PRINCIPLES OF FRAUD EXAMINATION

THIRD EDITION JOSEPH T. WELLS, CFE, CPA

WILEY
JOHN WILEY & SONS, INC.

CONTENTS
CHAPTER 1 INTRODUCTION 3 Cash Larceny Data from the ACFE 2009 Global Fraud Survey 75 Cash Larceny Schemes 75 Larceny at the Point of Sale 76 Larceny of Receivables 80 Cash Larceny from the Deposit 81 Case Study: The 01' Fake Surprise Audit Gets 'Em Every Time 84 Proactive Computer Audit Tests for Detecting Cash Larceny 85 Summary 87 Essential Terms 87 Review Questions 87 Discussion Issues 88 Endnotes 88 CHAPTER 4 BILLING SCHEMES 91

Fraud Examination Methodology 5 Predication 5 Fraud Theory Approach 5 Tools Used in Fraud Examinations 6 Defining Occupational Fraud and Abuse 8 Defining Fraud 8 Defining Abuse 10 Research in Occupational Fraud and Abuse 12 Edwin H. Sutherland 12 Donald R. Cressey 13 Dr. W. Steve Albrecht 21 Richard C. Hollinger 24 The 2010 Report to the Nations on Occupational Fraud and Abuse 30 Detecting and Preventing Occupational Fraud 42 Summary 44 Essential Terms 44 Review Questions 45 Discussion Issues 46 Endnotes 46 CHAPTER 2 SKIMMING 49

Case Study: Shy Doc Gave Good Face 49 Overview 51 Skimming Data from the ACFE 2009 Global Fraud Survey 52 Skimming Schemes 52 Sales Skimming 53 Receivables Skimming 60 Case Study: Beverage Man Takes the Plunge 61 Proactive Computer Audit Tests Detecting Skimming 67 Summary 70 Essential Terms 70 Review Questions 70 Discussion Issues 71 Endnotes 71 CHAPTER 3 CASH LARCENY 73 73

Case Study: Bank Teller Gets Nabbed for Theft Overview 75

Case Study: Medical School Treats Fraud and Abuse 91 Overview 93 Billing Scheme Data from the ACFE 2009 Global Fraud Survey 94 Billing Schemes 95 Shell Company Schemes 95 Billing Schemes Involving Non-Accomplice Vendors 103 Pay-and-Return Schemes 103 Overbilling with a Non-Accomplice Vendor's Invoices 104 Case Study: Cover Story: Internal Fraud 104 Preventing and Detecting Fraudulent Invoices from a Non-Accomplice Vendor 106 Personal Purchases With Company Funds 107 Personal Purchases through False Invoicing 107 Personal Purchases on Credit Cards or Other Company Accounts 111 Preventing and Detecting Personal Purchases on Company Credit Cards and Purchasing Cards 112 Proactive Computer Audit Tests for Detecting Billing Schemes 112 Summary 115 Essential Terms 115 Review Questions 116 Discussion Issues 116 Endnotes 116

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CONTENTS CHAPTER 5 CHECK TAMPERING 119

Case Study: A Wolf in Sheep's Clothing 119 Overview 121 Check Tampering Data from the ACFE 2009 Global Fraud Survey 121 Check Tampering Schemes 121 Forged Maker Schemes 123 Forged Endorsement Schemes 128 Altered Payee Schemes 133 Concealed Check Schemes 136 Authorized Maker Schemes 138 Concealing Check Tampering 140 The Fraudster Reconciling the Bank Statement 141 Case Study: What Are Friends For? 142 Re-Altering Checks 144 Falsifying the Disbursements Journal 144 Reissuing Intercepted Checks 145 Bogus Supporting Documents 145 Electronic Payment Tampering 146 Prevention and Detection 146 Proactive Computer Audit Tests for Detecting Check Tampering Schemes 148 Summary 149 Essential Terms 150 Review Questions 150 Discussion Issues 151 Endnotes 151
CHAPTER 6 PAYROLL SCHEMES 153

