Forensic Accounting and Fraud Examination Midterm Exam Questions and Complete Solutions

Forensic Accounting and Fraud Examination Midterm Exam Questions and Complete Solutions Forensic Accounting - Ans: Use of accounting knowledge or skill for courtroom purposes. Can therefore involve not only fraud, but also bankruptcy, business valuation, disputes, divorce, and other litigation. Fraud Examination - Ans: Involves obtaining documentary evidence, interviewing witnesses and potential subjects, writing investigative reports, testifying to findings, and assisting in the general detection and prevention of fraud Fraud (Black's Law Dictionary) - Ans: Intentional perversion of truth for the purpose of inducing another, in reliance upon perversion of truth, to part with some valuable thing belonging to him or to surrender a legal right Occupational Fraud and Abuse - Ans: Use of occupation for personal enrichment (even just $1) through deliberate misuse or misapplication of employer's resources/assets 1. Material false statement 2. Knowledge that statement was false 3. Reliance on the statement by the victim 4. Damages - Ans: Four Elements of Fraud Edwin H. Sutherland's definition of "white-collar crime" - Ans: Criminal acts of corporations, individuals in corporate capacity Edwin H. Sutherland's Theory of Differential Association - Ans: Crime is learned from intimate personal groups, not genetic Donald R. Cressey - Ans: - Was Edwin Sutherland's student - Studied embezzlers (why people become 'trust violators') - Developed the Fraud Triangle Pressure, perceived opportunity, and rationalization - Ans: Fraud Triangle Pressure, perceived opportunity, rationalization, and capability (being able to live with the guilt) - Ans: Fraud Diamond 1. Living beyond means 2. Overwhelming desire for personal gain 3. High personal debt 4. Close association with customers --> collusion? 5. Pay not commensurate with job 6. Wheeler-dealer 7. Strong challenge to beat system 8. Excessive gambling 9. Family/peer pressure - Ans: Steve Albrecht's Nine Motivators of Fraud Fraud Scale (?) - Ans: Situational pressures, opportunity to commit, personal interity 1. Tip (39.1%) 2. Internal audit (16.5%) 3. Management review (13.4%) 4. Accident (5.6%) 5. External audit (3.8%) - Ans: Highest Detection to Lowest 1. Employees (40.9%) 2. Managers (36.8%) 3. Owners (18.9%) - Ans: ALL Fraud (not just f/s) rates (by management at the firm): Corruption --> Bribery, conflicts of interest, illegal gratuities, and extortion - Ans: Corruption part of the fraud tree Asset Misappropriation --> Cash, inventory Cash --> Larceny, skimming, fraudulent disbursements - Ans: Asset misappropriation part of the fraud tree Fraudulent statements --> Financial, non-financial - Ans: Fraudulent statements part of the fraud tree 1. Asset misappropriation 2. Corruption 3. Fraudulent statements - Ans: Most common fraud schemes 1. Fraudulent statements 2. Corruption 3. Asset misappropriation - Ans: Most expensive fraud schemes (median loss) Asset Misappropriation - Ans: Misuse of a company asset for personal gain; includes more than theft or embezzlement (use of company computer to surf internet, company car for personal trips, stealing cash, false invoicing, etc) - False debits to expenses (most common) - Omitted credits -- concealment for cash skimming - Out of balance conditions -- asset removed but no credit - Forced balance -- adds wrong, perp has access to bonds - Ans: Four ways of concealing asset misappropriations - Larceny - Skimming - Fraudulent Disbursements - Ans: 3 Ways to Misappropriate Cash - Misuse - Larceny - Ans: 2 Ways to Misappropriate Inventory Skimming - Ans: Theft of cash from victim organization before the cash hits the accounting system (off-book fraud, no direct audit trail, books stay balanced, most common form of cash fraud) - Unrecorded sales (perp makes sale, pockets money, never records sale) - Understated sales (perp pockets a portion of a sale, either records sale at lower price or smaller quantity of goods sold) - Ans: Sales Skimming is broken into: - Surveillance of employees at point of sale - Maintain secure area for employees to store coats, purses, etc - Look for coded markers near registers - Investigate gaps in transaction sequence/pre-numbered receipts - Ans: What are four countermeasures for sales skimming? Lapping - Ans: Stealing customer A's payment, applying customer B's payment to A's account, etc. Most common concealment technique; perp may keep second set of books to track misapplications - Watch for employees who put in a lot of time after hours and on weekends - Enforce mandatory vacations - Spot-check daily deposits to A/R, verify names on checks match postings - Compare A/R postings to dates payments were mailed by customers - Ans: What are four countermeasures for lapping? - Segregate all cash receipting functions - Supervise employees at all cash collection points and who open mail - Place