Certified Forensic

Accountant
Module 3: Topic 7
Recognizing Employee Fraud
THE FRAUD PROBLEM IN PERSPECTIVE
The three elements of the fraud triangle are present in many
cases of the fraud against the company:
1. Pressure Usually related to financial pressure such as large
medical bills, gambling problems, dug habits, and extravagant
living.
2. Opportunity Required committing fraud.
Rationalization Likely depends on the type of criminal and the
criminal’s personality type or possible personality disorder.
The rationalization component of the fraud triangle suggests
three
possible types of individuals who may commit fraud:
– Fundamentally dishonest employee without personality disorder
This person could habitually be dishonest but dies not have a
personality disorder. Rationalization comes easily because the person
is accustomed to dishonestly.
Honesty of Employees
 Fundamentally dishonest employee with a personality disorder.
The following are characteristics that apply to persons with these
types of mental disorder:

• Non-conformist behavior; tend to be misfits.

• Habitual lying and dishonesty.
• Impulsiveness.
• Irritability and aggressiveness.
• Insensitivity to harming self and others.
• Strong disregard for the needs of self and others.
• Tendency to blame others for personal faults and mistakes.
• Lack of responsibility.
• Difficulty in establishing and maintaining close relationships.
• Absence of the ability to feel emotions or the full range of normal
emotions.
Employee Fraud and Corporate Culture

Employee Frauds and Corporate Culture

The following factors in the corporate culture can
contribute to these pressures.

•Poor employee compensation

•Excessive pressure to perform
•Hostile work environment
•Corporate financial troubles
•Negative examples set by top management
 EMPLOYEE FRAUD SCHEMES
The general rule is that the more liquid the asset, the
more likely it is to be a target of employee fraud. This
tends to make cash and inventories the top targets for
employee fraud. However, because they are obvious
targets, they may be areas that have the strongest
controls, forcing dishonest employees to search for
secondary targets from paper clops to major items of
plant and equipment. Almost anything can be stolen.
 OVERVIEW OF FRAUD:
Definition of Employee Fraud
 White collar crime is fraud perpetrated by people who work in offices
and steal with a pencil or a computer terminal. The contrast is violent
street crime.
 Employee fraud is the use of fraudulent means to take money or other
property from an employer. It consists of three phases: (1) the
fraudulent act, (2) the conversion of the money or property to the
fraudster's use and (3) the cover-up.
 Embezzlement is a type of fraud involving employees' or
nonemployees' wrongfully taking money or property entrusted to their
care, custody, and control, often accompanied by false accounting
entries and other forms of lying and cover-up.
 Larceny is simple theft of an employers property that is not entrusted
to an employee's care, custody or control.
 Defalcation is another name for employee fraud and embezzlement.

Source: McGraw-Hill/Irwin 2007

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 Revenue Cycle Fraud

• Cash Collection Fraud

• Basic Sales Skimming
• Advanced Sales Skimming
• Checks Swapped for Cash
• Cash Box Robbery
• Shortchange Sales
• Mail Room Theft
• Cash Processing
Example of Cash Register Fraud
Check Washing Scheme
Accounts Receivable Fraud

Frauds in this category center in improper credit approvals,

improper credits, and improper write-offs.

• Fraudulent credit approvals

• Improper credits
• Improper write-offs
Expenditures Cycle Frauds

There are many types of expenditure cycle frauds. This section

discusses the major expenditure cycle fraud schemes.

• Improper Purchases and Payments

• Unauthorized Purchases
• Fraudulent Purchases to Related Purchases
• Misappropriation of Petty Cash
• Abuse of Company Credit Cards or Expense Accounts
• Unauthorized Payments
• Theft of Company Checks
• Fraudulent Returns
• Theft of inventory and Other Assets
Common Issues: Expense Reports
o Personal charges on expense report; often disguised as business charges

o Massages

o Clothing

o Personal phone calls and cable TV bills

o Gifts to employees or customers

o Local meals with staff that are not business related

o Local meals with family and friends

o Charges that consistently exceed policy guidelines; usually involves hotel and
meal costs
o Meal attendees listed, but they never attended the meal
o Charges deliberately misclassified (e.g., Massage listed as Business Meal) 15
o Equipment purchases charged as business expenses
Payroll Fraud
When it comes to the payroll, there are as many ways to cheat as
there are employees. Common areas of payroll fraud include the
following:
• Improper hiring
• Improper changes to employee personnel files for pay raises
• Improper work-related reporting

