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5
National Commission on Fraudulent Financial Reporting, Report of the National Commission on
Fraudulent Financial Reporting (Washington, DC: NCFFR, 1987), p. 2.
6
In an article entitled “Six Common Myths about Fraud,” Joseph T. Wells, chairman of the Association
of Certified Fraud Examiners, identifies such myths as: (1) Most people will not commit fraud; (2)
Fraud is not material; (3) Most fraud goes undetected; (4) Fraud is usually well concealed; (5) The au-
ditor can™t do a better job in detecting fraud; and (6) Prosecuting fraud perpetrators deters others. For
further discussion, see Journal of Accountancy 169, No. 2 (February 1990), pp. 82“88. Also see
Joseph T. Wells, “Occupational Fraud: The Audit as Deterrent,” Journal of Accountancy 193, No. 4
(April 2002), pp. 24“28.
Meaning of Fraud in a Financial Statement Audit 323



Exhibit 11.1 Association of Certified Fraud Examiners, 2002 Report to the
Nation, Occupational Fraud and Abuse, Executive Summary

• This study covers 663 occupational fraud cases that caused over $7 billion in losses.
• Certified fraud examiners estimate that six percent of revenues will be lost in 2002 as a
result of occupational fraud and abuse. Applied to the U.S. Gross Domestic Product, this
translates to losses of approximately $600 billion, or about $4,500 per employee.
• Over half of the frauds in this study caused losses of at least $100,000 and nearly one in
six caused losses in excess of $1 million.
• All occupational frauds fall into one of three categories: asset misappropriations, cor-
ruption, or fraudulent statements.
• Over 80% of occupational frauds involve asset misappropriations. Cash is the targeted
asset 90% of the time.
• Corruption schemes account for 13% of all occupational frauds and they cause over
$500,000 in losses, on average.
• Fraudulent statements are the most costly form of occupational fraud with median
losses of $4.25 million per scheme.
• The average scheme in this study lasted 18 months before it was detected.
• The most common method for detecting occupational fraud is by a tip from an employee,
customer, vendor or anonymous source. The second most common method is by accident.
• Organizations with fraud hotlines cut their fraud losses by approximately 50% per
scheme. Internal audits, external audits, and background checks also significantly re-
duce fraud losses.
• The typical perpetrator is a first-time offender. Only seven percent of occupational fraud-
sters in this study were known to have prior convictions for fraud-related offenses.
• Small businesses are the most vulnerable to occupational fraud and abuse. The average
scheme in a small business causes $127,500 in losses. The average scheme in the largest
companies costs $97,000.

Source: Association of Certified Fraud Examiners, 2002 Report to the Nation Occupational Fraud
and Abuse (Austin, TX: ACFE, 2002) p. ii.



• Respondents™ replies indicated that the better the directors™ understanding of the
business as a whole, the lower the incidence of fraud they suffered.
• However, less than half the respondents believed that their directors had a good
understanding of areas outside their core business, including remote and overseas
operations.
• Less than a quarter of the respondents believed their directors had a good under-
standing of electronic communication or information technology.
• With the millennium approaching fast, three in four organisations had failed to in-
clude within their Year 2000 projects an assessment of the vulnerability of their
computer systems to fraud.
• The proportion of organisations with fraud reporting policies was higher than in
our last survey, but communication of these to the workforce was still poor.7

7
Ernst & Young, Fraud: The Unmanaged Risk, An International Survey of the Effect of Fraud on Busi-
ness (London: Ernst & Young, 1998), p. 1.
324 A Perspective on Fraud and the Auditor



Exhibit 11.2 Detecting and Preventing Fraud

Obviously, a key to dealing with fraud is detecting it when it occurs. Respondents were
asked how the frauds they investigated were initially discovered. There were 532 responses
to this question, the results of which are summarized below. The most common method of
detection was a tip from an employee, which occurred in over a quarter of the cases re-
viewed. This data suggests that effective reporting mechanisms and open channels of com-
munication from employees to management can have a positive effect on fraud detection
and mitigation.

