Internal Controls
“There is no kind of
dishonesty into which
otherwise good people
more easily and frequently
fall than that of defrauding
the government.”
Benjamin Franklin
How Does Fraud Occur?
 Poor internal controls
– Lack of proper authorizations
– No separation of authorization, custody, and record keeping
– No independent checks on performance
– Lack of clear lines of authority
– Inadequate documentation
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Management override of internal controls
Collusion between employees and 3rd parties
Collusion between employees and management
Limited, unclear, or no policies and procedures
Poor or non-existent ethics and/or policy
“We all can learn from audit standards”
Statement on Auditing Standards No. 99

Exercise professional skepticism

Conduct brainstorming

Identify and assess risks

Communicate
Challenges We Face

74% of us believe our ethics are higher than those of our peers

83% of us say that at least one-half of the people we know would list
us as one of the most ethical people they know

92% of us are satisfied with our ethics and character
Would you commit a felony to pay for needed
surgery for your child?
Yes – 97 percent
Would you commit a felony to pay for needed
surgery for your spouse?
Yes – 42 percent
“In the real world, successful people do what they have to
do to win, even if others consider it cheating.”
We do what we must to win
200 Olympians
1. Performance enhancing drug, no one will find out, no side affects,
and win all races next 5 years
195
2. Performance enhancing drug, win all races next 5 years, then die
from side affects, but no one will find out
100
Future Work Force (College)
11% reported cheating in 1963
49% reported cheating in 1993
75% reported cheating in 2003, 2005, 2006, 2007
50% in graduate school in 2006
Trust Is Not A Control
Former Director, Federal Emergency Management Agency

Assistant City Manager, Emergency Services Division

Assistant to the City Manager
Trust Is Not A Control
Former Deputy Chief Information Officer, U.S. Department of Homeland
Security

Bachelor’s Degree (1993), Master’s Degree (1995), and Doctorate
(2000)

Hamilton University

Unaccredited fee-for-degree “distance learning” center (“Diploma
Mill”)

