What's Your Fraud IQ?

BY ANDI MCNEAL, CPA, CFE
September 1, 2009

Placing a sizable amount of trust in staff members is part of the cost of doing business. Trusting workers with access to information, products, vendors and funds is necessary to run an effective and efficient operation. But some employees—when faced with sufficient pressure, a perceived opportunity, and the ability to rationalize a criminal act—will take advantage of that trust and defraud their employers.

 

How well do you know the signs and symptoms of employee embezzlement? Do you know what to do when you suspect an employee is stealing? Take this quiz to gauge your knowledge of the red flags and investigative methods for internal fraud.

 

1. Which of the following fraud schemes generally does not leave an audit trail and, consequently, is among the hardest to detect?

 

a. Sales skimming

b. False billing

c. Check tampering

d. Inventory theft

 

2. The employee hotline for Aspiring Inc. received an anonymous call alleging that several employees are receiving kickbacks from a local vendor. Management has decided to launch a formal investigation into the allegations. Who should be primarily responsible for directing the fraud examination?

 

a. The head of the company’s security department

b. The partner of the company’s external audit firm

c. The company’s legal counsel

d. The company’s human resources manager

 

 

3. Charlotte Grey, CPA, is conducting the annual audit of XYZ Corp.’s financial statements. While performing the yearend inventory procedures, she notices that several inventory items are regularly purchased at prices above the industry standard. These same items are also frequently purchased well before the typical reorder point and are, therefore, consistently overstocked. She notes that XYZ has recently changed vendors for these items, and she can’t locate the new vendor on the company’s approved vendor list. Which of the following fraud schemes might these findings indicate is occurring?

 

a. Inventory theft

b. Asset overvaluation

c. Bribery

d. Lapping

 

 

4. Thoroughly examining canceled checks that are returned with the bank statement and reviewing vendor complaints regarding nonpayment are both proactive tests that can help detect:

 

a. Shell company schemes

b. Forged endorsement schemes

c. Skimming schemes

d. Fictitious refund schemes

 

 

5. Lincoln Bartuska is investigating some suspicious activity at ZX & Co., a regional office supply store. As part of his investigation, Bartuska compared inventory adjustments to refund transactions by employees. He also looked for any sales transactions where the sale was posted to one credit card and a refund was posted to another credit card. What type of scheme is Bartuska most likely looking for?

 

a. Cash larceny

b. Inventory theft

c. Credit card skimming

d. Fictitious refunds

 

 

6. Which of the following may be a sign that an organization is being victimized by a falsified hours scheme?

 

a. Several employees appear on the personnel employee roster but are not on the most recent payroll check list.

b. The payroll expenses for the company unexpectedly exceed budgeted projections and prior years’ totals.

c. One employee consistently submits more requests for expense reimbursements than all other employees within the department.

d. The FICA tax withheld on several employees’ paychecks does not equal 7.65% of the employees’ gross pay.

 

 

7. When returning a stapler he borrowed from a co-worker, Johannes Kiebler noticed a notebook on the coworker’s desk that contained what appeared to be a second set of accounts receivable records. Kiebler managed to quickly read among the scribbles: “Sept. 2, Customer Q, $3,200,” “Sept. 3, Customer R, $2,900,” and “Sept. 5, Customer S, $2,650—need $2,400.” What type of scheme did Kiebler most likely catch the co-worker perpetrating?

 

a. Lapping

b. Kiting

c. Altered payee

d. Falsified billing

 

 

8. An unexplained increase in bad debt expense can be a red flag that an employee is stealing inventory from the company warehouse.

 

a. True

b. False

 

 

9. Which of the following might be a warning sign of a shell company scheme?

 

a. A vendor that is not listed in the phone book

b. An unexpected and significant increase in “consulting expenses”

c. Invoices lacking details of the items purchased

d. All of the above

 

 

10. Gerri Alderman is an internal auditor for Steen Corp. She ran a report that listed payments to employees for business expenses that occurred while the employee was on vacation. What type of fraud scheme is Alderman most likely to find?

