By Craig L. Greene, CPA/CFF, CFE, MCJ

 

I. Why Auditors Fail to Detect Fraud

A. An over-reliance on inquiry as the only means of audit evidence.

B. A lack of awareness that some observed conditions,
    "RED FLAGS" may indicate a material fraud.

C. A tendency to look at current numbers in isolation from
    the past or other relevant information.

D. Allowing time & budget pressures to influence the audit

E. A lack of skepticism

 

II. Factors and Conditions

There a number of factors and conditions that the auditor needs to be aware of that may present a risk of material misstatement.

A. Management Characteristics and Influence over the Control Environment

B. Industry Conditions

C. Operating Characteristics and Financial Stability

 

Management Characteristics & Influence Over the Control Environment

1. A significant portion of management's compensation represented by bonuses, stock options, or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position or cash flow.
2. An excessive interest by management in maintaining or increasing the entity's stock price or earnings trend through the use of unusually aggressive accounting practices.
3. A failure by management (either executive management, financial management, or the entity's governing body) to display and communicate an appropriate attitude regarding internal control and the financial reporting process.
4. An ineffective means of communicating and supporting the entity's values or ethics, or communication of inappropriate values or ethics.

Industry Conditions

1. New accounting, statutory, or regulatory requirements that could impair the financial stability or profitability of the entity.
2. Declining industry with increasing failures and significant declines in customer demands.
3. Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence.

Operating Characteristics and Financial Stability

1. Significant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity - including need for funds to finance major research and development or other capital expenditures.
2. Overly complex organizational structure involving numerous or unusual legal entities, managerial lines of authority, or contractual arrangements without apparent business justification.
3. Unrealistically aggressive sales or profitability incentives.
4. Unusually high dependence on debt or marginal ability to meet debt repayment requirements; debt covenants that are difficult to maintain.

 

III. Common Fraud Schemes

A. Cash

1. Most common way cash is defrauded is through
    fraudulent disbursements.

2. Under these schemes, the employee uses the
    entities checks to either:

a. withdraw cash directly for his/her benefit or

b. pay personal expenses

3. Entities that handle large amounts of cash are susceptible
    to theft of cash on hand:

a. Skimming

b. Substituting personal checks for cash.

c. Fictitious refunds or discounts

d. Altered credit card receipts

4. What to Look For

a. Missing checks or checks out of sequence

b. Employee personal checks found in cash drawers

c. Large, unexplained reconciling items in the bank
    reconciliations

d. Unusual endorsements on checks

e. Bank statements that do not include
    canceled checks

f. Some canceled checks are missing

g. Disbursements unsupported by invoices
    or other documentation

h. Customer complaints

i. Altered or missing cash register tapes

5. Example Audit Procedures

a. Examine bank reconciliations

b. Review bank statements and canceled checks

c. Obtain a bank cut-off statement

d. Perform analytical procedures (at high precision
    levels) on expense reports

e. Search for and examine unusual expense
    account activity close to year end

f. Perform surprise cash accounts

g. Analyze sales discounts and returns

h. Review vendor list with management and
    investigate any payments to unknown
    or unusual vendors

i. Compare check endorsements to payee information

 

B. Revenue Recognition-Frauds

1. Recording fictitious sales

2. Recognizing revenue on transactions that do
    not meet the revenue recognition criteria

3. Sham transactions

4. Recognizing revenues in the improper period

5. What to Look For

a. Excessive credit memo and credit adjustments to accounts
    receivable after the end of the accounting period.

b. Customer complaints and discrepancies in accounts
    receivable confirmations.

c. Unusual entries to the accounts receivable subledger
    or sales journal

d. Missing or altered source documents or the inability of the client
    to produce original documents in a reasonable time.

e. A lack of cash flow from operating activities has been reported.

f. Unusual reconciling differences between sales
   and the general ledger.

g. Sales to customers in the last month before the end of the
    accounting period at terms more favorable than previous
    months.

h. Sales with affiliates and related parties.

i. Pre-dated or post-dated transactions.

j. Journal entries made to the sales or revenue account
   directly, that is, not posted from the accounts receivable
   subledger or sales journal.

k. Large or unusual adjustments to sales accounts made
    just prior to or just after the end of the period.

