Audit hasn't found fraud

Dallas ISD audit hasn't found fraud, but that's not its aim

Kent Fischer. McClatchy - Tribune Business News. Washington: May 3, 2008.

Abstract (Summary)
Two professional fraud hunters, however, were skeptical of Mr. Lowe's assertion, given that the Dallas Independent School District's 2006-07 finances are undergoing a routine "comprehensive audit," not a "forensic audit" in which auditors scrub the books for criminality.

To see more of The Dallas Morning News, or to subscribe to the newspaper, go to http://www.dallasnews.com. Copyright (c) 2008, The Dallas Morning News Distributed by McClatchy-Tribune Information Services. For reprints, email tmsreprints@permissionsgroup.com, call 800-374-7985 or 847-635-6550, send a fax to 847-635-6968, or write to The Permissions Group Inc., 1247 Milwaukee Ave., Suite 303, Glenview, IL 60025, USA.

May 3--When Dallas school officials recently reassured the public that a long-overdue audit of district finances has not turned up any fraud, they failed to mention that their auditors are not specifically looking for fraud.

"No one stole anything," school board President Jack Lowe said at a meeting last week. "There's no money missing."

Two professional fraud hunters, however, were skeptical of Mr. Lowe's assertion, given that the Dallas Independent School District's 2006-07 finances are undergoing a routine "comprehensive audit," not a "forensic audit" in which auditors scrub the books for criminality.

"It sounds like wishful thinking," said James Ratley, president of the Association of Certified Fraud Examiners. "Generally, audit techniques are not designed to detect fraud. Auditors may well have [told district leaders] 'We found no indications of fraud,' but that doesn't mean a whole lot because their purpose is not to look for fraud."

The comments of Mr. Lowe and others came over the last several weeks after trustees received reports on the district's overdue audit. At a meeting last week, district auditor Deloitte & Touche laid out, in broad terms, widespread problems within the district's finance departments.

Deloitte director Reem Samra told trustees that the district lacks an "effective internal control environment," that employees are inadequately trained and that top officials had failed to properly oversee financial transactions. Auditors found these problems everywhere they looked, including financial accounting, grant compliance and anti-fraud programs.

Despite that, Mr. Lowe said he believes "with a high degree of certainty" that there is no wide-scale fraud or theft at the district.

"My question would be: How does he know?" Mr. Ratley asked. "To say that no fraud is present [in that environment] is like me saying that there are no speeders right now on I-35."

Generally, annual audits do not proactively search for fraud. Instead, they aim to verify financial statements, most often by comparing transactions and spending against policies, procedures and internal controls.

Annual audits are not the same thing as intently looking for wrongdoing, said Sandy Alexander, a certified fraud examiner and president of CFO Pros, a Dallas fraud investigation firm.

"Very few frauds are uncovered under the course of an annual audit," Mr. Alexander said. "Most frauds are discovered by whistleblowers."

DISD spokesman Jon Dahlander said Deloitte brought in forensic auditors to examine payroll. The audit team found "a relatively small number of exceptions, all of which have been accounted for." In auditing lingo, an "exception" is a payment or transaction that should not have occurred.

The district did not respond to a request for details on how many payroll problems auditors discovered and how much they amounted to.

Payroll accounts for about $1 billion a year in district spending, roughly 85 percent of DISD's expenditures. That would mean the remainder of the district's spending, roughly $160 million, is yet to be scrutinized by fraud examiners.

Mr. Lowe said the district recently created two new investigative departments capable of conducting fraud investigations. He said he would like those departments -- the Office of Professional Responsibility and a new Internal Audit office -- to conduct fraud investigations for the district.
"We do have an in-house fraud audit team, and I have a lot of confidence in them," Mr. Lowe said.

Read More....

Protect Your Shop with Back-to-Basics Controls

SocGen Falls into a Familiar Hole: Protect Your Shop with Back-to-Basics Controls

Val Mulcahy, Carol McGinn. The RMA Journal. Philadelphia: Apr 2008. Vol. 90, Iss. 7; pg. 58, 7 pgs

Abstract (Summary)
Many smaller frauds have escaped the light of public scrutiny either because they fell below the hurdle of media interest, or because they resulted in profits, thus ensuring that the control weaknesses never saw the light of day. It's time for a back-to-basics commonsense approach to trading-room controls. The financial industry has become dazzled by the mathematics of trading, but has neglected to ensure that the rudimentary controls remain in place. At the heart of back to basics is segregation of duties (SOD), the mother of good internal controls. Presented is a back-to-basics punch list of internal controls, including SOD. The list includes: 1. small department/remote offices, 2. weak segregation duties, 3. new products launched without full review, 4. poor training of oversight staff, 5. aggressive or aberrant behavior, 6. absence of transparency/culture of opaqueness, 7. bonus pressures, and 8. culture of greed or arrogance.

Basic controls get results when institutions manage the complexity in modern financial products. At the heart of the basics is segregation of duties.

IT WAS SAD to see Société Générale, another mighty derivatives gladiator, trip over its own shoelaces and fall into a familiar hole in the road. In what may be perhaps the world's biggest financial fraud, this French institution announced that one of its junior traders, Jérôme Kerviel, ran up billions in losses, forcing the bank to raise more capital-and putting the institution's future in jeopardy.

The past decade is littered with celebrated war stories of ended careers and the occasional demise of an institution. The underlying story behind the following institutions' losses is their control failures.

Many smaller frauds have escaped the light of public scrutiny either because they fell below the hurdle of media interest, or because they resulted in profits, thus ensuring that the control weaknesses never saw the light of day.

It's time for a back-to-basics commonsense approach to trading-room controls. The financial industry has become dazzled by the mathematics of trading, but has neglected to ensure that the rudimentary controls remain in place. Institutions have shaped their controls around the mathematics of their sophisticated risk systems, rather than asking the obvious questions, such as:

? Is this person raising internal trades that have not been substantiated?

? Is this person writing trades with counterparties we can't see?

? What else is this trader doing that is flying under the radar of our mathematics?

Why is it, then, that the financial market players and overseers have failed in their jobs? Are the products too complex to be controlled by trained back-office staff? Are the wayward traders too clever? Not at all! The much- praised Corrigan Report on Counterparty Risk Management, issued in 2005, stressed that there is, indeed, complexity in modern financial products, but there remains a need for "time-honored basics of managerial competence, sound judgment, common sense, and disciplined corporate governance." Back to basics gets results.

At the heart of back to basics is segregation of duties (SOD), the mother of good internal controls. No sooner is a new financial scandal uncovered than the hunt begins to discover what element of SOD has broken within the organization. All of those companies that have fallen prey to deadly frauds-and the list is long-ignored basic SOD controls and, as a direct result, were ruined or severely wounded.

Back-to-Basics Punch List

What follows is a back-to-basics punch list of internal controls, including SOD. (These and other controls are discussed in the author's RMA course, Risk Mitigation Strategies for Trading Operations.)

Small Departments/ Remote Offices

Small, not big, is dangerous. Frauds are less usual in a bank's main office or in a department where supervisors and managers watch traders and office staff. But although they are less usual, they are not impossible. Barings blew up in its Singapore office and Daiwa in its New York office. Branch offices or small departments are most at risk, as these units often have less supervision and SOD. Controls tend not to be as tight. There is no second pair of eyes automatically scrutinizing the daily flows.

In the head office there are more people, and the responsibilities of each are outlined more clearly. Well-trained people in central oversight functions, if they are uneasy, should have the professionalism to "cry uncle" and initiate a "pause and reevaluation" of the subject product's operational risk hazards. It's a hard call, but necessary. The oversight and risk management units are accountable, too.

Weak Segregation of Duties

Société Générale (SocGen) disclosed that its trader had breached several firewalls and performed back-office style controls. That ability should be an absolute no-no in any organization. In the day-to-day rush, segregation-of-duty procedures may seem like a hindrance. However, the tone from top management must reinforce these standards and discipline any observed breaches. SOD is a non-negotiable control. Achieving a balance between excessive red tape and effective SOD takes time and requires the judgment of experienced operations managers.

In a small office, it can be difficult to segregate duties because there are not enough people to break down responsibilities. But even in a larger office where there is a slipshod SOD culture, people may not want to bother with the red tape required to complete a transaction. They may know the manual requires certain steps, but they opt to "get this deal out tonight." Or, they may believe a new product can't wait for all of the necessary approvals because profits could be forgone in the fast-moving market. They glide over the traditional segregation of duties.

Segregation of duties must apply to all personnel, especially now that the middle office is increasingly managing derivatives. Critical legacy back-office controls can be subverted by an ill-defined middle office. More staff with highly specialized skills-quantitative, credit, legal, and product knowledge-are working in the middle offices. It is inevitable that there will be high-energy "can do" folks, and that is good for customer service. However, the middle office is a tool of the support function, not a lackey of the trader function. That distinction must be reviewed regularly to ensure the middle-office staff does not act as surrogate traders. They are an integral part of the SOD, and their role is to keep in check the power of the trader. They deserve a higher pay grade than those performing routine operational functions, but they must exercise extra scrutiny. Middle office must not see its role as circumventing legacy operational controls.

New Products Launched Without Full Review

Institutions often try to work around the new product review. Some institutions lack a culture that requires it, while others don't adhere to the reviews. They launch a product and announce it will achieve certain goals. The goals aren't achieved, and the systems the institution hopes to have in place before getting to the next level aren't there. For instance, a pilot project might be approved that permits the back office to manually keep the accounting and risk records while traders do no more than a set limit of trades per month. However, if the product is successful, traders start overtrading, and high volume and proper oversight become a problem on a manual system.

The New Products Committee must perform a follow- up review to make sure systems are in place to accommodate the trades.

That new-product review did not take place at Kidder Peabody when it introduced its forward-dated zero coupon strips. Kidder's accounting system couldn't account for immediate delivery zero coupon securities, and basically the wheels fell off the accounting system.

