the nature of fraud (3)-final

© Paul Lower 2010

FRAUD DETECTION & CONTROL

BACKGROUND TO FRAUD

© Paul Lower 2010

Background to Fraud

The man who is admired for the ingenuity of his larceny is almost always rediscovering some earlier form of fraud.

The basic forms are all known, have all been practiced. The manners of capitalism improve. The morals may not.

John Kenneth Galbraith

© Paul Lower 2010

Background to Fraud

• What is fraud?

© Paul Lower 2010

Background to Fraud

Fraud (noun)

deceit, trickery, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage

Cambridge Dictionary

© Paul Lower 2010

Background to Fraud

Fraud is:Any illegal acts characterised by deceit, concealment or violation of trust. These acts are not dependent on the application of threat of violence or of physical force.

Frauds are perpetrated by individuals and organisations to obtain money, property or services; to avoid payment or loss of services ; or to secure personal or business advantage.

Association of Certified Fraud Examiners

© Paul Lower 2010

Background to Fraud

Fraud is:Occupational Fraud is defined as:

The use of one’s occupation for personal enrichment, through the deliberate misuse or misapplication of the employing organisation’s resources or assets.

© Paul Lower 2010

Background to Fraud

• Five elements of fraud

1. A representation about a fact

2. Made intentionally, knowingly, or recklessly

3. A fact which is material

4. And known to be false

5. By which the victim suffers harm or damage

© Paul Lower 2010

Background to Fraud

• With increasing stock prices, increasing profits and increasing wealth for everyone, no one worried about potential problems.

• How to value a dot.com company:

– Take their loss for the year

– Multiply the result by negative 1 to make it positive

– Multiply that number by at least 100

– If stock price is less than the result…buy; if not, buy anyway

© Paul Lower 2010

Background to Fraud

Fraud falls in to two categories

Theft

Money

Services

Information (ID theft)

Physical assets

Deception

Accounting fraud

Lying to shareholders

Lying to employees

Deceiving partners, customers, clients, service providers and the official authorities

© Paul Lower 2010

Background to Fraud

• How much is lost to fraud?

– City of London Fraud Squad estimates that:

• UK losses in 1985 estimated at £1bn

• UK losses in 1994 had reached £4bn

– Fraud Advisory Panel more recently estimated that:

• UK annual economic cost is £14bn

• Equates to £230 per head of population

• Although this was thought likely to be understated

© Paul Lower 2010

Background to Fraud


– Association of Certified Fraud Examiners estimates:

• Annual US losses average 7% of gross revenue

• US losses in 2008 reached $994bn

© Paul Lower 2010

Background to Fraud


– But significant levels of fraud are never reported

– Various reasons for non disclosure

• Loss of reputation

• Fear of bad publicity

• Fear of consequential legal claims

© Paul Lower 2010

Background to Fraud

• Financial sector fraud – the myths & realty

– Majority of organisations still complacent about fraud1

– Only 49% of US executives thought their organisation’s anti fraud strategies were “very well defined”

– Number and size of financial statement frauds are increasing

– Number and size of frauds against organizations are increasing

1 “Preventing Fraud” www.protiviti.com

© Paul Lower 2010

Background to Fraud


– Some recent frauds include several people—as many as 20 or 30 (seems to indicate moral decay)

– Many investors have lost confidence in credibility of financial statements and corporate reports

1 “Preventing Fraud” www.protiviti.com

Example of a Fraud– Large Fraud of $2.6

Billion over 9 years

– Year 1 $600K

– Year 3 $4 million



– Year 9 $2.6 billion

– In years 8 and 9, four of the world’s largest banks were involved and lost over $500 million

0

500,000,000

1,000,000,000

1,500,000,000

2,000,000,000

2,500,000,000

3,000,000,000

Year 1 Year 3 Year 5 Year 7 Year 9

Fraud Cost….Example

– Bank

– $100 Million Fraud

– Profit Margin = 10 %

– $1 Billion in Revenues Needed

– At $100 per year per Checking Account, 10 Million New Accounts

© Paul Lower 2010

Background to Fraud


– Majority of organisations still complacent about fraud

– Only 49% of US executives thought their organisation’s anti fraud strategies were “very well defined”

– Less than 50% of organisations have anti-fraud programmes, policies and controls in place

– Research by Deloitte Forensic Center shows there is still a substantial “fraud control gap”

© Paul Lower 2010

Background to Fraud

• Myth #1

– We have very little fraud here

• Management believes it because they want to

• Blind to obvious frauds taking place around them

• Sub-prime mortgages are a good example

– Lure of profit meant fraud was encouraged

– Self certified loans widespread

– Fraudulent applications actually encouraged

© Paul Lower 2010

Background to Fraud

• Myth #2

– Ethics and compliance training has us covered

• Assumes employees can detect the ‘red flags’

• But ethics has little to do with fraud

• Not all unethical practices are fraudulent

• Increase in fraud suggests training ineffective

© Paul Lower 2010

Background to Fraud

• Myth #3

– Fraud is an unavoidable cost of doing business

• Often heard in relation to credit card companies

• But Enron case shows ultimate flaw in this myth

• Employees lost livelihoods and pension savings

• Bear Stearns $1.6bn sub-prime mortgage fraud ultimately brought down the bank

© Paul Lower 2010

Background to Fraud

• Myth #4

– Fraud is controlled through the use of accounting standards.

