Master of Forensic Accounting: AFC 712: Accounting Fraud Examination

Handout 4
Updated: April 2011

Prof. Dr. Syed Noh Syed Ahmad

AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad


Preamble to Handout 5
‡ It is not possible to discuss all the possible frauds and fraud schemes involving employees. These fraud schemes are aptly named as ³fraud against the organisation´ ± the perpetrators of such fraud illegally took assets from the organisations for their own benefits. These assets include:
± ± ± ± Cash: physically or through fraudulent disbursements Inventory Other assets: Fixed assets, etc Corruption, bribery, kickbacks, etc
AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 2

‡ In terms of the fraud schemes, the types and methods used are as many as the perpetrators can imagine. ‡ Thus the focus for this handout is on the red flags for these frauds. ‡ For details and examples of these frauds, please refer to the text books for the program and internet sites.
AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 3

it is usually committed by knowledgeable people who know how to circumvent the system by knowing how to capitalize on the weaknesses in the business. However. Committing inventory fraud does not require unusually high intellect.) AFC 712 April 2011 HO 4 Prof. Persons who are involved in this type of fraud are those dealing directly and indirectly with the acquisition. (Compare this with Inventory fraud in financial statements. receiving and recording of the inventory processes. It has brought down multi-million dollar corporations with ease. Syed Noh Syed Ahmad 4 . Dr.Inventory Fraud ‡ Inventory fraud is one of the most damaging types of fraudulent activity that can go on in a corporation due to the value of the inventory and its far-reaching effects on the financial statements and investors.

Syed Noh Syed Ahmad 5 .What is Inventory Fraud? ‡ Fictitious Inventory ‡ Misuse of non-cash assets ‡ Misappropriation of non-cash assets ± Larceny ± Asset requisitions and transfers ± Purchasing and receiving schemes ± False shipments [None cash assets include inventory. Dr.] AFC 712 April 2011 HO 4 Prof. and other physical assets.

misuse or theft of the inventory. i. Dr. ‡ A simple example of fictitious inventory is to increase inventory asset value is by creating various records for items that do not exist: unsupported journal entries. the investigator normally uses other means to substantiate the existence and value of inventory. is very common.e. Syed Noh Syed Ahmad 6 . The instances of this type of inventory fraud. even though it does not involved the physical aspect of inventory . AFC 712 April 2011 HO 4 Prof. could be included as inventory fraud. inflated inventory count sheets. as discussed in the session concerning financial statement fraud. Since it can be difficult for the investigator to spot such phony documents.FICTITIOUS INVENTORY ‡ Fictitious inventory. the resulting financial statements would be considered as fraudulent. This is because of its impact on the financial statements and thus. bogus shipping and receiving reports and fake purchase orders.

Double-counting inventory in transit between locations. obsolete items or lower value materials. Diluted inventory so it is less valuable (e. 8. Manipulating the inventory counts/compilations for locations not visited by the auditor. adding water to liquid substances). or other containers. 9.g. 7 4. Consigned inventory. inventory that is rented. Empty boxes or "hollow squares" in stacked goods. Including in inventory merchandise recorded as sold but not yet shipped to a customer ("bill and hold sales"). Mislabeled boxes containing scrap. AFC 712 April 2011 HO 4 Prof. Dr. Programming the computer to produce fraudulent physical quantity tabulations or priced inventory listings. 10. 3. 5. 6.Examples of Fictitious Inventory Fraud Scheme (These are just a sample of the many possible inventory frauds!! I am sure that you wil be able to come up with a few more!!): 1. Physically moving inventory and counting it at two locations. 2. 7. or traded-in items for which credits have not been issued. Altering the inventory counts for those items the auditor did not test count.. Syed Noh Syed Ahmad .

increased wear on equipment. Syed Noh Syed Ahmad 8 .Misuse of Company Assets ‡ ³Borrowing´ company assets for personal use: ± Company vehicles ± Supplies ± Computers & office equipment ‡ Results in lost productivity. Dr. AFC 712 April 2011 HO 4 Prof. etc.

