Fraud Detection – Scenarios & Tests by Process
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This guide provides examples of fraud, and analytical procedures used to detect these frauds in six areas:1. Cash and Cash Sales
2. Accounts Receivable/Sales
3. Inventory/Cost of Sales
4. Accounts Payable
5. Payroll
6. Other Fraud Areas
The guide can be used for training purposes to ensure auditors understand the types of illegal activities that can occur within standard business processes.
CASH AND CASH SALES
Petty Cash
1. Often overlooked because it is not material, petty cash can be the locus of fraud. If this fraud is not detected and corrected it can lead to larger amounts being taken.
2. One company in the southeast was defrauded of nearly $100,000 in petty cash funds.
TEST: Look for a pattern of frequent reimbursements and/or expenditures for services and/or expendable items, that is, no assets that can be substantiated.
Cash Sales
1. Cash sales provide opportunity for theft of cash.
2. Cash sales can be unreported.
TEST: Watch inventory turnover and inventory write offs . Prenumbered sales tickets should be used. All purchases of inventory should be identified by invoice and purchase order.
Kiting
1. Kiting is based on the fact that there is a two-day to two-week delay in clearing deposits and withdrawals.
2. It is the use or withdrawal of nonexistent funds from a checking account.
3. Funds are withdrawn before they clear and then are covered with new deposits.
4. In complex cases, double counting of funds is possible as funds are counted as present in one account and as a deposit waiting to clear in another account.
TEST: Look for delayed payments on accounts.
ACCOUNTS RECEIVABLE / SALES
Destruction of Ledgers
1. An accounts receivable clerk was able to intercept customer receipts. He then removed and destroyed the customer’s ledger card in order to hide the fraud. The out-of-balance condition was relatively small, so the auditor made an adjusting entry each month to make the subsidiary ledger agree with the general ledger.
2. Over a two-year period this pilferage amounted to a significant shortage.
TEST: Analysis of the steadily declining gross profit percentage. Upon investigation, the small adjustments were seen to be in total quite significant, and the pilferage was discovered.
Lapping
Payments made by customers are partly or entirely intercepted by employees and future payments are used to cover older deficits before the customers discover the error in their accounts. The scheme usually grows to the point where it is difficult to disguise. The employee then inserts a personal check to cover the deficit and is detected by this action, by customer complaints, or by an analysis of account aging.
1. A manager of a local branch intercepted customer payments and lapped them with later payments to divert attention from the theft.
2. The auditors’ confirmation letters included some of these accounts. The manager called the customers to explain that the auditor had made an error and to tell them how to respond on the confirmation.
3. At one point the lapping became difficult to cover and the manager inserted a personal check to collections to help bring things back into balance.
TEST: Look for a decrease in accounts receivables or an increase in aging of receivables.
Intercepting Receipts and Destroying Invoices
1. Hanah F. was a cashier for a company. The company prepared invoices in three forms, one for the customer, one for accounting, and one for the accounts receivable clerk.
2. Hanah functioned as both accounting and cash receipts clerk, because the company trusted her and because it did not emphasize controls.
3. To pay for a variety of personal needs, Hanah would intercept customer payments or replace them with cash from the cash drawer and destroy the two copies of the invoice.
4. Prenumbered forms were not reconciled, so eventually her thefts amounted to about $50,000.
TEST: Note how a poor control environment makes analytical review less effective. Unless amounts are large or some employee tips management off, this type of theft is difficult to detect.
Diverting Receipts and Manipulating Writeoffs
The computer personnel of a hospital were able to divert customer payments of more than $60,000. The computer records were manipulated to show that these accounts had been written off as uncollectible.
TEST: Watch the trend of receivables written off. There should be a predictable relationship to sales and to total receivables, over time and in comparison to the average for the industry.
Selling a Company
1. A new company was starting to experience a good bit of success; a related company offered to purchase the new company.
2. During the purchase negotiations, the owner of the small new company beefed up the sales and profit picture of the company by making purchases on his own account.
