CFE Exam Quiz 10

Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers, but can also involve legitimate customers. For example, a fictitious invoice can be prepared (but not mailed) for a legitimate customer even the goods are not delivered or the services are not rendered. At the end of the accounting period, the sale will be reversed, which will help conceal the fraud. However, the artificially high revenues of the period might lead to a revenue shortfall in the new period, creating the need for more fictitious sales. Another method is to use legitimate customers and artificially inflate or alter invoices to reflect higher amounts or quantities than
are actually sold.

The challenge with both of these methods is balancing the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with recording the entry. However, accounts receivable stay on the books as an asset until they are collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense. Mysterious accounts receivable on the books that are long overdue are a common sign of a fictitious revenue scheme.

Fictitious sales schemes are not always elaborate, however. Less complex methods include shipments of false or defective products. In one instance, a company shipped goods to a customer and recorded revenue, even though the customer had agreed only to evaluate the product, not purchase it. In some extreme cases, goods are shipped and booked as revenue to customers who did not order them.

The following red flags are associated with fictitious revenues:
• An unusually large amount of long-overdue accounts receivable
• Outstanding accounts receivable from customers that are difficult or impossible to identify and contact
• Rapid growth or unusual profitability especially compared to that of other companies in the same industry
• Recurring negative cash flows from operations or an inability to generate positive cash flows from operations while reporting earnings and earnings
growth.
• Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities are not
audited or are audited by a separate firm
• Significant, unusual, or highly complex transactions, especially those close to the period’s end that poses difficult “substance over form”
questions.
• Unusual growth in the days’ sales in receivables ratio (receivables/average daily sales).
• A significant volume of sales to entities whose substance and ownership is not known.
• An unusual increase in sales by a minority of units within a company or in sales recorded by corporate headquarters.

Complaints of consumer fraud can be found as far back as the first century when Pliny the Elder told of the adulterated honey being sold in Rome and the mixing of wine with gypsum, lime, pitch, rosin, wood ashes, salt, sulfur, and other artificial additives. Schemes against consumers range from home repair frauds to more sophisticated scams. Fraud is notably common in the repair and service industries. Home repair fraud, frequently perpetrated against the elderly, ranges from the sale or use of substandard materials—such as roofing—to securing payment without doing any work at all. Automobile repairs often involve fraudulent acts. One study maintained that 53 cents of every “repair” dollar were wasted because of unnecessary work, overcharging, services never performed, or incompetence.

Advance-fee swindles are structured to obtain an illegal gain by falsely promising the delivery of a product or service. In some schemes, the product is marketed to a large number of customers, and then the operation is shut down prior to the delivery stage. People who find themselves in debt sometimes turn to consolidation agencies for help. These agencies do not advance loans, but rather act as an intermediary between debtor and creditor. Some agencies are legitimate, but many are not. In a typical scenario, the debtor contacts the agency, which compiles a list of the creditors and the number of monthly payments. The agency usually writes letters to the creditors requesting a workout plan at lower monthly payments spread over a longer period of time. The creditors will often offer such an arrangement if they feel that the debt will thereby be paid or if the workout plan will forestall bankruptcy or default by the creditor. Unscrupulous debt consolidation schemes often involve the agency collecting the money from the debtor but not forwarding it to the creditors. In some instances, considerable time can pass before the debtor finds out that his money has been misappropriated. Another variation of the debt consolidation scheme occurs when customers are guaranteed that they will receive a loan or a credit card regardless of their credit rating. Typically, the victims have been rejected by legitimate financial institutions because their credit ratings are poor. The victim must pay a processing fee for the application to be accepted. After the victim pays the fee, the con artist disappears.

Decades-old home-based business scams have in recent years migrated to and flourished on the Internet. These scams are especially effective during a downturn in the economy and typically prey on those who are desperate for work or supplemental income. Many companies marketing home-based businesses require a person to buy materials for assembly at-home products, while other common ploys include stuffing envelopes or processing medical bills. The consumer is promised that the company will purchase the completed products, and when it does not, the consumer is left with a bad investment and a stock of low-quality, worthless goods.

This is often used in middle-aged or elderly women who are likely to have a savings account. Pretending to find a wallet full of money, the con men convince their targeted victims that they should divide the “discovered” money. As a show of good faith, each should withdraw a sum of money from their bank and turn it over to a lawyer or another third party for safekeeping. They agree to place an ad in a newspaper for the lost wallet. If it is not claimed within a certain amount of time, they will split the money. Of course, when the designated time expires, the victim will find that the lawyer was part of the scam and that her money has vanished.

