Category Archives: Financial Fraud

Inventory of Fraud

One of the first frauds I worked on early in my career was a scheme by management to overstate the periodic inventory of the Prison Industries system of a state Department of Corrections.   In that case the manipulation was carried out by creating false inventory counts and altering records after the physical count.

What made this an especially interesting case of management fraud were the various reasons that the audit report subsequently revealed why accounting management had decided to overstate the inventory:

  • To overstate the income of Prison Industries.
  • To achieve internally projected goals.
  • To increase Prison Industry’s perceived value in the eyes of State government administration.
  • To meet Department of Corrections stiff goals for Prison Industry management.
  • To hide poor operational performance.
  • To enhance the perceived performance of individual members of Prison Industries management.
  • To hide the theft of some inventory.

These reasons are in contrast to fraudster goals if a fraud scheme’s overall objective is to show reduced inventory:

  • To reduce income.
  • The entity has achieved its goals and wants to show reduced results.
  • To reduce the overall value of the business or enterprise.
  • A new management team is in place and wants to defer reporting additional performance to the future.

Such inventory counting related schemes are likely to occur with inventory components perceived to be less likely of being counted or in conjunction with a planned reason for the false count. The hope is that any examiner/auditor will view the false count as an error versus an intentional plan to misstate the inventory. Therefore, the examiner needs to ensure that management has no record of the test counts. Certain types of inventory counts are more susceptible to being false, such as:

  • Periodic Inventory. This particular inventory is susceptible to false counting because the auditor has no inventory reports to determine what the inventory should have been prior to the count.
  • Perpetual Inventory. Variances or in-transit items are often used as an explanation for any deviations.
  • Multiple Inventory locations. The non-tested sites are susceptible to false counts because the auditor is not performing procedures at those locations. Management may also use other scams in conjunction with the false-count fraud schemes.

As every accounting student knows, inventory is tangible property that either (1) is held for sale in the ordinary course of business (finished goods); (2) is in the process of production for such sale (work in process); or (3) is currently consumed either directly or indirectly in the production of goods or services available for sale (raw materials). The primary basis of accounting for inventory is cost. By definition, inventory excludes long-term assets subject to depreciation accounting.

The inventory records at Prison Industries were complex. Inventory was constantly being transferred between manufacturing processes, was often dispensed in several locations across the state’s correctional system, and normally comprised a significantly large amount of items. For these reasons, as well as the variety of decisions made about direct valuations, inventory was an appealing place for management to decide to commit financial statement fraud, in this case by manipulating and altering the physical inventory count.

Inventory falsification occurred at Prison Industries when the entity showed inventory on its financial statements that both did not exist and was improperly valued;  the two methods were  used simultaneously.  Techniques used to inflate the value of inventory included the creation of false documents, such as inventory count sheets, receiving reports, and manipulation of the actual physical inventory. During the fraud, it was common for management to insert phony inventory count sheets during the inventory observation or to alter the quantities on the count sheets. There where instances where management created the illusion that inventory existed with the help of phony inventory items. Simply put, some items of inventory that appeared real on paper were actually fake.

The fraud examination was originated as a result of predication provided by a Hot Line tip and featured the application of a number of procedures.

Interviews were conducted with management and personnel. Questions asked included the following to determine whether the inventory represented by management actually existed and whether it was properly valued:

– Do the inventories included in the Prison Industries balance sheet physically exist?
– Does the inventory represent items held for use in the ordinary course of production?
– Do inventory quantities include all items on hand or in transit?
– Are inventory listings accurately compiled and are they properly included in the inventory accounts?
– Does the State have legal title or ownership rights to the inventory items?
– Does the inventory exclude items billed to customers or owned by others?
– Are inventory costs the result of an acceptable method consistently applied?
– Are inventories properly classified in the balance sheet and are the related disclosures adequate?

The examiners calculated the inventory turnover ratio. The inventory turnover ratio measures how fast inventory was moving through the entity. If the inventory is inflated, then the average inventory balance will be overstated, causing the inventory turnover ratio to decline. The  inventory turnover ratio was compared with the results from prior years and with industry averages for reasonableness.

Price tests were performed. A fraud examiner must determine whether the pricing of the inventory is reasonable. Price testing employs vouching, tracing, and re-computation procedures to test the auditee’s  pricing of its inventory. An examiner should test the application of prices by vouching items to vendors’ invoices and to cost accounting records to verify that the inventory is properly priced. For example, an examiner selects from the inventory detail item L243, classified as a raw material. According to the company’s records as of the balance sheet date, there are twenty L243s at $120 apiece. The examiner reviews the last invoice representing the purchase of L243s and discovers that the company purchased the L243s at $60 apiece. This price discrepancy is a sign that management might be trying to inflate the value of its inventory. Vendors’ invoices should also be traced to the books to confirm proper price recording. Examiners should recompute the quantities indicated on-hand by the observation with vendor prices to determine that the inventory, balances on the balance sheet are correct.

Following the fraud examination inventory was re-performed. The physical inventory was re-performed to ensure that the enterprise’s application of corrective action to methods for counting inventory would result in an accurate and reliable count in future. The re-examination of physical inventory included observation, as well as inquiries and physical examination (i.e., test counts). It is important to remember that management is responsible for the propriety of the inventory. The examiner observed the re-taking of the inventory to satisfy his/her reliance on management’s representations of the quantities and prices.

Cut off tests were performed. A cut-off test is a procedure to control the shipping and receiving activities at the physical inventory date. For the time of the physical inventory, the examiner  noted the numbers of the last pre-numbered shipping and receiving documents because purchases of inventory often are recorded when received and sales recorded when shipped. Identifying the document numbers helped the examiner determine whether the inventory was properly or improperly included or excluded from the inventory counts. For instance, if management indicated that the last shipping document for 1991 was #2500, then the examiner would assume that #2501 was shipped in January 1992. If, upon review of shipping document #2501, the examiner notices that the inventory was shipped in 1991, then there is the possibility that management is inflating the quantity and value of the company’s inventory at year-end. Therefore, inquiry and further testing are warranted. These cut-off numbers are often used in conjunction with the cut-off test used in accounts receivable and accounts payable testing. If cut-off procedures appear unclear or indicate possible inclusions in inventory of goods sold, then cut-off tests should be expanded.

There are several other audit procedures that can be used in detecting inventory fraud scenarios. These include:

  • Reviewing the statement of cash flows and asking whether the increases and decreases in cash make sense in relation to the inventory account balances and changes.
  • Computing the inventory turnover ratio and days-to-sell ratio. Do these ratios make sense in relation to what the auditor has verified regarding the physical aspects of the inventory?
  • Computing the percentage of gross profit and the related percentage of the cost of goods sold, and then the trend to look for understatement of the cost of goods sold percentage.
  • Ensuring there is a consistent use of the inventory cost flow assumption. For example, the use of first-in-first out (FIFO) gives a higher net income in an inflationary environment.

It was the large number of items comprising the inventory that made it an attractive target for fraudulent manipulation at Prison Industries. Theft and misuse are the actions of choice when it comes to inventory fraud. The rationale typically Is: “Who is going to miss a few hundred widgets in an inventory of thousands, perhaps millions?” The size of inventory as a percentage of the amount of total assets also makes it an easy target for management-initiated financial reporting misstatement. Having the possibility of two types of fraudulent acts ganging up on inventories at the same time, the CFE doesn’t want to waste time going down the wrong path, so it’s very important to determine which fraudulent act is likely occurring.

Any discussion of fraud likelihood involves the concepts of concealment, conversion, and opportunity. So, in addition to “how” the Inventory fraud took place, other questions need to be addressed, such as: How sophisticated is the concealment strategy? Who has the most benefit to gain by the theft, misuse, or misstatement of the inventories? Who has and where are the opportunities to divert/misstate inventories? These are the questions that need to be answered by the CFE/auditor, and fortunately, the tools and guidance are available from the ACFE to achieve the right answers when faced with almost any pattern of inventory fraud.

Regulating the Financial Data Breach

During several years of my early career, I was employed as a Manager of Operations Research by a mid-sized bank holding company. My small staff and I would endlessly discuss issues related to fraud prevention and develop techniques to keep our customer’s checking and savings accounts safe, secure and private. A never ending battle!