Bachelor’s Degree (2000), Master’s Degree (2000), and Doctorate
(2001)
Reasons We Miss Fraud
Reasons We Miss Fraud
 Personalities
 Pressure
 Face Value
 Auditor v. Investigator
 Avoid Conflict
 Business Operations
 Checklists
 The “Right” People
 Education
 Warning Signs
Personalities
 Clients’ strong personalities create difficulties
 Taken in by friendly personalities
 Need to be liked by the client
Personalities
 Auditors requested to see a sampling of 400 invoices for ZZZZ Best
work. Of those 400, the auditors would select 20.
 ZZZZ Best provided 20 fake invoices.
 Auditors asked to see 400 original invoices – CFO protested and
auditors backed down.
Face Value
 Accept answers on face value
 Lack of skepticism – never taught and not in personality
Face Value
 Crazy Eddie’s – one of the 20th century’s most infamous financial
statement frauds
 Employees helped auditors with inventory counts
 10 equals 25
Watch What They Say
 “The balance sheet is strong.”
 “The third quarter is looking great.”
 “Our stock is an incredible bargain at current prices.”
-- CEO Ken Lay, Enron
Watch What They Say
 “We are confident in our marks and the reasonableness of our
valuation methods.”
 “We have a high degree of certainty in what we have booked to
date.”
-- CEO Martin Sullivan, AIG
Watch What They Say
 “Our liquidity and balance sheet are strong.”
 “We don’t see any pressure on our liquidity, let alone a liquidity
crisis.”
-- CEO Alan Schwartz, Bear Stearns
Watch What They Say
 “We are on the right track to put these last two quarters behind us.”
-- CEO Richard Fuld, Lehman Brothers
 “Our liquidity pool also remains strong at $42 billion.”
-- CFO Ian Lowitt, Lehman Brothers
Watch What They Say
“In today’s regulatory environment, it’s
virtually impossible to violate rules.”
-- Bernard Madoff
Oct. 20, 2007
Avoid Conflict
“People are just too damn lazy.”
-- ZZZZ Best’s former CFO
Rather than drive out to confirm an address where ZZZZ Best was
supposedly doing $45 million in business, the auditors would make a
phone call and were satisfied.
Checklists
 Use too many checklists – try to get them done versus
understanding the questions
 Too narrow focused – don’t look to see if things make sense from
a broader perspective
 Budget & task oriented
Fraudsters Stay One Step Ahead
 Electric wheelchair
 $5,000
 Billed at least 1,000 times ($5 million) for same wheelchair
Checklists
• Do you?
• How?
• Have you?
• Describe?
• Can you?
• What?
• Are you?
• Explain?
Education
 Fraud and stupid can look just a like
 More of a mind-set
 Focus on exceptions, oddities, accounting irregularities, and patterns of
conduct
Education
“No one ever asked.”
-- Mark Morze, ZZZZ Best’s former CFO
Education
 Does the company possess all of the licenses it needs to conduct
the business it does?
 How does the company generate the 30%, 40%, 50%, and 60%
profit margins that appear on its books?
 Why do the company’s bids for complicated, million-dollar
projects fit on a single page?
Education
 Why is the company constantly in need of additional cash?
 Why did the company waste $2 million on equipment it could
have rented for 90% less?
 Can we (the auditors) speak to at least one satisfied customer?
Education
 Why is business conducted only with cashier’s checks?
 How can the company’s revenues grow by 400% in 6 months, while
the company’s general & administrative costs barely grow at all?
 Why aren’t any of the company’s vendors in the Yellow Pages?
Education
 Why do the company’s estimates for project costs always equal—
to the penny—the supply sheets from the vendors?
 Why are there no addresses on the work invoices?
 Where are all the government forms regarding permits, licenses,
etc.?
Education
 Where is all the paperwork on vendor deliveries?
 Could the auditors have a tour of one or two of the company’s
warehouses or other facilities?
 Can the auditors speak with a few of the company’s vendors or
subcontractors? If not, why not?
The “Right” People
 Too much time on prior year testing & tick marks
 Spend too little time talking to the “right” people
The “Right” People
 Chairman
 Chief Accounting Officer
 Chief Executive Officer
 Chief Compliance Officer
 Chief Operating Officer
 Chief Audit Executive
 Chief Financial Officer
 Chief Legal Officer
The “Right” People
 Accounting Manager
 Payroll Manager
 A/P Manager
 H/R Manager
 Warehouse Foreman
 Q/A Manager
 Billing Manager
 Contracting Officer
Why Warning Signs are Important?
“The average fraud scheme lasted 24 months
before it was detected.”
-- ACFE 2008 Report to the Nation
Professional Services Contract
Effective Date
Contract
Amount
Contract Price
09/12/04
$ 85,850
$ 85,850
Mod #1
11/22/04
$ 30,800
$116,650
Mod #2
04/08/05
$ 78,400
$195,050
Mod #3
09/12/05
$
1,400
$196,450
Mod #4
09/30/05
$148,600
$345,050
Warning Signs
 Unexplained employee absences
 Refusal to produce records, files or documents
 Excessive overtime
 Missing documentation
Warning Signs
 Payments to a vendor post office box
 No original source documents
 Lack of competitive bidding
 No exceptions or errors
Warning Signs
 Significant life-style changes
 Refusal to take vacation
 Excessive movement of funds between accounts
 Single vendor
Warning Signs
 Excessive or unjustified changes in accounting personnel
 Premature or excessive destruction of controlled documents
 Excessive cash transactions
 High rate of employee turnover
Warning Signs
 Customer complaints
 Can’t talk to people (protection)
 Turning down promotions or transfers
 Improperly trained employees
Warning Signs
 Delivery location not the office, plant or job site
 Invoices with minimal information
 Increase in purchasing inventory but no increase in sales
 Lack of physical security over assets / inventory
Warning Signs
 Increase in scrap materials and reorders for same items
 Inventory that is slow to turnover
 Vendors that pick up payments
 Consistent cash flow problems
Warning Signs
 Significantly outpace other companies in same industry
 Frequently change auditors, banks, and attorneys
 Dramatic changes in key ratios or ratios too good
 Excessive number of checking accounts
Warning Signs
 Failure to reconcile bank statements or a conflict of duties on the part of
performing reconciliations
 Accounts receivable grows substantially faster than sales
 Growth in accounts payable substantially exceeds revenue growth
Warning Signs
 Majority of net income comes from one-time gains
 Operating expenses decline sharply relative to sales
 Company cash flows come primarily from assets sales, borrowings or
equity offerings
 Change in accounting principles and estimates
Warning Signs
 Numerous adjustments
 Key personnel going to work for vendors
 Lack of segregation of duties
