

Actively Searching for Inventory-Related Control

Symptoms 422

Actively Searching for Behavioral or Verbal and Lifestyle

Symptoms 422

Actively Searching for Tips and Complaints 422

Review of the Learning Objectives 423

Key Terms 423

Questions 424

Short Cases 427

Case Studies 431

Internet Assignments 433

Debates 434

End Notes 434

APPENDIX A: Strategic Reasoning and Detecting

Revenue- and Inventory-Related Fraud 435

CHAPTER 13

Liability, Asset, and Inadequate Disclosure Frauds. .445

Understating Liabilities 446

Ways to Manipulate Liabilities 447

Identifying Understatement of Liability Fraud

Exposures 448

Understating Accounts Payable 448

Understating Accrued Liabilities 449

Recognizing Unearned Revenue (Liability) as Earned

Revenue 450

Underrecording Future Obligations 450

Not Recording or Underrecording Various Types of Debt

(Notes, Mortgages, etc.) 451

Omission of Contingent Liabilities 451

Detecting Understatement of Liability Fraud

Symptoms 451

Analytical Symptoms 452

Accounting or Documentary Symptoms 452

Proactively Searching for Symptoms Related to the

Underreporting of Liabilities 453

Focusing on Changes in Recorded Balances from Period

to Period 453

Focusing on Changes in Relationships from Period to

Period 454

Comparing Financial Statement Information with Other

Companies 454

Comparing Financial Statement Amounts with Assets

They Are Supposed to Represent or with Nonfinancial

Statement Factors 456

Actively Searching for “Accounting and Documentary”

Symptoms 456

Overstatement of Asset Fraud 456

Identifying Asset Overstatement Fraud 458

Improper Capitalization of Costs as Assets That Should

Be Expensed in the Current Period 458

The Slippery Slope of Earnings Management 459

Inflated Assets through Mergers and Acquisitions (or

Restructuring) or by Manipulating Intercompany

Accounts and/or Transactions 459

Overstatement of Fixed Assets (Property, Plant, and

Equipment) 462

Cash and Short-Term Investment Fraud 462

Overstatement of Accounts Receivable (Not Related to

Revenue Recognition) or Inventory (Not Related to

Cost of Goods Sold) 463

Summary of Overstatement of Asset Fraud

Exposures 463

Identifying and Actively Searching for Asset

Overstatement Fraud Symptoms 463

Inappropriately Capitalizing Costs That Should Be

Expensed 464

Overstating Assets through Mergers, Acquisitions, or

Restructurings or Manipulating Intercompany

Accounts or Transactions 466

Overstatement of Cash and Short-Term Investments

(Including Marketable Securities) 468

Overstatement of Receivables and/or Inventory (Not

Revenue- or Cost of Goods Sold–Related) 469

Inadequate Disclosure Fraud 469

Kinds of Disclosure Fraud 470

Misrepresentations about the Nature of the Company or

Its Products 470

Misrepresentations in MD&A and Other Nonfinancial

Information in Financial Reports 471

Misleading Footnote Disclosures 471

Detecting Inadequate Disclosure Fraud 472

Symptoms Related to Overall Misrepresentation about the

Company or Its Assets 473

Disclosure Fraud Related to Financial Reports and

Financial Statement Footnotes 474

Other Types of Financial Statement Fraud 475

Inappropriate Accounting for Nonmonetary

Transactions 475

Inappropriate Accounting for Roundtrip

Transactions 475

Improper Accounting for Foreign Payments in Violation

of the Foreign Corrupt Practices Act (FCPA) 476

Improper Use of Non-GAAP Financial Measures 476

Contents ix

Improper Use of Off-Balance-Sheet Arrangements 476

Review of the Learning Objectives 477

Key Terms 478

Questions 478

Short Cases 481

Case Studies 485

Internet Assignments 488

Debates 488

End Notes 489

APPENDIX A: Strategic Reasoning and Detecting

Liability, Asset, and Inadequate Disclosure

Frauds 490

PART 6 Other Types of Fraud

CHAPTER 14

Fraud against Organizations. . . . . . . . . . . . . . . . . . . .503

Fraud Statistics 505

Asset Misappropriations 506

Theft of Cash through Larceny 507

Theft of Cash through Skimming 508

Cash Theft through Fraudulent Disbursements 508

Theft of Inventory and Other Assets 514

Corruption 516

Bribery 516

Conflicts of Interest 518

Economic Extortion and Illegal Gratuities 519

Review of the Learning Objectives 520

Key Terms 520

Questions 520

Short Cases 522

Case Studies 525

Internet Assignments 526

Debates 526

End Notes 526

CHAPTER 15

Consumer Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .529

Consumer Fraud and Its Seriousness 530

Identity Theft 531

How Identity Theft Occurs 532

How Fraudsters Convert Personal Information to

Financial Gain 534

Stealing a Victim’s Identity 535

Minimizing the Risk 536

Prosecution of Identity Theft 539

Once Identity Theft Has Occurred 540

Identity Theft—Concluding Comments 541

Other Types of Consumer and Investment Scams 543

Foreign Advance-Fee Scams 543

Work-at-Home Schemes 545

Bogus Mystery Shopping Scams 549

Telemarketing Fraud 549

Investment Scams 553

Review of the Learning Objectives 555

Key Terms 556

Questions 556

Short Cases 558

Cases Studies 560

Internet Assignments 562

Debates 562

End Notes 562

CHAPTER 16

Bankruptcy, Divorce, and Tax Fraud . . . . . . . . . . .565

Overview of Tax, Divorce, and Bankruptcy Frauds 566

Fraud Examiners’ Roles in Bankruptcy and Divorce

Cases 566

Tax Fraud 567

Fraud and the Criminal Investigation Division 568

CI Investigative Careers 571

Divorce Fraud 571

Participants in Divorce Cases 572

Bankruptcy Fraud 572

The Bankruptcy Code 574

Civil and Criminal Bankruptcy Fraud Statutes 574

Civil Bankruptcy Statutes 575

Participants in the Bankruptcy Process 576

Fraud Investigator’s Relationship to Participants in

Bankruptcy Proceedings 578

Bankruptcy and Divorce Fraud Schemes—The Planned

Bankruptcy (Bust-Out) 579

Fraudulent Concealment of Assets or Income in

Bankruptcies or Divorces 580

The Debtor’s or Divorcee’s Estate 580

Bankruptcy Statutes Concerning Concealment of

Assets 580

Means of Concealing Assets or Income 581

Indicators of Concealment 581

Fraudulent Transfers 581

Civil Liability for False Accusations 582

Money Laundering 582

The Money Laundering Process 583

Efforts to Combat Money Laundering 583

Detecting Money Laundering Schemes 583

Review of the Learning Objectives 585

Key Terms 586

Questions 586

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