It was a simpler time back then technically but since a large proportion of fraud committed against banks and financial institutions today still involves the illegal use of stolen customer or bank data, some of the newest and most important laws and regulations that management assurance professionals, like CFEs, must be aware of in our practice, and with which our client banks must comply, relate to the safeguarding of confidential data both from internal theft and from breaches of the bank’s information security defenses by outside criminals.

As the ACFE tells us, there is no silver bullet for fully protecting any organization from the ever growing threat of information theft. Yet full implementation of the measures specified by required provisions of now in place federal banking regulators can at least lower the risk of a costly breach occurring. This is particularly true since the size of recent data breaches across all industries have forced Federal enforcement agencies to become increasingly active in monitoring compliance with the critical rules governing the safeguarding of customer credit card data, bank account information, Social Security numbers, and other personal identifying information. Among these key rules are the Federal Reserve Board’s Interagency Guidelines Establishing Information Security Standards, which define customer information as any record containing nonpublic personal information about an individual who has obtained a financial product or service from an institution that is to be used primarily for personal, family, or household purposes and who has an ongoing relationship with the institution.

Its important to realize that, under the Interagency Guidelines, customer information refers not only to information pertaining to people who do business with the bank (i.e., consumers); it also encompasses, for example, information about (1) an individual who applies for but does not obtain a loan; (2) an individual who guarantees a loan; (3) an employee; or (4) a prospective employee. A financial institution must also require, by contract, its own service providers who have access to consumer information to develop appropriate measures for the proper disposal of the information.

The FRB’s Guidelines are to a large extent drawn from the information protection provisions of the Gramm Leach Bliley Act (GLBA) of 1999, which repealed the Depression-era Glass-Steagall Act that substantially restricted banking activities. However, GLBA is best known for its formalization of legal standards for the protection of private customer information and for rules and requirements for organizations to safeguard such information. Since its enactment, numerous additional rules and standards have been put into place to fine-tune the measures that banks and other organizations must take to protect consumers from the identity-related crimes to which information theft inevitably leads.

Among GLBA’s most important information security provisions affecting financial institutions is the so-called Financial Privacy Rule. It requires banks to provide consumers with a privacy notice at the time the consumer relationship is established and every year thereafter.

The notice must provide details collected about the consumer, where that information is shared, how that information is used, and how it is protected. Each time the privacy notice is renewed, the consumer must be given the choice to opt out of the organization’s right to share the information with third-party entities. That means that if bank customers do not want their information sold to another company, which will in all likelihood use it for marketing purposes, they must indicate that preference to the financial institution.

CFEs should note , that most pro-privacy advocacy groups strongly object to this and other privacy related elements of GLBA because, in their view, these provisions do not provide substantive protection of consumer privacy. One major advocacy group has stated that GLBA does not protect consumers because it unfairly places the burden on the individual to protect privacy with an opt-out standard. By placing the burden on the customer to protect his or her data, GLBA weakens customer power to control their financial information. The agreement’s opt-out provisions do not require institutions to provide a standard of protection for their customers regardless of whether they opt-out of the agreement. This provision is based on the assumption that financial companies will share information unless expressly told not to do so by their customers and, if customers neglect to respond, it gives institutions the freedom to disclose customer nonpublic personal information.

CFEs need to be aware, however, that for bank clients, regardless of how effective, or not, GLBA may be in protecting customer information, noncompliance with the Act itself is not an option. Because of the current explosion in breaches of bank information security systems, the privacy issue has to some degree been overshadowed by the urgency to physically protect customer data; for that reason, compliance with the Interagency Guidelines concerning information security is more critical than ever. The basic elements partially overlap with the preventive measures against internal bank employee abuse of the bank’s computer systems. However, they go quite a bit further by requiring banks to:

—Design an information security program to control the risks identified through a security risk assessment, commensurate with the sensitivity of the information and the complexity and scope of its activities.
—Evaluate a variety of policies, procedures, and technical controls and adopt those measures that are found to most effectively minimize the identified risks.
—Application and enforcement of access controls on customer information systems, including controls to authenticate and permit access only to authorized individuals and to prevent employees from providing customer information to unauthorized individuals who may seek to obtain this information through fraudulent means.
—Access restrictions at physical locations containing customer information, such as buildings, computer facilities, and records storage facilities to permit access only to authorized individuals.
—Encryption of electronic customer information, including while in transit or in storage on networks or systems to which unauthorized individuals may gain access.
—Procedures designed to ensure that customer information system modifications are consistent with the institution’s information security program.
—Dual control procedures, segregation of duties, and employee background checks for employees with responsibilities for or access to customer information.
—Monitoring systems and procedures to detect actual and attempted attacks on or intrusions into customer information systems.
—Response programs that specify actions to be taken when the institution suspects or detects that unauthorized individuals have gained access to customer information systems, including appropriate reports to regulatory and law enforcement agencies.
—Measures to protect against destruction, loss, or damage of customer information due to potential environmental hazards, such as fire and water damage or technological failures.

The Interagency Guidelines require a financial institution to determine whether to adopt controls to authenticate and permit only authorized individuals access to certain forms of customer information. Under this control, a financial institution also should consider the need for a firewall to safeguard confidential electronic records. If the institution maintains Internet or other external connectivity, its systems may require multiple firewalls with adequate capacity, proper placement, and appropriate configurations.

Similarly, the institution must consider whether its risk assessment warrants encryption of electronic customer information. If it does, the institution must adopt necessary encryption measures that protect information in transit, in storage, or both. The Interagency Guidelines do not impose specific authentication or encryption standards, so it is advisable for CFEs to consult outside experts on the technical details applicable to your client institution’s security requirements especially when conducting after the fact fraud examinations.

The financial institution also must consider the use of an intrusion detection system to alert it to attacks on computer systems that store customer information. In assessing the need for such a system, the institution should evaluate the ability, or lack thereof, of its staff to rapidly and accurately identify an intrusion. It also should assess the damage that could occur between the time an intrusion occurs and the time the intrusion is recognized and action is taken.

The regulatory agencies have also provided our clients with requirements for responding to information breaches. These are contained in a related document entitled Interagency Guidance on Response Programs for Unauthorized Access to Customer Information and Customer Notice (Incident Response Guidance). According to the Incident Response Guidance, a financial institution should develop and implement a response program as part of its information security program. The response program should address unauthorized access to or use of customer information that could result in substantial harm or inconvenience to a customer.

Finally, the Interagency Guidelines require financial institutions to train staff to prepare and implement their information security programs. The institution should consider providing specialized training to ensure that personnel sufficiently protect customer information in accordance with its information security program.

For example, an institution should:

—Train staff to recognize and respond to schemes to commit fraud or identity theft, such as guarding against pretext spam calling.
—Provide staff members responsible for building or maintaining computer systems and local and wide area networks with adequate training, including instruction about computer security.
—Train staff to properly dispose of customer information.

Trust but Check

The community support for a business, and business in general, depends on the credibility that stakeholders place in corporate commitments, the company’s reputation, and the strength of its competitive advantage. All of these depend on the trust that stakeholders place in a company’s activities. Trust, in turn, depends on the values underlying corporate activities. Off-shore accounts, manipulation of shell corporations to evade taxes, loan fraud and management self-dealing are just a few instances of the moral cancer that, drop by drop, erodes trust until the point where the free enterprise systems of democratic nations are replaced by naked oligarchy, kleptocracy and cultures of corruption.

If the interests of all stakeholders are systematically not respected, then action that continues to be often painful to shareholders, officers, and directors usually occurs. In fact, it is unlikely that businesses or professions can achieve their long-run strategic objectives without the support of key stakeholders, such as shareholders, employees, customers, creditors, suppliers, governments, and host communities.

A constant theme and trend (as echoed in the trade press) has become increasingly more evident since the turn of the century. The judgment and moral character of executives, owners, boards of directors, and auditors has been often insufficient, on their own, to prevent increasingly severe corporate, ethical, and governance scandals. Governments and regulators world-wide have been required to constantly tighten guidelines and governance regulations to assure the protection of the public. The self-interested lure of greed has proven to be too strong for many to resist, and they have succumbed to conflicts of interest when left too much on their own. Corporations that were once able to shift jurisdictions to avoid new regulations regarding tax and other matters now are facing global measures designed to expose and control questionable ethics and governance practices. Assurance professionals themselves, of all types, are also facing international standards of behavior.