The customers of fraudulent telemarketing operations are not the only victims. Fronters are often poorly educated and easily taken advantage of by the career criminals who run the operations. Salespeople might face hidden costs in a work agreement, similar to the ones involved in the items they push on unsuspecting customers. For example, boiler room operators hold back parts of their phone lists and sell them to crew members as “hot leads.” Telecom veterans know how to operate a gift sting that bilks both the customer and the salesperson. Operators overstate the retail value of the gifts, so the customers get less than they paid for; then, by giving agents an inflated wholesale cost, the operators can pay these workers less commission, which is figured on the “profit margin” between wholesale and retail. The salespeople in boiler rooms are sometimes as desperate as their victims. Most are unemployed, with little education or marketable skills. Telemarketing promises easy work and big pay without any experience. Many people who start out as fronters, however, are serving an apprenticeship in their criminal careers. They are enticed by cars, mobile phones, and other perks. Former workers have reported that supervisors sprinkled lines of cocaine along with the phone bank table and threw handfuls of money into the air, promising the proceeds to whoever made the next sale. Naturally, there are no payroll taxes deducted from paychecks, so employees can owe big tax bills at the end of the year. Fronters’ commission payments are often shorted or withheld. Paychecks frequently fail to clear the bank. Owners promise big profit shares for a month or two and then shut down the business. They tell the workers that their assets have been frozen by creditors or regulators. Workers lose their jobs and usually their last weeks’ commissions

A Ponzi scheme is generally defined as an illegal business practice in which new investors’ money is used to make payments to earlier investors. The investment opportunity is typically presented with the promise of uncommonly high returns. Whereas perpetrators of a simple investment scam take in as much money as possible and then disappear, a Ponzi scheme stays in business by turning some of the money back into the business. Ponzi scheme perpetrators use a few conspicuous rewards early in the scheme to generate interest and grow their business; then, if they’re smart and lucky, the operators disappear. Everyone involved in promoting the scheme pretends to mount a legitimate organization, but little or no commercial activity takes place. Payoffs are made from the pool of investor funds; the rest is siphoned into operators’ pockets. Schemes might run for at least a year. Some Ponzis have flourished for a decade or more.

By their very nature, Ponzi schemes are prone to leaving a host of fraud indicators for those unaffected by the investment promoter’s fraudulent claims. Several red flags can help investigators uncover Ponzi schemes:
• Sounds too good to be true: If an investment sounds too good to be true, it probably is.
• Promises of low risk or high rewards: Promoters of Ponzi schemes typically promise implausibly high or quick returns with little risk. As all legitimate investments include some degree of risk, any guarantee that an investment will perform in a certain way is a clear signal that it might be part of a Ponzi scheme.
• History of consistent returns: Any firm that generates remarkably consistent returns regardless of market conditions should raise suspicions.
• High-pressure sales tactics: Reputable investment firms and agents do not push potential investors to act immediately, and legitimate investment opportunities are rarely that time-sensitive.
• The pressure to reinvest: Often, fraudsters keep Ponzi schemes alive by convincing investors to reinvest their profits rather than take a payout.
• Complex trading strategies: Legitimate agents should be able to provide clear explanations about their investment strategies. For obvious reasons, Ponzi-scheme boosters purposefully employ complicated strategies that confound unsophisticated investors.
• Lack of transparency or access: Secrecy surrounding the operations of a financial company should be an immediate warning sign. Ponzi operators are often unlicensed and their supposed investments are typically unregistered. Additionally, a lack of access to regular statements or an online account should trigger the alarm.
• Lack of segregation of duties: Investors should be wary of any financial manager who manages, administers, and retains custody of the fund in question.

