F1_Session10_notes

Kaplan Financial 楷博财经教育 1 Copyright © Kaplan Financial www.kaplan-financial.com.cn Fraud What is fraud? 1. An intentional act involving the use of deception to obtain an unjust or illegal advantage. v Also known as Theft by deception v Committed by individuals among management who are in charge of governance, employees or third parties. v It’s a criminal offence (punishable by fine or by imprisonment) What is Error?  An unintentional mistake.  An inevitable part of human nature. • Need internal checks to prevent or detect any possible errors.  Example:  Clerk accidentally entering an invoice twice into the ledger. What is Irregularity?  It is something contrary to a particular rule or standard.  Example:  If a petty cash system designed to limit individual vouchers to less than $50, but allowed a single voucher of $70 to be processed. What is misstatement?  It is something stated wrongly.  Can arise due to fraud, other irregularity or error  Example:  When a balance sheet shows a building at cost $1m, whereas the actual cost was $1.3m. Fraud in financial statements  Consists of  Use of deception to obtain an unjust or illegal financial advantage  Intentional misrepresentations affecting the financial statements  Instance of fraud according to courts  Deliberate falsification of documents/records  Deliberate ignoring of errors requiring correction  Deliberate suppression of relevant information.  Fraud by management  Managers may deliberately select inappropriate accounting policies  Fraud by employees  Employees may steel the proceeds of cash sales and omit to enter the sale into the accounting records  Fraud by Third parties Kaplan Financial 楷博财经教育 2 Copyright © Kaplan Financial www.kaplan-financial.com.cn  Third parties may send bogus invoices to the company, hoping that they will be paid in error. Prerequisites of fraud 1. Dishonesty 2. Opportunity 3. Motive  All three are usually required  Fraud is more likely to occur in a business environment with poor or no controls.  High potential of fraud in companies  When control environment is lax  When few specific control activities are implemented Why so many financial statement frauds all of a sudden?  Good economy was masking many problems  Moral decay in society  Executive incentives  Wall Street expectations—rewards for short-term behavior  Nature of accounting rules  Behavior of CPA firms  Greed by investment banks, commercial banks, and investors  Educator failures Factors that might increase the risk of fraud and risk 1. Management domination by one person, or a small group of people. 2. Unnecessarily complex corporate structure. 3. High turnover rate of key accounting personnel 4. Personnel who do not take leave/holidays 5. Understaffed accounting department 6. Volatile business environment 7. Inadequate working capital 8. Deteriorating quality of earnings 9. Inadequate segregation of duties 10. Lack of monitoring of control systems 11. Unusual transactions- in cash, or direct to numbered bank accounts 12. Payments for services disproportionate to effort 13. Significant transactions with related parties 14. Inadequate IT systems. Types of Fraud  Fraudulent Financial Statements  Employee Fraud  Vendor Fraud  Customer Fraud Kaplan Financial 楷博财经教育 3 Copyright © Kaplan Financial www.kaplan-financial.com.cn  Investment Scams  Bankruptcy Frauds  Miscellaneous Frauds Frauds by management 1. Financial statement fraud  Window dressing and cooking the books : Entering into of transactions before the year end that are often reversed out after the year end, the substance of which was primarily to improve the appearance of the company’s financial statements.  Delaying company’s expense: Showing an expense as an asset on the balance sheet rather than writing it off immediately against profits is a quick way to improve your reported profits ( WorldCom)  Accelerating company’s expense : If a bonus scheme is introduced that will pay you a bonus if next year’s profits are high, you might be tempted to charge as many expenses as you can to this year, thus improving next year’s profit.  Manipulation of revenue recognition: If a company is engaged on a long-term contract, they are supposed to recognize the revenues from the contract on a reasonable basis as the contract is fulfilled. It would be fraudulent to recognize all the revenue in the first year of the contract and none in subsequent years.  Off-balance sheet accounting: Off-balance sheet accounting is the deliberate exclusion of certain assets and liabilities from the published balance sheet.  Example: Short-term lease: if you lease a building for say 2 years then under current accounting practices you do not have to show the asset or the related obligation to pay the rental amounts on the balance sheet. You have the use of the asset and you have a contractual obligation to pay the rentals, but neither the asset or the liability are shown on your balance sheet. 2. Misappropriation of assets  Employees steal assets to a minor degree( paper.)  Management may steal physical assets( inventory or non-current assets) and adjust the accounts to show that these items were written off  Management may sell intellectual property to a competitor for cash. 3. False insurance claims  A manager may steal a high value asset ( notebook) and claim that it was stolen from him while on company business. The company then lodges and insurance claim to remedy its loss. The insurance company is defrauded. 