The purpose of this document is to provide common understanding of the potential fraud schemes and scenarios that ABC Company has included in its entity-level fraud risk assessment. Each of these schemes/scenarios was should be examined by the Internal Audit group and senior management from each of the functional areas within the company.
Fraud Schemes/Scenarios and Definitions
Benefits Fraud: Encompasses the receipt of benefits by employees that are not eligible, dependents of employees that are not eligible, or the receipt of benefits beyond their departure date from the company.
Bid Rigging: This scheme occurs when an employee fraudulently assists a vendor in winning a contract through the competitive bidding process. This may include related party transactions and vendor kickbacks, among other frauds.
Check Fraud: Check fraud includes the use of technology to design/reproduce bank checks and simple check forgery.
Check Theft: This scheme involves interception of a valid disbursement prior to delivery to the rightful recipient.
Collateral or Records Management: Employee could use titles to secure other/personal debt.
Concealment of Investing Activity: This scheme involves the failure of personnel to report investing activity for inclusion in the financial statement preparation process.
Disguised purchases: This scheme involves the utilization of company funds to make non-company related purchases. The purchase may benefit the employee or another party and is intended to have the appearance of a purchase made in the normal course of business.
Early Recognition of Revenue: Companies try to enhance revenue by manipulating the recognition of revenue. Improper revenue recognition entails recognizing 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, entering into “bill and hold” transactions, holding the books open until after shipment so that the sale can be recorded in the desired period, entering into side agreements, and channel stuffing.
Earnings Management/Smoothing: The pressure to meet or beat analyst expectations may lead management to engage in dubious practices such as “big bath” restructuring charges, creative acquisition accounting, “cookie jar reserves,” “immaterial” misapplications of accounting principles, and the premature recognition of revenue. Insistence on aggressive application of accounting principles, on always being “on the edge” and on applying “soft” methods allowing for a lot of “running room” 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.
Electronic Transaction Fraud: This scheme is similar to embezzlement, but specifically relates to diversion, theft, or misappropriation of funds that are received or disbursed electronically. This scheme may be perpetuated at the initiation point of the transaction, during transmission, or at the destination of the transaction.
Embezzlement: The property of another party is wrongfully taken or converted for the wrongdoer’s benefit. This may include theft of cash or property or the use of company assets for personal gain.
Employee Fraud: While every industry is at risk for employee fraud, the nature of the financial services industry makes it an attractive target for employees who can figure out how to work around existing or lax controls and, for example, create dummy loans, siphon money from customer accounts, or arrange to get kickbacks for providing services. This may also include fraud resulting from a “rogue employee,” e.g., the trader who manages to trade off-book and/or hide his trading losses in accounts that only he controls or from insider dealing, i.e., the use of non-public information for personal gain.
Fictitious Borrowing/Borrowing Fraud: Personnel may enter into borrowing arrangements for personal gain utilizing company credentials/collateral.
Fictitious Vendors: This scheme involves intent to divert funds to an employee or another party with no corresponding receipt of goods or services.
Fictitious/False Employees: This refers to someone on payroll who does not actually work for the company. Through the falsification of personnel or payroll records a fraudster causes paychecks to be generated to a “ghost.” The fraudster or an accomplice then converts these paychecks. 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.
Financial Statement Fraud: Misstatement(s) of an entity’s financial statements accomplished by: (a) overstatement of revenue and revenue-related assets or (b) understatement of costs or expenses and their related liabilities (c) omission or manipulation of required disclosures which involves violation(s) of Generally Accepted Accounting Principles (“GAAP”) and which defrauds investors or creditors of the entity by manipulation, deception, or contrivance using false and misleading financial information.
Fraudulent Account Activity: This scheme involves the manipulation of customer accounts to conceal delinquency or boost portfolio performance metrics. The scheme may involve changing receivables status to current or manipulating bankruptcy account status to boost the quality of receivables and lessen the need for a bad debt reserve.
Fraudulent Capitalization of Costs: This scheme involves the capitalization of costs that do not provide a benefit to future periods. Management may undertake this effort to delay the recognition of period expenses and lessen the current P&L impact.
Fraudulent Journal Entries: Some characteristics may include entries (1) made to unrelated, unusual or seldom-used accounts; (2) made by individuals who typically do not make journal entries; (3) made with little or no support; (4) made post-closing or at the end of a period such as quarter or year end and might be reversed in a subsequent period; (5) include round numbers; and/or (6) 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 intercompany accounts to hide expenses, and/or the capitalization of costs that should be expensed.
Fraudulent Disbursements: In fraudulent disbursement schemes, an employee makes a distribution of company funds for a dishonest purpose. Examples of fraudulent disbursements include forging company checks, the submission of false invoices, doctoring timecards and so forth.
Fraudulent Loan Setup/Funding Disbursement: This scheme involves booking loans that do not exist, or disbursing funds to fictitious customers. This scheme can inflate revenues, assets (loan receivables) and may also include embezzlement of funds.
Identity Theft: A crime in which an imposter obtains key pieces of personal information, such as Social Security or driver’s license numbers, in order to impersonate someone else.
Inflated Time Reporting: Employees may intentionally report hours that were not spent working. This may involve reporting hours for days the employee did not work, incrementing hours beyond those actually spent at work, and failing to report vacation or sick time.
