Financial Accounting: A User Perspective, Fourth Canadian Edition
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Fraud: Techniques and Strategies for Detection
Definitions, Costs, and Long-Term Effects of Fraud
In its most general form, fraud can be defined as an act of deceit or a deceptive trick. Applying
this to the workplace, “occupational fraud” can be defined as “the use of one’s occupation for
personal enrichment, through the deliberate misuse or misapplication of the employing
organizations’ services or assets”. This definition is very broad and includes fraud schemes as
simple as pilferage of company supplies (a form of asset misappropriation fraud) to complex
financial statement frauds.
Asset misappropriation accounts for over 90 percent of all occupational frauds, compared to
financial statement frauds which account for only 8 percent of frauds. This means that while
financial statement frauds can be very costly in terms of dollars and human costs, asset
misappropriation frauds are far more likely to happen to a company.
It is an unfortunate fact of life that some level of fraud is unavoidable, and for those in business it
is a serious occupational hazard. It is estimated that this “white collar crime” costs North
American business more than $660 billion annually.
The costs and the long-term effects of fraud are many:

Businesses that are victims of fraud not only bear the cost of the fraud itself (to the extent
that they are unable to recover the funds), but also the costs of investigating the fraud, of
clearing up the problem, and of ensuring there is no recurrence. In addition, financial losses
arising from fraudulent activity may lead to layoffs, plant closures, or even business failures.
For those companies able to survive a fraudulent event, they may still miss key business
opportunities.

Fraud also extracts a huge personal cost. It can have very traumatic effects on individuals,
and lead, in some cases, to marriage breakups, nervous disorders, and even suicides.
Too often, complacency is the fraudster’s best ally. Conversely, the fraudster’s toughest foe is a
potential target that turns out to be both vigilant and well prepared to meet this challenge. The
bad news is that external audits no longer seem to be the deterrent they once were. In its 2002
Report to the Nation on Occupational Fraud and Abuse, the Association of Certified Fraud
Examiners (ACFE) reported that audited companies suffered less severe fraud losses than
unaudited ones. However, in its 2004 report, the ACFE noted that median losses are higher in
organizations with an external audit, and it was “disappointing to find no trend indicating
reduced losses as a result of external audits.”
While external audits account for approximately 10 percent of initial fraud detection, it is
encouraging to note that internal audits account for approximately 24 percent. Clearly, effective
internal controls and internal audits have proven useful in the fight against fraud.
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Financial Accounting: A User Perspective, Fourth Canadian Edition
Hoskin, Fizzell, Cherry
The Certified Fraud Examiners 2004 report found that the majority of all frauds were perpetrated
on private, not public, companies with the greatest number of fraud cases involving companies
with fewer than 100 employees. These frauds averaged $123,000 in losses. The typical
perpetrator of fraud is a trusted, educated, long-time employee.
The higher number of frauds documented in small, private companies are likely the result of a
lack of internal controls, failure to segregate duties, and fewer accounting services by an outside
accounting firm. These companies either can’t afford or don’t have the personnel for certain
controls or services, resulting in weak internal control environments that are more susceptible to
fraud.
Perpetrators of Fraud and Reasons for Fraud
It is generally acknowledged within fraud prevention circles that much of our society, and hence
the population of any given organization, is inherently honest. Conversely, a certain segment of
the population is inherently dishonest and little will deter them from deceit. A third segment of
the population may commit acts of dishonesty if the need and opportunity coexist. Thus, an
honest person with a high degree of personal integrity may commit fraud, given a set of
situational pressures and high opportunity. Conversely, a person of low personal integrity may
not commit fraud if not exposed to situational pressures and if there are strong controls, which
provide little or no opportunity for fraud. Therefore, business environment and culture are
extremely important factors.
Management can control the opportunities for fraud through good internal controls, good
management, good policies, and good procedures. Management can control the situational
pressures and the personal integrity of employees by not only knowing their people, but also by
setting the tone themselves.
Fraudsters’ rationalizations, when confronted with their misdeeds, are often very interesting:
“Everyone else is doing it.”
“The company can afford it.”
“I’m underpaid -- I deserved it.”
“I should have been promoted.”
“I worked overtime but didn’t get paid for it.”
“It’s a big company -- I’m not hurting anyone.”
“I wasn’t stealing; I was just borrowing the money.”
To illustrate this further, imagine a person who is a pillar of the community – a well-respected,
honest employee, a person with a background no more criminal than that of most. This person
finds himself with an unshareable problem and an opportunity to steal money from his company.