New products are an important component of a successful trading shop. The challenge is to ensure that all departments, including operations, audit, compliance, credit risk, market risk, and finance, review each new product proposal and express their concerns-even to the point of veto. Even after a product is approved, it must be funded and held to its target performance milestones. Inadequacy of funding or below-par performance must trigger suspension of the new-product authorization until it is corrected. SocGen has not yet said if and when Kerviel's business passed this process.

It can be easy for financial institutions to get seduced by large profits. Staff at all levels of the governance chain may not stop and question the commonsense improbability of the rogue trader's spectacular profits. Baring Brothers, for instance, knew it wanted to get into equities trading in the Far East. Barings had one trader in that region producing incredible profits supposedly out of the low-risk arbitrage of two exchanges in Asia. In fact someone doing some due diligence would have discovered that the huge profits didn't make sense in the declared business model. It's important for managers to question where those profits are coming from and how they are being generated from the lines of business.

Again, a breakeven performance when the whole marketis declining may be a red flag. In Daiwa, for instance, the rogue trader didn't show any losses, although traders everywhere else seemed to have losses for some quarters or even years. That was extraordinary. It was the smoke signal his managers should have seen. When the bottom line is positive, it's hard to ask where the money comes from. Often the trader will claim some secret model that no one can understand as his reason for making money, so his managers stop questioning his tactics. When the auditor timidly raises a red flag or a customer raises a question, as was the case in Société Générale, a trader will hide behind his profits.

Poor Training of Oversight Staff

There's a frantic pace on the trading floor, and new tasks are introduced constantly. Managers must juggle their staff turnover and ensure new staff members receive sufficient training. The key is to staff for excellence. No control protects you better than alert control staff brave enough to raise their hands when in doubt. Recruit, train, motivate, and reward with that goal in mind, and do all that you can to limit turnover. Training should be broad, encompassing the full life cycle of a particular product. It should not be just a quick review with a trader or other back-office personnel for a few hours.

Self-assessment risk reviews are a tremendous tool for staff training. In a self-assessment, you ask all the back-to-basics, dumb questions: Where does the profit come from for that product? There must be a plain English explanation of the business model and the associated risks. It must be communicated to all support and oversight areas. It must be widely understood and accepted. If we know where a profit comes from and we've analyzed it well, then it's easy to see all the risk points.

Self-assessment forces everybody in the support and risk oversight departments to see all the mechanical steps that go into making the profit on a product and to understand the risks that arise from that transaction. Define each risk point and devise an effective control for it. Then use a checklist to determine who is checking this risk and how often and whether they've been properly trained to check it. This knowledge base motivates support staff and encourages the brave to ask the awkward questions.

Aggressive or Aberrant Behavior

The hostile, bullying, harassing, uncommunicative, cliquey, or dishonest trader is often at the center of a fraud. The rogue trader will try to override legitimate controls. Such behavior must be disciplined immediately, and the offender should be dismissed if coaching fails. In addition, further discreet audit reviews of their function should be initiated immediately.

Approaching, coaching, or disciplining a high-performing bully trader may be impossible, even for a senior operations manager. Often, the rogue trader is a bully who overpowers the auditor or oversight officers. By sheer force of temperament, the bully trader can browbeat people into believing his actions are legitimate. The key is not to become embattled. Calmly document and elevate to a level above you so that the bank is well aware of the risks you see.

Neither SocGen's Kerviel nor the trader at Daiwa were bullies, but their work pattern was suspicious. The behavior of both traders should have given cause for special, albeit discreet, audit reviews. The "overworked /too busy to take a vacation" accusation is a tough call in practice. Some trading jobs are hugely time consuming. Options traders are notorious for arduous rebalancing of their books and prolonged back-testing of scenarios. However, only men and women, not accounting records, perpetrate frauds.

Management's role is to keep the rogue trader in check. Top management must set the tone that auditing, compliance, and oversight functions are essential parts of the institution's corporate governance. Even if a trader is making money, he may not be the trader the bank wants. It may be that the trader is making money because he has bullied everybody and they are covering up something. Management must confront the trader when smoke signals appear.

Absence of Transparency/Culture of Opaqueness

Transparency is an environment, not a procedure. Whenever you find opaqueness in an organization, you will find problems. We all dislike revealing our missteps and uncertainties, but secretive management eventually suffocates upward communication channels. Once a product is on the books, there must be full transparency. Risk records and ledgers must be subject to the full rigors of SOD and external confirmation not be kept by one person or front-office staff. Records and performance pertaining to that product should be open to all oversight functions. Mistakes, errors, and most important the "awkward questions" must be investigated and documented and remedial actions taken.

Not only the trader but also the whole organization may foster a culture of secrecy. For example, Credit Suisse, when it was caught in its Chiasso branch losses, didn't disclose its losses. After all, confidentiality is the hallmark of Swiss bank accounts. So when the Chiasso branch manager created a completely fictitious portfolio of investments and set of accompanying books, branch management just told auditors they could not inspect the books. That answer was accepted within the culture. Even when the losses emerged, there was a delay in candor with the regulators. In Daiwa's case, the U.S. Federal Reserve was incensed by the failure of openness. SocGen raises the question again.

If the directors or the senior officers set a secretive tone, that culture filters down and chokes off the channels of communication. It's like blocking a chimney stack, making it impossible for the smoke signals of fraud to be seen.

Bonus Pressures

Usually rogue credit officers and operations officers steal money, whereas traders defraud by inflating their bonus pool. Inordinate bonus payouts should trigger a discreet audit review. The process should review all the asset accounts associated with trading and ensure they have been externally verified, especially for unsettled trades.

It's not easy to ensure that bonuses are fair. Senior management must ask several questions: What profit did the trader make? What percentage will be paid out? What were the origins of the profits? Is it reasonable that Mr. A. or Ms. B. gets paid this bonus after having generated that income? Senior management must understand where that income is coming from before they set any bonus percentage.

Culture of Greed or Arrogance

Our industry holds performance as the highest, if not the only, criterion for success. Moderation in appetite and grace in winning are appreciated, but neither scores any points. Hence, greed and arrogance sometimes spin out of control.

Surely, however, Kerviel seems the opposite of this model. Another form of arrogance was at play. SocGen justifiably prided itself on the outstanding qualifications of its recruits and a heavy emphasis on the power of its mathematical risk control management. It may have been blind to the value of the more mundane control checks that were probably there for the taking.

Conclusion

The industry doesn't have a manual on war stories. Like bridge engineers, we have to look for the failures in past designs before we sign off on each new bridge. Conventional wisdom proclaims that thinking positively earns bigger bonuses than revisiting past failures, but we ignore war stories at our peril. We can't presume that no one will make the obvious billion-dollar mistake.

Segregation of duties and tight internal controls are key. We must ask:

? What are we making money from?

? What are our risks and operational procedures?

? Who's managing those procedures?

Every person in the department must be involved in that self-assessment because every risk should have someone responsible for monitoring it.

Nothing is new in the back-to-basics approach, but sometimes people lack the personal courage, trading experience, or seniority to enforce the basics. Or they may not be properly recognized and credited for raising questions. Don't shoot the messengers who bring bad news. When someone raises a question, it should not be brushed aside because the department is making a fortune. Encourage those who question why a trade happened. Somebody has to raise the question, and everyone should be prepared to say, "We made a mistake."
[Sidebar]
Risk Mitigation Strategies for Trading Operations
This one-day RMA course covers basic operational controls
By Carol McGinn
DESPITE THE GROWING complexity of capital markets, the well-understood, commonsense, and back-to-basics controls are still the most effective. Good control strategies, though uncomplicated, require you to be alert and diligent in your independent monitoring of your institution?s trading operations.
RMA?s one-day course covers basic operational controls and provides practical takeaways that you can immediately apply at your institution. The course also uses a series of case studies and examines the control failures in each so that you can apply lessons learned from these major operations failures.
Course instructor Val Mulcahy says case studies are an excellent teaching tool and ?provide key evidence of the similarities of weaknesses in the trail of war stories.? Two cases from the course illustrate this point vividly.
The first is the case of Nick Leeson, a 28-year-old trader working in the Singapore office of the British Barings Investment Bank in 1995. He lost money in a technical derivatives equity arbitrage business between Far East exchanges. To hide the losses, he began to enter fake and unauthorized trades over a two-year period. In the end, the scandal collapsed the centuries-old bank.
The RMA course covers the lessons learned from this case, including:
* The vital role of segregation of duties.
* The critical need for a culture of control awareness.
* The importance of new-product planning and ongoing control.
* The need for the head office to react to the ?oddball? smoke signals arising out of excessive cash movements to settle margin calls.
Allied Irish Bank?s debacle in 2000 is ?a spectacular litany of all that can go wrong,? says Mulcahy. The bank?s Baltimore office was too small to support the complex trading it permitted. Control staff were underqualified and undertrained, and traders and department heads were too arrogant and extravagant to oversee department staff. A laundry list of violations against just about every core control feature provides several lessons learned:
* Scrutiny is hard work. It means understanding the business, looking at events, asking questions, instituting action plans, and following up for results.
* Trade support and oversight department staff must have industry experience, and their training is paramount.
* Audit staff must be up to the challenge of the business.
* Daily profit and loss must be produced by finance/ operations independently of the traders.
* Reported data must be internally consistent.
* Trade confirmation must be independent and universally applied to all trades, even brokered trades.
* Aged confirmations must be reported to management for action.
"It's crucial to learn how to identify appropriate actions for avoiding control failures," says Mulcahy, "and to develop plans to mitigate persistent operational losses. This course addresses those issues from every perspective, whether you're middle-market trading staff, compliance personnel, or capital markets."
With his background, Mulcahy is uniquely qualified to speak to each of these perspectives. He has more than 25 years' experience in challenging chief financial officer and chief operating officer roles in both the United States and Europe. He has held senior financial and risk management positions at several institutions, including Bank of America, BankBoston, Chase Manhattan, and Chemical Bank, as well as international banks, U.S. securities dealers, a life insurance company, and a major CPA firm.