• Allows companies and auditors to be extremely creative.

• Examples are SPEs and other types of off-balance sheet financing, revenue recognition approaches, merger reserves, pension accounting, and other accounting schemes.

• It is impossible to make rules for every situation

**Consider accounting principles

© Paul Lower 2010

Background to Fraud


– Easy to become complacent about fraud

– But doing so can be very costly

– Fraud can damage any organisation

– Cannot be ignored

– Some very strong arguments for preventing, identifying, investigating and eliminating fraud

© Paul Lower 2010

Background to Fraud

• Justification for eliminating fraud

– Economic

• Cost of fraud is huge in all major economies

• Misappropriated funds could be usefully employed

• Fraud erodes confidence

© Paul Lower 2010

Background to Fraud


– Economic

– Social

• Fraud is the same as any other crime

• Fraud is not a victimless crime

• White collar crime is no better than burglary

• Tackling fraud is part of an even handed approach to crime at all levels of society

© Paul Lower 2010

Background to Fraud


– Economic

– Social

– International

• Government wants developing countries to prosper

• Freedom from fraud and corruption

• Fraud goes with terrorism and drug trafficking

• Proceeds of crime finances further crime

© Paul Lower 2010

Background to Fraud


– Economic

– Social

– International

– Moral

• In a fair society fraud is indefensible in any sector

• Fraud and corruption affect attitudes and ethics

• Prevents public sector reform in developing nations

© Paul Lower 2010


ANTI-FRAUD AGENCIES

© Paul Lower 2010

UK - FSA

Independent NGO set up in 2000

Regulates UK financial services industry

Objective is to reduce financial crime in financial services

Maintain public awareness and market confidence

Protect consumers of financial products and services

Financial Services Authority

© Paul Lower 2010

UK - SFO

Independent government department under Attorney General

Investigates and prosecutes serious fraud and corruption

Applies and polices regulations set out by FSA

Instrumental in maintaining confidence in financial sector

Has been criticised for inability to convict in complex cases

Prosecuted 237 cases since 1987 – 71% conviction rate

Serious Fraud Office

© Paul Lower 2010

US - SEC

Established following the Wall Street Crash

Its mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation

Oversees disclosure of information to public investors

Maintains fair, orderly, and efficient markets

Oversees investment management and advisory industry

Recommends investigations of securities law violations

Securities and Exchange Commission

© Paul Lower 2010

Nigeria - EFCC

Economic and Financial Crimes Commission

The Establishment Act 2004 mandates the EFCC to:

Prevent, investigate, prosecute and penalise financial crime

Enforce the provisions of laws and regulations including

The Money Laundering Act 1995

The Money Laundering (Prohibition) Act 2004

The Advance Fee Fraud and Other Fraud Related Offences Act 1995

The Failed Banks and Financial Malpractices in Banks Act 1994

The Banks and other Financial Institutions Act 1991

© Paul Lower 2010

Nigeria - EFCC


Mrs Farida WaziriChairwoman EFCC

EFCC operations

Advance Fee Fraud Section

Handles advance fee fraud:

Fraud using fake claims and identities

Entices (cyber) victims with false promises

Inheritance, contract and credit card scams

Commonly referred to as 419 fraud

© Paul Lower 2010

Nigeria - EFCC



EFCC operations


Economic Governance Section

Fraud involving abuse of office

Diversion and theft of public funds

Covers ministries, parastatals and government agencies

© Paul Lower 2010

Nigeria - EFCC



EFCC operations



Bank Fraud Section

Handles fraud in banks and financial institutions

Including counterfeiting, illegal charge transfers, passing ‘dud’ cheques and forex fraud