4. Using company’s assets for personal use  Using the company’s assets as collateral for a personal loan in favor of the manager. Frauds by employees 1. Sales ledger fraud  Teeming and lading Kaplan Financial 楷博财经教育 4 Copyright © Kaplan Financial www.kaplan-financial.com.cn • The receipts from one debtor are pocketed by the fraudster, with this sales ledger balance being cleared by a subsequent receipt from another debtor.  Stealing cash sales • Pocketing the proceeds of cash sales and never entering them in the accounting records.  Stealing cheques received. • Stealing receipts from debtors( cheques received in post) and then writing off the sales ledger balance as a bad debt. 2. Purchase ledger fraud  A dummy purchase invoice can be entered into the purchase ledger records with the cash being paid to a bank account set up for the purpose by the fraudulent purchase ledger clerk.  Purchase ledger clerk can collude with a third party to inflate the amount of an invoice with the surplus amount being shared between the protagonists. 3. Skimming schemes  The fraudster diverts small amounts from a large number of transactions, believing that no one will bother to investigate the small differences individually although in aggregate they can total to a worthwhile sum. 4. Payroll fraud  Add a bogus employee to the payroll and to pay their monthly ‘salary’ into a bank account set up for the purpose by the fraudster. Frauds by third parties 1. False billing  Send a bogus invoice to a company, claiming that it is in respect of the company’s inclusion in a non-existent trade directory or similar. 2. Bank account fraud  Some companies print their bank account details on their invoices, inviting debtors to pay money directly into the account. Alternatively they may pay their bills by cheques that show both the bank account numbers and what the required signature looks like.  The fraudster can set up standing orders and direct debits out of the account and into the bank account under their control.  This situation is avoided by designating the account ‘ deposit only’ so that no one can set up a standing order, etc. on the account 3. Advance free fraud  This is a confidence trick where a company is invited to pay a modest fee up front in the promise of being paid a large amount in the future.  Example : Email from Nigeria( 419 frauds) 4. Ponzi schemes Kaplan Financial 楷博财经教育 5 Copyright © Kaplan Financial www.kaplan-financial.com.cn  It is a fraudulent investment offer that involves paying abnormally high returns to early investors out of the new money paid in by subsequent investors, rather than from any genuine underlying business.  Example: Charles Ponzi emigrated to America in 1903, and set up his savings scheme in Boston offering 50% interest in 45 days or ‘double your money’ in 90 days. About 4000 people send him a total of $15m for the scheme. It eventually collapsed. The possible implications of fraud to the company  Spectrum of implication of fraud: from the immaterial to the critical..  Misuse of assets  Loss of assets  Financial difficulties  Collapse of the company  When fraud happens companies often look around for someone external to blame.  External auditors are known to carry insurance against being sued as they are often the first target.  The best way to punish a fraudulent employee is by reporting to police(negative publicity for company) and take legal action thus preventing him from doing fraud again.. Measures to prevent fraud  Principal Strategy: Establish an effective internal control system.  Components of Internal control system • The control environment • The risk assessment process • The information system • Control activities and • Monitoring of controls Note: The first step of any fraud prevention system is therefore to ensure that each of the five components above is set up and working properly Internal Fraud prevention system Component Example in practice Control environment A formal organization structure assigns authority and responsibility throughout the company Risk assessment process The company employs IT experts who can advice on incorporating new technologies into the production process Information system Monthly management accounts are submitted to senior management so that they can monitor the company’s performance on a timely basis. Kaplan Financial 楷博财经教育 6 Copyright © Kaplan Financial www.kaplan-financial.com.cn Control activities Segregation of duties is enforced in the accounts department Monitoring of controls Internal audit are charged with reviewing the effectiveness of internal controls throughout the business Duties of management in preventing and detecting fraud  The duties of the board of directors  The board of directors is required by the Combined Code to maintain a sound system of internal control.  Annually review the effectiveness of the Internal control system  The duties of the audit committee  Monitor and review the company’s internal control and risk management systems.( Ensure the effectiveness of the controls)  The duties of the employees generally ( including senior employees below board level)  Specific duties of the contract are set out in their contract of employment and in what they are told by their supervisors, but there will always be an implied duty to act honestly and to report suspected or actual frauds encountered to supervisors.  Fraud prevention and detection is the responsibility of every employee in the company not just the board of directors.  In the context of fraud, ‘teeming and lading’ is most likely to occur in which area of operation?  Sales  Quality Control  Advertising and promotion  Despatch