These changes have come about because of the pressures brought to bear on corporations and management by the reporting of scandals and abuses by a still potent free press and by suits by activist investors and other involved stakeholders. But changes in laws, regulations, and standards are only part of what stakeholders have contributed. The expectations for good ethical behavior and good governance practices have changed. Failure to comply with these expectations now impacts reputations, profits, and careers even if the behavior is strictly within legal boundaries.

As ACFE training tells us, it’s become increasingly evident to most executives, owners, and auditors that their individual success is directly related to their ability to develop and maintain a corporate culture of integrity. They cannot afford the loss of reputation, revenue, reliability, and credibility as a result of a loss of integrity. It is no longer an effective, sustainable, or medium or long-term strategy to project or practice questionable ethics. ACFE training goes on to indicate a number of causes, or signs, of ethical problems within any given corporation:

— Pressure to meet goals, especially financial ones, at any cost;
–A culture that does not foster open and candid conversation and discussion;
–A CEO who is surrounded by people who will agree and flatter the CEO, as well as a CEO whose reputation is ‘beyond criticism’;
–Weak boards that do not exercise their fiduciary responsibilities with diligence;
–An organization that promotes people on the basis of nepotism and favoritism;
–Hubris. The arrogant belief that rules are for other people, but not for us;
–A flawed cost/benefit attitude that suggests that poor ethical behavior in one area can be offset by good ethical behavior in another area.

The LIBOR rate scandal of 2012 is an almost perfect example of ethical collapse and manifests a majority of the red flags enumerated above. The scandal featured the systematic manipulation of a benchmark interest rate, supported by a culture of fraud in the world’s biggest banks, in an environment where little or no regulation prevailed. After decades of abuse that enriched the big banks, their shareholders, executives and traders, at the expense of others, investigations and lawsuits were finally undertaken resulting in prosecutions and huge penalties for the banks and the individual traders involved.

The London Interbank Offered Rate (LIBOR) rate is a rate of interest, first computed in 1985 by the British Banking Association (BBA), the Bank of England and others, to serve as a readily available reference or benchmark rate for many financial contracts and arrangements. Prior to its creation, contracts utilized many privately negotiated rates, which were difficult to verify, and not necessarily related to the market rate for the security in question. The LIBOR rate, which is the average interest rate estimated by leading banks that they would be charged if they were to borrow from other banks, provided a simple alternative that came to be widely used.

At the time of the LIBOR scandal, 18 of the largest banks in the world provided their estimates of the costs they would have had to pay for a variety of interbank loans (loans from other banks) just prior to 11:00 a.m. on the submission day. These estimates were submitted to Reuters news agency (who acted for the BBA) for calculation of the average, and its publication, and dissemination. Reuters set aside the four highest and four lowest estimates and averaged the remaining ten.

So huge were the investments affected that a small manipulation in the LIBOR rate could have a very significant impact on the profit of the banks and of the traders involved in the manipulation.

Insiders to the banking system knew about the manipulation of LIBOR rate submissions for decades, but changes were not made until the public became aware of the problem, and until the U.S. Department of Justice (DOJ) forced the U.K. government to act. The president of the New York Federal Reserve Bank (Fed), at that time emailed the governor of the Bank of England in June 2008, suggesting ways to “enhance” LIBOR. Although ensuing emails report agreement on the suggestions, and articles appeared in the trade press from 2008 to 2011, serious changes were not applied until October 2012 when the U.K. government accepted the recommendations of the Wheatley Review of Libor. This Review by Martin Wheatley, managing director of British Financial Services Authority, was commissioned in June 2012 in view of investigations, charges and settlements that were raising public awareness of LIBOR deficiencies.

One of the motivations for creating the Wheatley Review involved the prosecution of a former UBS and later Citigroup Inc. trader, on criminal fraud charges for manipulating the LIBOR rates. The trader, known to insiders as the “Rain Man” for his abilities and demeanor, allegedly sought his superiors approval before attempting to influence the LIBOR rates, an act that some observers thought at the time would provide a strong defense against conviction.

Insiders who knew of LIBOR manipulations were generally reluctant to take a public stand for earlier change. However, on July 27, 2012, a former trader for Morgan Stanley in London, published an article that told of his earlier attempts to bring LIBOR rate manipulations to the attention of authorities, but without success. In his article, he indicated how he learned as a new trader in 1991 that the banks manipulated their rate submissions to make profit on specific contracts, and to mask liquidity problems such as during the subprime lending crisis of 2008. For example, if the LIBOR rate submissions were misstated to be low, the discounted valuation of related assets would be raised, thus providing misleadingly higher levels of short-term, near-cash assets than should have been reported.

Numerous studies since the scandal have detailed the effects of unethical LIBOR manipulation. Just two examples of such manipulation. At the time of the scandal many home owners borrowed their mortgage loans on a variable- or adjustable-rate basis, rather than a fixed-rate basis. Consequently, many of these borrowers received a new rate at the first of every month based on the LIBOR rate. A study prepared for a class action lawsuit has shown that on the first of each month for the period 2007-2009, the LIBOR rate rose more than 7.5 basis points on average. As a consequence, one observer estimated that each LIBOR submitting bank may be liable for as much as $2.3 billion.

Municipalities raise funds through the issue of bonds, and many were encouraged to issue variable-rate, rather than fixed-rate, bonds to take advantage of lower interest payments. For example, the saving could be as much as $1 million on a $100 million bond. After issue, the municipalities were encouraged to buy interest rate swaps from their investment banks to hedge their risk of volatility in the variable rates by converting or swapping into a fixed rate arrangement. The seller of the swap agrees to pay the municipality for any requirement to pay interest at more than the fixed rate agreed if interest rates rise, but if interest rates fall the swap seller buys the bonds at the lower variable interest rate. However, the variable rate was linked to the LIBOR rate, which was artificially depressed, thus costing U.S. municipalities as much as $10 billion. Class action suits were eventually launched to recover these losses, which cost municipalities, hospitals, and other non-profits as much as $600 million a year.

At the end of the day, trust in each other and in our counter-parties is all we really have as economic actors; CFE’s and forensic accountants thus have a vital role to play in investigating, documenting and assisting in the identification and possible prosecution of those who, like the LIBOR manipulators, knowingly collude in making the choice to violate that trust.

Using Control to Foster a Culture of Honesty

One of the most frequent questions we seem to receive as practicing CFEs from clients and corporate counsel alike regards the proactive steps management can take to create what’s commonly designated a ‘culture of honesty’. What kinds of programs and controls can an entity implement to create such a culture and to prevent fraud?

The potential of being caught most often persuades likely perpetrators not to commit a contemplated fraud. As the ACFE has long told us, because of this principle, the existence of a thorough control system is essential to any effective program of fraud prevention and constitutes one of the most vital underpinnings of an honest culture.

Corporations and other organizations can be held liable for criminal acts committed as a matter of organizational policy. Fortunately, most organizations do not expressly set out to break the law. However, corporations and other organizations may also be held liable for the criminal acts of their employees if those acts are perpetrated in the course and scope of their employment and for the ostensible purpose of benefiting the corporation. An employee’s acts are considered to be in the course and scope of employment if the employee has actual authority or apparent authority to engage in those acts. Apparent authority means that a third party would reasonably believe the employee is authorized to perform the act on behalf of the company. Therefore, an organization could be held liable for something an employee does on behalf of the organization even if the employee is not authorized to perform that act.

An organization will not be vicariously liable for the acts of an employee unless the employee acted for the ostensible purpose of benefiting the corporation. This does not mean the corporation has to receive an actual benefit from the illegal acts of its employee. All that is required is that the employee intended to benefit the corporation. A company cannot seek to avoid vicarious liability for the acts of its employees by simply claiming that it did not know what was going on. Legally speaking, an organization is deemed to have knowledge of all facts known by its officers and employees. That is, if a prosecutor can prove that an officer or employee knew of conduct that raised a question as to the company’s liability, and the prosecutor can show that the company willfully failed to act to correct the situation, then the company may be held liable, even if senior management had no knowledge or suspicion of the wrongdoing.