Dr. Syed Noh Syed Ahmad 9 . with access to secure inventory ‡ Examples: ± After-hours theft from warehouse/storeroom This is very common ± with or without µinside¶ help ± Fake sales scheme AFC 712 April 2011 HO 4 Prof.Inventory Larceny ‡ Strict theft of inventory ‡ Unconcealed on the books ‡ Persons involved are often highly trusted.

Shrinkage ‡ Employees sometimes falsify asset transfer forms AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 10 .‡ Fake Sales ‡ Purchasing and Receiving Schemes ‡ Fraudulent Asset Requisitions ‡ False Shipments of Inventory ‡ the assets requested are then classified as ‡ Concealing Inventory damaged or scrap. Dr.

‡ Shipping costs decreasing as a percentage of inventory. Dr. Syed Noh Syed Ahmad 11 . ‡ Falling cost of sales as a percentage of sales. ‡ Inventory rising faster than total assets move up.Red Flags for Inventory Fraud ‡ Inventory increasing faster than sales. ‡ Cost of goods sold on the books not agreeing with tax returns AFC 712 April 2011 HO 4 Prof. ‡ Decreasing inventory turnover.

ASSESSING THE RISK OF INVENTORY FRAUD ‡ Statement on Auditing Standards no. Dr. (this Statement is included in your reading materials) lists many factors at play in cases of inventory fraud affecting either the financial statements or specifically the inventory. 82. Syed Noh Syed Ahmad 12 . Consideration of Fraud in a Financial Statement Audit. the higher the risk for inventory fraud: AFC 712 April 2011 HO 4 Prof. The more ³yes´ answers.

‡ Is the company attempting to obtain financing secured by inventory? ‡ Is inventory a significant balance sheet item? ‡ Has the percentage of inventory to total assets increased over time? ‡ Has the ratio of cost of sales to total sales decreased over time? ‡ Have shipping costs fallen compared with total inventory? ‡ Has inventory turnover slowed over time? AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 13 .

or does it have a complex system to determine the value of inventory? ‡ Is the company involved in technology or another volatile or rapidly changing industry? AFC 712 April 2011 HO 4 Prof.‡ Have there been significant adjusting entries that have increased the inventory balance? ‡ After the close of an accounting period. Dr. have material reversing entries been made to the inventory account? ‡ Is the company a manufacturer. Syed Noh Syed Ahmad 14 .

Dr.Chapter 3: Skimming AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 15 .

16 . with a median loss of $50.0% Larceny 4.Skimming Schemes Cash Schemes Fraud Disb 67.1% Skimming 28.9% AFC 712 April 2011 HO 4 Prof. ‡ 316 cases of skimming were reported.000. Dr. Syed Noh Syed Ahmad ‡ Skimming makes up approximately 29% of cash frauds.

Dr. Syed Noh Syed Ahmad 17 .What is Skimming? ‡ Definition: theft of cash from victim organization before the cash hits the accounting system ‡ Off-book fraud ‡ No direct audit trail ‡ Books stay balanced ‡ Most common form of cash fraud AFC 712 April 2011 HO 4 Prof.

Syed Noh Syed Ahmad 18 . Dr.Deterrence Steps for Skimming ‡ ‡ ‡ ‡ Identify all revenue sources Determine where they enter the organization Record accountability immediately Restrictively endorse all checks ³For Deposit Only´ immediately ‡ Include revenue sources in organization¶s budget ‡ Review budget versus actual revenue ‡ Identify and investigate significant variances AFC 712 April 2011 HO 4 Prof.

Dr.Common Skimming Schemes ‡ Sales skimming ‡ Receivables skimming ‡ Refunds and other skimming schemes AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 19 .

3% Sales 64. . Dr.5% Recvbls 25. as opposed to receivables. 203 involved the theft of sales.Skimming Schemes ± Breakdown of Cases Other 10.2% AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad ‡ Of 316 skimming schemes that were studied. ‡ Sales skimming is easier to conceal because payments are 20 not expected.