restrictive endorsements on all checks received - Enforce mandatory vacations - Conduct surprise audits/cash counts - Ans: What are five CONTROLS for skimming? Cash - Ans: Currency and checks Cash Larceny - Ans: Intentional taking of employer's cash without employer's consent Skimming: theft of off-book funds; more costly, more common Larceny: theft of on-book funds; less costly than skimming, less common than skimming, has a direct audit trail - Ans: Compare skimming vs. larceny - Theft of cash on hand from cash register or cash box or posted customer payments - Theft from the deposit - Ans: 2 Cash Larceny Schemes - Cash receipts and cash counts - Bank deposits and reconciliation - Posting deposits - Cash disbursements - Surprise cash counts - Review check and cash composition of daily bank deposit - Ans: What are 6 cash larceny controls? Check Tampering - Ans: Form of fraudulent disbursement in which an employee prepares a fraudulent check for own benefit or converts a check intended for someone else - Forged maker schemes - Forged endorsement schemes - Altered payee schemes - Ans: What are 3 check tampering schemes? Forged Maker Scheme - Ans: Perp forges name of authorized signer by getting a blank check by obtaining a voided check that was not destroyed, or by printing a counterfeit company check - Keep blank check storage secured and incorporate water mark or security threads - Investigate out-of-sequence or duplicate check numbers on bank statements (indicates stolen or counterfeit check stock) - Ans: What are two countermeasures for stolen checks? Forged Endorsement Scheme - Ans: Perp intercepts a company check intended for a third party and converts check by forging endorsement Altered Payee Schemes - Ans: Checks not prepared by perp: - Check washing - White out payee name - "Tacking on" (IRS becomes I.R. Stevens) - Code fraudulent check "void" - When statement arrives, destroy bogus checks - Force totals on reconciliation (add wrong) - Ans: Concealing check tampering if the perp reconciles the bank statement - Re-alter cancelled checks to match postings - Enter false info in disbursements journal - Code checks to very active or dormant accounts - If check to legitimate payee was intercepted, perp may re-issue check so payee doesn't complain - Create bogus support for checks - Ans: Concealing check tampering if payee/amount was altered - Excessive number of voided checks - Missing checks - Non-payroll checks payable to employees - Altered payee or endorsements on returned checks - Ans: Four General Check Tampering Red Flags - Separate check cutting and posting, check signing, check delivery, and bank statement reconciliation - Require proper support for all checks - Mail checks immediately after signing - Ans: What are 3 check tampering controls? Register Disbursements - Ans: Form of fraudulent disbursement where cash is stolen from the cash register, the perp enters a reversing transaction to justify the disbursement of funds, and the register is balanced 1. False Refunds 2. False Voids - Ans: What are the two principle schemes of register disbursements? False Refunds - Ans: Fictitious refund in which no merchandise is actually returned, so inventory is overstated; or overstated refunds in which there is a legitimate refund, but the perp skims the excess False Voids - Ans: Perp makes a sale and keeps the customer's receipts; after the customer is gone, the perp uses receipt to process a false void; perp pockets the money - Periodically run trend analysis, look for employees who process too many reversals - Look for refunds/voids in recurring amounts, especially round numbers - Look for excessive refunds/voids just below review levels - Encourage customers to examine their receipts - Ans: What are four countermeasures for register disbursements? Billing Schemes - Ans: Schemes attacking the purchasing function, causing the organization to buy goods/services that are nonexistent, overpriced, or not needed. Perp submits a bogus invoice or other support, victim organization issues a check, and perp collects payment - Shell company schemes - Non-accomplice vendor schemes - Personal purchases with company funds - Ans: What are three common billing schemes? Shell Company - Ans: Fictitious entity created for purpose of committing fraud. It only exists on paper. Usually consists of bank account and mail drop and is generally registered with the state or county Shell Company Schemes - Ans: What kind of scheme: - Usually invoice for services, not goods - Services not tangible, harder to verify - Get paid by: - Perp has authority to approve payment - Supervisor "rubber stamps" purchases - Perp prepares bogus support documents - Collusion among several employees - Look up vendor in phone book/google earth - Contact others in industry - Visit address to verify existence - Periodically run comparison reports between vendor/employee addresses - Ans: What are some shell company