In addition, the evolving legal principle of ‘conscious avoidance’ allows the government to prove the employer had knowledge of a particular fact which establishes liability by showing that the employer knew there was a high probability the fact existed and consciously avoided confirming the fact. Employers cannot simply turn a blind eye when there is reason to believe that there may be criminal conduct within the organization. If steps are not taken to deter the activity, the company itself may be found liable. The corporation can be held criminally responsible even if those in management had no knowledge of participation in the underlying criminal events and even if there were specific policies or instructions prohibiting the activity undertaken by the employee(s). The acts of any employee, from the lowest clerk on up to the CEO, can impute liability upon a corporation. In fact, a corporation can be criminally responsible for the collective knowledge of several of its employees even if no single employee intended to commit an offense. Thus, the combination of vicarious or imputed corporate criminal liability and the current U.S. Sentencing Guidelines for Organizations can create a risk for corporations today.

Although many of our client companies do not realize it, the current legal environment imposes a responsibility on companies to ferret out employee misconduct and to deal with any known or suspected instances of misconduct by taking timely and decisive measures.

First, the doctrine of accountability suggests that officers and directors aware of potentially illegal conduct by senior employees may be liable for any recurrence of similar misconduct and may have an obligation to halt and cure any continuing effects of the initial misconduct.

Second, the Corporate Sentencing Guidelines, provide stiff penalties for corporations that fail to take voluntary action to redress apparent misconduct by senior employees.

Third, the Private Litigation Securities Reform Act requires, as a matter of statute, that independent auditors look for, and assess, management’s response to indications of fraud or other potential illegality. Where the corporation does not have a history of responding to indications of wrongdoing, the auditors may not be able to reach a conclusion that the company took appropriate and prompt action in response to indications of fraud.

Fourth, courts have held that a director’s duty of care includes a duty to attempt in good faith to assure corporate information and reporting systems exist. These systems must be reasonably designed to provide senior management and the board of directors timely, accurate information which would permit them to reach informed judgments concerning the corporation’s compliance with law and its business performance. In addition, courts have also stated that the failure to create an adequate compliance system, under some circumstances, could render a director liable for losses caused by non-compliance with applicable legal standards. Therefore, directors should make sure that their companies have a corporate compliance plan in place to detect misconduct and deal with it effectively. The directors should then monitor the company’s adherence to the compliance program. Doing so will help the corporation avoid fines under the Sentencing Guidelines and help prevent individual liability on the part of the directors and officers.

The control environment sets the moral tone of an organization, influencing the control consciousness of the organization and providing a foundation for all other control components. This component considers whether managers and employees within the organization exhibit integrity in their activities. COSO envisions that upper management will be responsible for the control environment of organizations. Employees look to management for guidance in most business affairs, and organizational ethics are no different. It is important for upper management to operate in an ethical manner, and it is equally important for employees to view management in a positive light. Managers must set an appropriate moral tone for the operations of an organization.

In addition to merely setting a good example, however, COSO suggests that upper management take direct control of an organization’s efforts at internal controls. This idea should be regularly reinforced within the organization. There are several actions that management can take to establish the proper control environment for an organization and foster a culture of honesty. These include:

–The establishment of a code of ethics for the organization. The code should be disseminated to all employees and every new employee should be required to read and sign it. The code should also be disseminated to contractors who do work on behalf of the organization. Under certain circumstances, companies may face liability due to the actions of independent contractors. It is therefore very important to explain the organization’s standards to any outside party with whom the organization conducts business.

–Careful screening of job applicants. One of the easiest ways to establish a strong moral tone for an organization is to hire morally sound employees. Too often, the hiring process is conducted in a slipshod manner. Organizations should conduct thorough background checks on all new employees, especially managers. In addition, it is important to conduct thorough interviews with applicants to ensure that they have adequate skills to perform the duties that will be required of them.

–Proper assignment of authority and responsibility. In addition to hiring qualified, ethical employees, it is important to put these people in situations where they are able to thrive without resorting to unethical conduct. Organizations should provide employees with well-defined job descriptions and performance goals. Performance goals should be routinely reviewed to ensure that they do not set unrealistic standards. Training should be provided on a consistent basis to ensure that employees maintain the skills to perform effectively. Regular training on ethics will also help employees identify potential trouble spots and avoid getting caught in compromising situations. Finally, management should quickly determine where deficiencies in an employee’s conduct exist and work with the employee to fix the problem.

–Effective disciplinary measures. No control environment will be effective unless there is consistent discipline for ethical violations. Consistent discipline requires a well-defined set of sanctions for violations, and strict adherence to the prescribed disciplinary measures. If one employee is punished for an act and another employee is not punished for a similar act, the moral force of the company’s ethics policy will be diminished. The levels of discipline must be sufficient to deter violations. It may also be advisable to reward ethical conduct. This will reinforce the importance of organizational ethics in the eyes of employees.

Monitoring is the process that assesses the quality of a control environment over time. This component should include regular evaluations of the entire control system. It also requires the ongoing monitoring of day-to-day activities by managers and employees. This may involve reviewing the accuracy of financial information, or verifying inventories, supplies, equipment and other organization assets. Finally, organizations should conduct independent evaluations of their internal control systems. An effective monitoring system should provide for the free flow of upstream communication.

Concealment Strategies & Fraud Scenarios

I remember Joseph Wells mentioning at an ACFE conference years ago that identifying the specific asset concealment strategy selected by a fraudster was often key to the investigator’s subsequent understanding of the entire fraud scenario the fraudster had chosen to implement. What Joe meant was that a fraud scenario is the unique way the inherent fraud scheme has occurred (or can occur) at an examined entity; therefore, a fraud scenario describes how an inherent fraud risk will occur under specific circumstances. Upon identification, a specific fraud scenario, and its associated concealment strategy, become the basis for fraud risk assessment and for the examiner’s subsequent fraud examination program.

Fraud concealment involves the strategies used by the perpetrator of the fraud scenario to conceal the true intent of his or her transaction(s). Common concealment strategies include false documents, false representations, false approvals, avoiding or circumventing control levels, internal control evasion, blocking access to information, enhancing the effects of geographic distance between documents and controls, and the application of both real and perceived pressure. Wells also pointed out that an important aspect of fraud concealment pertains to the level of sophistication demonstrated by the perpetrator; the connection between concealment strategies and fraud scenarios is essential in any discussion of fraud risk structure.

As an example, consider a rights of return fraud scenario related to ordered merchandise. Most industries allow customers to return products for any number of reasons. Rights of return refers to circumstances, whether as a matter of contract or of existing practice, under which a product may be returned after its sale either in exchange for a cash refund, or for a credit applied to amounts owed or to be owed for other products, or in exchange for other products. GAAP allows companies to recognize revenue in certain cases, even though the customer may have a right of return. When customers are given a right of return, revenue may be recognized at the time of sale if the sales price is substantially fixed or determinable at the date of sale, the buyer has paid or is obligated to pay the seller, the obligation to pay is not contingent on resale of the product, the buyer’s obligation to the seller does not change in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale is economically separate from the seller, the seller does not have significant obligations for future performance or to bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.

Sales revenue not recognizable at the time of sale is recognized either once the return privilege has substantially expired or if the conditions have been subsequently met. Companies sometimes stray by establishing accounting policies or sales agreements that grant customers vague or liberal rights of returns, refunds, or exchanges; that fail to fix the sales price; or that make payment contingent upon resale of the product, receipt of funding from a lender, or some other future event. Payment terms that extend over a substantial portion of the period in which the customer is expected to use or market the purchased products may also create problems. These terms effectively create consignment arrangements, because, no economic risk has been transferred to the purchaser.

Frauds in connection with rights of return typically involve concealment of the existence of the right, either by contract or arising from accepted practice, and/or departure from GAAP specified conditions. Concealment usually takes one or more of the following forms:

• Use of side letters: created and maintained separate and apart from the sales contract, that provide the buyer with a right of return;

• Obligations by oral promise or some other form of understanding between seller and buyer that is honored as a customary practice but arranged covertly and hidden;

• Misrepresentations designed to mischaracterize the nature of arrangements, particularly in respect of:

–Consignment arrangements made to appear to be final sales;

–Concealment of contingencies, under which the buyer can return the products, including failure to resell the products, trial periods, and product performance conditions;

–Failure to disclose the existence, or extent, of stock rotation rights, price protection concessions, or annual returned-goods limitations;

–Arrangement of transactions, with straw counterparties, agents, related parties, or other special purpose entities in which the true nature of the arrangements is concealed or obscured, but, ultimately, the counterparty does not actually have any significant economic risk in the “sale”.

Sometimes the purchaser is complicit in the act of concealment, for example, by negotiating a side letter, and this makes detection of the fraud even more difficult. Further, such frauds often involve collusion among several individuals within an organization, such as salespersons, their supervisors, and possibly both marketing and financial managers.