Mulcahy has in-depth operational expertise in all major domestic and international capital markets products, including U.S. equity and fixed-income securities underwriting and trading, swaps, options, derivatives, foreign exchange, and asset-backed securitizations.
Risk Mitigation Strategies for Trading Operations will be held June 17, 2008, in New York. For more information or to register, contact RMA Customer Care at 800-677-7621.

Read More....

Accountants Offer Valuable Lessons for Avoiding Fraud

Accountants Offer Valuable Lessons for Avoiding Fraud

Martin C Daks. NJBIZ. New Brunswick: Jul 14, 2008. Vol. 21, Iss. 29; pg. 5, 2 pgs

Abstract (Summary)
"In theory, transactions should be verified by a second person with a three-way match involving a purchase order [issued by the company authorizing the transaction], an invoice and a cancelled check," Sonnenberg says. Starting in July 2006, Rogers allegedly wrote out more than 60 company checks to himself for amounts ranging from $10,046.73 to $38,119.38, according to documents filed in federal district court in Camden.

A SMALL-BUSINESS owner's worst nightmare came true when a bookkeeper embezzled more than $ 1 million from his long- time Pennsauken employer, according to a lawsuit playing out in a Camden courtroom. Accountants say the case, Dependable Distribution Services Inc. v. Michael Rogers, illustrates the challenges small companies can face when it comes to implementing an effective system of checks and balances.

Having one employee write checks and record them - as Rogers allegedly did - represents a serious lapse in internal control and invites fraud, some accountants say. Small companies that can't afford to hire many administrative employees may be particularly at risk, since they often have one person take on multiple functions. But safeguarding a company's checkbook doesn't have to cost a lot, accountants say.

"Unfortunately, it is not uncommon for an internal accountant or bookkeeper to embezzle funds if they're not closely watched," says Harvey Sonnenberg, a partner with the internal control and Sarbanes-Oxley group at the Edison office of Weiser LLP, a CPA firm. Sonnenberg and the others quoted in this article are not involved with Dependable Distribution Services Inc. or Rogers' case.

"In theory, transactions should be verified by a second person with a three-way match involving a purchase order [issued by the company authorizing the transaction], an invoice and a cancelled check," Sonnenberg says. "This way, if the payee or amount on the check does not match the invoice, you know right away that there's a problem."

Another solution is to have an outside accountant review the company's checking activity on a periodic basis, says Ricardo Solano Jr., a director at Gibbons P.C., a Newark-based law firm.

"But the cost can be a problem, especially for a small firm," says Solano.

In the absence of an outside auditor, an employee other than the bookkeeper should routinely review a batch of checks, keeping an eye out for any unusual transactions, says Solano.

But apparently no such oversight existed when Rogers joined the firm in 1992 as a bookkeeper-accountant who was responsible for paying bills and payroll. Court records show Rogers was also tasked with updating the general ledger at Dependable, which has 77 employees and rings up about $8.9 million a year in sales, according to Hoovers, an industry and market information provider. Dependable's controller, Denis Dribin, who signed the complaint against Rogers, declined to talk about the case.

Starting in July 2006, Rogers allegedly wrote out more than 60 company checks to himself for amounts ranging from $10,046.73 to $38,119.38, according to documents filed in federal district court in Camden. He was able to cash $1.3 million of unauthorized checks before the scheme was discovered, according to the lawsuit, which was filed June 26. The lawsuit seeks a jury trial and a return of the funds.

To throw off suspicion, Rogers signed the checks with an executive's signature stamp, and falsely recorded them on the company's books as payments to third-party providers and to the company's president.

Solano, a former Assistant United States Attorney with the District of New Jersey, says the Dependable case reminds him of an embezzlement he helped investigate.

In that case, a Hoboken Housing Authority accounting manager snatched $111,083 by issuing HHA checks to himself without authorization, according to Solano.

"Basically, he had the run of the operation and no one was checking up on him," explains Solano. "As I recall, the scheme wasn't discovered until a routine outside audit was done. Then it became clear that the manager was writing checks to himself and depositing them into his personal bank accounts."

Living above one's means can be a tip-off that something's not right, says Kenneth Nielsen Goldmann, a partner with the Roseland-based CPA firm J.H. Cohn.

He recalled a case in the news where a photograph pointed the way to fraud at a New Jersey college.

"A few years back, a college employee was in the office of the institution's chief financial officer, admiring a photograph of the executive at her Florida vacation home," says Goldmann. "That was not unusual. But then the employee noticed a brand-new Mercedes was parked in the driveway in the photo and started to wonder how the executive of an educational institution could pull that off. Things took off from there, and it turned out she had been embezzling funds from the college."

But rather than hoping for a lucky break like that, Goldmann says a few simple steps can help to deter or discover an embezzler.

"One step is to require the employee to take a vacation for at least a week," he says. "That gives someone else a chance to do the employee's job and possibly uncover unauthorized transactions or improper recordkeeping by performing bank reconciliations and other analyses."

Another option, particularly with a small company, is to toss signature stamps and instead require the chief executive's personal signature on every check, according to E. Martin Davidoff, a Dayton CPA and tax attorney.

"I trust my bookkeeper, but she does not sign any of our checks," says Davidoff, who has a 12-employee accounting practice. "Not only that, but all of the bank statements are sent directly to me, unopened."

Davidoff recalls a case where he was called in to investigate some shady dealings by a lawyer who was suspected of embezzling money from a wealthy elderly woman.

"The lawyer had served two generations of the woman's family and had 'power of attorney,' or the authority to pay bills for the family," Davidoff says. "But the woman and her CPA began to get suspicious about some of the transactions. I was called in, looked at the bank statements and asked the attorney to show me the bills associated with the checks he was drawing."


The attorney, who wrote an estimated $600,000 of checks for non-existent transactions, was unable to produce bills, and at age 64 was ultimately jailed for fraud, Davidoff says.
"There's no telling who's out for your money," warns Davidoff. "Reviewing bank statements and other documentation, and segregating duties can help to safeguard your cash

Read More....

Financial Fraud Examination and Management

The Saint Xavier University Graduate Program in Financial Fraud Examination and Management

William J Kresse. Issues in Accounting Education. Sarasota: Nov 2008. Vol. 23, Iss. 4; pg. 601, 8 pgs

Abstract (Summary)
It is this sort of Critical Combination of Conditions that describes the synergistic situation that led to the development of the Saint Xavier University Graduate Programs in Financial Fraud Examination and Management. This article will describe the serendipity and transformations that took place to create this highly successful program, which, to date, has educated more than 200 students, including officers, detectives, and agents of the Chicago Police Department, the FBI, the US Justice Department, and US Air Force Office of Special Investigations. One of the continuing challenges for all schools in this area is the proper balance between the disciplines of accounting, law, psychology, sociology, criminology, intelligence, information systems, computer forensics, and the greater forensic science fields. Each discipline has much to learn from the others; continued inclusion and interaction will be key to success in the future, as they have been related to the achievements of the past.

INTRODUCTION

A Critical Combination of Conditions

To an auditor, a "Critical Combination of Conditions" is a situation in which two or more weaknesses in internal control, none of which would be serious by itself, coalesce to create a significant material weakness in internal control. But in the larger universe, a Critical Combination of Conditions can also describe a positive circumstance where disparate factors converge at the right time and place so as to create a whole that is significantly greater than the sum of its parts. It is this sort of Critical Combination of Conditions that describes the synergistic situation that led to the development of the Saint Xavier University Graduate Programs in Financial Fraud Examination and Management.

This article will describe the serendipity and transformations that took place to create this highly successful program, which, to date, has educated more than 200 students, including officers, detectives, and agents of the Chicago Police Department, the FBI, the U.S. Justice Department, and U.S. Air Force Office of Special Investigations.

BACKGROUND

Founded in 1846 by the Sisters of Mercy, Saint Xavier University is a Catholic, coeducational, comprehensive university offering undergraduate and graduate degree programs to 5,722 students in its four colleges. Saint Xavier University has 183 full-time faculty members and 245 adjunct faculty members. Saint Xavier University's 74-acre Chicago campus is located in the southwest quadrant of the city of Chicago, and its 35-acre Orland Park campus is located in the southwest suburb of Orland Park, Illinois. Additionally, Saint Xavier University offers courses and programs at its Loop Location at the Chicago Bar Association Building in downtown Chicago. As the business college of Saint Xavier University, the Graham School of Management provides theoretically sound and practically oriented undergraduate and graduate programs to serve the broad needs of students interested in the challenging fields of business and management. All of the Graham School's business programs are accredited by the Association of Collegiate Business Schools and Programs.

As the nation's second largest police department, the Chicago Police Department serves the approximately 2.9 million residents of the nation's third-most populous city, covering an area of over 228.5 square miles. The Department has 15,675 employees, including 13,600 sworn police officers, and has an annual budget of over $1 billion.

Since 1998, the Saint Xavier University Graham School of Management/Chicago Police Department "Partnership in Education" program has combined the talents of both institutions in a number of progressive educational, research, strategic, and training endeavors. These endeavors include the Graham School offering both graduate and undergraduate courses to members of the law enforcement community at the Chicago Police Education and Training Center ("Chicago Police Academy"). Since its inception, nearly 1,000 Chicago police officers, including some high-ranking officials, have graduated from this formal educational component of the Partnership in Education.

The Saint Xavier University Graham School of Management offers its entire M.B.A. program at the Chicago Police Academy, exclusively for officers and employees of the Chicago Police Department and other law enforcement agencies. The police agencies involved have found that the M.B.A. course material is highly adaptable, allowing law enforcement officers to use the knowledge, skills, and abilities developed while obtaining this degree in a variety of ways to better serve the citizenry.