3. The eventual sales figure for the new company was determined by the net assets figure of the new company plus a figure for goodwill as a percent of net assets, so the owner was able to capitalize on these phony sales.
TEST: Inventory turnover analysis might show the problem, if the owner was not showing a shipment or credit to inventory for the sales. Also, analysis of customer mix of cash sales as a portion of total sales or comparison to production capacity might uncover the problem.
Sales on Consignment
1. Companies can boost reported sales by showing shipments of goods on consignment or on a trial basis as valid sales. A Company, maker of modular homes, followed this practice in 1970-1971. The modular homes were shipped to customers without a binding contract for purchase.
2. The company can keep attention away from such a situation by adding periodic credits and new charges so that the account appears active, even though no sale has occurred.
TEST: Watch inventory turnover; there should be a decline in turnover to reflect the slow moving, obsolete items. An aging of receivables, if not prepared or manipulated, might show up the problem. If the fraud is carried out on a small scale, it might be difficult to detect.
Intercompany Receivables
1. AX Company had a subsidiary, a brewery that was losing money badly. The brewery was transferred to a new entity called The Investment Company, another subsidiary of AX Company.
2. Then AX made loans to The Investment Company and carried them as accounts receivable. The Investment Co used the money to pay off the debts of the brewery. By shifting the debt around, Standard was able to obscure the fact of its failing ventures.
TEST: Careful analysis should be done of all intercompany transactions, receivables turnover, and large receivables balances.
INVENTORY/COST OF SALES
Excessive Write-downs
Excessive write-downs in one year can make it easier to steal sales in the following year. The relatively low amount for beginning inventory in the following year will make it easy to steal sales and still show a normal gross margin percentage.
Sheet Metal Case
1. Management had falsified the inventory tags and added the falsified tags to the box of tags the auditors had tested. The tags were added at night, and the auditor did not detect the fraud initially. Later, the auditor did an analytical review of inventory and discovered a significant decline in turnover.
2. To examine further, the auditor determined the space that would be needed to store the inventory claimed and determined that it substantially exceeded the warehouse space.
3. Looking back at the tags, the auditor noticed that some of the tags listed sheet metal weighing about 50,000 pounds-which was more than the yard equipment could carry.
4. Faced with discrepancies, management admitted the attempt to overstate inventory and profit and agreed to an adjustment.
TEST: Perform a reasonableness test of inventory quantity.
Internal Competitor
1. A salesman for a branch office opened a business that would compete with his employer’s.
2. Goods and services then were taken from the employer’s inventory and other employees.
TEST: Check inventory turnover, analysis of sales, gross margin, and profit performance, all of which must suffer if significant sales are stolen.
Supplies
1. The cost of packing and related supplies for a branch location has been rising steadily. The purchases are from local suppliers and from local cash working funds.
2. There was no inventory account for these purchases. The invoices were signed as approved by various employees, and receiving reports were signed. A handwriting expert indicated the signatures could not have been done by a person using his or her ordinary style of writing.
3. Upon investigation, the auditors found no inventory of the supplies.
4. The purchases were phony and four employees were discharged.
TEST: Steeply rising supplies expense.
Oil Corporation
Computer personnel at a New Jersey location manipulated the records of oil transfers to cover the theft of $20 million of fuel over seven years.
TEST: This kind of fraud is very difficult to detect. It involves the computer and collusion. Only when it is on such large scale that analytical tests will sense it, or when someone tells the story, will it be uncovered.
Repair Parts
A stock receiving clerk in the repair department of an appliance dealer, in collusion with a supplier, had the supplier deliver appliances to his home and bill the company for repair parts. Because the clerk received parts, he was able to falsify the receiving reports.
TEST: Do a detailed analysis of inventory by category.
The Branch X Case
1. A local branch of a large company had been experiencing a steady trend of losses. The internal audit staff investigated to determine the cause. Initially, no cause could be determined.
2. After constant probing of top management, the local manager said he had found the cause. A stockroom clerk had been stealing and had been fired, but the losses continued.
3. The local manager indicated that another clerk, a friend of the first, also had been involved and also had been fired.