Insider Trading: Insider trading is an illegal act that involves the use of non-public information to purchase/sell company stock. Insider trading most often involves executive management or financial reporting personnel who have access to company performance results in advance of public filings.
Intentional Misapplication of Payments: This scheme involves taking a customer payment and applying it to another customer, or another type of payable due from the customer.
Kiting: Check kiting is the act of writing checks against a bank account with insufficient funds to cover the check in hopes that funds will be available prior to the payee depositing the check.
Lapping: 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.”
Loss Allowance Manipulation: The scheme involves changing allowance calculation assumptions, changing input data, or simply changing the end result of the allowance calculation to delay the impact of impending losses. This scheme most often must be continued over time to conceal inevitable write-offs and may lead to other fraudulent journal entries (defined above).
Manipulation of Bonus/Commission Criteria/Results: This scheme is similar to embezzlement, but has distinct characteristics. Personnel responsible for submitting bonus/commission attainment (HR, department management) may modify compensation criteria or performance results to increase bonus/commission payouts to themselves or the employees that work for them. In many cases, this scheme is justified by management to reward employees that are perceived to be strong performers that are not rewarded by established performance metrics.
Manipulation of Derivative Position: This scheme involves the intentional misreporting of derivative position to conceal a poor business decision or simply increase earnings. This scheme can be accomplished in a variety of manners including the destruction or concealment of supporting documentation, falsifying documentation related to hedging activities, or modifying the actual position to one more favorable to the company.
Manipulation of Inventory: This scheme involves the modification of inventory records to overstate assets or failure to recognize the decline/impairment to its value. This scheme may involve the falsification or destruction of records in an attempt to substantiate activity in the period that did not occur.
Manipulation or Concealment of Trigger Reporting: This scheme involves the intentional cover up or falsification of performance reports that would otherwise result in the violation of debt covenants.
Misappropriation of Customer Payments/Funds: Often accompanies embezzlement, but is a separate and distinct offense. Misapplication is the wrongful taking or conversion of another’s property, in this case customer payments, for the benefit of someone else – that of the employee or for another customer.
Misappropriation of Funds: Often accompanies embezzlement, but is a separate and distinct offense. Misapplication is the wrongful taking or conversion of another’s property, in this case company funds, for the benefit of someone else.
Misappropriation of Trustee Payments/Funds: Often accompanies embezzlement, but is a separate and distinct offense. Misapplication is the wrongful taking or conversion of another’s property, in this case trustee payments, for the benefit of someone else.
Misleading Analyst Forecasts: This scheme is perpetuated by management to conceal a pending downturn or flat revenues or to predict a significant in increase in revenue despite the lack of supporting analysis.
Overstatement of Assets: Areas where assets can easily be overstated include inventory valuation, accounts receivable, business combinations, and fixed assets:
- Inventory valuation: the failure to write down obsolete inventory, manipulation of physical inventory counts, recording “bill and hold” items as sales and including these items in inventory
- Accounts receivable: fictitious receivables and the failure to write-off bad debts
- Business combinations: setting up excessive merger reserves and taking the reserves into income
- Fixed assets: capitalizing costs that should be expensed or booking an asset although the related equipment might be leased
Proprietary Information Dissemination: This scheme involves the intentional dissemination of private company information to potential customers, vendors or suppliers that give them an unfair advantage in dealing with the company, whether applying for a loan or providing goods/services. This scheme may be coupled with other acts such as embezzlement or bid rigging (defined above).
Speculative Investing: This scheme involves company personnel, either on their own, or at the direction of management, to enter into derivative/hedging transactions with no specific risk that is attempting to be mitigated. This may be an attempt to circumvent investing policies in an effort to boost earnings or to profit individually from the transaction.
Tax Evasion: The company intentionally evades payment of taxes that is otherwise owed to a taxing authority. This conduct can include but is not limited to the concealment of assets or income, keeping two sets of books, manipulation of quarterly payment estimates, and the destruction of books and records.
Title Fraud: This scheme involves the use of company assets, in this case vehicle titles, to secure personal/others debt. This scheme is most likely to occur with Collateral or Records Management employees due to their access to such documents.
Unrecorded, Deferred, or Understated 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. In one high profile case, liabilities were hidden in off-balance sheet affiliates.
Other Fraud Schemes/Scenarios to Consider
|Collusion with Dealers
Concealment or Manipulation of financial results and disclosures
Dealer buyback – Theft of Funds
Diversion of Funds/Misappropriation of Assets
Diversion/Misappropriation of Funds
Diversion/Theft of DisbursementsElectronic Payments Fraud
Failure to Record/Remit Payroll Taxes
|Manipulation of Bank Account Status
Manipulation of Estimates to Alter Quarterly Tax Payments
Manipulation of Payroll Records
Manipulation of Performance Forecasting
Manipulation of Performance Results
Manipulation of Significant Accounting Estimates
Manipulation or Theft of Fees
Management Circumvention/Override of Loan Setup Controls
Principal Credit Adjustments to Increase Recoveries
Principal Credit Adjustments to Reduce/Pay-Off Loans
Related Party Purchases
Related Party Transactions
Terminated Employee Payments
Unauthorized Electronic Payments
Unsupported Top-Side Entries
Use of Resources for Personal Gain