Production Cycle Frauds

Production cycle fraud involves theft of raw materials and finished
goods. Most such thefts can be prevented by good physical security
and authorization controls.
•  Waste, Scrap, and Spoiled Goods
 Other Types of Employee Fraud
• Financial Statement Fraud
• Insider Trading
• Employee Fraud in General
 THE AUDIT PROCESS IN DETECTING AND
PREVENTING EMPLOYEE FRAUD

• Audit Trail
• Chain of Custody- chronological documentation or paper trail that
records the sequence of custody, control, transfer, analysis, and
disposition of physical or electronic evidence. 
• Authorization and Approval
• Internal Audit
• Physical Security and Monitoring
• Fraud Reporting Hotlines, Training, and Education
 VENDOR FRAUD
Examples of vendor fraud schemes follow:

• Short shipments
• Balance due billing
• Substandard goods
• Fraudulent cost-plus billing
 Common Issues:
Improper Payments to Vendors
o Payment to vendors for services not rendered

o Overpaying vendors to generate cash; in many cases, services are not

rendered

o Deliberate overcharges by vendors

o Giving credits to vendors for no reason

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 Common Issues: Conflict of Interest

o Employee conducts business with a vendor in

whom he/she has a direct or indirect financial
interest e.g. catering business in office

o Employee receives kickbacks from a vendor in

exchange for providing business to the vendor

• One symptom of possible fraud may be the

lack of competitive bidding for a vendor

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 EMPLOYEE FRAUD METHODS IN
ELECTRONIC ACCOUNTING
INFORMATION SYSTEMS

This section discusses concepts relating to employee fraud within

the context of computerized accounting systems. Various
computer-related frauds can completely bypass standard controls
or destroy, eliminate, alter, or obscure the audit trail related to
the fraud.
Major Modes of Electronic Fraud
WALKING THE WALK OF FRAUD DETECTION PROGRAMS
 
Efforts to create employees fraud prevention programs are not
always sufficient to deter the crimes that have been discussed.
However, there are actions that should be considered.

Three critical self-assessment questions organizations might

address:
• Is there a published ethics policy definition of fraud?
• Is fraud included in the company’s overall business risk
assessment?
• Is there a plan in place to respond to risk and to limit damage to
the business?
 Red Flags

• What is a red flag?

• Often times red flags were
present in a situation but
either not recognized or not
acted upon.
• Sometimes an error is just an
error but you don’t know if
you don’t investigate.

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Source: McGraw-Hill/Irwin 2007
 Common Red Flag Examples
• Employee lifestyle o Refusal to take vacation or
changes sick leave
• Living beyond means o Control issues – unwilling
• Significant debt/credit to share duties
problems o Complain about
• Behavioral changes – inadequate pay
indication of drug, o Irritability and/or
alcohol, gambling, family defensiveness
issues o Weak internal controls
• High employee turnover
in an area
• Limited staff/lack of
segregation of duties
Source: McGraw-Hill/Irwin 2007
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 RED FLAGS

Source: ACFE 2012 Report to the Nation

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Source: Association of CFEs (ACFE)
Business Policies

Many organizations today look at an ethics policy to set

the proper tone towards motivating positive behaviors
as well preventing negative ones. It stands to reason
then that companies would want to have a proper
policy in place to battle fraud. An ethics policy can help
in prevention, in fighting fraud and mitigating its
damages.
 
SAMPLE BUSINESS ETHICS POLICY
We exist because we maintain our customer base.
 
The successful operation and reputation of [Company] depends upon the principles of fairness and ethical
conduct of our employees. Our reputation for integrity and excellence requires careful compliance with the
spirit and letter of all laws and regulations, as well as a personal commitment to the highest standards of
conduct and integrity.
 
The survival and success of this organization depends upon our customers’ trust. We must preserve that
trust. Employees have a duty to [Company], our customers and our shareholders to act in way that will
always merit the continued trust and confidence of the public and our customers.
[Company], its directors, managers, employees and vendors will comply with all applicable laws and
regulations, company policies, and community and industry standards. Directors, officers and employees
must conduct business in accordance with the letter, spirit and intent of all applicable laws and refrain from
any illegal, dishonest or unethical conduct.
 
