Common
Fraud Scenarios
This page provides
illustrations of different types of frauds and how such frauds could be
perpetrated. The focus
of your assessment should be on those programmes and controls that are intended
to mitigate the risk of fraudulent actions that could have a material impact on
financial reporting.
For example, fraud might
include:
-
Fraudulent financial
reporting – inappropriate earnings management or “cooking the books” – e.g.,
improper revenue recognition, intentional overstatement of assets or
understatement of liabilities, etc.
-
Misappropriation of assets –
theft
-
Expenditures and liabilities
incurred for improper or illegal purposes – e.g., bribery and corruption
payments that can result in reputation loss
-
Fraudulently obtained
revenue and assets and/or avoidance of costs and expenses – e.g., scams and tax
fraud that can result in reputation loss
Using the four categories of
fraud listed above, the common fraud scenarios can be summarised as follows:
1) Fraudulent financial
reporting:
-
Earnings management
-
Improper revenue recognition
-
Overstatement of assets
-
Understatement of liabilities
-
Fraudulent journal entries
-
Round-trip or “wash” trades
2) Misappropriation of assets:
-
Billing schemes
-
Collusion
-
Concealment
-
Forgery
-
Ghost employees
-
Cross-firing
-
Teeming and Lading (Lapping)
-
Misapplication
-
Payroll fraud
-
Theft
3)
Expenditures and liabilities
incurred for improper or illegal purposes:
-
Bribes
-
Conflicts of interest
-
Kickbacks
-
Concealment
-
Money laundering
4)
Fraudulently obtained revenue
and assets and/or cost and expenses illegally avoided:
-
Concealment
-
Scams
-
Tax fraud
These common schemes and
scenarios can occur in any industry. However, the way such frauds are
perpetrated might be industry specific. An example of how scenarios may be used
is as follows:
-
Identify relevant scenarios
that could potentially occur within the organisation, resulting in a material
impact on the financial statements.
-
For each identified scenario,
describe how it would be perpetrated within the organisation, the individuals
who could make it happen and the financial statement accounts that would be
affected.
-
Based on the documented
scenarios, identify the controls that would prevent, deter or detect each
scenario.
-
Compare the controls in place
with the controls documented above and identify any gaps.
-
Develop action plans to remedy
significant gaps.
Asset Misappropriations: Fraudulent Payments
In fraudulent payment schemes,
an employee makes a distribution of company funds for a dishonest purpose.
Examples of fraudulent payments include forging company cheques, the submission
of false invoices and doctoring timesheets.
Billing Schemes
Billing schemes are a popular
form of employee fraud mainly because they offer the prospect of large rewards.
Since the majority of most businesses’ payments are made in the purchasing
cycle, larger thefts can be hidden through false-billing schemes than through
other kinds of fraudulent payments. There are three principal types of billing
schemes:
-
False invoicing via shell
companies
-
False invoicing via
non-accomplice vendors
-
Personal purchases made with
company funds.
Bribery
Bribery schemes generally fall
into two broad categories: kickbacks and bid-rigging schemes.
Kickbacks are undisclosed
payments made by vendors to employees of purchasing companies. The purpose of a
kickback is usually to enlist the corrupt employee in an over-billing scheme.
Sometimes vendors pay kickbacks simply to get extra business from the purchasing
company.
Bid-rigging schemes occur when
an employee fraudulently assists a vendor in winning a contract through the
competitive bidding process.
Collusion
One way to obtain approval of a
fraudulent timesheet is to collude with a supervisor who authorises timekeeping
information. In these schemes, a supervisor knowingly signs false timesheets and
the employee kicks back a portion of the overpaid wages to the supervisor. In
some cases, the supervisor may take the entire amount of the overpayment.
It may be particularly
difficult to detect payroll fraud when a supervisor colludes with an employee,
because managers are often relied upon as a control to assure proper
timekeeping.
Concealment - Fictitious Sales and Accounts Receivable (Debtors)
When the perpetrator makes an
adjusting entry to the stock and cost of sales accounts, there is no sales
transaction on the books that corresponds to these entries. In order to fix this
problem, a perpetrator might enter a debit to accounts receivable and a
corresponding credit to the sales account so that it appears the missing goods
have been sold.
Concealment - Write-Off of Stock and Other Assets
Writing off stock and other
assets is a relatively common way for employees to remove assets from the books
before or after they are stolen. This eliminates the problem of shrinkage that
inherently exists in every case of non-cash asset misappropriation.
Concealment - Physical Padding
Most methods of concealment
deal with altering stock records, either changing the perpetual inventory or
miscounting during the physical stock-take. Alternatively, some employees try to
make it appear that there are more assets present in the warehouse or stockroom
than there actually are. Empty boxes, for example, may be stacked on shelves to
create the illusion of extra inventory.
Conflicts of Interest
An employee or agent is put
into a position of self-dealing. One example would be if an accountant of an
organisation set up an off-balance sheet entity, which he managed and transacted
business with, thereby becoming personally enriched. This scenario compromises
the internal control structure because independent parties are not bargaining at
arm’s length with each other.
Earnings Management
The pressure to meet or beat
targets may lead management to engage in dubious practices such as restructuring
charges, creative acquisition accounting, misapplications of accounting
principles, and the premature recognition of revenue.