 

a. Petty cash larceny

b. Concealed expenses

c. Mischaracterized expense reimbursement

d. Falsified salary

 

 

ANSWERS

 

1. (a) Skimming is the theft of an organization’s cash receipts before they are entered into the accounting system. In a sales skimming scheme, the fraudster collects the customer’s payment at the point of sale, but simply pockets the money without recording the sale or the payment. Because no entry is made on the victim organization’s books, there is no direct audit trail of the transaction. In many cases, indirect evidence—such as inventory shortages or lower-than-expected sales—provides the only indication that the fraud has occurred.

 

2. (c) An investigation into alleged employee theft is a minefield of legal pitfalls. Without proper guidance, investigators can run afoul of issues such as employee privacy and wrongful termination. Therefore, in most situations, investigations should be headed up by legal counsel who can provide clear professional guidance on these issues. Additionally, allowing an attorney to direct the investigation may allow any collected evidence to be protected under the attorney-client privilege.

 

3. (c) The combination of findings that Charlotte Grey discovered could indicate that a bribery scheme is occurring. For example, one of XYZ’s purchasing agents may be accepting bribes for diverting orders for these inventory items to a new vendor—one that has not been through the company’s usual vetting process. The vendor would likely charge an inflated price for the items to cover the amount of the kickbacks paid to the purchasing agent. Additionally, the bribery scheme might explain the overstocked quantity of the goods on hand, as both the purchasing agent and the vendor may push through excessive purchases to increase their take from the scam.

 

4. (b) Forged endorsement schemes are a form of check tampering in which an employee intercepts a company check intended for another party, fraudulently endorses the check, and uses it for his or her own benefit. Checks that have been pilfered as part of a forged endorsement scheme may have dual endorsements or obviously forged endorsements on the back. Consequently, the employee who reconciles the bank statement should be required to thoroughly examine and compare the front and back of canceled checks for any signs of manipulation or forgery. Additionally, if a fraudster misappropriates a check payable to a vendor, the vendor will likely complain about the company’s nonpayment. Reviewing complaints of this nature from vendors may help uncover a forged endorsement scheme.

 

5. (d) Fictitious refund schemes occur when an employee processes a fake refund transaction as if a customer were returning previously purchased merchandise and then pockets the amount of the refund. Several tests can be used to detect this type of scheme, including:

  • Searching for a large number of refunds just below the management review amount.
  • Searching for customer sales and related refunds that occurred on the same day.
  • Comparing inventory adjustments to refund transactions by employee.
  • Identifying sales posted to one credit card with related refunds posted to another card.
  • Extracting the names of all employees who can post both refunds and inventory adjustments.
  • Placing random customer service calls to customers who have returned merchandise to verify that the return transaction was valid.

 

6. (b) The most common method of payroll abuse involves submitting claims for excess compensation. Without attentive oversight, hourly employees can simply falsify the amount of hours reported to increase the size of their paycheck. One of the biggest resulting red flags is payroll expenses—for an employee, a department, or the company as a whole—that are higher than expected. Other warning signs of such schemes include excessive overtime claims for an employee or department, inconsistent net payroll check amounts for salaried employees, and timecards that contain unexplained alterations, errors or discrepancies.

 

7. (a) During a lapping scheme, the perpetrator embezzles money from one customer’s incoming payment, then attempts to cover that payment with later receipts from other customers. The misapplied payments must then be covered with other subsequent receipts, creating a snowball effect. As Kiebler observed, lapping schemes can become so onerous to keep up with that the perpetrator may create a second set of books to maintain the fraud. To end the escalating confusion, the perpetrator must eventually either make restitution or create a journal entry to adjust the affected accounts receivable balances for the shortfall.

 

8. (a) To cover the theft of inventory from the company’s warehouse, some perpetrators will record fictitious sales of the missing merchandise on the company books. Of course, this results in accounts receivable due from customers who did not receive any goods, and who will therefore not pay for these transactions. To keep the fake sales from coming to light, the perpetrator must then either cancel the fake sales or write them off as bad debts.

