Preventing a Fraud meltdown in your company

Preventing a Koss Meltdown at your Company:

How to Prevent and Detect Fraud: Implementing Internal Controls

Presenters David Buslee

– MBA UC Irvine– Certified Managerial Accountant– Certified Financial Manager– Partner – B2BCFO

Paul Rodrigues– Certified Public Account– Masters in Tax– Certified Fraud Examiner– Certified in Financial Forensics– Principal at Chortek and Gottschalk

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Goal

To Educate You on What is Happening To Scare You to Death To Make You Paranoid To Provide Best Practices

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What is Fraud

The elements of fraud are:– A representation about a material fact– Which is false– And made intentionally, knowingly, or recklessly– Which is believed– And acted upon by the victim– To the victim’s damage

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Common Myths About Fraud

It can’t happen on MY watch No one would do that here... We have an excellent accounting system My accounting clerk is my best employee We don’t handle cash - What’s to steal Problem Employees are likely suspects I wouldn’t know where to start looking

The Fraud Triangle

Opportunity - Generally provided through weaknesses in the internal controls.

Pressure - Can be imposed due to problems or vices

Rationalization - Occurs when the individual develops a justification for their fraudulent activities.

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Fraud Schemes

Three categories of fraud schemes according to the Association of Certified Fraud Examiners:

A. fraudulent statementsB. corruptionC. asset misappropriation

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A. Fraudulent Statements

Misstating the financial statements to make the copy appear better than it is

Usually occurs as management fraud May be tied to focus on short-term financial

measures for success May also be related to management bonus

packages being tied to financial statements

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B. Corruption Examples:

– bribery– illegal gratuities– conflicts of interest– economic extortion– Kickbacks

Foreign Corrupt Practice Act of 1977: – indicative of extent of corruption in business world– impacted accounting by requiring accurate records

and internal controls

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C. Asset Misappropriation

Most common type of fraud and often occurs as employee fraud.

Examples:– making charges to expense accounts to cover theft of

asset (especially cash)– lapping: using checks from one account to cover theft

from a different account– transaction fraud: deleting, altering, or adding false

transactions to steal assets

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How Management Encourages Fraud

Management Attitude - Do Nothing Little or poor Applicant screening No written policies or procedures Inadequate training - classroom or OJT Responsibility, accountability, and authority not established or

documented Goals and objectives neither established nor monitored for

success Weak Enforcement Policy Break accounting and policy rules - “Too Much Bureaucracy” Inconsistent application of policies or procedures - may result in

unfair treatment of employees - favoritism - low morale Not listening to employees - treatment of whistleblowers We’ll get them to resign - the problem will go away

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Employee Fraud

Committed by non-management personnel Usually consists of: an employee taking cash

or other assets for personal gain by circumventing a company’s system of internal controls

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Management Fraud

It is perpetrated at levels of management above the one to which internal control structure relates.

It frequently involves using the financial statements to create an illusion that an entity is more healthy and prosperous than it actually is.

If it involves misappropriation of assets, it frequently is shrouded in a maze of complex business transactions.

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Who Commits Fraud ?

Almost anyone, rationalize they are just in borrowing, believe they deserve what they take, plan to repay - never do. Will continue to commit fraud until caught.

– Has an addictive need - alcohol, drugs, gambling, sex, shopping– Is intelligent– Has a position of trust and responsibility– Understands and skillfully uses technology– Is well respected in the community– Is married, 2 children, owns home

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Perpetrator’s History

87%

6%7%

Perpetrator's Criminal His-tory

Never charged or convicted

Charged but not con-victed

Prior Convic-tions

83%

5%

12%

Perpetrator's Employment History

Never Pun-ished or Terminated

Previously Punished

Previously Terminated

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Victim Organizations

Private Companies

Public Companies

Government

Not-for-Profit

$0 $50,000 $100,000 $150,000 $200,000 $250,000 $300,000

Organization Type of Victim - Median Loss

20082006

Median Loss

Type

of V

ictim

Org

aniz

atio

n

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Victim Organizations

10,000+

1,000 - 9,999

100 - 999

<100

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0%

Size of Victim Organization - Frequency

20062008

Percent of Cases

Num

ber o

f Em

ploy

ees

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Victim Organizations

Lack of Internal Controls

Lack of Management Review

Override of Existing Controls

Poor Tone from the Top

Lack of Competent Oversight

Lack o f Independent Audits

Lack of Clear Lines of Authority

Lack of Employee Fraud Education

Lack of Reporting Mechanism

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%

Primary Internal Control Weakness Observed by CFE

Percent of Cases

Mos

t Im

porta

nt C

ontri

butin

g Fa

ctor

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What is a RED FLAG of Fraud?

A red flag is a set of circumstances that are unusual in nature or vary from normal activity. It is a signal that something is out of the ordinary and may need to be investigated further. These are warning signs.

Some Red Flags are easily discerned, while others may be more subdued and/or concealed.

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Detection of Fraud Schemes

©2008 by the Association of Certified Fraud Examiners, Inc.

Initial Detection Method by Organization Type8

8The sum of percentages in this chart exceeds 100 percent because in some cases respondents identified more than one detection method.

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How Costly is Fraud The direct amount that is misappropriated is

oftentimes only a small portion of the cost to an organization.

Intangible Costs– Distraction of organization– Employee morale– Embarrassment– Loss of customer confidence

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Red Flags Knowing how to spot and investigate Red Flags is

imperative in a proactive fraud deterrence program. Learn to spot the behavioral and data red flags. When red flags are present, investigate and

document. Data mining is an effective tool for identifying red

flags in the company data files

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Behavioral Red Flags

Fraudsters oftentimes demonstrate behaviors that may serve as warning signs

Some perpetrators may act irritable, may spend lavishly or become secretive.