INITIAL DETECTION OF FRAUDS
METHOD/PERCENT OF CASESa
Tip from Employee (26.3%) 140


By Accident (18.8%) 100


Internal Audit (18.6%) 99


Internal Controls (15.4%) 82


External Audit (11.5%) 61


Tip from Customer (8.6%) 46


Anonymous Tip (6.2%) 33


Tip from Vendor (5.1%) 27
Notification by Law
Enforcement (1.7%) 9
|||||||||| | | | | | |
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
CASES


Respondents were asked, based on their own expertise, which of the following eight mea-
sures are most helpful in preventing fraud against organizations. Each participant ranked
the following measures in order of their perceived effectiveness, assigning a “1” to the
measure that is most effective, a “2” to the measure that is next most effective, and so on.
Thus, the most effective anti-fraud measures would have the lowest average scores.
A strong system of internal controls was viewed as the most effective anti-fraud measure
by a wide margin. Detailed background checks on new employees were thought to be the
next most important measure, followed by regular fraud audits.
Meaning of Fraud in a Financial Statement Audit 325



WHICH MEASURES ARE MOST HELPFUL IN PREVENTING FRAUD?
RESPONSES
Strong Internal controls 1.62

Background checks on new employees 3.70

Regular fraud audits 3.97

Established fraud policies 4.08

Willingness of companies to prosecute 4.47

Ethics training for employees 4.86

Anonymous fraud reporting mechanisms 5.02

Workplace surveillance 6.07
| | | | | | | |
8 7 6 5 4 3 2 1
LEAST MOST
EFFECTIVE EFFECTIVE

AVERAGE



Source: Association of Certified Fraud Examiners, 2002 Report to the Nation, Occupational Fraud
and Abuse (Austin, TX: ACFE, 2002), pp. 11“12. For the complete report, visit the Association™s
web site at www.CFEnet.com.
a
Total exceeds 100% because some participants cited more than one method for initial discovery of
the frauds.




As David Sherwin, head of Ernst & Young™s Fraud Investigation Group, asserts:

Companies need to act positively to prevent fraud from happening in the first place.
They should ensure all the simple steps are conscientiously applied.
Areas of neglect include:
• Lack of knowledge of the workings of remote sites and overseas operations. Se-
nior management reveals that it still doesn™t make regular visits to remote loca-
tions in order to ensure that adequate controls are in place”placing too much
reliance, instead, on local management.
• Poor understanding by directors of electronic communications and IT. Although
computer systems are being widely reviewed to eliminate “millennium bomb”
problems, the vulnerability of these systems to fraud was checked by only one in
four companies surveyed.
326 A Perspective on Fraud and the Auditor


• Inadequate fraud-reporting policies for staff. While most companies are devel-
oping such policies, communication remains poor. Over half the companies said
they were opposed to hotlines to enable staff to report fraud. Such opposition was
lowest in the U.S. and greatest in continental Europe.8


Intentional Distortions of Financial Statements
Concerning management™s deliberate misrepresentations in the entity™s financial po-
sition and results of operations, L. B. Sawyer, A. A. Murphy, and M. Crossley report:

Management fraud has been found in overstatements of inventory to show healthy
assets which are, in truth, sickly . . . the acceptance of inferior goods to conceal a tot-
tering cash position . . . delayed key expenditures to increase current profits to the
detriment of the long-range survival of the company . . . overstatements of receiv-
ables to puff both assets and sales . . . fictitious sales which construct a facade of vig-
orous business volume . . . and understatements of liabilities to gloss over the
financial picture.9