It’s easy to see that once a CFE has identified one or more of these concealment strategies as operative in a given entity, the process of developing a descriptive fraud scenario, completing a related risk assessment and constructing a fraud examination program will be a relatively straight forward process. As a working example, of a senario and related concealment strategies …

Over two decades ago the SEC charged a major computer equipment manufacturer with overstating revenue in the amount of $500,000 on transactions for which products had been shipped, but for which, at the time of shipment, the company had no reasonable expectation that the customer would accept and pay for the products. The company eventually accepted back most of the product as sales returns during the following quarter.

The SEC noted that the manufacturer’s written distribution agreements generally allowed the distributor wide latitude to return product to the company for credit whenever the product was, in the distributor’s opinion, damaged, obsolete, or otherwise unable to be sold. According to the SEC, in preparing the manufacturer’s financial statements for the target year, company personnel submitted a proposed allowance for future product returns that was unreasonably low in light of the high level of returns the manufacturer had received in the first several months of the year.

The SEC determined that various officers and employees in the accounting and sales departments knew the exact amount of returns the company had received before the year end, when the company’s independent auditors finished their fieldwork on the annual audit. Had the manufacturer revised the allowance for sales returns to reflect the returns information, the SEC concluded it would have had to reduce the net revenue reported for the fiscal year. Instead, the SEC found that several of the manufacturer’s officers and employees devised schemes to prevent the auditors from discovering the true amount of the returns, including 1), keeping the auditors away from the area at the manufacturer’s headquarters where the returned goods were stored, and 2), accounting personnel altering records in the computer system to reduce the level of returns. After all the facts were assembled, the SEC took disciplinary action against several company executives.

As with side agreements, a broad base of inquiry into company practices may be one of the best assessment techniques the CFE has regarding possible concealment strategies supporting fraud scenarios involving returns and exchanges. In addition to inquiries of this kind, the ACFE recommends that CFE’s may consider using analytics like:

• Compare returns in the current period with prior periods and ask about unusual increases.

• Because companies may slow the return process to avoid reducing sales in the current period, determine whether returns are processed in timely fashion. The facts can also be double-checked by confirming with customers.

• Calculate the sales return percentage (sales returns divided by total sales) and ask about any unusual increase.

• Compare returns after a reporting period with both the return reserve and the monthly returns to determine if they appear reasonable.

• Determine whether sales commissions are paid at the time of sale or at the time of collection. Sales commissions paid at the time of sale provide incentives to inflate sales artificially to meet internal and external market pressures.

• Determine whether product returns are adjusted from sales commissions. Sales returns processed through the so-called house account may provide a hidden mechanism to inflate sales to phony customers, collect undue commissions, and return the product to the vendor without being penalized by having commissions adjusted for the returned goods.

Analytics Confronts the Normal

The Information Audit and Control Association (ISACA) tells us that we produce and store more data in a day now than mankind did altogether in the last 2,000 years. The data that is produced daily is estimated to be one exabyte, which is the computer storage equivalent of one quintillion bytes, which is the same as one million terabytes. Not too long ago, about 15 years, a terabyte of data was considered a huge amount of data; today the latest Swiss Army knife comes with a 1 terabyte flash drive.

When an interaction with a business is complete, the information from the interaction is only as good as the pieces of data that get captured during that interaction. A customer walks into a bank and withdraws cash. The transaction that just happened gets stored as a monetary withdrawal transaction with certain characteristics in the form of associated data. There might be information on the date and time when the withdrawal happened; there may be information on which customer made the withdrawal (if there are multiple customers who operate the same account). The amount of cash that was withdrawn, the account from which the money was extracted, the teller/ATM who facilitated the withdrawal, the balance on the account after the withdrawal, and so forth, are all typically recorded. But these are just a few of the data elements that can get captured in any withdrawal transaction. Just imagine all the different interactions possible on all the assorted products that a bank has to offer: checking accounts, savings accounts, credit cards, debit cards, mortgage loans, home equity lines of credit, brokerage, and so on. The data that gets captured during all these interactions goes through data-checking processes and gets stored somewhere internally or in the cloud.  The data that gets stored this way has been steadily growing over the past few decades, and, most importantly for fraud examiners, most of this data carries tons of information about the nuances of the individual customers’ normal behavior.

In addition to what the customer does, from the same data, by looking at a different dimension of the data, examiners can also understand what is normal for certain other related entities. For example, by looking at all the customer withdrawals at a single ARM, CFEs can gain a good understanding of what is normal for that particular ATM terminal.  Understanding the normal behavior of customers is very useful in detecting fraud since deviation from normal behavior is a such a primary indicator of fraud. Understanding non-fraud or normal behavior is not only important at the main account holder level but also at all the entity levels associated with that individual account. The same data presents completely different information when observed in the context of one entity versus another. In this sense, having all the data saved and then analyzed and understood is a key element in tackling the fraud threat to any organization.

Any systematic, numbers-based system of understanding of the phenomenon of fraud as a past occurring event is dependent on an accurate description of exactly what happened through the data stream that got accumulated before, during, and after the fraud scenario occurred. Allowing the data to speak is the key to the success of any model-based system. This data needs to be saved and interpreted very precisely for the examiner’s models to make sense. The first crucial step to building a model is to define, understand, and interpret fraud scenarios correctly. At first glance, this seems like a very easy problem to solve. In practical terms, it is a lot more complicated process than it seems.

The level of understanding of the fraud episode or scenario itself varies greatly among the different business processes involved with handling the various products and functions within an organization. Typically, fraud can have a significant impact on the bottom line of any organization. Looking at the level of specific information that is systematically stored and analyzed about fraud in financial institutions for example, one would arrive at the conclusion that such storage needs to be a lot more systematic and rigorous than it typically is today. There are several factors influencing this. Unlike some of the other types of risk involved in client organizations, fraud risk is a censored problem. For example, if we are looking at serious delinquency, bankruptcy, or charge-off risk in credit card portfolios, the actual dollars-at-risk quantity is very well understood. Based on past data, it is relatively straightforward to quantify precise credit dollars at risk by looking at how many customers defaulted on a loan or didn’t pay their monthly bill for three or more cycles or declared bankruptcy. Based on this, it is easy to quantify the amount at risk as far as credit risk goes. However, in fraud, it is virtually impossible to quantify the actual amount that would have gone out the door as the fraud is stopped immediately after detection. The problem is censored as soon as some intervention takes place, making it difficult to precisely quantify the potential risk.

Another challenge in the process of quantifying fraud is how well the fraud episode itself gets recorded. Consider the case of a credit card number getting stolen without the physical card getting stolen. During a certain period, both the legitimate cardholder and the fraudster are charging using the card. If the fraud detection system in the issuing institution doesn’t identify the fraudulent transactions as they were happening in real time, typically fraud is identified when the cardholder gets the monthly statement and figures out that some of the charges were not made by him/her. Then the cardholder calls the issuer to report the fraud.  In the not too distant past, all that used to get recorded by the bank was the cardholder’s estimate of when the fraud episode began, even though there were additional details about the fraudulent transactions that were likely shared by the cardholder. If all that gets recorded is the cardholder’s estimate of when the fraud episode began, ambiguity is introduced regarding the granularity of the actual fraud episode. The initial estimate of the fraud amount becomes a rough estimate at best.
In the case in which the bank’s fraud detection system was able to catch the fraud during the actual fraud episode, the fraudulent transactions tended to be recorded by a fraud analyst, and sometimes not too accurately. If the transaction was marked as fraud or non-fraud incorrectly, this problem was typically not corrected even after the correct information flowed in. When eventually the transactions that were actually fraudulent were identified using the actual postings of the transactions, relating this back to the authorization transactions was often not a straightforward process. Sometimes the amounts of the transactions may have varied slightly. For example, the authorization transaction of a restaurant charge is sometimes unlikely to include the tip that the customer added to the bill. The posted amount when this transaction gets reconciled would look slightly different from the authorized amount. All of this poses an interesting challenge when designing a data-driven analytical system to combat fraud.

The level of accuracy associated with recording fraud data also tends to be dependent on whether the fraud loss is a liability for the customer or to the financial institution. To a significant extent, the answer to the question, “Whose loss is it?” really drives how well past fraud data is recorded. In the case of unsecured lending such as credit cards, most of the liability lies with the banks, and the banks tend to care a lot more about this type of loss. Hence systems are put in place to capture this data on a historical basis reasonably accurately.