The chances are very good that if in that situation you walked up to him and said, “Fred, steal
the money from your boss,” he would look at you in horror as if you had suggested he should
solve his problem robbing someone at gunpoint. If instead you said, “Fred, steal the money from
your company,” there would probably be a less horrified reaction. Nevertheless, honest and
trusted persons just don’t do those things. However, honest and trusted persons do “borrow” and
if you were to suggest that Fred should secretly borrow some money from his firm, you would
have helped him over a tremendous hurdle. Then he would be able to tell himself that he is
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Financial Accounting: A User Perspective, Fourth Canadian Edition
Hoskin, Fizzell, Cherry
merely borrowing the money and he can continue to believe that he is an honest citizen, even as
he is robbing his company blind.
Fighting Fraud in Business Organizations
The proactive and reactive landscape of fraud seems to have changed in the past couple of years.
After the well-publicized scandals of WorldCom, Enron, and others, the era of the SarbanesOxley Act1 with greater corporate governance, and new auditing standards have all contributed
to a more watchful eye and increased accountability.
Historically, there have been three types of combatants charged with the responsibility of
keeping an eye on the financial wellbeing of companies: external auditors, internal auditors, and
criminal investigators.

The independent external auditors play a proactive role, in that these auditors must
determine the extent to which statements may need to be restated; but their role can be
reactive if they actually find that a fraud has occurred.

The role of internal auditors has grown in the post-WorldCom and Enron era, together with
the requirements under Sarbanes-Oxley (and some similar legislation and regulatory
requirements in Canada) for certification of financial statements.

The least proactive in terms of fraud detection have historically been the criminal
investigators. They are typically not retained until evidence of a fraud has been discovered.
During the past few years, we have certainly seen a marked increase in the number of high
profile companies under investigation for financial statement fraud and related accounting
irregularities. However, one of the most frequently asked questions in the wake of these recent
developments has been “Where were the auditors when these irregularities occurred, and why
wasn’t the fraud detected by them?” There are three principal reasons why auditors do not seem
to detect fraud to the extent that the general public might expect:
1. A general misunderstanding of the auditors’ responsibilities in a financial statement
audit, and misperceptions about the distinction between a financial statement audit
and a fraud investigation.
2. Active concealment of the fraud, by senior management, from the auditors.
3. Audit failures.
The objective of a financial statement audit is to obtain reasonable assurance about whether the
financial statements are free from material misstatement, whether caused by error or fraud.
Because its objective is to obtain reasonable assurance that the financial statements are free from
1
The Sarbanes-Oxley Act was passed in the United States in the aftermath of a number of financial scandals
involving major American corporations. It requires (amongst other things) that companies adhere to certain
standards to ensure effective corporate governance and internal controls, and that the senior executives and directors
of corporations accept responsibility for their organizations’ control systems and financial statements.
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Financial Accounting: A User Perspective, Fourth Canadian Edition
Hoskin, Fizzell, Cherry
material misstatement, the scope of a financial statement audit is limited. A financial statement
auditor typically reviews only a limited sample of selected transactions, on a test basis.
It is important to remember that:
 The nature of a financial statement audit, unlike a fraud investigation, is not intended to
provide absolute assurance against fraud. The auditors are merely required to seek out the
presence of certain fraud risk factors.
 Intentional acts by corporate management to conceal the existence of fraud have been at the
heart of many recently publicized cases.
As a fraud combatant, the duties of the traditional auditor have suffered from what is known as
an “expectation gap.” The public thinks that auditors will find fraud, and should indeed attempt
to seek out fraud at every turn of an audit. However, generally accepted auditing standards
(GAAS) instruct auditors to plan and perform audits to merely obtain reasonable assurance that
the financial statements are free of material misstatements, whether caused by error or fraud. In
other words, the traditional auditors’ role has essentially been that of watchdogs, as opposed to
bloodhounds.
Criminal investigators or forensic accountants have a different mind-set, as they do not maintain
the neutrality of traditional auditors. In other words, typically when a forensic accountant is
brought into a situation, there is already evidence that some fraudulent event has taken place.
The factors of need/greed, opportunity, and low expectation of being caught are usually
described as the matches that start fraud fires. Fair treatment of employees can reduce the
need/greed factor, while other features of good internal control systems reduce the opportunity
for fraud to be committed as well as increase the likelihood that fraud and its perpetrators will be
detected.