In an illegal pyramid scheme, an operation generates revenue by continually recruiting new members. Although the operation might offer merchandise or services for sale, the only significant revenues come from recruitment. Not all organizations with a pyramid structure are engaging in illegal activity. Some legitimate merchandising companies use a pyramid structure to rank their employee-owners and to determine those people’s compensation. A pyramid structure becomes an illegal pyramid scheme when the recruitment of new members takes precedence over the product or service that the company is ostensibly promoting. The more members that are recruited, the higher the investor is purported to rise in the ranks of the enterprise, and the more money the investor is supposed to make. This belief is supported by the fact that pyramid schemes are designed to initially pay off to investors. To determine the legality of a pyramid, courts often apply the 70 Percent Rule. This rule requires that at least 70 percent of a distributor’s profits come from retail sales. Of course, this figure can be difficult to verify. Distributors routinely sign falsified compliance statements out of fear that authorities will shut the whole business down, causing everyone to lose.

• They do pay off. Unlike a simple con game in which the fraudster throws the ruse, grabs the cash, and exits, pyramiding builds up the take by paying initial investors. This makes for excellent testimonials. Early players circulate the word and bring in new targets. Initial payoffs also keep early players coming back. Payoffs make the enterprise look legitimate and fuel the expansion process.
• They operate mainly through preexisting affiliations. Community groups, religious organizations, and social clubs all make enticing targets for pyramids’. Any pyramid requires a healthy pool of participants, so a large group already gathered together is ideal. Besides that, pyramids’ know how to manipulate the trust that people place in these groups.
• They use ingenuity and false logic in their pitches. The product fronts available for pyramiding are myriad, from bath soap to electronics. Fronts in financial instruments

Pyramids of every stripe use a seductive, though false, logic in their pitch: “Everybody has friends and associates; you only have to sign up three or four people below you.” Of course, the laws of mathematics spell doom to this logic. There simply aren’t enough players to keep even a small pyramid running. Three people, each finding three people, will quickly play out their available friends and associates—if not mathematically, then socially. There’s also a reasonable limit on how quickly money can grow. The pyramid, then, is built to overcome people’s most common misgivings about investing. Promoters offer far more than an “undertaking of great advantage, nobody to know what it is.” They are very specific in their prospectus. The offer sounds good and (within its own logic) makes sense. The “opportunity” is usually pitched by someone familiar to the victim, or at least by someone with an affinity the victim trusts. Most important, the pyramid does return people’s money, with the incredible profits attached as promised. Speed is another potent weapon in the pyramid arsenal. Cons say, “Get in now, or regret it forever.” They don’t have time—because of market demand or commitments elsewhere— for the person to check out the deal. That’s because a moderate amount of due diligence research will expose the deal as a scheme.

Identity theft is a common type of fraud that is non-discriminatory in nature. Anyone can be targeted; the victim might be a college student, a retiree, a schoolteacher, or a successful attorney. Even businesses are susceptible to identity theft. Although there is no universal definition of identity theft, most law enforcement organizations use a definition similar to the following: Identity theft and fraud are crimes in which someone wrongfully obtains and uses another person’s personal data in some way that involves fraud or deception, typically for economic gain. Personal identification data includes name, address, government identification number, date of birth, mother’s maiden name, or other identifying information. The perpetrator exploits
this information by opening bank or credit card accounts, taking over existing accounts, obtaining loans, leasing cars or apartments, or applying for wireless telephone and utility services in the victim’s name without his knowledge. Technological advancements that facilitate the electronic transfer of personal information and the transmission of financial transactions have greatly contributed to the recent increase in occurrences of identity theft. As such technologies continue to develop, this type of fraud will likely remain a serious problem that affects many people.

Business identity theft, or the misappropriation of an organization’s sensitive identifying information necessary to imitate the business’s identity for illicit purposes, has become a growing problem. Criminals obtain businesses’ identifying information through various means, such as searching for them online, examining filings with regulators, reviewing tax forms, phishing, or social engineering. Numerous schemes related to business identity theft have been reported, ranging from fraudulent credit card applications too complex multi-million-dollar bogus stock sales. In some cases, long-dormant businesses have been fraudulently reinstated and used for nefarious purposes. Owners of small businesses are particularly at risk for business identity theft. This segment of the business community possesses the lines of credit, capital, and other features desired by fraudsters, while often lacking the resources and technology needed to properly defend against identity theft. Smaller companies and individually owned businesses often rely heavily on the owner’s personal credit, making the impact of business identity theft even more destructive. Furthermore, small businesses might be especially wary of revealing identity theft out of fear that consumers will take their business to a larger company that ostensibly offers an increased level of data security.