Expense Reimbursement Schemes 180 Mischaracterized Expense Reimbursements 180 Overstated Expense Reimbursements 183 Fictitious Expense Reimbursement Schemes 185 Multiple Reimbursement Schemes 188 Case Study: The Extravagant Salesman 189 Proactive Computer Audit Tests for Detecting Expense Reimbursement Schemes 191 Summary 191 Essential Terms 191 Review Questions 192 Discussion Issues 192 Endnotes 192 > CHAPTER 8
195

REGISTER DISBURSEMENT SCHEMES

Case Study: Say Cheese! 153 Overview 155 Payroll Scheme Data from the ACFE 2009 Global Fraud Survey 155 Payroll Schemes 156 Ghost Employees 156 Falsified Hours and Salary 161 Commission Schemes 165 Case Study: The All-American Girl 167 Proactive Computer Audit Tests for Detecting Payroll 'Fraud 169 Summary 173 Essential Terms 174 Review Questions 174 Discussion Issues 174 Endnotes 174 CHAPTER 7 177 EXPENSE REIMBURSEMENT SCHEMES

Case Study: Demotion Sets Fraud In Motion 195 Overview 197 Register Disbursement Data from the ACFE 2009 Global Fraud Survey 197 Register Disbursement Schemes. 197 False Refunds 198 Case Study: A Silent Crime 200 False Voids 202 Concealing Register Disbursements 204 Small Disbursements 204 Destroying Records 205 Preventing and Detecting Register Disbursement Schemes 205 Proactive Computer Audit Tests for Detecting Register Disbursement Schemes 206 Summary 207 Essential Terms 207 Review Questions 207 Discussion Issues 208 Endnotes 208
CHAPTER 9 NONCASH ASSETS 211

Case Study: Frequent Flier's Fraud Crashes 177 Overview 179 Expense Reimbursement Data from the ACFE 2009 Global Fraud Survey 179

Case Study: Chipping Away At High-Tech Theft 211 Overview 213 Noncash Misappropriation Data from the ACFE 2009 Global Fraud Survey 213 Noncash Misappropriation Schemes 215 Misuse of Noncash Assets 215 Unconcealed Larceny Schemes 216 Asset Requisitions and Transfers 220 Purchasing and Receiving Schemes 221 False Shipments of Inventory and Other Assets 222 Case Study: Hard Drives and Bad Luck 224 Other Schemes 226 Concealing Inventory Shrinkage 226 Altered Inventory Records 227

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Fictitious Sales and Accounts Receivable 227 Write Off Inventory and Other Assets 228 Physical Padding 228 Preventing and Detecting Thefts of Noncash Tangible Assets That are Concealed by Fraudulent Support 228 Misappropriation of Intangible Assets 229 Misappropriation of Information 229 Misappropriation of Securities 230 Proactive Computer Audit Tests for Detecting Noncash Misappropriations 231 Summary 233 Essential Terms 233 Review Questions 233 Discussion Issues 234 Endnotes 234 CHAPTER 10 CORRUPTION 237

Case Study: Why Is This Furniture Falling Apart? 237 Overview 239 Corruption Data from the ACFE 2009 Global Fraud Survey 239 Corruption Schemes 241 Bribery 242 Kickback Schemes 242 Overbilling Schemes 244 Bid-Rigging Schemes 248 Something of Value 253 Illegal Gratuities 254 Economic Extortion 254 Conflicts of Interest 255 , Case Study: Working Double Duty 256 Purchasing Schemes 258 Sales Schemes 260 Other Conflict of Interest Schemes 261 Preventing and Detecting Conflicts of Interest 261 Proactive Computer Audit Tests for Detecting Corruption 262 Summary 265 Essential Terms 265 Review Questions 266 Discussion Issues 266 Endnotes 267 CHAPTER 11
269