STAGES OF DEVELOPMENT

It was against the background of a preexisting relationship with the Chicago Police Department that the Graduate Programs in Financial Fraud Examination and Management was developed. Saint Xavier University's involvement in teaching Fraud Examination began in 2001 and was a direct result of the Graham School of Management offering its M.B.A. program at the Chicago Police Academy. But the program did not come into existence in one instance. Rather, the program evolved over time through several stages. This section will discuss these stages of development.

Stage 1: Directed Study Course in Fraud Examination

One of the police officers enrolled in the M.B.A. program at the Chicago Police Academy had an impediment to graduation. Because of job commitments, he was only able to take courses intermittently over several semesters. But after years of classes, this officer was now only one elective course away from graduating with an M.B.A. However, all of the classes scheduled at the Police Academy for the following semester were courses that this officer had already taken. As a result, the officer approached the program director for academic programming at the Police Academy and asked if it was possible to complete his degree with a "Directed Study" course. This officer, a detective in the Chicago Police Financial Crimes Unit, suggested that the topic be related to fraud and fraud examination. The director for academic programming at the Police Academy, aware that I had research interests and prior experience in fraud examination and forensic accounting, approached me to oversee a directed study course for the Financial Crimes detective. With the approval of the Dean of the Graham School of Management, I agreed to create and teach this directed study course.

Stage 2: Fraud Examination Independent Study Course

In 2002, news of the directed study course in Fraud Examination quickly spread through the ranks of the M.B.A. students at the Police Academy. Simultaneously, the director for academic programming at the Police Academy surveyed the M.B.A. students regarding their interests for elective courses and concentrations. The survey results showed that a substantial number of students were interested in a course or a concentration in fraud examination. Subsequently, a single independent study course in Fraud Examination was developed and offered. Because the independent study course was a pilot class, a survey of the students completing the course was conducted to determine the students' reaction and interest. The survey showed that the students appreciated the fraud examination independent study course and were interested in additional courses in fraud examination.

Stage 3: Financial Fraud Examination and Management Graduate Program Proposal

Survey results suggested sufficient interest to formulate and offer a four-course concentration in "Financial Fraud Examination and Management." During the 2003-2004 academic year, a group of Graham School faculty members set out to design the concentration. Under Graham School guidelines for concentrations, students matriculating toward an M.B.A. degree in Financial Fraud Examination and Management would be required to take the usual M.B.A. core courses along with the four new Financial Fraud Examination and Management concentration courses. Alternatively, students may earn a graduate certificate in Financial Fraud Examination and Management by taking just the four Financial Fraud Examination and Management concentration courses.

In order to design the four Financial Fraud Examination and Management courses with sufficient rigor, the Graham School faculty involved in the proposed program looked to the body of knowledge developed by the Association of Certified Fraud Examiners, as expressed in the ACFE's Fraud Examiners Manual. Additionally, the faculty members consulted with professionals in accounting, law, management, information technology, and law enforcement in order to ensure that in these four courses contained the necessary substantive fraud examination topics. Upon completion of the design of the concentration in Financial Fraud Examination and Management, a formal proposal was prepared and sent to the Graham School faculty and the Saint Xavier University Faculty Senate for their respective deliberations and approvals. Both bodies approved the proposal unanimously.

The four courses that constitute the Financial Fraud Examination and Management proposal are described below.

I. Fraud Examination

The "Fraud Examination" course is generally the first taken by students enrolled in me Financial Fraud Examination and Management program. The objective of this course is to provide the student with a broad knowledge of the different types of business and occupational frauds. Course coverage includes asset misappropriation, cash schemes, accounting systems schemes, and corruption. Additionally, students also gain knowledge of the law as it relates to fraud, anti-fraud deterrence, controls and countermeasures, and fraud examination procedures and techniques. This course contains specialized modules covering interviewing and interrogation techniques, bankruptcy fraud, procurement fraud, expert witnessing and testifying, data analytics and software, communications, and report preparation. Assignments included in this course include simulation exercises requiring the use of data analysis software, case investigations, fraud audits, and report writing.

II. Identity Theft and Computer-Related Fraud

The objective of this course is to provide students with an understanding of the different types of business frauds mat can be perpetrated using computers, along with the related fraud of identity theft. Topics covered include, but are not limited to, Internet and ecommerce fraud, money laundering, assessing risk, and detecting computer-related fraud, as well as management, legal, emical, and privacy issues related to technology. Additionally, the course focuses on threats to, and vulnerabilities of, computers, computers systems, and networks, along with data theft and manipulation, personal and credit information theft, computer viruses, and security systems and protocols.

In addition, this course addresses the contemporary crime of identity theft including prevention, deterrence, and detection. Specifically, the identity theft modules cover the patterns of identity theft, the means by which this crime is perpetrated, the demographics of victims, the financial and economic impact of this crime, and measures to prevent, detect, and deter identity theft. Saint Xavier University is uniquely positioned to teach about identity theft. The Graham School of Management is involved as a partner along with several large corporations, financial services firms, and federal, state, and local law enforcement agencies in the Chicago Metropolitan Identity Theft Task Force. Additionally, several of the instructors in me Financial Fraud Examination and Management program are involved in research in identity theft, including an extensive study of identity theft cases reported in the City of Chicago that was funded by the Institute for Fraud Prevention (IFP).

III. Financial Statement Fraud

The objective of mis course is to educate the student in the variety of ways that fraud can be perpetrated involving a company's financial statements, including content about fraud schemes including, but not limited to, recording premature or fictitious revenues, failing to record expenses, capitalizing expenses, inflating assets, and ignoring liabilities. Additional topics covered include earnings management, improper classifications and disclosures, misleading pro forma measures of earnings, and problems with cash flow reporting. This course also examines cases where fraud was detected, early warning signs of possible fraud, and the techniques used to discover these frauds.

IV. Ethical Issues in Fraud Examination

Saint Xavier University brands itself "A Catholic University in the Mercy Tradition." As such, it was determined that for the Financial Fraud Examination and Management program to be presented in a manner consistent with the university's mission, a separate and unique course addressing ethics should be required. From this decision, "Ethical Issues in Financial Fraud Examination and Management" was born. The "Ethical Issues" course covers several topics, from the various philosophical theories regarding ethics and morality, to the codes of conduct followed by Certified Fraud Examiners, Certified Public Accountants, and other related professionals. The focus of this course is not only on the fraud examiner, but also on the fraud perpetrator. Accordingly, modules in this course concentrate on the ethical, psychological, sociological, and economic motivations of the fraudster. Moreover, the course explores what moves an individual to commit fraud, what moves a business to commit fraud, the striking similarities of both, and the significant environmental impact the latter has on the former. Additionally, this course delves into the area of organizational ethics and studies the connection between detecting and preventing fraud and understanding the corporate ethical environment in which fraud is committed. Students review recent cases of corporate fraud and attempt to examine the underlying devolution of corporate attitudes from legitimate pursuit of profit to illegal conduct.

Stage 4: Financial Fraud Examination and Management Program Commencement/Expansion

The courses constituting the Financial Fraud Examination and Management graduate program were placed on me schedule of classes offered at the Chicago Police Academy for the 2004-2005 academic year. Additionally, in time for the 2004-2005 academic year, the Graham School began admitting into the Financial Fraud Examination and Management program students eligible for the Chicago Police Academy M.B.A. program. The announcement of the Financial Fraud Examination and Management program was well received. Despite relatively little marketing of me program, the Graham School experienced a surge in applications for the four-course concentration. Based on the positive feedback from the Police Academy, the M.B.A. students at the other Graham School locations were surveyed to assess interest in offering the Financial Fraud Examination and Management courses at locations other man the Chicago Police Academy. Among other matters, the surveys found that many students viewed me Financial Fraud Examination and Management program as an appropriate program for students with accounting degrees looking for both an exciting career pam and the additional credit hours needed to sit for the CPA examination. Based on me encouraging results of the surveys and the positive feedback from student and faculty evaluations, the program was rolled out at the Saint Xavier University primary campus on the Southwest Side of Chicago in me 2005-2006 academic year and at the Saint Xavier University location at the Chicago Bar Association Building in downtown Chicago in the 2006-2007 academic year.

Stage 5: Model Curriculum/Evaluation and Modification

In December 2005, the Exposure Draft of the National Institute of Justice Special Report Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students ("Model Curriculum") was issued. Further, I attended the first education conference hosted by West Virginia University at the Pittsburgh Airport Hyatt on the Model Curriculum (September 8, 2006). With the Graham School having offered the entire Financial Fraud Examination and Management program for two years at that point, as Director of Graduate Programs in Financial Fraud Examination and Management, I decided that mis would be a good time for the first major evaluation of me program. In conducting the evaluation, the Model Curriculum was used as the rubric by which to assess the Financial Fraud Examination and Management program and to make any modifications to the program deemed appropriate.

Extremely useful in conducting this program evaluation was me Implementation Guide for the Model Curriculum (available by request to: FFAModel@mail.wvu.edu). The evaluation had a pleasant result: the bulk of the topics suggested in the Model Curriculum appear to have been addressed in me Saint Xavier University Financial Fraud Examination and Management program. However, it was also discovered that there were areas where the Saint Xavier University program was found wanting. As such, me faculty members in the Financial Fraud Examination and Management program were asked to review their courses and consider modifying them where appropriate to add content to cover topics suggested in the Model Curriculum that had not previously been included in the courses. Some topics suggested in the Model Curriculum could not be adequately or appropriately retrofitted into the existing four-course Financial Fraud Examination and Management curriculum. However, as me Model Curriculum provides flexibility for schools to make individual choices that are best for their students and their students' future employers, the Saint Xavier University program, while not perfectly aligned with the Model Curriculum, was nonemeless found to be in compliance with the guidelines. In addition, at this same time, a number of students in the Financial Fraud Examination and Management program requested an additional course mat would both synthesize the material from the four existing courses, and prepare the students for taking me Certified Fraud Examiners examination. Accordingly, as a result of mis evaluation process, an additional course, Fraud Examination Capstone, was added to me Financial Fraud Examination and Management program.