 

9. (d) A shell company is a fictitious vendor created by a fraudster for the sole purpose of generating false payments from the victim organization. Many shell company schemes are perpetrated using nothing more than a company name and a printed invoice template. Red flags that an employee is using a shell company to defraud the organization include vendor invoices lacking details—such as phone number, invoice number or information about the items purchased—and invoices from a vendor that is not on the approved vendor list, has no record of a physical address, or is not listed in the phone book.

 

Additionally, shell company schemes frequently involve the purchase of fictitious services, such as consulting or administrative services, as these purchases are less verifiable than purchases of goods. Consequently, unexpected and significant increases in these types of expense accounts may be indicative of a fraudulent billing scheme.

 

10. (c) Most companies reimburse employees for business-related travel expenses, such as transportation, lodging and meals. Dishonest employees may take advantage of this policy by requesting reimbursement for expenses that were incurred during a personal trip and claiming that the travel was for a business purpose. However, searching expense reimbursement claims for costs incurred during the same period an employee was on vacation can help identify mischaracterized expense reimbursement schemes.

 

SCORING

If you answered nine or 10 questions correctly, congratulations. Your arsenal of antifraud knowledge is well-armed and ready to aid in the fight against fraudulent conduct. Keep up the good work.

 

If you answered seven or eight questions correctly, you’re on the right track. Use the resources listed on the previous page to continue to build on your knowledge of fraud detection and investigation.

 

If you answered fewer than seven questions correctly, you may want to brush up on your antifraud knowledge. The resources that accompany this article are a good place to start. Enhancing your understanding of fraud detection and investigation concepts will help ensure that you have what it takes to keep your assets protected from would-be fraudsters.

 

Andi McNeal (amcneal@acfe.com) is research manager for the Association of Certified Fraud Examiners.

 

AICPA RESOURCES

 

JofA articles

 

Past articles are available at journalofaccountancy.com. In the search box, click “Open Advanced Search” and then search by title.

 

Web site

Antifraud/Forensic Accounting resources, fvs.aicpa.org/Resources/Antifraud+Forensic+Accounting/

 

Publications

  • Managing the Business Risk of Fraud: A Practical Guide, tinyurl.com/bhkmeu
  • How Fraud Hurts You and Your Organization (#056513HS)

 

Webcast

“Ponzi Schemes, Bernard Madoff and Beyond,” an archived Webcast (#780157)

 

CPE

  • Fraud and the CPA, a CPE self-study course (#738600HS)
  • Common Frauds and Internal Controls for Revenue, Purchasing and Cash Receipts, a CPE self-study course (#753350)
  • Purchasing, Inventory, and Cash Disbursements: Common Frauds and Internal Controls, a CPE self-study course (#753330)
  • Revenue and Cash Receipts: Common Frauds and Internal Controls, a CPE self-study course (#753340)

 

For more information or to place an order, go to cpa2biz.com or call the Institute at 888-777-7077.

 

FVS Section

Membership in the Forensic and Valuation Services (FVS) Section provides you with access to numerous specialized resources in the forensic and valuation services discipline areas, including practice guides and exclusive member discounts for products and events. Go to aicpa.org/FVS to learn more about the FVS Section, or to join go to tinyurl.com/d93r6w.

 

On-Site Learning Courses

  • Advanced Forensic Techniques for Accountants (Course Acronym: AFTA)
  • Auditing for Internal Fraud (Course Acronym: FE-AIF)
  • Detecting Misappropriation Schemes (Course Acronym: FE-MS)
  • Forensics and Financial Fraud: Real-World Issues & Answers (Course Acronym: FFF)
  • Fraud and the Financial Statement Audit: Auditor Responsibilities (Course Acronym: FFSA)
  • Identifying Fraudulent Financial Transactions (Course Acronym: FE-FFT)

 

To access on-site training courses, go to aicpalearning.org, click on “On-Site Training” and search by “Acronym Index.” If you need assistance, please contact a training representative at 800-634-6780 (option 1).

 

OTHER RESOURCES

 

Association of Certified Fraud Examiners

 

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