Unlike some fraudsters who steal as a result of a perceived need, most identity thieves make a living stealing identity for profit or, at the very least, to supplement their incomes generously. Although he can be an employee, friend, or relative, the fraudster usually falls into one or more of the following profiles:
• Been convicted, served time in prison, wishes to conceal his identity
• Been convicted, served time in prison, and is looking for a “safer” way to commit a
crime and stay out of prison
• College student looking for an “easy” way to work his way through school
• Landlord
• Rental car agent
• Undocumented immigrant needing an identity
• Illegal telemarketer

While an individual might think that he is careful with his personal information, in reality, a lot of information can be easily found and acquired by identity thieves without him even realizing it. An innocent inquiry for the most basic of information, such as verifying an address or mother’s maiden name for a banker’s files, can be the start of a financial nightmare. The most common ways information is obtained are:
• Sorting through discarded trash
• Shoulder surfing
• Searching through coworkers’ desk drawers
• Stealing incoming or outgoing mail
• Using an accomplice within the organization
• Soliciting identifiers through false job application schemes
• Checking utility companies, health clubs, and schools
• Examining certifications and licenses placed on workplace walls
• Using pretext, ruse, or gag calls
• Looking at rental and loan applications
• Consulting public records
• Using the Internet

Comparative financial statements provide information for current and past accounting periods. Accounts expressed in whole dollar amounts yield a limited amount of information. The conversion of these numbers into ratios or percentages allows the reader of the statements to analyze them based on their relationship to each other; in addition, it allows the reader to more readily compare current performance with past performance. In fraud detection and investigation, the determination of the reasons for relationships and changes in amounts can be important. These determinations are the red flags that point a fraud examiner in the direction of possible fraud. If large enough, a fraudulent misstatement can affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements do not make sense when analyzed closely. Financial statement analysis includes the following:
• Vertical analysis
• Horizontal analysis
• Ratio analysis

There are traditionally two methods of percentage analysis of financial statements: horizontal and vertical analysis. Vertical analysis is a technique for analyzing the relationships among the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages of a specified base value. This method is often referred to as common sizing financial statements because it allows an analyst to compare entities of different sizes more easily. In the vertical analysis of an income statement, net sales are the base value and are assigned 100 percent. On the balance sheet, total assets are assigned 100 percent on the asset side, and total liabilities and equity are expressed as 100 percent. All other items in each
of the sections are expressed as a percentage of these numbers. The vertical analysis emphasizes the relationship of statement items within each accounting period. These relationships can be used with historical averages to determine statement anomalies.

Horizont l analysis is a technique for analyzing the percentage change in individual financial statement line items from one period to the next. The first period in the analysis is considered the base period, and the changes in the subsequent period are computed as a percentage of the base period. If more than two periods are presented, each period’s changes are computed as a percentage of the preceding period. The resulting percentages are then
studied in detail. As is the case with vertical analysis, this technique does not work for small, immaterial frauds.

Ratio analysis is a means of measuring the relationship between two different financial statement amounts. The relationship and comparison are the keys to the analysis. Many professionals, including bankers, investors, and business owners, as well as major investment firms, use this method. Ratio analysis allows for internal evaluations using financial statement data. Traditionally, financial statement ratios are compared to an entity’s industry averages. The ratios and comparisons can be very useful in detecting red flags for a fraud examination. If the financial ratios present a significant change from one year to the next or over a period of years, it becomes obvious that there could be a problem. As in all other analyses, specific
changes are often explained by changes in business operations. If a change in specific ratios is detected, the appropriate source accounts should be researched and examined in detail to determine if fraud has occurred. For instance, a significant decrease in a company’s current ratio might point to an increase in current liabilities or a reduction in assets, both of which could be used to cover fraud.

Financial statement fraud does not occur in an isolated environment. People in organizations who have both motive and opportunity are the prime candidates to commit fraudulent misstatement. In the overwhelming majority of situations, two key managers participate actively in the fraud: the chief executive officer and the chief financial officer. Others become involved largely out of necessity. Those who are not directly involved most often are not aware that anything is wrong. Investigations of financial statement frauds are unique in that they almost always involve interviewing the executive management of the organization. To detect or deter financial statement fraud, it is absolutely necessary that top management is interviewed by a competent and experienced fraud examiner who possesses the ability to solicit honest answers to tough—but vital—questions about whether anyone has tampered with the books.