Fraud Examination Capstone Course

The new Fraud Examination Capstone course is open only to those students who have already successfully completed the four other Financial Fraud Examination and Management courses. The articulated objectives of this course are the following:

* develop the capacity to think strategically and critically about fraud examination in an organization;

* build skills in conducting financial fraud examinations in a variety of situations;

* understand the managerial tasks associated with implementing and executing a financial fraud examination;

* integrate the knowledge gained in earlier Financial Fraud Examination and Management courses;

* demonstrate how these concepts fit together to form and effectuate an effective financial fraud examination;

* master the skills needed to sit for and successfully complete the Certified Fraud Examiner examination; and

* become more aware of the importance of exemplary ethical principles, sound personal values, and the social responsibilities of a professional financial fraud examiner.

The Fraud Examination Capstone course includes several lectures leading to comprehensive fraud examination practical problems, exercises, and case projects. Additionally, mis new course allowed the Financial Fraud Examination and Management program to add modules that address those topics suggested in the Model Curriculum that were not possible to be placed elsewhere in the Financial Fraud Examination and Management curriculum.

Stage 6: Further Evaluation and Modification

The fields of fraud examination and forensic accounting are constantly and rapidly changing. In response to this environment, the Saint Xavier University graduate programs in Financial Fraud Examination and Management have incorporated structural mechanisms to regularly assess the program. These assessments primarily focus on the relevance of the content and substantive rigor of the program. However, also included in the assessment process are protocols to evaluate procedural matters and peripheral matters, such as career counseling and community and professional outreach. These assessments are primarily not only conducted through student evaluations and faculty surveys, but also include programs for obtaining input from local professionals involved in fraud examination and forensic accounting.

Data received from these various assessment modes are regularly summarized and reported to the faculty in the Financial Fraud Examination and Management program and the leadership of the Graham School of Management. This same group regularly convenes in brainstorming sessions to address any problems mat have been brought to light through this assessment program and cultivate any modifications to the program deemed necessary or helpful. As such, further changes in the Saint Xavier University Financial Fraud Examination and Management program are not just likely, but are deliberately anticipated and expected.

CONCLUSION

To date, the Saint Xavier University Graham School of Management's Graduate Programs in Financial Fraud Examination and Management have been successful beyond anyone's initial forecast. However, in order for that success to continue, the program must continuously be assessed, evaluated, and modified in order to keep its process and content rigorous and relevant. The most significant factor leading to modifications in me program thus far has been the National Institute of Justice Special Report, Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students. Through implementing the suggestions contained in the Model Curriculum, Saint Xavier University has been able to both improve the Financial Fraud Examination and Management program and hold itself out as comparable to the most rigorous programs in fraud examination and forensic accounting offered anywhere.

One of the continuing challenges for all schools in this area is the proper balance between the disciplines of accounting, law, psychology, sociology, criminology, intelligence, information systems, computer forensics, and the greater forensic science fields. Each discipline has much to learn from the others; continued inclusion and interaction will be key to success in the future, as they have been related to the achievements of the past.

Finally, appropriate attention to research is imperative. The issues of access to data and access to subjects for surveys and experiments, along with the development of new and improved research designs, must be addressed. Further, increasing research regarding fraud meory and improving investigative tools and techniques is integral to the long-term viability of this emerging discipline. The ingrethents of multi-disciplinary inclusion and embracing research have been instrumental to the development of Saint Xavier University's graduate programs in Financial Fraud Examination and Management. They will be part of our future commitment as well.

Read More....

Business Leaders' Take on Fraud: Corrosive

Business Leaders' Take on Fraud: Corrosive

Anonymous. Journal of Accountancy. New York: Jan 2007. Vol. 203, Iss. 1; pg. 34, 5 pgs

Abstract (Summary)
Several executives shared their views on fraud. Marsh & McLennan Cos Inc president and CEO Michael G. Cherkasky said when a company like theirs does business globally with countries that are not as regulated as those in the US, it is important those countries comport with their norms, not the other way around. Private-sector companies must realize they cannot count on government to reduce fraud; this is a task that companies must undertake themselves. China Institute of Directors professor of economics Tommy Seah believes the rate of fraud in China is greater. Although the penalty for white-collar crime is more severe in China than in America, the Chinese see fraud as an opportunity to break out of the chain of poverty. UK Fraud Advisory Panel chairman Rosalind Wright sees a steep rise in the incidence of identity thefts of all types, including phishing, pharming and theft of corporate identity.

U.S. GIANT RESPONDS QUICKLY TO BID-RIGGING CHARGES

Michael G. Cherkasky, president and CEO of Marsh & McLennan Cos. Inc. (MMC), has had a distinguished career as a manager, prosecutor, investigator and trial attorney and spent 16 years in the criminal justice system, including serving as chief of the Investigations Division for the New York County District Attorney's Office. In October 2004, New York Attorney General Eliot Spitzer filed a civil action against Marsh & McLennan, charging it with bid rigging and accepting kickbacks from selected insurers for steering business to them. The company's board of directors acted quickly and within two weeks named Cherkasky as the new CEO. Cherkasky vowed to resolve the legal and regulatory issues and to revamp MMS's business practices. Although there is the potential for litigation by other states, MMC settled with Spitzer in January 2005 for $850 million to be paid over four years.

JofA: What went wrong at MMC to bring forth allegations of bid rigging and kickbacks? Is this a common industry practice, or was it unique to MMC?

Michael G. Cherkasky: I would certainly not call it a common industry practice; the vast majority of business people are honest and ethical. In our case, a small group of individuals put their own interests above those of the company. We had paid these individuals for profit, not for service, which was a mistake. Organizations must maintain a delicate balance between encouraging performance and discouraging illegal or unethical conduct to achieve results.

Being a former prosecutor, I've seen companies handle these crises two ways. They can deny the allegations and fight, usually unsuccessfully, in the courtroom, or they can take ownership of their conduct and fix the problem. I can't emphasize it enough; the latter is the only correct choice.

JofA: Did your strong law enforcement background play a role in your being selected as the new head of MMC?

Cherkasky: There is no question that that had much to do with my being named CEO. This company was on the brink of being in real trouble. We initially lost $10 billion in market capitalization. It took us a full year to recover, but now we have turned the corner. That is a lesson that companies should learn from us. The conduct at MMC was not material to the financial statements as a whole, but when it comes to high-profile cases, there is no such thing as "immaterial" fraud. The financial impact to our company was many times that of the alleged illegalities. That is why it is vitally important that organizations have processes and procedures to prevent wrongdoing in the first place. Our business, like most others, is based on trust. The board recognized this critical concept and decided that MMC was going to be as clean as possible. That is the real lesson other organizations can take away from our situation. Great companies have had, and will continue to have, the same kinds of issues. It is how the company reacts that will make the difference.

JofA: How will MMC prevent such conduct in the future?

Cherkasky: Obviously, the first thing is to set the proper tone at the top. Now, everyone in the company knows that we not only expect but demand ethical behavior. We have greatly improved our audit process to ensure that our financial transactions have adequate documentation. We now have a compliance infrastructure that is world-class. We make better use of our internal audit function to test compliance, and we constantly seek ways to improve it.

JofA: Since MMC is a global entity, what fraud issues concern you the most?

Cherkasky: When a company like ours does business globally with countries that are not as regulated as those in the United States, it is important those countries comport with our norms, not the other way around. For example, we know that a common way of getting business in some nations is to pay for it with bribes and kickbacks. Not only is that conduct illegal for American companies but it is not the right way to do business. MMC has made the decision not to engage in ventures in certain countries. In others we have greatly improved our audit and management practices to ensure we comply with the law. Private-sector companies must realize they cannot count on government to reduce fraud; this is a task that companies must undertake themselves. It is up to the public sector to set standards, but the private sector must enforce them. Certified fraud examiners and CPAs play a critical role in this task.

MAKING HEADWAY IN EUROPE

Max-Peter Ratzel is director of the European Police Organization-Europol. Previously, at the German Federal Criminal Police Office, he was senior adviser and head of units in information and technology, organized crime, property crime and international cooperation. As head of the BKA Department of Organized and General Crime in Wiesbaden, Germany, he coordinated the prevention of and the fight against international illicit drug trafficking, child pornography, Internet crime, the spread of counterfeit money and trafficking in human beings.

JofA: Businesses operate in Europe in much the same way as businesses in the United States. Does that mean fraud schemes familiar in the United States are functioning in the European economies?

Max-Peter Ratzel: The Northern and Atlantic parts of Europe show signs that "boiler room" fraud is on the rise again, and of course the Nigerian or 419 fraud is still all over Europe. Most Americans are familiar with 419 frauds, although perhaps not by that name. In a typical scenario, the victim receives a letter or e-mail from a person falsely claiming to be the recipient of millions of dollars and willing to share the loot with someone who will deposit it in a U.S. bank. But the fraudster requests various "fees" from the victim first. Once those monies are paid, the fraudster disappears. The 419 frauds are a variation of advance fee swindles.

A particularly complicated type of fraud that is rapidly developing in the same region is called "liquidation constructions." These frauds get liquidities out of corporate tax shelters without being taxed. We are especially concerned because skilled professionals, such as accountants and lawyers, are offering their services as financial facilitators for the target companies to mount these constructions, eagerly using offshore and tax havens all over the world.

JofA: Are financial statement frauds active in Europe?

Ratzel: Those frauds are problems in Europe to the extent they are problems all over the world. A number of spectacular financial statement fraud cases have been exposed throughout Europe and vigorously covered by the world press. Fraud at Super Club, Philips, L&H, Parmalat, Hold, Shell, ELF Aquitaine and other companies has troubled many institutional and private investors.