Increased Regulatory Emphasis on Reducing Fraud
The new emphasis on internal controls offers accountants and auditors the opportunity to become
more involved in helping management prevent and detect fraud. The goal of the new guidelines
and requirements is for internal controls to be so effective that fraud is virtually impossible. The
onus is on management to create the most effective internal control system possible, to prevent it
or to detect and eliminate it.
The Sarbanes-Oxley Act and similar legislation and regulatory requirements in Canada, passed
in the wake of Enron and other scandals, also seek to reduce the likelihood of fraud by making
the officers and directors of public companies (in particular, their CEOs and CFOs) directly
accountable for their organization’s internal controls and financial disclosures.
The first step toward compliance is the establishment of an effective audit committee. Every
public company must have one. Generally, the members of the audit committee all have to be
members of the board of directors, but independent ones in the sense that they perform no other
corporate duties and receive no compensation other than their directors’ fees. As well, at least
one member of the audit committee must generally be a financial expert.
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Financial Accounting: A User Perspective, Fourth Canadian Edition
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Management must identify and assess both the risk of fraudulent financial reporting within its
own operations and the adequacy of its internal controls. Although it varies from company to
company, the audit committee’s role as to internal auditing and monitoring of CEO/CFO activity
must include a review of the effectiveness of internal controls and the internal audit function.
The integrity and impartiality of the chief internal auditor and the members of the internal audit
team should be beyond question. The chief internal auditor should report to a senior officer not
involved in the production of financial statements, and should have direct access to the CEO and
the chair of the audit committee at all times.
It is noteworthy that of the 663 known fraud cases studied by the members of the Association of
Certified Fraud Examiners for its 2002 report, internal audit teams were responsible for
discovering only 18.6 percent, while mere chance turned up 18.8 percent. Tips from other
employees were responsible for a larger portion, revealing 26.3 percent of the fraud cases
studied. (Fortunately, the ACFE’s 2004 report indicated that the effectiveness for internal audits
had improved; they then accounted for approximately 24 percent of initial fraud detections.)
The audit committee should also act to ensure the total independence of the external auditors,
and review the external audit fees and any related consulting fees. As a result of these
requirements, top management will now be under the watchful eye of more independent boards
and external auditors—and will be held directly accountable for their company’s financial
statements.
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Financial Accounting: A User Perspective, Fourth Canadian Edition
Hoskin, Fizzell, Cherry
Common Types of Fraud
The most common types of fraud include:
1. Duplicate payment fraud
2. Multiple payee fraud
3. Shell fraud
4. Defective shipment fraud
5. Defective delivery fraud
6. Defective pricing fraud
1. Duplicate Payment Fraud
Duplicate payment fraud involves the issue of two or more identical cheques to pay the same
debt. One serves to pay the creditor, while the other(s) are recovered and cashed by the
perpetrator. Normally, the fraud occurs when an employee of an entity initiates the necessary
documentation to cause the additional payment(s) to be made to a vendor or contractor to satisfy
a debt. The employee may act alone or in collusion with an employee of the vendor or
contractor. The perpetrator arranges to intercept the second cheque (and any additional cheques
that may be issued) and cash them.
The employee/perpetrator may initiate the duplicate payment using a second copy of the
vendor’s invoice, which is usually easy to obtain by just asking for one, or by simply
photocopying or scanning the original invoice. Purchase orders, receiving documents, and the
like which were prepared for the original invoice may be copied in order to “document” the
duplicate payment(s). The approval signatures and initials are usually forged.
Sometimes a dishonest employee will conspire with a vendor’s employee, in which case the
conspirator will provide second invoices, simplifying the preparation of a second cheque in
payment and assuring interception of the duplicate payment cheque.
2. Multiple Payee Fraud
Multiple payee fraud involves paying a legitimate vendor’s invoice two or more times but
issuing the additional cheques to different payees. Note that multiple payee fraud is similar to
duplicate payment fraud with one important difference—the payment cheques are not identical.
This usually makes detection more difficult. This type of fraud involves two or more payments to
different vendors or contractors for the same debt. One of the payees is usually the legitimate
vendor who delivered the products or services. The others are fraudulent and are often
conspirators in the fraud.
3. Shell Fraud
Shell fraud involves payments to vendors or contractors—real or fictitious—to settle alleged
debts for fictitious projects, materials, or services. All the underlying documentation is forged.
This type of fraud may or may not involve conspiracy with contractors or suppliers. All of the
payment money generated is pocketed by the perpetrator(s).