4. This sequence was repeated for a third and fourth stockroom clerk, but the losses continued.
5. A second investigation by the internal audit department covered improper disbursements. The local manager had approved payments to friends for goods and services not received by the company. Several employees in the local branch had known of the problem but were afraid to say anything until it got too serious.
TEST: Do a detailed analysis of expense and trends for each category; do not rely on management’s explanations.
Railroad Co.
1. Railroad Co. merged with Central Railroad in 1972. Then Railroad Co. began a $200 million investment campaign, mostly in real estate, which demanded large amounts of cash.
2. The working capital problem was solved temporarily by borrowing Eurodollars at high interest rates and large amounts of commercial paper. The cash position was worsened by the interest cost, high executive salaries, large dividends, and difficulties in collecting receivables.
3. Railroad Co. failed to write off junk boxcars that had essentially no value. Other boxcars were re-routed so they could not be found. They then were repainted and sold to other railroads.
TEST: Check receivable turnover, inventory turnover, aging of receivables, fixed asset productivity analysis, and analysis of fixed charge coverage.
Phone Theft
1. A major telephone company was defrauded many years ago by a college student. The student recognized through examining computer listings thrown out in the trash that the telephone company had installed an automatic ordering system for installers.
2. Understanding the codes, the student was able to telephone the company’s computer over a touch-tone telephone and order parts to be delivered at authorized sites.
3. After delivery, the student picked up the orders and sold them on the black market.
4. When the student was turned in to the police by a fellow student, the telephone company was asked to determine how much the student had defrauded. The telephone company was unable to determine the size of the fraud, or even the fact that a fraud had occurred.
5. The system relied on authorized installers at predetermined construction sites to order parts. The company did not consider the fact that unauthorized people might request these parts.
6. Therefore, if an order was received from an authorized installer, for delivery of parts at an authorized site, the delivery was made.
7. Because the evidence produced by that transaction was electronic, and it contained all valid codes, there was no way to differentiate a fraudulent transaction from a valid transaction.
8. In this case, the student entered into plea bargaining and was able to escape with a six-month jail term. After 90 days, the student was out of jail and was hired by the telephone company as a consultant to prevent that type of computer crime from recurring.
TEST: Perform periodic analysis of quantities ordered by location.
Procurement Schemes
Procurement schemes are purchasing transactions that involve bribes, kickbacks, or conflict of interests situations.
1. Tailoring of specifications. The specifications for the purchase order are tailored so that the order will have to go to a certain firm, usually signaled by unusually tight specifications.
2. Collusion. Predetermined arrangements designate one of a group of bidders to receive the award. Perhaps several of the bidders are closely related.
3. Kickbacks. The purchasing agent receives a kickback on the amount of award.
TEST: Perform periodic analysis of purchased quantity by vendor.
False Bills of Lading
False bills of lading are fraudulent misstatements of the weight or the volume of goods shipped, with the overshipment being stolen.
ACCOUNTS PAYABLE
Unrecorded Liabilities
1. A company was nearly insolvent, but the executives did not want to see it fail because their outside financial interests were at stake.
2. To continue basic maintenance of plant and equipment, the executives loaned the company money using legitimate documents but failed to disclose the loan in financial reports.
3. Payments on the loan were charged to maintenance expense.
TEST: Analyze the relationship between recorded expenses and the physical aspects of the firm’s office, plant, and equipment. Evidence that expenses might be understated is also an indication of a possible unrecorded liability. False accounts payable are used to withdraw cash fraudulently from a company under the guise of a legitimate business expense. Often it happens between related companies or to phony companies. Disbursements not for a business purpose occur if management diverts cash from the company for personal uses by having personal items purchased through the company. Double billing is the submission of multiple invoices for the same products or services. If it is detected, the defense is usually that it was a “simple error.” Watch for a pattern of such errors.
PAYROLL
Employment Agency Expense
1. The personnel manager, in collusion with an employment agency, arranged to have many of the new direct hires and transfers charged as having been acquired through the employment agency.