000 21 . Dr.000 AFC 712 April 2011 HO 4 Prof.000 $52. Syed Noh Syed Ahmad $50.500 Skimming Receivables $30.000 $35.000 $40.000 $45.Skimming Schemes Median Losses Skimming Sales $44.000 $55.

Sales Skimming Schemes ‡ Unrecorded sales ± Perp makes a sale. Dr. pockets money ± Never records sale ‡ Understated sales ± Perp pockets a portion of a sale ± Either records sale at lower price or smaller quantity of goods sold AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 22 .

Sales Skimming Schemes
‡ Register manipulations
± Cash register clerk rings ³no sale´ ± Pockets money ± Looks like transaction was recorded

‡ Skimming during off-hours
± Perps sell company merchandise on weekends or after hours

AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad


Sales Skimming Countermeasures
‡ Surveillance of employees at point of sale ‡ Maintain secure area for employees to store coats, purses, etc. ‡ Investigate gaps in transaction sequence/pre-numbered receipts ‡ Look for excessive non-sale transactions (voids, refunds) at cash registers
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Sales Skimming Countermeasures
‡ Encourage customers to request receipts (forces employees to ring up sales) ‡ Rotate employee schedules, measure variances in revenue based on employee ‡ Use a secret shopper service

AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad


Skimming Off-Site Sales ‡ Remote salespersons largely unsupervised ‡ Common with insurance salespersons: ± Sell a policy. Syed Noh Syed Ahmad 26 . Dr. policy never filed ‡ Property managers: ± Lease a property. list it as vacant ± Pocket rents AFC 712 April 2011 HO 4 Prof.

Dr.Skimming Off-Site Sales ± Countermeasures ‡ Require external sales staff to maintain activity logs ‡ Spot-check activity log entries by independent personnel ‡ Monitor customer complaints independent of sales staff ‡ Conduct sales trend analysis on external salespersons AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 27 .

Syed Noh Syed Ahmad 28 .Theft in the Mailroom ‡ Mailroom employees steal incoming checks ‡ Checks never logged ‡ Usually occurs when one employee opens mail unsupervised AFC 712 April 2011 HO 4 Prof. Dr.

Syed Noh Syed Ahmad 29 . verify that they are logged AFC 712 April 2011 HO 4 Prof. Dr.Theft in the Mailroom Countermeasures ‡ Open mail in visible area with supervisory presence or video cameras ‡ Use two employees to open mail ‡ No purses or briefcases where mail is opened ‡ Have incoming payments sent to lockbox ‡ Mail marked checks to company.

Dr. Syed Noh Syed Ahmad 30 .Receivables Skimming ‡ More difficult to conceal than sales skimming ‡ Incoming payments ³expected´ ‡ Can result in delinquent customer accounts ‡ Perp must take steps to conceal the fraud AFC 712 April 2011 HO 4 Prof.

Syed Noh Syed Ahmad 31 . Dr.How Skimming is Concealed ‡ ‡ ‡ ‡ ‡ Destroy or alter transaction records Lapping Steal customer statements False account entries Inventory padding AFC 712 April 2011 HO 4 Prof.

‡ Most common concealment technique ‡ Perp may keep 2nd set of books to track misapplications AFC 712 April 2011 HO 4 Prof. Dr. etc. Syed Noh Syed Ahmad 32 .Lapping ‡ Steal customer A¶s payment ‡ Apply customer B¶s payment to A¶s account.

verify names on checks match postings ‡ Compare a/r postings to dates payments were mailed by customers AFC 712 April 2011 HO 4 Prof. Dr.Lapping ± Countermeasures ‡ Watch for employees who put in a lot of time after-hours and on weekends (lapping schemes take a lot of work) ‡ Enforce mandatory vacations ‡ Spot-check daily deposits to accounts receivable. Syed Noh Syed Ahmad 33 .