In the case of secured lending, ID theft, and so on, a significant portion of the liability is really on the customer, and it is up to the customer to prove to the bank that he or she has been defrauded. Interestingly, this shift of liability also tends to have an impact on the quality of the fraud data captured. In the case of fraud associated with automated clearing house (ACH) batches and domestic and international wires, the problem is twofold: The fraud instances are very infrequent, making it impossible for the banks to have a uniform method of recording frauds; and the liability shifts are dependent on the geography.  Most international locations put the onus on the customer, while in the United States there is legislation requiring banks to have fraud detection systems in place.

The extent to which our client organizations take responsibility also tends to depend on how much they care about the customer who has been defrauded. When a very valuable customer complains about fraud on her account, a bank is likely to pay attention.  Given that most such frauds are not large scale, there is less need to establish elaborate systems to focus on and collect the data and keep track of past irregularities. The past fraud information is also influenced heavily by whether the fraud is third-party or first-party fraud. Third-party fraud is where the fraud is committed clearly by a third party, not the two parties involved in a transaction. In first-party fraud, the perpetrator of the fraud is the one who has the relationship with the bank. The fraudster in this case goes to great lengths to prevent the banks from knowing that fraud is happening. In this case, there is no reporting of the fraud by the customer. Until the bank figures out that fraud is going on, there is no data that can be collected. Also, such fraud could go on for quite a while and some of it might never be identified. This poses some interesting problems. Internal fraud where the employee of the institution is committing fraud could also take significantly longer to find. Hence the data on this tends to be scarce as well.

In summary, one of the most significant challenges in fraud analytics is to build a sufficient database of normal client transactions.  The normal transactions of any organization constitute the baseline from which abnormal, fraudulent or irregular transactions, can be identified and analyzed.  The pinpointing of the irregular is thus foundational to the development of the transaction processing edits which prevent the irregular transactions embodying fraud from even being processed and paid on the front end; furnishing the key to modern, analytically based fraud prevention.

First Things First

About a decade ago, I attended a training session at the Virginia State Police training center conducted by James D. Ratley, then the training director for the ACFE. The training session contained some valuable advice for CFE’s and forensic accountants on immediate do’s and don’ts if an examiner strongly suspects the presence of employee perpetrated financial fraud within a client’s organization. Mr. Ratley’s counsel is as relevant today as it was then.

Ratley advised that every significant employee matter (whether a theft is involved or not) requires thoughtful examiner deliberation before any action is taken, since hasty moves will likely prove detrimental to both the investigator and to the client company. Consequently, knowing what should not be done if fraud is suspected is often more important to an eventual successful outcome than what should be done.

First, the investigator should not initially confront the employee with his or her suspicions until the investigator has first taken several important preliminary investigative steps.  Even when those steps have been taken, it may prove necessary to use a different method of informing the employee regarding her status, imminent material harm notwithstanding. False (or even valid) accusations can lead to defamation lawsuits or at the very least to an extremely uncomfortable work environment. The hasty investigator or management could offend an innocent person by questioning her integrity; consequently, your client company may never be able to regain that person’s trust or prior level of commitment. That downside is just one example of the collateral damage that can result from a fraud. Even if the employee is ultimately found to be guilty, an investigator’s insinuation gives him or her time to alter records and conceal the theft, and perhaps even siphon off more assets. It takes only a moment for an experienced person to erase a computer’s hard drive and shred documents. Although, virtually all business records can be reconstructed, reconstruction is a costly and time-consuming process that always aggravates an already stressful situation.

Second, as a rule, never terminate or suspend the suspect employee until the preliminary investigative steps referred to above have been taken.  The desire on the part of management to take decisive action is understandable, but hasty actions may be detrimental to the subsequent investigation and to the company. Furthermore, there may be certain advantages to continuing the person’s employment status for a brief period because his or her continued status might compel the suspect to take certain actions to your client’s or to the investigation’s benefit. This doesn’t apply to government employees since, unlike private sector employees, they cannot be compelled to participate in the investigation. There can be occasions, however, where it is necessary to immediately terminate the employee. For example, employees who serve in a position whose continued employment could put others at risk physically, financially, or otherwise may need to be terminated immediately. Such circumstances are rare, but if they do occur, management (and the CFE) should document the entire process and advise corporate counsel immediately.

Third, again, as a rule, the investigator should never share her initial suspicions with other employees unless their assistance is crucial, and then only if they are requested to maintain strict confidentiality.  The CFE places an arduous burden on anyone in whom s/he has confided. Asking an employee to shoulder such responsibilities is uncharted territory for nearly anyone (including for the examiner) and can aggravate an already stressful situation. An examiner may view the confidence placed in an employee as a reflection of his and management’s trust. However, the employee may view the uninvited responsibility as taking sides with management at the expense of his relationship with other employees. Consequently, this step should be taken only if necessary and, again, after consultation with counsel and management.

Regarding the do’s, Ratley recommended that the instant that an employee fraud matter surfaces, the investigator should begin continuous documentation of all pertinent investigation-related actions taken. Such documentation includes a chronological, written narrative composed with as much specificity as time permits. Its form can take many shapes, such as handwritten notes, Microsoft Word files, spreadsheets, emails to yourself or others, and/or relevant data captured in almost any other reproducible medium. This effort will, of course, be time consuming for management but is yet another example of the collateral damage resulting from almost any employee fraud. The documentation should also reference all direct and related costs and expenses incurred by the investigator and by the client company. This documentation will support insurance claims and be vital to a subsequent restitution process.  Other collateral business damages, such as the loss of customers, suppliers, or the negative fiscal impact on other employees may also merit documentation as appropriate.

Meetings with corporate counsel are also an important do.  An employee fraud situation is complex and fraught with risk for the investigator and for the client company. The circumstances can require broad and deep expertise in employment law, criminal law, insurance law, banking law, malpractice law, and various other legal concentrations. Fortunately, most corporate attorneys will acknowledge when they need to seek additional expertise beyond their own experience since a victim company counsel specializing in corporate matters may have little or no background in matters of fraud. Acknowledgment by an attorney that s/he needs additional expertise is a testament to his or her integrity. Furthermore, the client’s attorney may contribute value by participating throughout the duration of the investigation and possible prosecution and by bringing to bear his or her cumulative knowledge of the company to the benefit of the organization.

Next, depending on the nature of the fraud and on the degree of its fiscal impact, CFEs should meet with the client’s CPA firm but exercise caution. The client CPA may be well versed in their involvement with your client through their work on income taxes, audit, review, and compilations, but not in forensic analysis or fraud examination. Larger CPA firms may have departments that they claim specialize in financial forensics; the truth is that actual experience in these matters can vary widely. Furthermore, remember that the situation occurred under your client CPA’s watch, so the firm may not be free of conflict.

Finally, do determine from management as early as possible the range of actions it might want to take with respect to the suspect employee if subsequent investigation confirms the suspicion that fraud has indeed occurred.  Deciding how to handle the matter of what to do with the employee by relying upon advice from management and from the legal team can be quite helpful in shaping what investigative steps are taken subsequently. Ratley pointed out that the level and availability of evidence often drive actions relating to the suspect. For example, the best course of action for management may be to do nothing immediately, to closely monitor and document the employee’s activities, to suspend the employee with pay, or immediately terminate the suspect’s employment. There may be valid reasons to exercise any one of these options.

Let’s say the CFE is advised by management to merely monitor and document the employee’s activities since the CFE currently lacks sufficient evidence to suspend or terminate the employee immediately. The CFE and the client’s IT operation could both be integral parts of this option by designing a plan to protect the client from further loss while the investigation continues behind the scenes. The investigation can take place after hours or under the guise of an “efficiency audit,” “business planning,” or other designation. In any case, this option will probably require the investigator to devote substantial time to observe the employee and to concurrently conduct the investigation.   The CFE will either assemble sufficient evidence to proceed or conclude there is inadequate substantiation to support the accusation.