2. The manager and the agent split the amount of the phony fees.
TEST: This fraud was detected by an analysis of employment expenses, which showed a significant increase in this expense. Also, the fraud could have been detected by comparing these expenses to the figures for other companies in the industry.
Computer Fraud
A programmer and computer operator in collusion were able to increase their pay fraudulently.
TEST: This fraud is hard to detect unless significant in amount or someone tells. In one case, the fraud was detected by manual analysis of payroll amounts, which disclosed that these employees had somewhat higher than average pay for their classification.
Business Expense Account
1. One executive was very tardy in repaying advances to his expense account, due to delays in reporting expenses and by other means.
2. An analysis of his account showed this pattern over many years.
3. The executive was investigated, and it was determined he was using the expense advance as an interest-free loan.
TEST: For each expense account analyze the relationship between average advances outstanding and average advance relative to average expense reported.
Double Dipping
1. A university professor has positions simultaneously at two local universities.
2. The fraud is detected when one of the universities asks about the amount of supplies, which seems too large for the size of the classes he is teaching.
TEST: Check use of supplies, company car, and so on. Compare reported financial data to reported operating data for discrepancies.
Phony Employees
1. A payroll clerk in a weak control environment was responsible for all phases of payroll accounting, including running the checks through the check-signing machine.
2. The clerk created phony employees and collected the pay for himself through petty cash and through phony bank accounts. Some of the phony employees were those who had been fired.
3. To divert attention, the clerk periodically fired the phony employees and hired new ones.
TEST: Analyze the relationship between operating and payroll data. Are they consistent? How do they compare to similar companies in the industry? Example: $2 million of a $15 million dollar payroll on a federal grant project.
OTHER FRAUD AREAS
Claims Department of Insurance Company
1. A claims department manager sets up his own company to investigate claims and pays himself from company funds for the investigation.
TEST: Examine the proportion of claims that are investigated. Analyze the total investigation costs over time and per claim, and compare to industry figures. Any change over time in the percentage of claims should be resolved and explained.
Shipping Expenses
1. A traffic manager creates his own transportation company and pays it for fictitious services.
2. In another case, a shipping manager had a budget for rental trucks to facilitate the orderly flow of shipments at peak times. The payments to rental truck agencies were fictitious and went into his pocket.
TEST: Compare total shipping costs to those of prior years and to the industry average. Estimate the shipping cost per item or per pound and compare with other shippers’ costs.
Advertising Expenses
In collusion with an advertising agent, a retail store manager agreed to purchase 16 one-minute local TV ads, with the idea that the agent would purchase eight of these ads and have the home office billed for all 16. The agent then would split a portion of the excess fee with the store manager.
TEST: Compare trends to prior years and to industry averages. This one could be difficult to detect if not substantial and no one tips off the auditor, unless there is a detailed regular investigation.
Payments to Contractors
Frequently errors and frauds can occur in payments to contractors.
TEST: Is the contract lump-sum or cost plus? Things to watch out for: (1) changes in contract, (2) solvency of the contractor, (3) ownership of plans and materials, (4) escalation clauses-they will make a lump-sum contract into a cost-plus contract, (5) the contractor’s controls for inventory and personnel-what are the chances we are paying for his employees’ fraud against him? Watch out if the contract is not specific on the following matters: overhead; field office expenses; small tools, repairs, maintenance; EDP charges; transportation; sales and other taxes; insurance coverage costs; freight; overtime and other wage premiums.
U.S. Inc.
1. U.S. Inc. showed bogus sales of real properties and other assets at substantial profit to the company.
2. The company wanted to bolster its stock price because one of the directors had a substantial amount of stock, and the stock was pledged as collateral on loans. The stock price had a significant effect on the director’s borrowing power.
TEST: Management pressures, management integrity. Review all nonoperating transactions for validity. Take note of management interests in stock price and their perceptions of how profit relates to stock price.
Arson for Profit
Fires may be set deliberately or property may be destroyed to collect insurance. The business press has reported that 20% to 30% of all fires are the result of arson.
TEST: The auditor should be alert to both under and over insurance coverage.