Stealing Customer Statements ‡ This is done when skimming causes a customer account to become delinquent ‡ Usually change customer address in billing system ‡ Replace real statements with counterfeits showing account current ‡ Keeps customer from alerting company AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 34 . Dr.

accounts receivable ‡ Separate mail function from accounts receivable AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 35 . Dr.Stealing Customer Statements Countermeasures ‡ Independent confirmations of aging a/r with customers ‡ Separate collections department from sales.

Syed Noh Syed Ahmad 36 .False Account Entries to Hide Skimming ‡ Debit expense account instead of cash ‡ Debit aging receivables or very large accounts ‡ Write off accounts as bad debts ‡ Create fraudulent ³discounts´ ‡ Force account balances (add wrong) AFC 712 April 2011 HO 4 Prof. Dr.

False Account Entries ± Countermeasures ‡ Separate duties of receiving cash. Dr. Syed Noh Syed Ahmad 37 . posting payments. and reconciling accounts ‡ Match deposit totals to a/r postings ‡ Investigate shortages in cash account ‡ Require supervisory approval for write-offs ‡ Look for rising trend in write-offs. discounts ‡ Look for large number of aging accounts AFC 712 April 2011 HO 4 Prof.

Dr. obsolete AFC 712 April 2011 HO 4 Prof. stolen.Inventory Padding ‡ Unrecorded sales cause inventory shrinkage ‡ Common concealment techniques: ± Forced reconciliation of perpetual & physical inventory ± False credits to inventory ± Write off as lost. Syed Noh Syed Ahmad 38 .

Syed Noh Syed Ahmad 39 . Dr.Skimming Controls ‡ Segregate all cash receipting functions ‡ Supervise employees at all cash collection points ‡ Supervise employees who open mail ‡ Place restrictive endorsements on all checks received ‡ Enforce mandatory vacations ‡ Conduct surprise audits/cash counts AFC 712 April 2011 HO 4 Prof.

Skimming Controls ‡ Supervisory authority for all price modifications and write-offs ‡ Independently confirm delinquent customer accts. Dr. ‡ Random customer satisfaction surveys ‡ Follow up on customer complaints AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 40 .

Dr. Syed Noh Syed Ahmad 41 .Cash Larceny AFC 712 April 2011 HO 4 Prof.

4. ‡ 45 cash larceny cases were reported. Syed Noh Syed Ahmad ‡ Larceny is the least common of the three major cash misappropriation categories.9% Fraud Disb 67.0% Cash Larc. with a median loss of $22. Dr.Cash Larceny Cash Schemes Skim 28.000.1% AFC 712 April 2011 HO 4 Prof. 42 .

Dr. Syed Noh Syed Ahmad 43 .What is Cash Larceny? ‡ Definition: ± Intentional taking ± Of employer¶s cash ± Without employer¶s consent ‡ ³Cash´ includes currency and checks AFC 712 April 2011 HO 4 Prof.

Dr.Cash Larceny v. Skimming ‡ Skimming is theft of off-book funds ‡ Cash larceny is theft of on-book funds ‡ Cash larceny: ± Less common than skimming ± Less costly than skimming ± Direct audit trail AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 44 .

Syed Noh Syed Ahmad 45 . Dr.Cash Larceny Schemes ‡ Theft of cash on hand ± From cash register or cash box ± Posted customer payments ‡ Theft from the deposit AFC 712 April 2011 HO 4 Prof.

Dr. Syed Noh Syed Ahmad 46 .How Cash Larceny is Concealed ‡ ‡ ‡ ‡ ‡ Unconcealed Personal check in register Reversing transactions (voids/refunds) Alter cash counts Destroy/alter transaction records AFC 712 April 2011 HO 4 Prof.

Cash Larceny from the Deposit ‡ Perp usually in charge of daily deposit ‡ Steal the currency. Dr. Syed Noh Syed Ahmad 47 . reconciles bank account ± Failure to reconcile deposits/receipts ± Deposit left unattended before going to bank AFC 712 April 2011 HO 4 Prof. deposit the checks ‡ Poor controls are the key ± One person prepares/makes deposit.