A fraud is a devastating event for any company but Mr. Ratley’s guidance about the first steps in an investigation of employee perpetrated financial fraud can help minimize the damage.  He concluded his remarks by making two additional points; first, few executives are familiar by experience with situations that require CFE or forensic accountant expertise; consequently, their often-well-meaning actions when confronted with the actuality of a fraud can result in costly mistakes regarding time, money and people. Although many such mistakes can be repaired given sufficient money and time, they are sometimes devastating and irrecoverable.  Second, attorneys, accountants and others in the service professions frequently lack sufficient experience to recognize the vast differences between civil and criminal processes.  Consequently, these professionals often can provide the best service to their corporate clients by referring and deferring to more capable fraud examination specialists like certified fraud examiners and experienced forensic accountants.

People, People & People

Our Chapter’s Vice-President Rumbi Petrolozzi’s comment in her last blog post to the effect that one of the most challenging tasks for the forensic accountant or auditor working proactively is defining the most effective and efficient scope of work for a risk-based assurance project. Because resources are always scarce, assurance professionals need to make sure they can meet both quality and scheduling requirements whilst staying within our fixed resource and cost constraints.

An essential step in defining the scope of a project is identifying the critical risks to review and the controls required to manage those risks. An efficient scope focuses on the subset of controls (i.e., the key controls) necessary to provide assurance. Performing tests of controls that are not critical is not efficient. Similarly, failing to test controls that could be the source of major fraud vulnerabilities leads to an ineffective audit.  As Rumbi points out, and too often overlooked, the root cause of most risk and control failures is people. After all, outstanding people are required to make an organization successful, and failing to hire, retain, and train a competent team of employees inevitably leads to business failure.

In an interview, a few decades ago, one of America’s most famous business leaders was asked what his greatest challenges were in turning one of his new companies around from failure to success. He is said to have responded that his three greatest challenges were “people, people, and people.” Certainly, when assurance professionals or management analyze the reasons for data breaches and control failures, people are generally found to be the root cause. For example, weaknesses may include (echoing Rumbi):

Insufficiently trained personnel to perform the work. A common material weakness in compliance with internal control over financial reporting requirements is a lack of experienced financial reporting personnel within a company. In more traditional anti-fraud process reviews, examiners often find that control weaknesses arise because individuals don’t understand the tasks they have to perform.

Insufficient numbers to perform the work. When CPAs find that important reconciliations are not performed timely, inventories are not counted, a backlog in transaction processing exists, or agreed-upon corrective actions to address prior audit findings aren’t completed, managers frequently offer the excuse that their area is understaffed.

Poor management and leadership. Fraud examiners find again and again, that micromanagers and dictators can destroy a solid finance function. At the other end of the spectrum, the absence of leadership, motivation, and communication can cause whole teams to flounder. Both situations generally lead to a failure to perform key controls consistently. For example, poor managers have difficulty retaining experienced professionals to perform account reconciliations on time and with acceptable levels of quality leading directly to an enhanced level of vulnerability to numerous fraud scenarios.

Ineffective human resource practices. In some cases, management may choose to accept a certain level of inefficiency and retain individuals who are not performing up to par. For instance, in an example cited by one of our ACFE training event speakers last year, the financial analysis group of a U.S. manufacturing company was failing to provide management with timely business information. Although the department was sufficiently staffed, the team members were ineffective. Still, management did not have the resolve to terminate poor performers, for fear it would not be possible to hire quality analysts to replace the people who were terminated.

In such examples, people-related weaknesses result in business process key control failures often leading to the facilitation of subsequent frauds. The key control failure was the symptom, and the people-related weakness was the root cause. As a result, the achievement of the business objective of fraud prevention is rendered at risk.

Consider a fraud examiner’s proactive assessment of an organization’s procurement function. If the examiner finds that all key controls are designed adequately and operating effectively, in compliance with company policy, and targeted cost savings are being generated, should s/he conclude the controls are adequate? What if that department has a staff attrition rate of 25 percent and morale is low? Does that change the fraud vulnerability assessment? Clearly, even if the standard set of controls were in place, the function would not be performing at optimal levels.  Just as people problems can lead to risk and control failures, exceptional people can help a company achieve success. In fact, an effective system of internal control considers the adequacy of controls not only to address the risks related to poor people-related management but also to recognize reduction in fraud vulnerability due to excellence in people-related management.

The people issue should be addressed in at least two phases of the assurance professional’s review process: planning and issue analysis (i.e., understanding weaknesses, their root cause, and the appropriate corrective actions).  In the planning phase, the examiner should consider how people-related anti-fraud controls might impact the review and which controls should be included in the scope. The following questions might be considered in relation to anti-fraud controls over staffing, organization, training, management and leadership, performance appraisals, and employee development:

–How significant would a failure of people-related controls be to the achievement of objectives and the management of business risk covered by the examination?
–How critical is excellence in people management to the achievement of operational excellence related to the objectives of the review?

Issue analysis requires a different approach. Reviewers may have to ask the question “why” three or more times before they get to the root cause of a problem. Consider the following little post-fraud dialogue (we’ve all heard variations) …

CFE: “Why weren’t the reconciliations completed on time?”
MANAGER. “Because we were busy closing the books and one staff member was on vacation.”
CFE: “You are still expected to complete the reconciliations, which are critical to closing the books. Even with one person on vacation, why were you too busy?”
MANAGER: “We just don’t have enough people to get everything done, even when we work through weekends and until late at night.”
CFE: “Why don’t you have enough people?”
MANAGER: “Management won’t let me hire anybody else because of cost constraints.”
CFE: “Why won’t management let you hire anybody? Don’t they realize the issue?”
MANAGER: “Well, I think they do, but I have been so busy that I may not have done an effective job of explaining the situation. Now that you are going to write this up as a control weakness, maybe they will.”

The root cause of the problem in this scenario is that the manager responsible for reconciliations failed to provide effective leadership. She did not communicate the problem and ensure she had sufficient resources to perform the work assigned. The root cause is a people problem, and the reviewer should address that directly in his or her final report. If the CFE only reports that the reconciliations weren’t completed on time, senior management might only press the manager to perform better without understanding the post-fraud need for both performance improvement and additional staff.

In many organizations, it’s difficult for a reviewer to discuss people issues with management, even when these issues can be seen to directly and clearly contribute to fraud vulnerably. Assurance professionals may find it tricky, for political reasons to recommend the hiring of additional staff or to explain that the existing staff members do not have the experience or training necessary to perform their assigned tasks. Additionally, we are likely to run into political resistance when reporting management and leadership failure. But, that’s the job assurance professionals are expected to perform; to provide an honest, objective assessment of the condition of critical anti-fraud controls including those related to people.  If the scope of our work does not consider people risks, or if reviewers are unable to report people-related weaknesses, we are not adding the value we should. We’re also failing to report on matters critical to the maintenance and extension of the client’s anti-fraud program.

The Other Assets Dance

Studies by the ACFE and various academics have revealed over the years that, while not as common as cash schemes, employee misappropriations of other types of corporate assets than cash can sometimes prove even more disastrous than cash theft for any organization that suffers them.  The median losses associated with noncash schemes is generally higher than cash schemes, being $100,000 as opposed to $60,000.

The other asset category includes such assets as inventories of all kinds, i.e., inventory for sale, supplies and equipment and some categories of fixed assets; in short, the term inventory and other assets is generally meant to encompass misapplication schemes involving any assets held by an enterprise other than cash.  The theft of non-cash assets is generally classified by the ACFE into three groups: inventory schemes, supplies schemes and other asset schemes; of these schemes inventory related schemes account for approximately 70% of the losses while misappropriation of company supplies accounts for another 20%…the remaining losses are associated with several types of fixed assets, equipment, and corporate related information.

Those who study these types of fraud generally lump non-cash assets together for describing how these types of assets are misappropriated since the methods for misappropriation don’t vary much among the various asset types.  The asset, no matter what it is, can be misused (or “borrowed”) or it can be stolen.  Assets that are misused rather than stolen outright include company assigned vehicles, company supplies of all kinds, computers, and other office equipment.  As a very frequently occurring example, a company executive might make use of a company car when on an out of the home office assignment; false documentation (both in writing and verbally) is provided to the company by the employee regarding the nature of her use of the vehicle.  At the end of the trip, the car is returned intact and the cost to the fraudster’s company is only a few hundred dollars at most; but what we have here is, nonetheless, an instance of fraud when a false statement or declaration accompanies the use.