Economic Entity 273 Going Concern 273 Monetary Unit 273 Periodicity 274 Historical Cost 274 Revenue Recognition 274 Matching 274 Full Disclosure 274 Cost-Benefit 275 Materiality 275 Industry Practice 275 Conservatism 275 Relevance and Reliability 275 Comparability and Consistency 276~~ ' Responsibility for Financial Statements 276 Users of Financial Statements 276 Types of Financial Statements 277 The Sarbanes-Oxley Act of 2002 278 Public Company Accounting Oversight Board 282 Certification Obligations for CEOs and CFOs 284 New Standards for Audit Committee Independence 285 New Standards for Auditor Independence 286 Enhanced Financial Disclosure Requirements 287 Protections for Corporate Whistleblowers under Sarbanes-Oxley 288 Enhanced Penalties for White-Collar Crime 289 Financial Statement Fraud Data from the ACFE 2009 Global Fraud Survey 291 Frequency and Cost 291 Types of Fraudulent Financial Statement Schemes 292 Summary 292 Essential Terms 292 Review Questions 293 Discussion Issues 293 CHAPTER 12 FRAUDULENT FINANCIAL STATEMENT SCHEMES 295 Case Study: That Way,Lies Madness 295 Overview 298 Defining Financial Statement Fraud 299 Costs of Financial Statement Fraud 299 Fictitious Revenues 301 Sales with Conditions 303 Pressures to Boost Revenues 303 Red Flags Associated with Fictitious Revenues 304 Timing Differences 305 Matching Revenues with Expenses 305 Premature Revenue Recognition 306 Long-Term Contracts 308 Channel Stuffing 308 Recording Expenses in the Wrong Period 308 Red Flags Associated with Timing Differences 309 Case Study: The Importance of Timing 309

A CCO UNTING PRINCIPLES AND FRA UD

Fraud In Financial Statements 269 Who Commits Financial Statement Fraud? 270 Why Do People Commit Financial Statement Fraud? 270 How Do People Commit Financial Statement Fraud? 271 Conceptual Framework for Financial Reporting 272

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CONTENTS

Concealed Liabilities and Expenses 310 Liability/Expense Omissions 310 Capitalized Expenses 312 Expensing Capital Expenditures 313 Returns and Allowances and Warranties 313 Red Flags Associated with Concealed Liabilities and Expenses 313 Improper Disclosures 314 Liability Omissions 314 Subsequent Events 314 Management Fraud 315 Related-Party Transactions 315 Accounting Changes 316 Red Flags Associated with Improper Disclosures 316 Improper Asset Valuation 317 _ Inventory Valuation 317 Accounts Receivable 318 Business Combinations 319 Fixed Assets 319 Red Flags Associated with Improper Asset Valuation. 322 Detection of Fraudulent Financial Statement Schemes 323 SAS No. 99 (AU 316)Consideration of Fraud in a Financial Statement Audit 323 Financial Statement Analysis 331 Deterrence of Financial Statement Fraud 337 Reduce Pressures to Commit Financial Statement Fraud 337 Reduce the Opportunity to Commit Financial Statement Fraud 337 Reduce Rationalization of Financial Statement Fraud 338 Case Study: All on the Surface 338 Summary 341 Essential Terms 341 Review Questions 342 Discussion Issues 342

CHAPTER 13

FRAUD RISK ASSESSMENT

343

Overview 343 What Is Fraud Risk? 343 Why Should an Organization Be Concerned about Fraud Risk? 344 Factors That Influence Fraud Risk 344 What Is a Fraud Risk Assessment? 345 What Is the Objective of a Fraud Risk Assessment? 345 Why Should Organizations Conduct Fraud Risk Assessments? 345 Improve Communication and Awareness about Fraud 345