Insistence on aggressive
application of accounting principles, of always being “on the edge” and on
applying “soft” methods allowing for a lot of leeway when making significant
estimates in the financial reporting process all contribute to an environment
that impair or reduce the quality of earnings and breed earnings management.
Forgery
When using this method, an
employee typically withholds his or her timesheet from those being sent to the
supervisor for approval, forges the supervisor’s signature or initials, and then
adds the timesheet to the others being sent to the payroll department. The
fraudulent timesheet arrives at the payroll department with what appears to be a
supervisor’s approval and a payment is subsequently issued.
Fraudulent Journal Entries
Some characteristics may
include entries:
-
Made to unrelated, unusual or
seldom-used accounts
-
Made by individuals who
typically do not make journal entries
-
Made with little or no
supporting documentation
-
Made post-closing or at the end
of a period such as quarter or year end and might be reversed in a subsequent
period
-
Include round numbers and/or
affect earnings.
Financial statement fraud is
frequently accomplished through the use of fraudulent journal entries and is a
form of management override of the internal control structure. Of particular
interest would be journal entries that mask fund diversion, the improper
reversal of reserve accounts, the use of inter-company accounts to hide
expenses, and/or the capitalisation of costs that should be expensed.
Ghost Employees
The term ghost employee refers
to someone on the payroll who does not actually work for the victim company.
Through the falsification of personnel or payroll records a fraudster causes
payments to be generated to a ghost. The fraudster or an accomplice then
converts these payments. The ghost employee may be a fictitious person or a real
individual who simply does not work for the victim employer. When the ghost is a
real person, it is often a friend or relative of the perpetrator.
Improper Revenue Recognition
Organisations sometimes try to
enhance revenue by manipulating the recognition of revenue. Improper revenue
recognition entails recognising revenue before a sale is complete, before the
product is delivered to a customer, or at a time when the customer still has
options to terminate, void or delay the sale. Examples of improper revenue
recognition include recording sales to nonexistent customers, recording
fictitious sales to legitimate customers, recording purchase orders as sales,
altering contract dates and shipping documents, holding the books open until
after shipment so that the sale can be recorded in the desired period.
Lapping (or teeming and lading)
Lapping customer payments is
one of the most common methods of concealing skimming. It is a technique, which
is particularly useful to employees who skim receivables. Lapping is the
crediting of one account through the abstraction of money from another account.
It is the fraudster’s version of “robbing Peter to pay Paul.”
Theft
Stealing, taking and carrying,
leading, riding, or driving away another’s personal property, with intent to
convert it or to deprive the owner thereof. For the purposes of classifying
asset misappropriations, the term is meant to refer to the most basic
type of asset theft, the schemes in which an employee simply takes an asset from
the company premises without attempting to conceal the theft in the books and
records. In other fraud schemes, employees may create false documentation to
justify the shipment of merchandise or tamper with records to conceal missing
assets.
Money Laundering
Money laundering often includes
the use of offshore accounts. It can be defined as the illegal practice of
filtering “dirty” money or ill-gotten gains through a series of transactions to
make it appear that the proceeds are from legal activities.
Overstatement of Assets
Areas where assets can easily
be overstated include stock valuation, accounts receivable and fixed assets:
-
Stock valuation – the failure
to write down obsolete stock and the manipulation of physical counts
-
Accounts receivable –
fictitious receivables and the failure to write-off bad debts
-
Fixed assets – capitalising
costs that should be expensed or booking an asset although the related equipment
might be leased
Payroll Schemes
Payroll schemes are similar to
billing schemes. The perpetrators of these frauds produce false documents, which
cause the victim company to unknowingly make a fraudulent payment. In payroll
schemes, the perpetrator typically falsifies a timesheet or alters information
in the payroll records. The major difference between payroll schemes and billing
schemes is that payroll frauds involve payments to employees rather than to
external parties. The most common payroll frauds are ghost employee schemes,
falsified hours and salary schemes, and commission schemes.
Round Trip or “Wash”
Trades
Simultaneous, pre-arranged
buy-sell trades with the same counter-party, at the same price and volume, and
over the same term, resulting in neither profit nor loss to the either
transacting party.
Skimming
Skimming is the removal of cash
from a victim entity prior to its entry in an accounting system. Employees who
skim from their companies steal sales or receivables before they are recorded in
the company books. Skimming schemes are known as “off-book” frauds, meaning
money is stolen before it is recorded in the victim organisation’s accounts.
Short-term skimming is that the perpetrator only keeps the stolen money for a
short while before eventually passing it on to his employer. The employee merely
delays the posting of the payment.
Turnaround
Sale or Flip
A special kind of purchasing
scheme sometimes used by fraudsters is called the turnaround sale or the flip.
In this type of scheme an employee knows his employer is seeking to purchase a
certain asset and takes advantage of the situation by purchasing the asset
himself (usually in the name of an accomplice or shell company). The fraudster
then turns around and resells the item to his employer at an inflated price.
Understatement of Liabilities
The most common methods used to
understate liabilities include failing to record liabilities and/or expenses,
failing to record warranty costs and liabilities and failing to disclose
contingent liabilities.
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