FRAUD EXAMINATION ALBRECHT, ALBRECHT, & ALBRECHT Proactive Approaches to Detecting Fraud CHAPTER 6 Learning Objectives 1. Explain the importance of proactive fraud detection. 2. Describe the role of commercial datamining software plays in detection. 3. List the advantages and disadvantages of data mining and digital analysis. 4. Recognize Benford’s Law. Learning Objectives 5. Understand inductive fraud detection. 6. Identify how fraud is detected by analyzing financial statements. How is the Case of Mr. Hamanaka Typical of Most Frauds? It started small and grew much larger! Match Terms and Definitions. Inductive fraud detection Determining the types of fraud that can occur then query to see if they exist Deductive fraud detection Proactively searching for fraud without determining the type of fraud to look for Commercial data-mining software Benford’s Law A mathematical algorithm that predicts the percentage a digit will occur Commercial software used to detect patterns in data Differentiate Between Detecting & Investigating Fraud. Detection Discovery of Fraud Answers the Question: Does a fraud exist? Investigation Preceded by Detection Proving a Fraud Answers the Questions: How? Who? Why? What? Where? When a fraud took place? Explain Data-Mining as a Means of Detecting Fraud. ACL- Audit Command Language Looking for Anomalies in Databases Difficulty Because ACLs Are Limited in What They Can Handle The Result Is They May Identify Thousands of Symptoms Because of Their Limitations Review How Benford’s Law Works. Examines the Frequency of Digits Appearing in a Database of Invoice #s or Amounts 0-9 Do Not Appear 10% Each List Disadvantages of Benford’s Law? Looks at a Large Company as a Whole, May Not Show Problems With Some Individual Vendors Not Precise Broad Identification of Symptoms Does Not Zero in on Perpetrators What is the 5 step Process for Inductive Fraud Detection? 1. Understand the Business 2. Understand the Types of Fraud that Occur in this Business 3. Understand the Symptoms these Types of Fraud Create 4. Use Databases & Information Systems to Search for Symptoms 5. Follow Through with Investigation to Determine if Fraud Exists or Not Compare the 3 Approaches. Commercial Data Mining Packages are least costly, but have limited usefulness. They provide excessive symptoms, but are easy to use and modify. Compare the 3 Approaches. Statistical analysis provides lots of symptoms and is very useful for discovering vendor kickback frauds. Compare the 3 Approaches The Inductive Approach is the most expensive to use. Summarize the Process Which Results in Financial Statements. Economic Transaction Journal Entry Financial Statements Produces Posted Analysis Source Documents General Ledger Effects Investor or Creditor Decisions Analysis Summarized What Effect Does the Size of the Fraud Have on the F/S? Small frauds are unlikely to affect F/S, usually detected when examining source documents Large frauds effect F/S, detected during analysis of unexplained changes in F/S Explain How Revenue Affects the Company’s Accounts. Accounts Receivable Revenue Cost of Goods Sold If Sales Increase Then Inventory How Can You Convert Balance Sheets & Income Statements to Change Statements? Compare Calculate Key Account Ratios Compare Balances from from Period to Period to Period Period Perform Horizontal Analysis Perform Vertical Analysis Match Ratio to Name. Current Quick Test CA – Inventory Average A/R Current Assets Current Liabilities A/R Turnover Sales Average A/R Days in Receivables 365 Days A/R Turnover Match Ratio to Name. Receivables % Bad Debt Expense Average A/R Bad Debt % 365 Days Inventory Turnover Inventory Turnover Days in Inventory Cost of Goods Sold Average A/R Accounts/Receivable Total Assets Match Ratio to Name. Cost of Goods Sold Percent Cost of Goods Sold Total Sales Inventory Percent Sales Returns Total Sales Property, Plant & Equipment Percent Inventory Total Assets Sales Return Percent Sales Ave. Property Plant & Equipment Match Ratio to Name. Debt to Equity Total Liabilities Total Assets Debt Percentage Net Income # Share of Stock Outstanding Profit Margin Days in Receivables Total Liabilities Total Equity Net Income Net Sales Describe How to Perform Vertical Analysis on: •An Income Statement •A Balance Sheet Describe How to Perform Horizontal Analysis on: •An Income Statement •A Balance Sheet What Questions Should Asked When Using a Statement of Cash Flows to Detect Fraud? Are there any unexpected changes in cash? Did A/R go up or down? Why? Why did inventory go up or down? Statement of Cash Flows From Investments From Earnings From Borrowings and Stock Issuances Cash Flows Cash Balance Cash Flows Dividends To Operations For Investments To Pay Off Loans Discuss the Use of Software for Detecting & Identifying Fraudsters. Difficulty of the List Information - Information can be in multiple formats Fuzzy Logic