Identify What Activities Are the Most Vulnerable to Fraud 345 Know Who Puts the Organization at the Greatest Risk 346 Develop Plans to Mitigate Fraud Risk 346 Develop Techniques to Determine Whether Fraud Has Occurred in High-Risk Areas 346 Assess Internal Controls 346 Comply with Regulations and Professional Standards 346 What Makes a Good Fraud Risk Assessment? 347 Collaborative Effort of Management and Auditors 347 The Right Sponsor 347 Independence and Objectivity of the People Leading and Conducting the Work 348 A Good Working Knowledge of the Business 348 Access to People at All Levels of the Organization 348 Engendered Trust 349 The Ability to Think the Unthinkable 349 A Plan to Keep It Alive and Relevant 349 Considerations for Developing an Effective Fraud Risk Assessment 349 Packaging It Right 349 One Size Does Not Fit All 350 Keeping It Simple 350 Preparing the Company for the Fraud Risk Assessment 350 Assembling the Right Team to Lead and Conduct the Fraud Risk Assessment 350 Determining the Best Techniques to Use in Conducting the Fraud Risk Assessment 351 Obtaining the Sponsor's Agreement on the Work to Be Performed 352 Educating the Organization and Openly Promoting the Process 352 Executing the Fraud Risk Assessment 352 Identifying Potential Inherent Fraud Risks 353 Assessing the Likelihood of Occurrence of the Identified Fraud Risks 355 Assessing the Significance to the Organization of the Fraud Risks 356 Evaluating Which People and Departments Are Most Likely to Commit Fraud, and Identifying the Methods They Are Likely to Use 356 Identifying and Mapping Existing Preventive and Detective Controls to the Relevant Fraud Risks 356 Evaluating Whether the Identified Controls Are Operating Effectively and Efficiently 357 Identifying and Evaluating Residual Fraud Risks Resulting from Ineffective or Nonexistent Controls 357 Addressing the Identified Fraud Risks 358 Establishing an Acceptable Level of Risk 358

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Responding to Residual Fraud Risks 358 Reporting the Results of the Fraud Risk Assessment 359 Considerations When Reporting the Assessment Results 359 Making an Impact with the Fraud Risk Assessment 360 Beginning a Dialogue across the Company 360 Looking for Fraud in High-Risk Areas 360 Holding Responsible Parties Accountable for Progress 360 Keeping the Assessment Alive and Relevant 361 The Fraud Risk Assessment and the Audit Process 361 Fraud Risk Assessment Tool 362 Summary 362 Essential Terms 362 Review Questions 363 Discussion Issues 363 Endnotes 363 CHAPTER 14 CONDUCTING INVESTIGATIONS AND WRITING REPORTS 365 When Is an Investigation Necessary? 365 Planning the Investigation 366 Selecting the Investigation Team 366 Developing Evidence 369 Covert Operations 369 Surveillance 370 Informants 370 "Dumpster-Diving" 370 Subpoenas 371 Search Warrants 371 Voluntary Consent 371 Preserving Documentary Evidence 371 Chain of Custody 372 Preserving the Document 372 Organizing Documentary Evidence 373 Chronologies 373 To-Do Lists 373 Using Computer Software to Organize Documents and Other Data 373 Sources of Information 374 In-House Sources 374 Public Information 374 Report Writing 382 Purpose of the Report 382 Know the Reader 383 Format 383 Opinions or Conclusions in Report 388 Summary 388 Essential Terms 389 Review Questions 389 Discussion Issues 390

CHAPTER 15

INTERVIEWING WITNESSES 391

Overview 391 Introductory Questions 391 General Rules for the Introductory Phase of the Interview 392 Informational Questions 394 Closing Questions 397 Assessment Questions 398 Verbal Clues to Deception 399 Nonverbal Clues 400 Typical Attitudes Displayed by Respondents 401 Admission-Seeking Questions 404 Steps in the Admission-Seeking Interview 406 Summary 415 Essential Terms 415 Review Questions 416 Discussion Issues 416 CHAPTER 16 OCCUPATIONAL FRA UD AND ABUSE: THE BIG PICTURE 417 Defining Abusive Conduct 417 Measuring the Level of Occupational Fraud and Abuse 419 The Human Factor 419 Understanding Fraud Deterrence 421 The Impact of Controls 421 The Perception of Detection 421 The Corporate Sentencing Guidelines 424 Definition of Corporate Sentencing 424 Vicarious or Imputed Liability 424 Requirements 425 The Ethical Connection 425 Concluding Thoughts 427 Summary 428 Essential Terms 428 Review Questions 429 Discussion Issues 429 Endnotes 429 APPENDIX A ONLINE SOURCES OF INFORMATION 431 APPENDIX B SAMPLE CODE OF BUSINESS ETHICS AND CONDUCT 439 APPENDIX C FRAUD RISK ASSESSMENT TOOL BIBLIOGRAPHY INDEX 489 483 453