With respect to legal cases concerning management fraud and the audit com-
mittee, the reader should review several cases in Chapter 4. Such a review indi-
cates that the SEC and the courts have ruled on the establishment of the audit
committee by the registrant in order to comply with the provisions of the federal
securities laws. As a result, the legal obligations of audit committee members have
intensified because their standard duty of care and loyalty to the entity has in-
creased in light of the management fraud activities. Consequently, the audit com-
mittee will look to the internal and external auditing executives as well as legal
counsel for assistance in preventing management fraud. In short, since manage-
ment fraud is perpetrated by the top executives of the entity, ordinarily it is con-
ducted on a sophisticated basis and thus requires the professional expertise of
auditors, legal counsel, or special investigators.
The rationale for management fraud is essentially attributable to “different
pressures” that force management into deliberate misrepresentations of accounting
information as well as the misappropriations of assets.10 Sawyer, Murphy, and
Crossley summarize the reasons:

• “Executives sometimes take rash steps from which they cannot retreat,” such
as setting unattainable objectives regarding the earnings per share figure. Such
rash actions may involve actually lying to the external auditors in order to in-
flate the bottom line of the entity.
• “Profit centers may distort facts to hold off divestments,” whereby manage-
ment of a subsidiary will deliberately manipulate transactions and alter docu-
ments and records to falsify its profitability performance.

8
Ernst & Young, Ernst™s & Young™s Business Upshot (Cleveland, OH) (July/August 1998), p. 3.
9
Lawrence B. Sawyer, Albert A. Murphy, and Michael Crossley, “Management Fraud: The Insidious
Specter,” Internal Auditor 36, No. 2 (April 1979), pp. 12“13.
10
Ibid., p. 17.
Meaning of Fraud in a Financial Statement Audit 327


• “Incompetent managers may deceive in order to survive,” based on their actual
performance versus their reported results.
• “Performance may be distorted to warrant larger bonuses,” through the ma-
nipulation of the reported figures regarding the company™s incentive plans.
• “The need to succeed can turn managers to deception,” whereby such individ-
uals place personal gains and self-interest before their stewardship account-
ability to their constituencies (discussed in Chapter 2).
• “Unscrupulous managers may serve interests which conflict,” as discussed in
Chapter 4 in relation to the state and federal statutory laws covering the directors
and officers. Such laws provide a standard duty of care and loyalty to the entity.
• “Profits may be inflated to obtain advantages in the marketplace,” whereby
the perpetrators are confident that “their own abilities transcend any fear of
detection.”
• “People who control both the assets and their records are in a perfect position
to falsify the latter.” Thus a sound system of internal control, discussed in
Chapter 8, is essential.11

Expanding on the aforementioned rationale and motivation for fraudulent fi-
nancial reporting, the National Commission on Fraudulent Financial Reporting
characterized various situations and opportunities:
Fraudulent financial reporting usually occurs as the result of certain environmental,
institutional, or individual forces and opportunities. These forces and opportunities
add pressures and incentives that encourage individuals and companies to engage in
fraudulent financial reporting and are present to some degree in all companies. If the
right combustible mixture of forces and opportunities is present, fraudulent financial
reporting may occur.
A frequent incentive for fraudulent financial reporting that improves the company™s
financial appearance is the desire to obtain a higher price from a stock or debt offer-
ing or to meet the expectations of investors. Another incentive may be the desire to
postpone dealing with financial difficulties and thus avoid, for example, violating a
restrictive debt covenant. Other times the incentive is personal gain: additional com-
pensation, promotion, or escape from penalty for poor performance.
Situational pressures on the company or an individual manager also may lead to
fraudulent financial reporting. Examples of these situational pressures include:
Sudden decreases in revenue or market share. A single company or an entire in-
dustry can experience these decreases.
Unrealistic budget pressures, particularly for short-term results. These pressures
may occur when headquarters arbitrarily determines profit objectives and budgets
without taking actual conditions into account.
Financial pressure resulting from bonus plans that depend on short-term eco-
nomic performance. This pressure is particularly acute when the bonus is a sig-
nificant component of the individual™s total compensation.

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