Chapter 7

Fraud

Fraud
• any illegal acts characterized by deceit, concealment or violation of trust.
• an intentional perversion of truth for the purpose of inducing another in reliance upon it to the part with some
valuable thing belonging to him or to surrender a legal right

Examples of Fraud:
• theft
• unauthorized or illegal use of company’s assets
• claims for goods or services not actually provided
• sale or assignment of fictitious or misrepresented assets
• intentional failure to act in circumstances when action is required
• illegal business activities

• Fraud can cause monetary loss that negatively impacts the organization.

Error refers to unintentional misstatement in financial statements, including omission of an amount or a disclosure
Examples of Error:
• Mistake in gathering or processing data from w/c FS are prepared
• Incorrect accounting estimate arising from oversight or misinterpretation of facts
• Mistake in application of accounting principles
Fraud Risk is the probability that fraud will occur and the potential severity or consequences to the org. when it occurs

Internal Auditors are responsible for:

• Assist companies in preventing and detecting fraud
• Evaluate management’s fraud risk assessment
• Have sufficient knowledge to identify indicators of fraud
• Understand enough about internal controls to identify opportunities for fraud
• Raise fraud awareness within the org

Key Principles in Managing Fraud

• A Fraud risk management should be in place.
• Fraud risk exposure should be assessed periodically.
• Prevention techniques should be established to mitigate possible impact on org.
• Detection techniques should be established to uncover fraud events.
• A reorting rocess should be in place to solicit input potential fraud.
Fraud Triangle
1. Incentives/ Pressures/Motivation
a. Power
b. Gratification of a desire
c. Pressure
2. Opportunities – a window of opportunity may arise for something to go wrong or creates circumstances for the
control to fail
3. Rationalization/ Justification – the reason why you committed the fraud
a. Defalcations
i. Personal financial problems
ii. Mistreatment of the company
iii. Sense of entitlement
iv. Everyone does it!
b. Fraudulent Financial Reporting
i. Compensation based on financial issues
ii. Ego
iii. Necessary for organization to survive

Types of Fraud
According to AICPA
1. Defalcations or Misappropriation of Asset (Theft)
• Corruption – fraudster use their influence in a transaction to gain personal benefit
• Larceny – stealing cash after it has been recorded on books.
• Skimming – stealing cash before it is recorded on books
• Fraudulent Disbursements
2. Fraudulent Financial Reporting or Distortion of FS – intentional manipulations of financial statements; typically
committed by management who has opportunity to overall internal controls.

According to ACFE
1. Misrepresentation of material facts
2. Concealment of Facts
3. Bribery
4. Conflicts of Interest
5. Theft of Money or Property
• Embezzlement – wrongful appropriation of money or property by a person to whom it has been lawfully
entrusted
• Larceny – wrongful taking of money or property of another with the intent to convert or deprive the owner of
its possession and use
• Theft or misappropriation of trade secrets
• Breach of Fiduciary Duty – not abiding by the duty of loyalty or duty of care that exist in a fiduciary relationship
 • Duty of Loyalty – requires the employee act solely in the best interest of the employer
• Duty of Care – requires the employee to conduct business affairs prudently with the skills and attention

Red Flag – conditions which normally present whenever a fraud is committed.

Financial Shenanigans – actions that intentionally distort reported financial performance and financial condition.
• Recording revenue too soon or of questionable quality
• Recording Bogus Revenue
• Boosting Income with one-time gains
• Shifting Current Expenses to Later or Earlier Period
• Failing to Record or Improperly Reducing Liabilities
• Shifting Current Revenue Revenue to a Later Period
• Shifting Future Exenses to the Current Period as a Special Charge

Procedures in Auditing Fraud

1. When there is a possibility of fraud, the auditor should consider that evidence might not be what it seems.
2. Obtaining Information about Fraud Risk Factors
a. Making Inquiries of management and others to obtain their views about the risk and fraud and controls set
up to address those risks
b. Perform analytical procedures and consider any unusual relationships.
c. Review risk factors
d. Review management responses to recommendations for control improvements and internal audit reports.
3. Developing an Audit Plan
4. Evaluating Evidence
5. Communicating the Existence of Fraud
6. Audit Documentation

Collusive Scheme – scheme performed by two or more individuals working together.

Elements of Fraud Risk Assessment

• Identify inherent fraud risk
• Assess likelihood and significance of inherent fraud risks.
• Respond to reasonably likely and significant inherent and residual fraud risks.

Fraud prevention – the most proactive fraud-fighting measure ; the design and implementation of control activities should
be coordinated effort spearheaded by mgt. with an assembled cast of employees.
Sample Fraud Preventive Controls
• Human Resources Procedures
• Authority Limits
 • Transaction-Level Procedures

Fraud Detection – having effective detective controls in place and visible is one of the strongest deterrents to fraudulent
behavior.
Sample Fraud Detection Control
• Whistle blower hotlines
• Process Controls
• Proactive Fraud Detection Procedures

Fraud Investigation and Corrective Action – a reporting process should be in place to solicit input on potential fraud, and
a coordinated approach to investigation and corrective action should be used to help ensure potential fraud is appropriately
and timely.

Risk Appetite – amount of risk, an organization is willing to accept in pursuit of value

Risk Tolerance – relates to risk appetite but differs in one fundamental way; the acceptable level of variation relative to
achievement of a specific objective, and often is best measured in the same units as those used to measure the related
objective.

Forensic Accounting – focuses on gathering evidence about economic transactions and reporting the legal framework
which allows such evidence to suitable to the purpose of establishing accountability or valuation.

Whistleblowing – act of disclosing adverse information to someone in the organization who is outside of the individual’s
normal chain of command, or to a governmental agency or other authority that is wholly outside of the organization.