countermeasures? - Check articles of incorporation - Conduct surveillance on mail drop - Review support: who requests, authorizes purchases? - Review cancelled checks for bank account info - Ans: How does one identify the perp of a shell company scheme? - Invoices can't be traced to shipments - Multiple payments to single vendor on same date - Pattern of purchases just below review level - Departments/employees consistently over budget - Unexplained rise in COGS - Unexplained fall in gross/net profits - Ans: What are some general billing scheme red flags? - Invoices, purchase orders, and receiving reports must be matched before payment issued - Purchasing department should be independent of receiving, shipping, and accounting - Purchases must have management approval - Use competitive bids for major purchases - Ans: What are some billing scheme controls? Payroll Fraud - Ans: Employee fraudulently generates overcompensation on his/her own behalf - Ghost employees - Falsified hours and salary - Commission schemes - Ans: What are three common payroll fraud schemes? Ghost Employee - Ans: Someone on the company payroll who does not actually work for the company Ghost Employee Scheme - Ans: 1. Add ghost to payroll 2. Document time worked 3. Issue paycheck 4. Deliver paycheck - Add completely fictitious person - Leave former employee on payroll - Add relative or friend of current employee - Ans: What are three common ways of adding ghost employees? - Keep paychecks secure until distribution - Distribution of paychecks should be independent of those with hiring authority - Investigate any returned paychecks with dual endorsements - Conduct proper background and reference checks for all new hires - Ans: What are four countermeasures for ghost employee schemes? - Background checks on all new hires - Appropriate approval for time worked, overtime, rate of pay, commission rates, etc. - Employee payments should be classified to appropriate expense accounts - Individual employee earnings should be tracked - Cancelled payroll checks should be compared to payroll, personnel records - Ans: What are five controls for payroll in general? Expense Reimbursement Fraud - Ans: Employees overstate business expenses to generate inflated reimbursements; very common and difficult to detect Countermeasures are detective; controls are preventative - Ans: Countermeasures vs. Controls - Mischaracterized expenses (claiming reimbursement for non-business expenses) - Overstated expenses - Fictitious expenses - Multiple reimbursements - Ans: What are four common expense reimbursement schemes? Expense reports should require 1. Original support documentation 2. Explanation of business purpose 3. Time and date 4. Place of expenditure 5. Amount - Ans: What five things should expense reports require as controls for expense reimbursement? Inventory Fraud - Ans: Misuse of non-cash assets including larceny, asset requisitions and transfers, purchasing and receiving schemes, and false shipments Look for - Expenses that always end in round numbers - Expenses that tend to fall just below the review limit - Ans: Fictitious expenses countermeasures Lost productivity, increased wear on equipment - Ans: What are two results of misuse of company assets? - Separate requisition, receipt, disbursement, conversion, and receipt from conversion of inventory - All shipments must be matched to sales - All merchandise received must be matched to purchase order and invoice - Ans: What are 3 inventory fraud controls? - Bribery (most common) - Illegal gratuities - Economic extortion - Conflicts of interest - Ans: What are four common corruption schemes? Bribery - Ans: Offering, giving, receiving, or soliciting any thing of value to influence an official act or business decision Illegal Gratuities - Ans: Lesser included offense of bribery where employee receives something of value because of official act or business decision (intent to influence is not required) Economic Extortion - Ans: Perp demands payment and threatens adverse economic consequences Ex: purchasing agent requires vendors to kick back portion of contract price Kickback Scheme - Ans: Undisclosed payment from vendor to employee of purchaser where the purpose is to obtain illegal assistance in an over-billing scheme Bid Rigging Scheme - Ans: Employee receives undisclosed benefit for assisting vendor in winning contract through competitive bidding process - Contracts not awarded to lowest bidder - Unusual bidding patterns - Fewer bidders than expected respond to proposals - Qualified contractors repeatedly fail to bid - Appearance of unknown bidders - Ans: What are 5 red flags in the bidding process? Payments tend to start small, increase as scheme progresses - Ans: Red flag regarding payment in a bidding scheme - Written policies specifically addressing bribery and related offenses - Only purchase from approved vendors - Periodically have independent personnel review organization's