Syed Noh Syed Ahmad 48 . Dr.Concealing Larceny from the Deposit ‡ Deposit lapping ± Steal Day 1 deposits ± Cover with subsequent receipts ‡ Deposits in transit ± Missing money carried on books as ³deposits in transit´ AFC 712 April 2011 HO 4 Prof.

deposits. etc. ‡ Investigate missing or altered sales records ‡ Have two people independently verify deposits on bank statement to postings in general ledger ‡ Maintain and review daily cash availability amounts AFC 712 April 2011 HO 4 Prof.Cash Larceny Countermeasures ‡ Investigate shortages in cash drawers. Dr. Syed Noh Syed Ahmad 49 .

Cash Larceny Countermeasures ‡ Have deposits delivered to bank under dual control ‡ If fraud suspected. verify deposit prior to dispatch without suspect¶s knowledge. verify at beginning of next day ‡ Make sure deposits in transit are first items to clear on next statement AFC 712 April 2011 HO 4 Prof. then contact bank to confirm that deposit was made ‡ Have deposits made in night drop. Syed Noh Syed Ahmad 50 . Dr.

Register Disbursement Schemes AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 51 .

What Are Register Disbursements? ‡ Form of fraudulent disbursement ‡ Cash stolen from cash register ‡ Perpetrator enters a reversing transaction to justify the disbursement of funds ‡ Register is balanced AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 52 . Dr.

500. . Syed Noh Syed Ahmad ‡ Register disbursements made up only 3% of fraudulent disbursement cases. ‡ 20 register disbursement cases were reported.Register Disbursements Fraudulent isbursements Billing 33. with a median loss of 53 $22.1% xpense 14.5% ther 8.5% egister 2.9% Payroll 16.3% heck amp 24.7% AFC 712 April 2011 HO 4 Prof. Dr.

Fraudulent Register Disbursements Two Principle Schemes: ‡ False refunds ‡ False voids AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 54 .

They were almost evenly split between fraudulent voids and refunds. 55 Voids 45% Refunds 55% AFC 712 April 2011 HO 4 Prof.Register Disbursements ± Breakdown of Cases Only 20 register disbursement cases were reported in the 1993 study. Dr. Syed Noh Syed Ahmad .

‡ Overa .000 $50. $20. Syed Noh Syed Ahmad s f r fra e v s was e ha f fra e ref e a s f a reg s er s he e was $22.Register Disbursements Median Losses ‡ The e a re ha w s he es.000 $40. he sb rse e Fra ef Fa V e s e s $0 AFC $20.000 4 Prof.000 56 $50. Dr.000 .000 $10.000 712 April 2011 HO$30.500.

skim excess AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 57 . Dr.False Refunds ‡ Fictitious refunds ± No merchandise actually returned ± Results in overstated inventory ‡ Overstated refunds ± Overstate a legitimate refund.

False Refunds Credit card refunds ‡ Credit refunds to accomplice account ± Accomplice kicks back portion of the refund ‡ Perp credits refund to his own account AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 58 .

uses receipt to process false void ± May need manager approval ± Forge signature ± Manager ³rubber stamps´ voids ‡ Perp pockets money AFC 712 April 2011 HO 4 Prof. keeps customer¶s receipt ‡ After customer gone.False Voids ‡ Perp makes sale. Syed Noh Syed Ahmad 59 . Dr.

Syed Noh Syed Ahmad 60 . Dr.Concealing Register Disbursements ‡ Multiple disbursements below review level ‡ Destroy transaction records ‡ Rely on company: nobody looking for fraud AFC 712 April 2011 HO 4 Prof.

it¶s free! AFC 712 April 2011 get Prof.Register Disbursements ± Countermeasures ‡ Periodically run trend analysis. especially round numbers ‡ Look for excessive refunds/voids just below review levels ‡ Encourage customers to examine their receipts ± if you don¶t HO 4 one. Dr. Syed Noh Syed Ahmad 61 . look for employees who process too many reversals ‡ Look for refunds/voids in recurring amounts.