 Inappropriate shipping costs
Warning Signs (Accounts Payable)
 Recurring identical amounts from same vendor
 Multiple vendors with similar names in accounting system
 Multiple remittance addresses for same vendor
 Vendor addresses don’t agree with application
Warning Signs (Accounts Payable)
 Sequential invoice numbers from same vendor
 Lack of segregation of duties:
 Process invoices & updates to vendor master file
 Check preparation & posting to vendor account
 Check preparation & mailing signed checks
Warning Signs (Accounts Payable)
 Excessive credit adjustments to specific vendor
 Systematic pattern of adjustments for goods returned
 Paid invoices not properly canceled
 Unrestricted access to blank checks, signature plates, and checksigning equipment
Warning Signs (Inventory/Production)
 Fluctuations in inventory accounts between months (e.g. debit
balance one month, credit balance the next)
 Excessive inventory write-offs without documentation or approvals
 Unrestricted access to inventory storage areas
Warning Signs (Inventory/Production)
 No segregation of duties:
 Receipt of inventory & issuing of materials
 Recording of inventory accounts & ordering materials
 Identification of obsolete & surplus materials and sale/disposal of
such materials
Warning Signs (Inventory/Production)
 No policy on identification, sale, and disposal of obsolete and surplus
materials
 No policy on inventory levels to be maintained (i.e., minimums,
maximums, reorder points)
 Lack of regular physical inventories by independent personnel
Warning Signs (Inventory/Production)
 Consistent production overruns beyond sales demand and backlog
orders
 Excessive production waste, spoilage, or other loss of raw materials
 Extended delay of good marked “for shipment” maintained within
shipping area
Warning Signs (Accounts Receivable)
 Lack of policies regarding write-offs
 No supervision or review of write-offs
 Duties of posting to accounts & receiving cash not segregated
Warning Signs (Accounts Receivable)
 Frequent undocumented or unapproved adjustments, credits, and
write-offs
 Dramatic increase in allowance for doubtful accounts
 Reluctance to reserve for or write off accounts receivable
Warning Signs (Accounts Receivable)
 Accounts receivable increasing or decreasing in a way not in accord
with changing sales figures
 Unexplained deterioration in collection cycle
Warning Signs (Construction Projects)
 One company repeatedly wins contracts
 Competitors continually submit bids that are unreasonably high, late,
or are disqualified
 An exclusive, consistent group of contractors bids on projects, and
winning bidders appear to be on rotation basis or follow a particular
pattern
Warning Signs (Construction Projects)
 Bids submitted by contractors are vastly higher than on similar jobs by
the same vendor
 Successful bidders subcontract work to competitors that submitted
excessive, unreasonable bids for the same job
 Bid paperwork submitted by various vendors contains similarities or
even identical items
Warning Signs (Construction Projects)
 Bidders who are qualified and capable of bidding do not bid
 Winning vendor is always the last to bid
 Numerous or large dollar change orders
Change Orders
Estimate
Low Bidder
Actual Cost
Claims
$1,500,000
$860,000
$5,200,000
$15,000,000
Contractor tried to recover cost overruns by using inflated
change orders:
134 change orders:
 Average contractor proposal: $50,000
 Average negotiated amount: $15,000
Warning Signs (Construction Projects)
 Certain contractors always bid against each other or never bid
against each other
 New vendors receive disproportionate number of winning bids
 Refusal to produce records, files or documents
SEC Report of Investigation (“Madoff”)
 The SEC focused its investigation too narrowly.
 The SEC did not seek records from an independent third-party, but
sought copies of such records from Madoff himself.
 The teams assembled were relatively inexperienced.
 There was insufficient planning for the examinations.
 No significant attempts made to analyze the numerous red flags.
SEC Report of Investigation (“Madoff”)
 Even when Madoff’s answers were seemingly implausible, the SEC
examiners accepted them at face value.
 The relatively inexperienced staff failed to appreciate the significance of
the analysis in the complaint, and almost immediately expressed
skepticism and disbelief.
 When Madoff provided evasive or contradictory answers to important
questions in testimony, they simply accepted as plausible his
explanations.
 They conducted their examination by simply asking Madoff about their
concerns and accepting his answers.
SEC Report of Investigation (“Madoff”)
 Madoff was the examiners primary contact and he carefully controlled to
whom they spoke at the firm.
 Examiners had a real difficult time dealing with Madoff as he was
described as growing increasingly agitated during the examination, and
attempting to dictate to the examiners what to focus on in the
examination and what documents they could review.
 Never verified Madoff’s purported trading with any independent third
parties.
• Madoff records indicated $2.5 billion in 100 equities – third party records
showed less than $18 million worth of equities.
SEC Report of Investigation (“Madoff”)
Shortly after the Madoff Enforcement investigation was effectively
concluded, the staff attorney of the investigation received the
highest performance rating available at the SEC, in part, for her
“ability to understand and analyze the complex issues of the
Madoff investigation.”
Fight Fraud – Who’s Responsible?
 Strong controls against fraud are the responsibility of everyone in the
organization.
 All levels of staff, including management, should have a basic
understanding of fraud and be aware of the red flags.
Source:
Managing the Business Risk of Fraud: A Practical Guide
(sponsored by IIA, AICPA, and ACFE)
Leverage Technology
 Vendors and employees with the same address (34 instances)
 Checks issued before invoice dates (45 instances)
 Vendors with no activity for a 2-year period (1,800 instances)
Leverage Technology
 Checks with no payee addresses (130 instances)
 Sequential invoice numbers from the same vendors (1,000 instances)
 Multiple invoices from the same vendor on the same date (4,500
instances)
Leverage Technology
 Missing check numbers (8,300 instances)
 Recurring identical amounts for the same vendors (630 instances,
ranging from 2 to 78 instances)
 Checks processed on Saturdays or Sundays (2,100 instances)
Contact Information
Don Mullinax
Shareholder
Forensic/Strategic Solutions, PC
2272 Colorado Blvd., Suite 1347
Los Angeles, CA 90041
213-617-1301 (office)
626-372-3657 (cell)
don@forensicstrategic.com