buying patterns - Establish and adhere to price thresholds for materials purchase - Ans: What are four controls for bribery schemes? - Pressure to show earnings - Look prosperous to investors - Dispel negative perceptions - Meet performance goals - Satisfy budgets - Ans: What are five motives for financial statement fraud? Company management - Ans: Who is usually responsible for financial statement fraud? Company owners, management, lending organizations, investors - Ans: Who are the victims of financial statement fraud? - Overstated assets or revenues - Understated liabilities (Enron) or expenses - Ans: In what 2 ways does fraud affect the financial statements? Financial statement fraud - Ans: What type of fraud occurs only 4% of the time, but averages $4 million in losses? (aka occurs infrequently, but most expensive) - Fictitious revenues - Timing differences - Concealed liabilities and expenses - Improper disclosures - Improper asset valuations - Ans: What are five financial statement fraud schemes? - Definition - Measurability - Relevance - Reliability - Ans: What are the four criteria for revenue recognition? Revenue - Ans: Actual or expected cash inflows that have occurred or will occur as a result of the enterprise's ongoing major or central operations during the period Fictitious Revenues - Ans: Involves the sale of goods or services which never occurred to fake or legitimate customers, in order to overstate or inflate sales to make the business appear more profitable; usually involves the manipulation of invoices - Revenue should be recognized when the sale is complete - In service business, revenue is recognized when the service has been rendered - Ans: What is the correct timing of revenue recognition for goods and services? - Understating liabilities --> equity has to increase in order to balance - Understating expenses --> net income is overstated, equity is also increased - Ans: What are the effects of understating liabilities and expenses? - Liability/expense omissions - Improper capitalizing/expensing - Returns and allowances and warranties - Ans: What are 3 methods of concealing liabilities? - Related party transactions - Liability omissions - Significant events - Management fraud - Accounting changes - Ans: What 5 things must be included on financial statements to prevent a user from being misled? - Valued at lower of cost or market - Should be written off if it has no current value - Can be overstated by manipulation of inventory count - Ans: How is inventory handled (2 ways) and how can it be overstated? - Fictitious receivables - Failure to write down receivables as bad debts - Ans: How can A/R be overstated? - Booking fictitious assets - Misrepresenting value - Improper capitalization of inventory and startup costs - Misclassifying assets - Ans: How can fixed assets be overstated/manipulated? SAS 82 and SAS 53 - Ans: What does SAS 99 supersede? - Provides description of fraud and its characteristics - Distinguishes fraud from errors - Requires brainstorming session - Elevates importance of professional skepticism - Divides fraud into fraudulent financial reporting and misappropriation of assets - Ans: What 5 things does SAS 99 do (big picture)? Fraudulent Financial Reporting - Ans: (SAS 99) Manipulation, falsification or alteration of accounting records or supporting documents; misrepresentation or intentional omissions of info from financial statements; intentional misapplication of accounting principle - Size, complexity, and ownership characteristics of the entity - Enforcement of formal code of conduct - Country-specific or business segment operating level - Ans: What are 3 fraud risk factors in assessing fraud risk? (SAS 99) - Performance of the risk assessment - Risk factors identified as being present - Response to risk factors - Ans: What does SAS 99 require documentation of? - Appropriate level of management should be notified - Communicate directly to audit committee if f/s are materially misstated? - Ans: What does SAS 99 require if fraud exists? What if the f/s are materially misstated? - Comply with certain legal and regulatory requirements - To a successor auditor when the successor makes inquiries in accordance with SAS 7 - In response to a subpoena - To a funding agency or other specified agency in accordance with government audit requirements - Ans: When would SAS 99 come into play? Why would a company need a fraud risk assessment? - Vertical analysis - Horizontal analysis - Ratio analysis - Net worth analysis - Data mining techniques - Industry comparisons - Historical comparisons - Ans: What are 7 ways of analyzing the financial statements? Vertical Analysis - Ans: Compares general ledger or financial statement balances to other balances within the same year; used in both balance sheet and income statement; highlights changes in account balances within the year as compared to others Horizontal Analysis - Ans: Compares changes