Dr. Syed Noh Syed Ahmad 62 .Register Disbursements ± Countermeasures ‡ Verify transactions by making random ³customer satisfaction´ calls to customers who have returned merchandise ‡ Be alert for multiple refunds for the same merchandise ‡ Look for refunds/voids with no corresponding sale AFC 712 April 2011 HO 4 Prof.

Syed Noh Syed Ahmad 63 . Dr.Register Disbursement Controls ‡ Require management approval for all refunds/voids ‡ Maintain management presence at cash registers ‡ Restrict access to control key that authorizes reversing entries ‡ Cashiers should not be allowed to reverse their own sales AFC 712 April 2011 HO 4 Prof.

Dr. Syed Noh Syed Ahmad 64 .Register Disbursement Controls ‡ Maintain file on all voids/refunds ‡ Require separate log-in code for every cashier ‡ Require copy of customer receipt with all reversals ‡ Someone independent of cashiers should prepare register count sheets AFC 712 April 2011 HO 4 Prof.

Register Disbursement Controls ‡ Observe Inventory ‡ Run perpetual inventory if possible AFC 712 April 2011 HO 4 Prof. Dr. Syed Noh Syed Ahmad 65 .

Dr. This may expose the organization to significant risk. we recommend that you consider the following: AFC 712 April 2011 HO 4 Prof. Syed Noh Syed Ahmad 66 . management is sometimes tempted to resolve the matter internally. When you become aware of incidents or suspicions of fraud in your organization.Initial Action In The Event Of Fraud .As Recommended By KPMG ‡ When fraud occurs or is suspected.

± Limit the scope of your concerns to a specific issue. ± Damage or mark any evidence or potential evidence.As Recommended By KPMG ‡ Do not: ± Respond emotionally or act hastily. ± Immediately confront the suspects. Syed Noh Syed Ahmad 67 . Dr. AFC 712 April 2011 HO 4 Prof.Initial Action In The Event Of Fraud .

Dr. ± Call in the professionals. ± Carefully preserve any evidence by removing access to documents and electronic media.As Recommended By KPMG ‡ Do ± Be objective in your assessment.Initial Action In The Event Of Fraud . ± Limit the number of people whom you discuss your suspicions. Syed Noh Syed Ahmad 68 . AFC 712 April 2011 HO 4 Prof.

computers. lockers. AFC 712 April 2011 HO 4 Prof. Dr. and also wrongful invasion of privacy (through improper searches of desk. personal storage). Be objective. voicemails. ‡ Guard against legal exposures to defamation. security camera tapes. libel and slander.documents. offers to waive reporting to the authorities or to waive prosecution in return for co-operation. Syed Noh Syed Ahmad 69 . ‡ Focus on the facts. inducements. Avoid communicating judgments / conclusions and making accusations unless evidence has been obtained. promises. violations of law on audio / videotaping of conversations and the use of threats. emails. personal laptops.G n l inv tig tion ul ‡ Preserve the evidence . phone logs.

Syed Noh Syed Ahmad 70 . losing the suspect's cooperation and creating a perception of a lack of objectivity. AFC 712 April 2011 HO 4 Prof.G n l inv tig tion ul ‡ Act professionally. Guard against other actions likely to be inconsistent with the corporate image or damaging to the corporate reputation. Dr. ‡ Ensure that disciplinary action does not precede the completion of the investigation to avoid the risk of making a wrongful termination.

both during and after. Syed Noh Syed Ahmad 71 . Consider how it will reflect on the company's reputation for being ethical. AFC 712 April 2011 HO 4 Prof. against fraud / illegal acts and for treating its employees with respect.G n l inv tig tion ul ‡ Always consider how the investigation will be perceived not only the subject but also by others. Dr. Inappropriate actions or a poorly conducted investigation can severely damage employee relations and set back the company's attempts to promote a law-abiding workplace.

Syed Noh Syed Ahmad 72 .AFC 712 April 2011 HO 4 Prof. Dr.