6. Example Audit Procedures

a. Perform a thorough review of original source documents
    including shipping documents, customer purchase orders,
    cash receipts, and written correspondence between the
    client and customer

b. Analyze and review credit memos and other accounts receivable
    adjustments for the period subsequent to the balance
    sheet date

c. As part of the accounts receivable confirmation effort, confirm
    with customers the terms of sales agreements, including the
    absence of right of return and terms that might preclude
    immediate revenue recognition.

d. Analyze all large or unusual sales made in the last month prior
    to the end of the period. Vouch to original source documents.
    Confirm terms of the transaction directly with the customer.

e. Scan the general ledger, accounts receivable subledger
    and sales journal for unusual activity.

f. Compare operating cash flow to sales. Analyze by salesperson,
    location, or product.

 

C. Accounts Receivable Frauds

1. Lapping

2. Posting improper credits to the account.

3. Altering internal copies of invoices.

4. Diversion of payments from written-off accounts.

5. What to Look For

a. Unexplained differences noted by customers on their
    accounts receivable confirmations.

b. Significant delays between the date the customer states
    a payment was made and the date payment was recorded
    as received by the company.

c. A significant number of credit entries and other adjustments
    made to the accounts receivable records.

d. Unexplained or inadequately explained differences
    between the accounts receivable subsidiary ledger
    and the general ledger.

e. Discrepancies between customer names and amounts on
    deposit slips and subledger accounts and amounts credited.

6. Example Audit Procedures

a. Confirm account activity (not just the balance)
    with the customer.

b. Perform analytical reviews of credit memo and write off activity.

c. Vouch credit memos and other writeoffs to receiving
    records for returned goods, customer correspondence
    and other documentation supporting the transaction.

 

D. Purchasing & Payroll

1. Most common fraud scheme is the payment of invoices to a fictitious company

2. Another common fraud is a kickback.

a. Allowing the vendor to submit fraudulent billing
    and approving payment

b. Excess purchasing of property or services

c. Bid rigging

3. Most common payroll fraud is the use of ghost employees

4. Another common fraud is an overpayment scheme

5. What to Look For - Fictitious Vendors

a. Photocopied invoices or invoices that have been tampered

b. Invoice numbers from the same vendor that occur
    in an unbroken consecutive sequence

c. Invoice from companies with a P.O. Box address
   and/or no phone number

d. Invoices from companies with the same address or phone
    number as an employee

e. The amount of each invoice from a particular vendor
    falls just below a threshold for review

f. Multiple companies that have the same address
   and phone number

6. What to Look For - Kickbacks

a. Purchasing agent handles all matters related to a vendor even
    though it might be outside or below his normal duties

b. Vendors who receive an inordinate amount of business
    for no apparent business reason

c. Vendor salesmen make frequent, unexplained visits
    to purchasing personnel

d. Prices from a particular vendor are unreasonably high
    when compared to others

e. Quality of goods or services received from a vendor is low

f. Tips or complaints from other employees or honest vendors

g. Key contracts awarded with no formal bid process

h. Purchase of excess goods

7. What to Look For - Ghost Employees

a. Employees with duplicate addresses, checking accounts,
    or social security numbers

b. Employees with no withholding taxes, insurance, or other
    normal deductions

8. Purchasing & Payroll - Audit Procedures

a. Review selected invoices and look for evidence that the
    invoice has been doctored

b. Perform a computerized search of the vendor list and look for:
    P.O. Box addresses, duplicate addresses, and vendors with
    no phone number

c. Determine if vendors are listed in the yellow pages
    of the phone book

d. Perform a computerized match of the vendor list with a list of
    employees and look for matches of addresses or phone
    numbers

e. Perform a computerized sort of invoices by vendor and look for
    unusual sequencing or amount

f. Review selected invoices and examine supporting documentation
    indicating goods or services were received

g. Perform a computerized search of payroll records to duplicate
    addresses, Social Security numbers, or bank accounts

h. Verify Social Security numbers by calling the Social Security
    Administration

i. Review personnel files and look for those that contain little
   or no evidence of activity

j. Observe a payroll check distribution