You cannot avoid acting properly.
 
In general, the use of good judgment wills provides proper guidance. However, if a situation arises where it
is difficult to determine the proper course of action or you feel you are being pressured to act improperly,
the matter must be discussed with your immediate supervisor. If you are uncomfortable discussing the
situation with your immediate supervisor, you must contact your supervisor’s superior, the head of the
human resources, corporate general counsel or the president. You must act.
 
Compliance with this policy is the responsibility of every [Company] employee. Disregarding or failing to
comply with this policy will lead to disciplinary action, up to and including possible termination of
employment.
Sample Rules of Conduct
We try to make this a safe and pleasant place to work. The cooperation of all employees is
necessary o carry this out. People who have worked together for a long time realize that one
person’s misconduct may harm all the rest, and they expect certain standards of conduct to
be set.
 
The following list of improper performances is considered to be against the best interest of
the majority and will be subject to corrective actions including reprimand, warning, layoff or
dismissal:
 
1.Employees that being at their appointed work places, ready to work, at the regular starting
time and failing to remain at such work places and at work until relieved.
2.Stealing
3.Willful damage to, or destruction or theft of property belonging to fellow employees or the
Company.
4.Fighting, horseplay or disorderly conduct.
5.Punching another’s time card or falsifying any time or production record.
6.Refusing or failing to carry out a legitimate instruction of a supervisor.
7.Leaving your work station (except for reasonable personal needs) without permission from
your supervisor.
8.Inattention to duties, visiting or loafing during working hours.
9.Coming to work under the influence of alcohol or any drug, or bringing alcoholic beverages
or drugs onto Company property.
10.Intentionally giving any false or misleading information to obtain employment, a leave of
absence, or for any other employment purpose.
11. Smoking contrary to established practice or violating any other
employment, a leave of absence, or for any other fire protection
regulation.
12. Willful or habitual violation of safety or health regulations.
13. Frequent tardiness or unexcused absences from work.
14. Carelessness or neglect resulting in abuse to equipment and tools.
15. Unauthorized possession of firearms, cameras, or weapons of any
kind on Company property.
16. Use of threatening, harassing or abusive language toward a fellow
employee.
17. Unauthorized distribution of literature, or written or printed matter
of any description on Company premises.
18. Failure to wear clothing conforming to established standards.
19. Employees shall not enter the plant or remain on the premises unless
they are on duty, scheduled to work, or are otherwise authorized by
the Management.
20. Unauthorized use of Company equipment
Fraud And Company’s Risk Assessment
An organization’s profile of business risk should be
comprehensive and include consideration of fraud.

Company’s Response to Risk

Responsibility for detecting fraud has been illusive since the
advent of computer generated accounting and financial
statement preparation.

Fraud and Security Policy

Another way to forensic accountant can assist in the fight against
fraud is in reviewing or helping to audit the company’s security
measures.

Staffing Role in Fraud Detection and Prevention

Of course, staff selection and promotion based on sound
employment practices can fight fraud and help insure that if fraud
is detected, it is reported.
COMPANY FRAUD PREVENTION, DETECTION,
AND MITIGATION MEASURES
Companies on the Front Lines in Preventing Employee Fraud
 
The following are some principles companies should employ to help
stop fraud and abuse:
 
• Have a fraud hotline.
• Institute a mandatory vacation policy
• Rotate assignments of employees who handle cash, payables, and
receivables
• Have a written and signed ethics policy
• Have internal auditors do different procedures each time they
audit a unit
COMPANY FRAUD PREVENTION, DETECTION,
AND MITIGATION MEASURES
• Observed and listen to employees. Look for lifestyle changes
• Really understand the business unit, and what function
employees actually perform
• Do not allow employees or executives to get away with anything
• In a small business, the owner should receive the monthly bank
statements unopened.
• Bank statements should always be reconciled
• Do not assume employees behave honestly
• Think outside the box.
Commercial Activities
 
Related to management audit procedures below are the following
commercial measures that can help prevent fraud:

1. Does the company follow strict credit- management practice and

enforce credit limits?
2. Does the company follow good practice on credit card and
counterfeit money?
3. Are goods received and their prices checked against delivery notes
and invoices?