In contrast, the costs of inventory misuse schemes can be very costly.  To many employees, inventory fraud of some kinds is not perceived as a crime, but rather as “borrowing” and, in truth, the actual cost of borrowing a laptop to do personal computing at home may often be immaterial if the asset is returned undamaged.  On the other hand, if the employee uses the laptop to operate a side business during and after normal work hours, the consequences can be more serious for the company, especially if the employee’s business is in competition with that of the employer.  Since the employee is not performing his or her assigned work duties, the employer suffers a loss of productivity and is defrauded of that portion of the employee’s wages related to the fraud.  If the employee’s low productivity continues for any length of time, the employer might have to engage additional employees to compensate which means more capital diverted to wages.  As noted above, if the employee’s business is like that of the employer’s, lost business for the employer would be an additional cost of the scheme.  If the employee had not contracted work for his own company, the business would presumably have gone to her employer. Unauthorized use of company equipment can also mean additional wear and tear, causing company owned equipment to break down sooner than it would have under normal operating conditions.

So, what about prevention?  There are preventative measures for control of other asset related frauds which, if properly installed and operating, may help prevent employee exploits directed against all the many types of inventories maintained by a typical business:
For each type of asset inventory (for sale, supplies, equipment, etc.), the following items (as appropriate) should be pre-numbered and controlled:

–requisitions
–receiving reports
–perpetual records
–raw materials requisitions
–shipping documents
–job cost sheets

The following duties related to the distinct types of asset inventories should be handled by different employees:

–requisition of inventory
–receipt of inventory
–disbursement of inventory
–conversion of inventory to scrap
–receipt of proceeds from disposal of scrape.

Someone independent of the purchasing or warehousing function should conduct physical observation of all asset inventories according to defined schedules.  Personnel conducting physical observations of these types of assets should be knowledgeable about the inventory, i.e., what types of material it should contain, where the material should physically be, etc.  All company owned merchandise should be physically guarded and locked; and access should be limited to authorized personnel only.

The Conflicted Board

Our last post about cyberfraud and business continuity elicited a comment about the vital role of corporate governance from an old colleague of mine now retired and living in Seattle.  But the wider question our commenter had was, ‘What are we as CFEs to make of a company whose Board willfully withholds for months information about a cyberfraud which negatively impacts it customers and the public? From the ethical point of view, does this render the Board somehow complicit in the public harm done?’

Governance of shareholder-controlled corporations refers to the oversight, monitoring, and controlling of a company’s activities and personnel to ensure support of the shareholders’ interests, in accordance with laws and the expectations of stakeholders. Governance has been more formally defined by the Organization for Economic Cooperation and Development (OECD) as a set of relationships between a company’s management, its Board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set (including about ethical continuity), and the means of attaining those objectives and monitoring performance. Good corporate governance should provide proper incentives for the Board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring.

The role and mandate of the Board of Directors is of paramount importance in the governance framework. Typically, the directors are elected by the shareholders at their annual meeting, which is held to receive the company’s audited annual financial statements and the audit report thereon, as well as the comments of the chairman of the Board, the senior company officers, and the company auditor.

A Board of Directors often divides itself into subcommittees that concentrate more deeply in specific areas than time would allow the whole Board to pursue. These subcommittees are charged with certain actions and/or reviews on behalf of the whole Board, with the proviso that the whole Board must be briefed on major matters and must vote on major decisions. Usually, at least three subcommittees are created to review matters related to (1) governance, (2) compensation, and (3) audit, and to present their recommendations to the full Board. The Governance Committee deals with codes of conduct and company policy, as well as the allocation of duties among the subcommittees of the Board. The Compensation Committee reviews the performance of senior officers, and makes recommendations on the nature and size of salaries, bonuses, and related remuneration plans. Most important to fraud examiners and assurance professionals, the Audit Committee reviews internal controls and systems that generate financial reports prepared by management; the appropriateness of those financial reports; the effectiveness of the company’s internal and external auditors; its whistle-blowing systems, and their findings; and recommends the re-election or not of the company’s external auditors.

The Board must approve the selection of a Chief Executive Officer (CEO), and many Boards are now approving the appointment of the Chief Financial Officer (CFO) as well because of the important of that position. Generally, the CEO appoints other senior executives, and they, in turn, appoint the executives who report to them. Members of these committees are selected for their expertise, interest, and character, with the expectation that the independent judgment of each director will be exercised in the best interest of the company. For example, the ACFE tells us, members of the Audit Committee must be financially literate, and have sufficient expertise to understand audit and financial matters. They must be of independent mind (i.e., not be part of management or be relying upon management for a significant portion of their annual income), and must be prepared to exercise that independence by voting for the interest of all shareholders, not just those of management or of specific limited shareholder groups.

Several behavioral expectations extend to all directors, i.e., to act in the best interest of the company (shareholders & stakeholders), to demonstrate loyalty by exercising independent judgment, acting in good faith, obedient to the interests of all and to demonstrate due care, diligence, and skill.

All directors are expected to demonstrate certain fiduciary duties. Shareholders are relying on directors to serve shareholders’ interests, not the directors’ own interests, nor those of management or a third party. This means that directors must exercise their own independent judgment in the best interests of the shareholders. The directors must do so in good faith (with true purpose, not deceit) on all occasions. They must exercise appropriate skill, diligence, and an expected level of care in all their actions.

Obviously, there will be times when directors will be able to make significant sums of money by misusing the trust with which they have been bestowed and at the expense of the other stakeholders of the company. At these times a director’s interests may conflict with those of the others. Therefore, care must be taken to ensure that such conflicts are disclosed, and that they are managed so that no harm comes to the other shareholders. For example, if a director has an interest in some property or in a company that is being purchased, s/he should disclose this to the other directors and refrain from voting on the acquisition. These actions should alert other directors to the potential self-dealing of the conflicted director, and thereby avoid the non-conflicted directors from being misled into thinking that the conflicted director was acting only with the corporation’s interests in mind.

From time to time, directors may be sued’ by shareholders or third parties who believe that the directors have failed to live up to appropriate expectations. However, courts will not second-guess reasonable decisions by non-conflicted directors that have been taken prudently and on a reasonably informed basis. This is known as the business judgment ru1e and it protects directors charged with breach of their duty of care if they have acted honestly and reasonably. Even if no breach of legal rights has occurred, shareholders may charge that their interests have been ‘oppressed’ (i.e., prejudiced unfairly, or unfairly disregarded) by a corporation or a director’s actions, and courts may grant what is referred to as an oppression remedy of financial compensation or other sanctions against the corporation or the director personally. If, however, the director has not been self-dealing or misappropriating the company’s opportunities, s/he will likely be protected from personal liability by the business judgment rule.

Some shareholders or third parties have chosen to sue directors ‘personally in tort’ for their conduct as directors, even when they have acted in good faith and within the scope of their duties, and when they believed they were acting in the best interests of the corporations they serve.  Recently, courts have held that directors cannot escape such personal liability by simply claiming that they did the action when performing their corporate responsibilities. Consequently, directors or officers must take care when making all decisions that they meet normal standards of behavior.

Consequently, when management and the Board of a company who has been the victim of a cyber-attack decides to withhold information about the attack (sometimes for weeks or months), fundamental questions about compliance with fiduciary standards and ethical duty toward other stakeholders and the public can quickly emerge.   The impact of recent corporate cyber-attack scandals on the public has the potential to change future governance expectations dramatically. Recognition that some of these situations appear to have resulted from management inattention or neglect (the failure to timely patch known software vulnerabilities, for example) has focused attention on just how well a corporation can expect to remediate its public face and ensure ongoing business continuity following such revelations to the public.

My colleague points out that so damaging were the apparently self-protective actions taken by the Boards of some of these victim companies in the wake of several recent attacks to protect their share price, (thereby shielding the interests of existing executives, directors, and investors in the short term) that the credibility of their entire corporate governance and accountability processes has been jeopardized, thus endangering, in some cases, even their ability to continue as viable going concerns.

In summary, in the United States, the Board of Directors sits at the apex of a company’s governing structure. A typical Board’s duties include reviewing the company’s overall business strategy, selecting and compensating the company’s senior executives; evaluating the company’s outside auditor, overseeing the company’s financial statements; and monitoring overall company performance. According to the Business Roundtable, the Board’s ‘paramount duty’ is to safeguard the interests of the company’s shareholders.  It’s fair to ask if a Board that chooses not to reveal to its stakeholders or to the general investor public a potentially devastating cyber-fraud for many months can be said to have meet either the letter or the spirit of its paramount duty.