• Avoid setting unachievable financial goals.
• Eliminate external pressures that might tempt accounting personnel to prepare fraudulent financial statements.
• Remove operational obstacles that block effective financial performance, such as working capital restraints, excess production volume, or inventory restraints.
• Establish clear and uniform accounting procedures that do not contain exception clauses.

• Maintain accurate and complete internal accounting records.
• Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others
who interface in the transactions between financial units.
• Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items.
• Segregate duties between employees, ensuring that no single individual has total control of one area.
• Maintain accurate personnel records, including background checks (where permitted by law) on new employees.
• Encourage strong supervisory and leadership relationships within groups to ensure
enforcement of accounting procedures.

Internal auditors are responsible for helping to deter fraud by examining and evaluating the adequacy and effectiveness of controls, along with the extent of the potential exposure in the various segments of an entity’s operations. The internal auditing standards state that the principal mechanism for deterring fraud is internal control. Primary responsibility for establishing and maintaining internal control rests with management. The Treadway Commission addresses this issue by recommending that internal audit departments or staffs have not only the support of top management but also the necessary resources available to carry out their mission. The internal auditors’ responsibility is to aid management in the deterrence of fraud by evaluating the adequacy and effectiveness of the company’s internal control system, as well as the company’s potential exposure to fraud, with particular consideration given to the five elements of internal control laid out by the Committee of Sponsoring Organizations (COSO). The five elements of internal control are discussed in more detail in the Fraud Prevention and Deterrence section of the Fraud Examiners Manual.

External auditors inspect clients’ accounting records and independently express an opinion as to whether financial statements are presented fairly in accordance with the applicable accounting standards of the entity, such as GAAP or IFRS. They must assert whether financial statements are free of material misstatement, whether due to error or fraud. Independence is the cornerstone of the auditing function. The only way external auditors can uncover and rectify instances of fraud is if they view the financial statements objectively. However, external auditors are not required to uncover all instances of fraud that might be occurring, as this would be a difficult and nearly impossible task.

Asset misappropriations are by far the most common of all occupational frauds. There are three major categories of asset misappropriation schemes. Cash receipts schemes are discussed in this section, fraudulent disbursements of cash are addressed in the next section, and the following section covers schemes involving the theft of inventory and other noncash assets. Cash is the focal point of most accounting schemes. Cash, both on deposit in banks and on hand as petty cash, can be misappropriated through many different schemes. These schemes can be either on-book or off-book, depending on where they occur. Cash receipts schemes fall into two categories: skimming and larceny. The difference between the two types of fraud depends completely on when the cash is stolen. Cash larceny is the theft of money that has already appeared on a victim organization’s books, while skimming is the theft of cash that has not yet been recorded in the accounting system. The way in which an employee extracts the cash might be exactly the same for a cash larceny or skimming scheme.

Skimming is the removal of cash from a victim entity prior to its entry in an accounting system. Employees who skim from their companies steal sales or receivables before they are recorded in the company books. Skimming schemes are known as off-book frauds, meaning cash is stolen before it is recorded in the victim organization’s accounts. This aspect of skimming schemes means they leave no direct audit trail. Because the stolen funds are never recorded, the victim organization might not be aware that the cash was ever received. Consequently, it can be difficult to detect that the cash has been stolen. This is the primary advantage of a skimming scheme to the fraudster. Skimming is one of the most common forms of occupational fraud. It can occur at any point where cash enters a business, so almost anyone who deals with the process of receiving cash might be in a position to skim money. This includes salespeople, tellers, waitpersons, and others who receive cash directly from customers. In addition, many skimming schemes are perpetrated by employees whose duties include receiving and logging payments made by customers through the mail. These employees slip customer payments out of the incoming mail instead of posting the payments to the proper revenue or receivables accounts. Those who deal directly with customers or who handle customer payments are obviously the most likely candidates to skim funds.

The most basic skimming scheme occurs when an employee sells goods or services to a customer and collects the customer’s payment, but makes no record of the sale. The employee simply keeps the money received from the customer instead of turning it over to his employer. The most difficult part in skimming at the register is that the employee must commit the overt act of taking money. If the employee takes the customer’s money and shoves it into his pocket without entering the transaction on the register, the customer will probably suspect something is wrong and might report the conduct to another employee or a manager. It is also possible that a manager, a fellow employee, or a surveillance camera will spot the illegal conduct. Therefore, it is often desirable for a perpetrator to act as though he is properly recording a transaction while he skims sales.