in account balances from year to year Ratio Analysis - Ans: Analyzes relationships between financial statement components Cash or current assets: current or quick ratios Receivables/inventory: turnover ratios Financial Statements: debt to equity, profit margin, or asset turnover ratios - Ans: What are ratios for cash or current assets? What about receivables/inventory? What about the financial statements as a whole? In general, CPAs can be held liable for constructive fraud (gross negligence) and fraud - Ans: In general, for what can CPAs be held liable? If the plaintiff can prove that the plaintiff acquired the stock, suffered a loss, and that the misstatements were material (no intent, negligence, or reliance has to be proven) - Ans: In Section 11 of the Securities Act of 1933 a CPA can be held liable for misstatements if the plaintiff proves what? If the plaintiff can prove that the plaintiff bought or sold the securities, suffered a loss, the misstatements or omissions were material, AND the auditor was grossly negligent or knew about it (scienter), AND the plaintiff relied on the misstatements (must prove intent and reliance) - Ans: In Rule 10b-5 of the Securities Act of 1934 a CPA can be held liable for misstatements if the plaintiff proves what? Severe penalties apply to: - Those who destroy records - Those who fail to maintain records for at least 7 years - Those who commit securities fraud and - Those who fail to report fraud - Ans: To whom do penalties apply? 1. Control environment 2. Risk Assessment (Fraud risk) 3. Control activities 4. Information and communication 5. Monitoring - Ans: 5 Elements of the COSO Framework Prevention is removing the root causes; deterrence is modifying behavior through negative sanctions - Ans: Prevention vs. Deterrence 1. Specify what conduct violates policy 2. Dishonest acts will be punished 3. Explain how to report misconduct - Ans: What are three essential elements to a company's code of conduct? - There are no "magic bullets" - It's impossible to detect all fraud - Don't over-reach in investigations - Deterrence is better than detection - Ans: What are Dr. Carpenter's concluding thoughts on fraud? 1. Description and characteristics of fraud 2. The importance of exercising professional skepticism 3. Discussion among engagement personnel regarding the risks of material misstatement due to fraud 4. Obtaining the info needed to identify risks of material misstatement due to fraud 5. Identifying risks that may result in a material misstatement due to fraud 6. Assessing the identified risks after taking into account an evaluation of the entity's programs and controls 7. Responding to the results of the assessment 8. Evaluating audit evidence 9. Communicating about fraud to management, the audit committee, and others 10. Documenting the auditor's consideration of fraud - Ans: What are the 10 subsesctions of SAS 99? (Dr. Carpenter will ask for 5 of these, most likely) To plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud - Ans: What is the auditor's responsibility according to SAS 99? To design and implement programs and controls to prevent, deter, and detect fraud - Ans: What is management's responsibility according to SAS 99? 1. Management or other employees have an incentive or are under pressure, providing a reason 2. Circumstances exist (absence of controls, etc) --> opportunity 3. Those involved are able to rationalize committing a fraudulent act - Ans: What are the three conditions present when fraud occurs, according to SAS 99? Public Company Accounting Oversight Board - Ans: What does PCAOB stand for? 1. Auditor's overall approach to the detection of financial fraud 2. Brainstorming sessions and fraud-related inquiries 3. Auditor's response to fraud risk factors 4. Financial statement misstatements 5. Risk of mgmt override of controls 6. Other areas to improve fraud detection - Ans: What 6 topics does the PCAOB's fraud release talk about? (Dr. Carpenter will probably ask for 4) 1. Auditors often document their consideration by checking off items on standard audit programs and checklists 2. Documentation didn't contain evidence of actual performance of procedures 3. Auditors failed to expand audit procedures - Ans: What 3 things did the PCAOB's fraud release see wrong with auditors? 1. Audit team was unable to demonstrate that brainstorming sessions were held 2. Audit teams' brainstorming sessions occurred after planning and fieldwork began 3. Key members of the audit team did not attend the brainstorming sessions - Ans: What 3 exceptions have the PCAOB specialists noted for brainstorming sessions? No - Ans: Does the PCAOB think auditors are reacting appropriately to fraud risk factors? - Analytical procedures - Confirmation process - Roll-forward of interim substantive testing - Review of interim financial info - Ans: What did the PCAOB cite as areas to improve? Bribery - Ans: What is the most common corruption scheme?