Since we live in a global economy, the disastrous consequences of large-scale fraud in Europe affect the American stock exchanges and vice versa. Several companies have been driven to the edge of bankruptcy and several billion euros in capitalization vaporized when stock prices dropped as a result of "cooking the books." The long-term effects on the well-being of citizens is devastating, affecting pension benefits and eroding employment. I am convinced that creating an awareness of the socially and economically disruptive nature of this fraud has a long way to go. The capital market is based on reliable and correct information. Society has to make sure the quality and reliability of that information is assured-if need be by criminal legislation as the ultimate remedy.

JofA: Have European nations passed any major laws similar to the Sarbanes-Oxley Act?

Ratzel: Over the last decade Europe began to develop corporate governance codes for the mandatory assessment of the internal audit activity, company risk-assessment processes; conflicts of interests and related-party transactions, controls restraining misappropriation of company assets that could result in the material misstatement of the financial statements; procedures for handling complaints and for accepting confidential submissions of concerns. Representative codes are the U.K. Combined Code of July 2003, the German Corporate Governance Code of December 2004, the French Lois de Security Financiered of July 2003, the Dutch Tabaksblat Code of 2005 and the Belgian Corporate Governance. Code (Lippens) of 2005. None of that legislation is as stringent as Sarbanes-Oxley particularly concerning corporate and criminal fraud accountability and white-collar crime penalty enhancements. There is a definite tendency in Europe to be less permissive toward corporate fraud together with an awareness of the harm it does both to the economy and to individuals. Corporate governance legislation in Europe will inevitably evolve from a voluntary approach to a more compelling conception like Sarbanes-Oxley.

CHINA: GET RICH QUICK AT ANY COST

Tommy Seah, CFE, is professor of economics at the China Institute of Directors in Shanghai. He is also a member of the Singapore Institute of Management, a fellow of the Institute of International Accountants and a chartered banker. He is an expert on fraud in the Chinese economy.

JofA: China's new market economy does not seem to square with its communist ideology. What are the reasons the Chinese government has embraced capitalist ideals?

Tommy Seah: Reality hits home. The extreme view is that the Chinese have come to terms with the fact that ideology does not feed an empty stomach. A more moderate reason would be that the government cannot keep marching backward when almost everyone else is marching forward. They also understand that it is economic growth that will give them the recognition they so badly need.

JofA: Are these economic reforms likely to continue, even when the current administration in China changes hands?

Seah: Absolutely; the masses have seen the light. There is no turning back. No amount of bureaucracy is going to change that. The Chinese people have changed. The new generation accepts capitalism as the norm. I have yet to meet a young Chinese who will introduce himself as a member of the Communist Party.

JofA: Do you believe the overall rate of fraud in China is higher, lower or the same as in America?

Seah: I believe the rate of fraud in China is greater. You have an oppressed people who are suddenly given some autonomy over economic decision making. The burgeoning economy in China means more opportunities to commit fraud. And although the penalty for white-collar crime is more severe in China than in America, the Chinese see fraud as an opportunity to break out of the chain of poverty. Lots of Chinese people have now traveled internationally; they see the good life capitalism brings, and many are impatient to get rich quickly Some see no shame in committing fraud because they believe they are just getting back what was theirs in the first place.

JofA: What other cultural differences affect the rate of fraud in China?

Seah: Most Western businesses adhere to corporate governance that is built on accounting principles, competition and disclosure, but for centuries Chinese business has relied upon "Guanxi," or connections. Most transactions are not covered by contracts, but by verbal commitments sealed with a handshake. Nepotism is not only common; it is accepted. China is also struggling with its lack of experience with modern-day methods of commerce. The Communist Party spent much of the last century destroying traditional Chinese values in an attempt to replace them with its own brand of puritanical morality However, those values were largely destroyed as a result of the influences of the Cultural Revolution, and today's Chinese haven't yet defined their own system of ethics. Now the citizens are being told that "to get rich is glorious" without the corresponding acceptable constraints.

JofA: What are some of the common ways Chinese enterprises defraud the American companies that invest there?

Seah: Foreign investments can be made only with the approval of the Chinese government. U.S. companies either invest directly in the Chinese enterprise or become partners. Whichever the case, local management and labor are used extensively, which gives rise to possible fraud in several areas. For instance,

* It is quite common for corrupt employees and management to bill American investors for goods and services in excess of market prices and pocket the difference.

* Local workers may set up competing businesses using the foreign investor's technology and other resources and divert sales to the new business. Or crooked employees can falsify production records and sell part of the investor's product "out the back door."

* They may use the investors' assets to secure loans for themselves; China has not yet developed a good system to track assets pledged as collateral, so it is sometimes difficult for U.S. companies to even know their property has been mortgaged.

* Dishonest executives of Chinese ventures can cook the books just like those of their U.S. counterparts.

JofA: How do American companies and investors protect themselves against fraud in China?

Seah: The same basic ways they protect themselves with their other foreign investments. Know whom you are dealing with by conducting sufficient due diligence. Make sure the agreement is structured in a way that gives the investor unfettered access to the operation and the accounting records. Hire a reputable international accounting firm to perform audits under international accounting standards. Provide hands-on oversight. Finally, keep in mind that most businesses in China operate honestly. It is the investor's obligation to see that they remain that way.

PAY-TO-PLAY IS KING

Paul Volcker is the chairman of the board of trustees of the Group of Thirty, commonly called the G30, in Washington, D.C. He was chairman of the Federal Reserve from 1979 to 1987, undersecretary of the U.S. Treasury for international monetary affairs and president of the Federal Reserve Bank of New York. Having developed a reputation as a brilliant investigator, Volcker was assigned by the United Nations to research possible corruption in the Iraqi Oil-for-Food Program (OFFP) in 2004. In its concluding report of September 7, 2005, the Volcker committee called the program the "largest, most complex and most ambitious humanitarian relief effort in the history of the United Nations." It achieved the goals of helping deprive Iraqi deposed dictator Saddam Hussein of weapons of mass destruction while at the same time maintaining minimal standards of nutrition and health for the Iraqi people in the face of a potential crisis. Of the approximately $ 110 billion in the OFFP, Volcker and his colleagues estimated that Hussein had manipulated about $1.8 billion to his own benefit. The report also was critical of the relationship between the son of U.N. Secretary-General Kofi Annan and a Swiss contractor for the OFFP The committee concluded that most of the problems with the program related to its administration and the lack of adequate controls.

JofA: What can our readers learn from the OFFP investigation as it pertains to the global state of fraud and corruption?

Paul Volcker: There certainly is a lot. For example, we discovered that fully half of the program's 4,500 contractors were paying kickbacks to do business with the Hussein government. To the credit of American contractors, most of them refused to participate. But that void was quickly filled by former Eastern Bloc contractors, principally Russians, and also the Chinese.

JofA: The United States frowns on corruption, and criminal prosecutions are commonplace. What is the situation elsewhere?

Volcker: Certainly, corruption is more egregious in many countries-in Africa, the Middle East and the former Soviet Union, to name a few. However, these acts simply don't have the same stigma attached as they do here at home. Many international companies and even governments view kickbacks as a necessary cost of doing business. Moreover, criminal prosecutions, in general, seem to be the exception and not the rule. Interestingly, in Australia, where corruption is frowned on, the Australian Wheat Board has found itself under a major investigation for allegedly paying $200 million in bribes to secure contracts with the previous Iraqi government.

JofA: With fraud and corruption endemic, how can the United States help control the problem?

Volcker: There is no easy solution. Certainly, the U.S. Foreign Corrupt Practices Act, which prohibits the payment of kickbacks by U.S. companies to foreign officials, is a strong deterrent for American business. United Nations regulations prohibit corruption, as does the World Bank. Although they don't completely stop the problem, they do provide enforcement mechanisms. But because of the rapidly expanding pace of international trade, I expect the total volume of corruption in general will get worse before it gets better.

JofA: In the United States, Enron and WorldCom have put accounting fraud center stage. But even without those two cases, the securities and Exchange Commission has reported record restatements of company earnings. To what do you attribute this seeming wave of fraud?

Volcker: First, the complexity of financial information makes it easier to mask fraud. Second, the huge compensation packages afforded executives-particularly stock options-provide great incentives to act dishonestly Third, the public has not demanded honesty and accountability from business. Finally, I believe that CPAs can, should and will do a better job detecting and preventing fraud. Reliance on credible financial information is vital to the nation's economy.

TRADITIONAL FRAUD MEETS FOREIGN VISITORS

Rosalind Wright, a barrister, is chairman of the United Kingdom Fraud Advisory Panel and an independent director of the Office of Fair Trading and the Department of Trade and Industry. She also chairs the supervisory committee of OLAF (the European Anti-Fraud Office), an agency of the European Commission. She was the director of the Serious Fraud Office and general counsel and an executive director for the securities and Futures Authority, one of the principal U.K. financial services regulators. She is considered one of the U.K.'s most knowledgeable authorities on fraud.

JofA: Please explain the background and function of the U.K. Fraud Advisory Panel.

Rosalind Wright: The panel is an independent body of volunteers drawn from the public and private sectors. Our role is to raise awareness of the social and economic damage caused by fraud and to develop effective remedies. Panel members include representatives from the law and accounting professions, industry associations, financial institutions, government agencies, law enforcement, regulatory authorities and academia.

Established in 1998 through a public-spirited initiative by the Institute of Chartered Accountants in England and Wales, the panel works to encourage a truly multidisciplinary perspective on fraud. No other organization has such a range and depth of knowledge, both of the problem and of the means to combat it. Today it is a registered charity and company limited by guarantee and funded by subscription, donation and sponsorship.

JofA: Are there particular fraud schemes that seem to be growing in the United Kingdom at present?

Wright: We see a steep rise in the incidence of identity thefts of all types, including phishing, pharming and theft of corporate identity. We also see a rise in traditional fraud schemes, such as theft by employees, advance fee frauds, highyield investment schemes and the use of fictitious prime bank instruments to deceive investors. Much of the fraud practiced on U.K. investors comes from overseas, particularly from countries that were part of the former Soviet Union (computer-related crime and attempts to obtain confidential customer information from institutions) and Nigeria and Canada (advance fee frauds).