© Paul Lower 2010

Nigeria - EFCC



EFCC operations



Bank Fraud Section

General Investigations Section

Handles other economic and financial frauds

© Paul Lower 2010


THE HUMAN ELEMENT OF FRAUD

© Paul Lower 2010

The Human Element of Fraud

• Who commits fraud

– Perpetrators inside the organisation

– Perpetrators external to the organisation

PwC, “Economic Crime: People, Culture and Controls” 2007

60%

40%

© Paul Lower 2010


• Who commits fraud

– External fraudsters for financial organisations include

• Dishonest customers

• Identity thieves

• Cheque forgers and counterfeiters

• Internet fraudsters – phishing scammers & hackers

• Credit card fraudsters

• Dishonest mortgage and loan brokers

© Paul Lower 2010


• The insider threat

– Research suggests 80% of employees are honest

– Experts use 20-60-20 rule to illustrate human aspect

• 20% of employees never steal

• 60% are “fence sitters” – tempted by opportunity

• 20% of employees are basically dishonest

© Paul Lower 2010


• The insider threat

– Helpful to consider insider threat in two key categories

• Employee level fraud

• Management level fraud

– Fraud less frequent at management level

– But losses generally much greater at this level

But why do employees commit fraud?

© Paul Lower 2010


Why employees commit fraud – The Fraud Triangle

RATIONALISATIONOPPORTUNITY

PRESSURE

© Paul Lower 2010


Why employees commit fraud – The Fraud Triangle1

PRESSURE

People with financial problems seek ways to commit fraud

Research applies to employees and management

Problems could include credit card debt

gambling debt

mortgage or rent arrears

1 Based on Donald Cressey’s 1940’s research on employee fraud

© Paul Lower 2010




PRESSURE

© Paul Lower 2010



OPPORTUNITY

Provided through weak internal controls

Weak supervision and review

Poor separation of duties

Absence of management approval

Weak system controls eg. Vendor set up

© Paul Lower 2010



RATIONALISATION

Crucial component of most frauds

Reconciles behavior with accepted notions of decency

“I really need this money - I’ll put it back when I’m paid”

“I can’t afford to lose everything – my home, car, everything”

“I deserve this money for all my effort”

© Paul Lower 2010


The Fraud DiamondSome say there is a new dimension to 21st century fraud

OPPORTUNITY RATIONALISATION

PRESSURE?GREED

© Paul Lower 2010


• Why does fraud happen

– Research tells us that 20% of employees are dishonest

– But another 60% are susceptible to the opportunity

• Provided through weak internal controls

• From weak supervision and review

• From poor separation of duties

• From absence of management approval

• For internal and external collusion

© Paul Lower 2010


• Why does fraud happen

– Research tells us that 20% of employees are dishonest

– Another 60% are susceptible to the opportunity

– And that’s only the insider threat!

– Similar statistics must apply to the external population

© Paul Lower 2010


• Anatomy of common financial frauds

– In this course we will examine

• How various frauds are carried out

• The red flags that help to detect the fraud

• The preventative controls that should be in place

© Paul Lower 2010


• How frauds are detected

Red flags are a set of circumstances that are unusual

Or vary from the normal activity

They draw attention to likely fraud

But statistics show they don’t always work

© Paul Lower 2010

How Frauds Are Detected

0% 10% 20% 30% 40% 50%

Police

External audit

Internal audit

Accident

Internal controls

Tip off

Research shows that most frauds are detected by tip off

Association of Certified Fraud Examiners 2008 report

46.2% of US frauds were detected by tip off in 2008

© Paul Lower 2010


• Red flags

– Studies of fraud cases consistently show that

– Red flags were present

– But were not recognised

– Or were recognised but not acted upon

© Paul Lower 2010


• Red flags

– Once a red flag has been noted action must be to

• Investigate determine if a fraud as been committed

• Or confirm the issue as an error

© Paul Lower 2010


• Examples of opportunity red flags

– Inventory is not counted

– Staff given authority but their work is not reviewed

– Too much responsibility placed in one employee

– The petty cash box is left unattended

– Monthly financial reports not reviewed by managers

– There is no internal audit function

© Paul Lower 2010


• Examples of employee red flags

– Lifestyle changes: expensive cars, jewelry, homes

– Personal debt and credit problems

– Behavioral changes: drugs, alcohol, gambling

– High employee turnover

– Refusal to take vacation or sick leave

– Lack of segregation of duties

© Paul Lower 2010


• Examples of management red flags

– Reluctance to provide information to auditors

– Decisions dominated by an individual or small group

– Managers display disrespect for regulatory bodies

– Managers intimidate accounting and legal personnel

– Frequent changes in external auditors

– Lifestyle changes: expensive cars, jewelry, homes

© Paul Lower 2010


• Examples of other red flags

– Weak internal control environment

– Decentralisation without adequate monitoring

– Excessive number of bank accounts

– Frequent changes in bank accounts

– Company assets sold under market value

– High employee turnover rate

© Paul Lower 2010


• Examples of other red flags -Cash is King!

• Investigate cash shortages

-2

-1

0

1

2

3

4

3months

6months

9months

Year

1998

1999

2000

2001

Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000, 1st two quarters in 2001.

the nature of fraud (3)-final

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