To execute shell fraud, the perpetrator conceives of a fictional purchase and prepares appropriate
paperwork and accounting entries, forging whatever signatures are necessary. Paperwork might
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Financial Accounting: A User Perspective, Fourth Canadian Edition
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include requisitions, purchase orders or contracts, and receiving reports—indeed, whatever is
needed to complete the document files. They are all forged and fictitious. Finally, all the
perpetrator must do to obtain payment is to submit a bogus invoice.
Once a cheque has been produced, if the paying entity’s internal controls are weak the
perpetrator simply takes the cheque out of the outgoing mail. Alternatively, sometimes the
perpetrator will telephone the payee and explain that a duplicate cheque was inadvertently sent
and ask to have it returned. The fact that the payee’s name is on the cheque is usually no problem
for a clever perpetrator.
Depending on the size of the entity and the internal controls in place, a perpetrator can work
alone to accomplish a shell fraud, particularly if he or she is in a key position. Normally,
however, shell frauds are best accomplished using an actual vendor or contractor serving in a
conspiratorial role.
Building maintenance projects seem to be a target of choice among shell fraud perpetrators.
There have been paint jobs that were never done, walls that were never constructed and even
buildings that were never built. Building cleaning service for things such as carpet cleaning,
washing walls, and cleaning blinds are particularly common targets because it is often difficult to
prove or disprove whether the services were actually performed.
4. Defective Shipment Fraud
Defective shipment fraud involves the provision or shipment of the victim’s (in this case the
supplier/shipper, not the purchaser/recipient) products or services that are superior in some
manner, without a corresponding increase in price to compensate the victim.
Perhaps the greatest incidence of defective shipment fraud occurs in shipments from victims’
warehouses. Whereas a shipping order may call for the shipment of 100 of some product, 110 are
shipped. Whereas a grade B product is what should be shipped, a grade A product is substituted.
In return, an “under the table” payment or other compensation is given to the fraudster(s)
working for the supplier/shipper company by the co-conspirator(s) working for the
purchaser/recipient company.
5. Defective Delivery Fraud
Defective delivery fraud involves the delivery of products or services that are inferior in some
manner. The products delivered may be short in quantity and/or of inferior quality to what was
ordered and paid for. For example, cheaper (less skilled) labour may be used on a job, and/or
fewer labour hours. The victim in this type of fraud is the purchaser/recipient company.
Most internal control systems require that designated employees must complete a receiving
report or other attestation, certifying that the product or service was delivered in accordance with
applicable purchase order or contract specifications, before a vendor’s invoice is processed for
payment. However, if Purchasing Department or Contracts Department employees are
overworked, underpaid, dissatisfied with their work, or are just “working for a pay cheque,” the
likelihood of defective delivery fraud can be greatly increased. Sometimes vendors or contractors
give generous gifts to customers’ key employees, or entertain them lavishly. In return, these
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employees perform only a perfunctory examination of incoming goods or services received from
those contractors, which allows the defective delivery to pass through the system.
A common example of defective delivery fraud involves interior painting jobs, in which two
coats of paint may be specified in the contract, and subsequently paid for, but only one coat is
actually applied.
A variation on defective delivery fraud requires superfluous specifications in a contract or
purchase order. As the service is being performed or the product is being delivered, the
superfluous features are eliminated. However, the vendor’s invoice still includes the cost of the
superfluous specifications, and the recipient victim pays for them. The result is the delivery of a
perfectly satisfactory service or product, which is not likely to raise any objections or suspicions
of inadequacy from users.
6. Defective Pricing Fraud
Defective pricing fraud involves either under-charging or over-charging for products or services.
In the case of under-charging, the victim is the vendor/supplier company; in the case of overcharging, the victim is the purchaser/recipient company. We will describe the latter case here.
Most internal control systems require that designated employees must verify the prices charged,
before a vendor’s invoice is processed for payment. However, as with defective delivery fraud, if
Contracts Department or Payables Department employees are overworked, underpaid,
dissatisfied with their work, or otherwise not motivated to perform their duties properly,
defective pricing fraud can quite easily occur. As noted previously, vendors or contractors may
be generous with gifts to customers’ key employees, or entertain them lavishly. The payback to
the vendors occurs when the prices they charge are not properly scrutinized, which allows the
fraudulent prices and overpayments to pass through the control system.
Source: Adapted from Silverstone, Howard and Davia, Howard R. Fraud 101 – Techniques and
Strategies for Detection. Second edition. Hoboken: John Wiley & Sons, Inc., 2005.
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