JofA: What programs does the Fraud Advisory Panel advocate to curb fraud?

Wright: We advocate greater emphasis by government on the risk of financial crime. At the moment, fraud is not a policing priority and, therefore, is not adequately funded by the U.K. Home Office. There are insufficient numbers of trained and specialist police officers and police financial investigators to deal with the amounts of fraud reported to them. Consequently, a large amount of major fraud goes uninvestigated.

We also advise businesses and the professions to report fraud to law enforcement. Many of the major frauds committed by employees and directors go unreported and therefore add to the numbers that are not investigated by the police.

We urge businesses and their advisers to raise the profile of fraud risk and to manage it effectively. We would like more emphasis on good business ethics within companies and more responsibility taken at the highest corporate level for managing fraud risk. We also alert the public to the more obvious attempts at fraud that crooks make daily.

JofA: In general, how effective do you think the U.K. accounting profession has been in deterring and detecting material frauds in organizations?

Wright: There is no doubt that an external audit is a deterrent to fraud, although it cannot be relied on to prevent or detect all frauds-or even all frauds that are material to the financial statements. Frauds can be well-disguised, involving collusion among a number of parties, and therefore very difficult to uncover. Audit is by its nature an unproductive cost; managers tend not to suspect fraud in their own organizations and pressure auditors to reduce costs, minimizing audit procedures to only those the auditors need to justify their opinions.

Auditors' contributions to the fight against fraud also have been reduced in recent years by the steady increase in the audit exemption limit, meaning that small companies no longer are required to have a regular audit, nor even have a regular relationship with a professional accountant.

Against this, professional accountants tend to advise clients routinely on the internal control procedures they should have in place to minimize business risks, including fraud. In addition accountants are bound by their professional ethics to ensure that their names are not associated with any documents they believe to be misleading. Accountants would normally undertake at least some level of review of, say, the tax returns with which they are associated, to ensure they are clearly not fraudulent.

Read More....

Assessing the Risks of Accounting Fraud

Assessing the Risks of Accounting Fraud

Robert Sidorsky. Commercial Lending Review. Riverwoods: Nov/Dec 2006. pg. 9, 8 pgs

Abstract (Summary)
Lenders must regularly confront the risk of fraudulent financial reporting in their credit decisions and loan management. A basic precautionary measure is to understand the common patterns and telltale signs of accounting fraud. This article provides an overview of: 1. the conditions conducive to accounting fraud or what are commonly called "red flags", 2. how accounting fraud is committed based on actual case histories, and 3. measures that can be taken to prevent and uncover theft of assets and fraudulent financial reporting. When the conditions conducive to fraud are understood, it is possible to institute a control environment and put in place specific controls designed to prevent and discover management theft. Lenders can significantly enhance their ability to evaluate financial statements and financial information in order to assess the risks and likelihood of fraud. It is important to understand how the control environment as well as specific controls and audit procedures are designed to prevent and uncover fraud.

Lenders must regularly confront the risk of fraudulent financial reporting in their credit decisions and loan management. Given that accounting fraud by definition involves chicanery, and in some instances elaborate cover-up of the borrower's true financial condition, what can be done to address and mitigate the risk of accounting fraud? A basic precautionary measure is to understand the common patterns and telltale signs of accounting fraud. By understanding how accounting fraud is perpetrated and, in particular, the patterns of fraudulent financial reporting that tend to be associated with particular industries, lenders and credit managers will be in a much better position to obtain and assess relevant financial information from the borrower and to address the risks with the borrower's financial officers and in-house and outside auditors.

This article provides an overview of (1) the conditions conducive to accounting fraud or what are commonly called "red flags"; (2) how accounting fraud is committed based on actual case histories; and (3) measures that can be taken to prevent and uncover theft of assets and fraudulent financial reporting. By gaining an understanding of these three interrelated subjects, lenders will significantly enhance their ability to assess and control credit risks.

The risks associated with accounting fraud are generally grouped within two broad categories. One is theft or looting of corporate assets by management insiders, and the other is fraudulent financial reporting.

Misappropriation of Assets

In cases of management theft, there are certain indicia of fraud or red flags that are typically present. These factors can generally be categorized as follows:

* Management style/dominant CEO/ability to override controls

* Weak internal controls/lack of segregation of duties

* Numerous manual journal entries

* Transactions that lack apparent business purpose/ unsupported transactions on the general ledger

Misappropriation or looting of corporate assets by insiders frequently takes place in a corporate environment in which the management style is characterized by a dominant chief executive officer who has the ability to override controls. It is very typical in these situations to have a control environment where there is a lack of adequate segregation of duties. In these circumstances, the dominant executive has the ability to commit fraud and often equates his or her own persona with that of the company failing to draw the line between corporate assets and self-dealing.

To commit fraud, the perpetrator of the theft will typically engage in a transaction or series of transactions that lack an apparent business purpose or are unsupported in the company's accounting records. Furthermore, to obtain receipt of the diverted assets or funds, the transaction typically must flow through entities or counterparties that are related parties subject to the control of the perpetrator, which may be disclosed or undisclosed related parties. Finally, these transactions may be reflected in numerous manual journal entries.

Some Case Examples

Some historical as well as more recent cases illustrate this recurring pattern in cases of fraudulent misappropriation. For example, in the DeLorean case,1 John Z. DeLorean, who had been a senior executive at General Motors, founded an eponymous automobile company, DeLorean Motor Company (DMC), in the late 1970s. DeLorean was able to obtain financing from a department of the British government in Northern Ireland to build a stainless steel, gull-wing sports car in a plant outside Belfast. At the very outset of the project, DeLorean announced to the board of directors that he had negotiated a contract to have the development and engineering of the car performed by Lotus Cars Limited in England but that Colin Chapman, who was the then head of Lotus, insisted that all of the money for the development work, approximately $18 million, be paid up front to a company in Geneva called GPD Services Inc. The $18 million was paid into the Swiss bank account of GPD, which was incorporated in Panama, pursuant to a contract entered into between the DeLorean companies and GPD. After the Northern Ireland subsidiary went into receivership and bankruptcy proceedings were commenced in the United States, DeLorean and Chapman were alleged to have misappropriated the money paid to GPD, splitting the funds between them. Lotus was paid approximately $22 million for its design and engineering work through supplemental or additional payments made under the contract with GPD.

This case involved many of the red flags discussed above. DeLorean, as the well-known founder of the start-up company, dominated the corporation and was able to override basic accounting controls-and such controls were lacking. The contract for performance of the development and engineering work with GPD was extremely vague and lacked accounting controls or performance benchmarks. Moreover, there was no mechanism for verifying if Lotus, the company actually performing the engineering work, was receiving the funds paid up front or how completion of the different phases of the work was to be determined.

Furthermore, the transaction at issue lacked an apparent business rationale. Since Lotus was to perform the engineering work in England, this called into question why payment was going to a mysterious, offshore company incorporated in Panama. Similarly, since the purported business justification for the contract with GPD was that it owned certain rights or patents involved in the engineering process, this raised the issue of whether there was any documentation or independent evidence to support GPD's ownership of such processes or patents. Finally, because GPD was a shell Panamanian corporation with a Swiss bank account, DeLorean and Chapman were able to control the flow of funds out of GPD's bank account. Thus, this case highlights many of the conditions conducive to misappropriation of assets outlined above.

Another example of alleged management theft involves an insolvent health maintenance organization (HMO) in New Jersey, which has resulted in ongoing litigation by the New Jersey Commissioner of Insurance against the officers and directors of the HMO, as well as its outside auditors and actuaries. In this case, the HMO was a start-up insurance company whose sole shareholder was a doctor who also owned and operated a network of related companies. Accordingly, there is the familiar pattern of the dominant owner or CEO and weak control environment. In this specific example, the owner arranged for contracts between the HMO, which received funds under Medicaid, with the various related-party entities controlled by him. These arrangements included a contract with a related-party company that ostensibly provided ambulance or transportation services for patients and a contract with another related-party company that purported to provide marketing services to the HMO. In practice, large sums were paid pursuant to these contracts to the related-party entities, which provided little or no services to the HMO. Thus, the alleged perpetrator of the fraud was able to siphon off millions of dollars from the regulated HMO to other unregulated businesses under his control.

The theft of corporate assets may also occur in situations where insiders conspire or collude with customers or outside vendors to misappropriate corporate assets. As noted above, in the DeLorean case, DeLorean was alleged to have colluded with Chapman, who was the chief executive of a vendor of DMC, to misappropriate corporate funds. In a typical case, a customer may bribe a corporate insider to allow the customer to engage in defalcation. For example, in a case involving a commodities trading firm in New York, a customer bribed the firm's credit manager so that he could take delivery of gold and silver on credit. As a result, the customer owed the firm in excess of $20 million, which was the largest account receivable balance on the company's books. To create the false appearance that the account receivable balance was fully secured, the customer provided collateral in the form of what were purported to be rare and extremely valuable coins. The credit manager, in return for bribes received from the customer, accepted the collateral knowing that it was counterfeit or of little value and placed values on the coins in the company's books that were far in excess of their true worth. The company's outside auditors observed and counted the coins each year as part of their annual examination of inventory but did not seek an independent verification of the authenticity or true value of the numismatic collateral.

Here again, the main feature of the fraud is the lack of an apparent business purpose for the transaction and its unusual nature. The red flags or indicia of fraud regarding this transaction included the following:

* The customer's account receivable balance was the largest on the company's books.

* There was no apparent business purpose for allowing the customer to carry such a large balance.

* Accepting coins as collateral was against company policy.

* The company was in the business of arbitrage trading of gold and silver and had no expertise in valuing coins.

* The customer traded through corporate entities incorporated in Uruguay and Panama while living in New York.