The presence of these signs do not, in and of itself, indicate fraud is occurring

Management and anti fraud professionals should be trained to identify potential warning signs so that they may be investigated.

25 ©2008 by the Association of Certified Fraud Examiners, Inc.

26 ©2008 by the Association of Certified Fraud Examiners, Inc.

Behavioral Red Flags Present During Fraud Scheme24

24The sum of percentages for each scheme type exceeds 100 percent because in several cases the perpetrator exhibited more than one behavioral red flag.

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Cash FraudRed Flags

Discrepancies between cash count and account balance

Mutilated/destroyed cash register receipts Employee working from open cash drawer Unexplained inventory adjustments Unexplained increase in the use of petty cash Personal checks included in cash funds Unusual journal entries affecting cash accounts Differences between daily receipts and bank deposits “Less Cash” line on deposit tickets indicates cash

taken

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Accounts Receivable FraudRed Flags

Customer complaints regarding amounts owed Discrepancies between deposit tickets and customer

records Different dates between deposits and customer

payments Unusual discounts or credits Increase in delinquent accounts Increase in the amount of write-offs Receivables with unusual characteristics Customers with unusual name, address or phone

number

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Inventory FraudRed Flags

Unexplained inventory shrinkage Excessive inventory adjustments Decrease in gross margins Unusual journal entries to inventory Unusual trash removal practices Increase in credit memos Temporary workers with access to

inventory

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Fixed Asset FraudRed Flags

Unusual or unexpected asset purchases Missing assets Unusual increases in repairs and

maintenance on assets that could be subject to personal use

Unusual fluctuations in depreciation accounts

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Accounts Payable/Vendor Fraud

Red Flags Higher-than-usual costs or expenses Vendor complaints Altered or modified vendor invoices Unexplained fluctuations in payables Unusual vendor names and addresses Unusual payees on checks Discrepancy between payees on checks and check

register Unusual increase in purchases from vendor(s) Copies of vendor invoices instead of originals Missing cancelled checks

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Payroll FraudRed Flags

Unusual fluctuations in payroll expense or hours Checks to employees with minimal personnel records Missing payroll checks Number of paychecks do not match the number of

employees Employee complaints regarding W-2 amounts Employees who pick up paychecks for other

employees Highly compensated employees who elect no

withholdings Dual endorsements on cancelled payroll checks

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Expense Reporting Fraud

Red Flags Improper or inadequate receipts underlying expenses Information on expense report differs from receipts Photocopies of expense receipts submitted instead of

originals Repeated entertainment expenses with customer with

no associated business Failure to utilize company credit cards when available Expenses submitted not in line with other employees

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The Perpetrators

Corruption

Billing

Skimming

Non-Cash

Check Tampering

Expense Reimbursement

Cash on Hand

Fraudulent Statements

Cash Larceny

Payroll

Register Disbursements

0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0

Fraud Schemes By Accounting Personnel

All Cases

Accounting

Percent of Cases

Type

of S

chem

e

Reduce Risk of Fraud:Tools of Protection

Segregation of Duties

Environment

Internal Control Procedures

Segregation of Duties

• No employee should be in a position to commit fraud and then conceal it

• Example: Person collecting/receipting cash should not:• Post cash receipts to the general ledger system• Process cash disbursements• Prepare billings• Make bank deposits, wire transfers

Environment

The same rules apply to all Don’t belittle internal control procedures Don’t allow management to override

procedures Be alert to employee’s outside interests

Internal Controls – Who?

As the owner, you are pulled in a variety of directions

Need to focus on the overall businessNo experience in creating controlsAs the “Finder” you can’t be constantly

involved in “Minder” activities

Controls - Part-time CFO

Experienced partner to CEOKnowledgeable in creating controls and

enforcing controlsEnables the “Finder” to concentrate on

building the businessCost effective alternative – can help build

sales and gross margins

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Controls - Part Time CFO Physical security Segregation of duties Employee monitoring Surprise audits Job rotation Examination of Documentation

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Your Bank – Account Control

Specify what, if any, ACH debits can hit your accounts

Require 2 signatures for any outbound wire Make sure they don’t give cash back on business

deposits Make sure they only deposit to business accounts Use a “token” for all account inquiries Only signors should access accounts Positive Pay and Reverse Positive Pay

Suspected Fraud ?

•Seek out a Fraud Practitioner…– Type of fraud:– Employee fraud - dismissal or prosecution of employees?– Vendor fraud?– Any misconduct involving a high-level officers, executives or

managers– Financial reporting fraud?– Complaints involving the Foreign Corrupt Practices Act (FCPA)– Certain industry practices

•Who should be in the know before any action is taken?•How was the (potential) fraud detected?•Involvement of authorities?

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Legal Considerations of Fraud

Intentionally false representation– Not an error– Lying or concealing actions– Pattern of unethical behavior

Personal material benefit Organizational or victim loss

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Summary Anyone can be a Fraudster – they tend to be

the most trusted employee Fraud Prevention Checkup Most Frauds are discovered by accident or tips Be vigilant for Red Flags Part Time CFO will create and enforce internal

and external controls Your Bank has many tools to prevent fraud Have a game plan for when fraud is suspected

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Contact InformationDavid Buslee

PartnerB2BCFO LLC(262) [email protected]

Paul RodriguesPrincipalChortek and Gottschalk(262) [email protected]