* The customer himself went by different names or aliases.

How to Prevent and Detect Theft

When the conditions conducive to fraud are understood, it is possible to institute a control environment and put in place specific controls designed to prevent and discover management theft. The control environment and specific controls that should be implemented to prevent and detect fraud include those listed in Exhibit 1.

Furthermore, audit procedures should also be designed and implemented to prevent and discover theft by management. These procedures should include the following:

* Question and document business purpose of significant transactions.

* Obtain specific third-party confirmations.

* Identify and document support for related-party transactions.

* Obtain independent valuations and appraisals of cassets.

* Investigate cash transfers, especially dealing with related parties.

In assessing credit risks, lenders in turn should take appropriate steps to satisfy themselves that the proper control environment and specific controls are in place.

Fraudulent Financial Reporting

Fraudulent financial reporting can and does take myriad forms. Nevertheless, there are also recurring or basic patterns of fraudulent financial reporting that are associated with particular industries. Accordingly, it is important for a lender to understand the type of fraudulent financial reporting associated with a particular industry, so as to be in a position to evaluate the specific nature of the risks. The industries used for illustration purposes below are construction, retail, technology and Internet and financial services.

Industry-Specific Patterns of Fraudulent Financial Reporting

The types of fraudulent financial reporting associated with these particular industries, the methods by which the fraudulent financial reporting is perpetrated and certain of the basic audit procedures designed to address the risk of fraud are set forth in Exhibit 2.

Construction

In the construction industry, fraudulent financial reporting typically involves misuse of the percentage-of-completion accounting method. The reason that percentage-of-completion accounting lends itself to manipulation, like many of the other areas discussed below, is because it requires estimation and judgment on the part of management rather than a fixed or readily quantifiable amount. Specifically, it requires management to make an accurate estimate of the projected costs to complete long-term construction projects and to determine the percentage of completion to date for purposes of recognizing revenue using the percentage-of-completion method. Thus, there is the opportunity for dishonest management that is under pressure to meet earning targets to knowingly underestimate the cost to complete and/or to exaggerate the percentage of completion on projects in order to inflate revenue recognition.

Some of the key factors in preventing and detecting manipulation or misuse of percentage-of-completion accounting are good controls over the estimation process, physical inspection of the project site to verify the percentage of completion, interviewing the project managers about the percentage of completion and the cost to complete and obtaining independent verification from outside experts.

Retail

In the retail industry, most accounting frauds involve some type of manipulation of inventory. The PharMor case2 is a leading example of a retail accounting fraud based on manipulation of inventory records. Before its bankruptcy, Phar-Mor was a drugstore chain that operated 300 stores and had reported sales of $3 billion in 1992. The massive $500 million accounting fraud orchestrated by Phar-Mor's CEO, Mickey Monus, which was the largest financial statement fraud ever disclosed in the United States at the time, consisted of recognizing revenues before they were earned, overstating accounts receivable, understating expenses, overstating fixed assets and overstating gross margins. All of these misstatements were concealed by the intentional overstatement of store inventory balances. Phar-Mor's CFO and accounting staff actively participated in the fraud by making hundreds of manual entries each quarter to the general ledger to reclassify what were basically expenses into the various store inventories. The false entries were therefore spread out through hundreds of items of inventory, such as bins of toothpaste, in hundreds of stores.

Certain of the basic types of audit procedures designed to prevent and detect this type of fraud include reviewing manual journal entries for unusual items and reconciling individual store balances with the general ledger.

Technology and Internet

In the technology and software industry, alleged fraudulent financial reporting invariably involves issues of revenue recognition on sales. There have been a series of class-action cases alleging securities fraud over the past few years, all of which have focused on the issue of recognizing revenue from sales before transactions are final or what the court in the MicroStrategy case colloquially referred to as: "Don't count your chickens before they hatch."3

In these cases, the fact pattern typically involves recognizing revenue on contracts that are not yet signed, where the goods are shipped on consignment and there is a right of return or services remained to be performed, such as customizing or upgrading the software product. In some cases, revenues are inflated by snipping goods to distributors, which were never ordered, or what is known as channelstuffing. In the particularly flagrant and well-known case of MiniScribe,4 revenues were created by shipping boxes of bricks instead of computer drives. Miniscribe bought a load of bricks, packed them into boxes, shipped the bricks to a phony customer's warehouse and reported the shipment as sales on its financial statements.

In these types of cases, some of the recurring signals or red flags of fraud are large transactions near year-end or quarter-end as well as inconsistent cash flow with the level of reported revenues. Some of the auditing procedures that are designed to identify this type of fraud are confirming the specific contract terms with the customer, confirming account receivable balances and observing the shipping cutoff.

Also in the dot.com world, fraudulent financial reporting is typically based on inflating revenues, since the key to raising funding and going public has been the ability to show revenue growth. In a series of cases, companies have tried to manufacture certain categories of revenue through barter transactions or three-party transactions known as "round-tripping. "

A good example of this kind of case is the homestore.com case.5 Homestore was an online real estate firm that would trade services with another company for advertising on Homestore's Web site at greatly inflated values. In economic terms, the transaction is effectively a wash, but Homestore would recognize the revenue and classify it as revenue from advertising. Homestore was also alleged to have entered into round-tripping transactions involving AOL and start-up companies looking to go public, in which Homestore would buy products or services from the start-up company that it did not need at inflated values in return for advertising on Homestore's Web site, for which AOL would be paid a sales commission. These cases, therefore, typically involve the misclassification or miscategorization of the source of revenues to provide the appearance on the company's financial statements that revenue is being generated in the desired category.

Financial Services

In the financial markets, fraudulent financial reporting typically involves so-called rogue traders who fail to close trades to avoid booking losses; losses continue to mount or the traders exceed their trading limits. Certain of the audit procedures designed to address those risks include searching for unmatched trades or unsettled trades, testing controls for enforcement of trading limits and extending confirmation procedures with trading counterparties.

The potential for fraudulent financial reporting also exists in all circumstances that involve the exercise of management judgment in valuing key assets on the balance sheet, whether it be the value of a residual interest in a portfolio of securitized mortgage loans or the value of an intangible asset, such as a film library, or the value of intellectual property, such as patents.

For example, within the banking industry, there were a series of lawsuits during the late 1990s alleging fraudulent financial reporting in connection with the bankruptcies of issuers of mortgagebacked or asset-backed securities. These bankrupt companies were typically engaged in the business of purchasing bundles of mortgage loans and then securitizing the loan portfolios and selling the securities to investors. The main asset on the issuer's balance sheet was the residual value of the securitized loan portfolio. To determine that valuation, management had to make a number of critical assumptions, in particular the discount rate that should be used, the rate of default and the rate of prepayment on the underlying basket of loans. Thus, the potential for fraudulent financial reporting exists because management is required to make estimates and judgments of projected default and prepayment rates for purposes of determining the residual value of the loan portfolio on the balance sheet.

The most notorious case of accounting fraud in this area is the First National Bank of Keystone case.6 Keystone was a small community bank located in an economically depressed coal mining region of West Virginia that was engaged on a very large scale in the sophisticated financial practice of securitizing subprime mortgages. Keystone was closed in 1999 by the office of the Comptroller of the Currency after regulators were unable to account for some $515 million of the $1.1 billion in assets recorded on Keystone's books. To thwart the investigation, the vice president of the bank buried several dump truck loads of documents and microfilm in her backyard with the dump truck openly moving through the town. The examiners discovered through direct verification with Keystone's loan servicers that $515 million in loans carried on the bank's books were not owned by the bank. The chairman of Keystone and senior executives involved in the fraud were convicted or pled guilty to counts of fraud and conspiracy and were sentenced to prison terms of up to 16 years.

Accordingly, the risk of fraud can only be evaluated in the context of understanding the risks and patterns of fraudulent financial reporting associated with a particular industry. Lenders should identify the areas that provide opportunity for management to engage in accounting fraud by exercising judgments.

Signals or Red Flags of Fraudulent Financial Reporting

In addition to understanding how fraud occurs within an industry, lenders should be alert to the symptoms or indicia of fraudulent financial reporting. Here again, certain signals of accounting fraud tend to recur in cases across the board and include the following:

* Persistent cash shortage and failure to pay bills when due

* Diminishing income or sales

* Growing inventories, accounts receivable and accounts payable, each of which is inconsistent with the business's revenue size and direction

* Creation and classification of suspense items in the accounting records

* Extensive "cleaning up" of account balances by journal entries at fiscal year-end

* Late or incomplete monthly financial reporting

* Recurring recommendations by auditors or consultants for improvement in systems, personnel, policies and procedures

* Increased aging or write-offs of accounts receivable

* Holding vendor checks for mailing outside the established system for paying bills

* The inability to contrast and match up reported financial information with known physical characteristics of the business because of business size, the form of presentation of the financial information or the physical movement of business assets at a faster pace than the reporting systems can gather and report

By understanding how accounting fraud is committed, the signals or red flags indicative of fraudulent financial reporting and the basic audit procedures designed to prevent and discover certain types of fraud, lenders can develop and apply more effective measures for assessing credit risk. In general, these measures for assessing credit risk should include the following:

* Require new and established customers to provide useful financial information.

* Look for trends, unusual fluctuations in numbers, management style, signs of cash problems, financing troubles, etc.

* If possible, use the customer's accounting department to assist in analysis.

* Use any leverage with the customer to get information.

* Communicate with sales and accounting.

* Aim to rate the customer's control environment and integrity.

* Use these ratings to negotiate terms of loan.

Conclusion

Lenders can significantly enhance their ability to evaluate financial statements and financial information in order to assess the risks and likelihood of fraud. It is important to understand how the control environment as well as specific controls and audit procedures are designed to prevent and uncover fraud. Loan officers can then seek and obtain information that addresses whether or not the overall control environment and specific controls and audit procedures are in place to provide adequate safeguards against accounting fraud.

Read More....