Fraud detection Techniques
Fraud Detection: Overview
Detection of fraud is challenging, particularly when frauds involve material financial statement misrepresentations, which occur only in approximately 2 percent of all economic statements. Fraud is usually covered and often occurs through teamwork. Generally, the documents supporting omitted transactions are not preserved in company files. False documents are often created or genuine documents are changed to support false transactions. While fraud detection procedures will not recognize all fraud, the use of thorough techniques can increase the probability that misstatements or misrepresentations will be discovered on a timely basis.
Auditors must know where to look for fraud detection. Understanding the incentives of those committing fraud and knowing in which financial records fraud is more likely to exist based on a risk evaluation helps find the areas that might be subject to maximum analysis. Likewise, being aware of the categories of transactions that permit further review, as well as other possible red flag displays, may alert auditors to areas that might need a closer look. Precise detection techniques discussed in this chapter comprise carrying out logical procedures, using random audit tests, observing and checking, doing investigations, and directing interviews. While these procedures may be implemented regularly in the development of a financial statement audit, dealing them with the mind-set of professional disbelief and with better understanding of the different types of fraudulent schemes may make the distinction between noticing and not noticing fraud. This section also discusses the significance of continually bringing together all of the evidence obtained through the use of these detection practices and assessing the danger of fraud on the basis of such evidence.
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The detection techniques described in this unit-including techniques operated as a regular part of audits-depend on on certain procedures and approaches to attain the preferred result of detecting fraud. These important procedures and methods include the following:
Accomplish all procedures with an approach of professional suspicion.
Consider deception techniques during the evaluation of documents, including the possibility of false documents.
Carefully understand and be alert to possible red flags that are probable indicators of abnormalities and likely indicators of areas requiring further examination.
Request more documentation in accomplishing audit responsibilities. Trust but confirm.
Laying a Foundation for Detection
An auditor's capability to detect fraud may be considerably improved by personal understanding of an enterprise and the surroundings in which he/she works. With this information, the auditor may be better able to recognize abnormalities or other possible red flags such as illogical analytic associations, control flaws, transactions that have no obvious business purpose, associated parties, and unpredicted financial performance. It is significant to understand the business, the control measures in place, the accounting process, the accounting strategies, the industry, and the overall economic environment affecting the company.
To understand the business, and how it makes cash, it is essential to identify the main business partners (clients, dealers, and so forth) and understand the corporate principles and administrative organization. To comprehend the industry, auditors might recognize competitors or comparable companies, decide how the competitors and comparable companies work, study changes in the competitive structure such as fusions and new competitors to the marketplace, alterations in the company's market share, and developments and overall concerns affecting the business. SAS 22 offers additional guidance on gaining knowledge about an entity's industry and its related industry. Such information provides a critical basis for the estimation of the evidence obtained through the techniques described later.
Evaluating the Risk of Fraud
Some level of doubt and risk present in any financial statement audit. For example, there may be doubt about the capability of organization and the accounting employees, about the efficiency of internal controls, about the excellence of evidence, and so on. These suspicions or risks are commonly classified as inborn risks, control risks, or detection risks.
Measuring the amount of danger present and recognizing the areas of highest risk are serious primary steps in identifying financial statement fraud. The auditor specially estimates fraud risk factors. Identification of the conditions that could increase the possibility of fraud, and other risk factors, should help in this evaluation.
Fraud Risk Factors
Always on Time
Marked to Standard
SAS 99 described fraud risk types that auditors may estimate in evaluating the risk of fraud. The 3 main types of fraud risk factors correlated with fraudulent financial reporting are management, industry, and operating characteristics together with financial stability.
• Management characteristics refer to to management's capabilities, pressures, style, and approach as they have to do with internal control and the financial reporting process. These characteristics consist of management's interest to involve in fraudulent financial reporting-for instance, compensation depending on achieving aggressive financial objectives; excessive contribution of nonfinancial organization in the selection of accounting values or estimates; high incomings of senior administration, counsel, or board members; tense relationship between administration and external auditors; and any known history of securities abuses.
• Industry characteristics are related to the financial and regulatory environment in which the entity functions, which range from constant features of that environment to altering features such as new accounting or regulatory necessities, greater than before competition, marketplace saturation, or implementation by the company of more forceful accounting policies to keep step with the industry.
• Operating characteristics and financial stability cover items such as the nature and complication of the object and its transactions, the environmental areas in which it functions, the number of localities where transactions are noted and payments are made, the entity's economic condition, and its productivity. So, the auditor would search for potential risk factors such as noteworthy pressure on the company to obtain more assets, fears of economic failure, or unfriendly takeover.
The two major types of fraud risk factors related to asset misuse are vulnerability of assets to misuse and competence of controls.
• Susceptibility of assets to misappropriation states to the kind or type of an entity's assets and the amount to which they are prone to theft or a deceitful scheme. An industry with stocks or fixed possessions that include stuffs of small size, high worth, or high demand often is more vulnerable, as is a company with easily exchangeable assets such as computer chips, diamonds or large quantities of cash receipts or cash on hand. Cash misuse is also included in this category through deceitful schemes such as dealer fraud.
• Adequacy of controls mentions the capability of controls to prevent or identify misappropriations of assets, due to the design, application, and observing of such controls.
Revisiting the Fraud Triangle
In the background of this conversation of potential red flags, it is sensible to reconsider the concept of the fraud triangle.
Incentive and pressure
Rationalization and attitude
Incentive and Pressure
Management or other staffs may find themselves offered motivations or placed under stress to do a fraud. When, for example, payment or development is significantly affected by individual, departmental, or company performance, individuals may have a motivation to influence results or force others to do so. Pressure may also come from the impractical beliefs of stockholders, banks, or other sources of finance. Few risk factors are carefully measured in the assessment of whether or not the business is at a greater or lesser degree of risk, owing to motivations or pressures that could possibly lead to measurable misstatements.
These risk factors include:
Situations that threaten the productivity or financial constancy of the business
Excessive pressure on management to meet or go beyond the expectations of third parties, including financiers and investors
Important threats to the private money of organization as a result of the performance of the business
Excessive internal pressures on divisional or departmental management forced by the board of directors or senior management
An effort to keep the company's listing on a stock exchange or debt rating
Inability to meet debt bonds or satisfy conditions in union or acquirement agreements
Motivation/incentive and pressure can take different forms in an organization: bonuses and incentive paid on behalf of a large portion of an employee or group's payment; triggers made into debt contracts linked to share price marks and levels; important stock option awards all through the organization but predominantly to upper management; and violent earnings-per-share and revenue objectives set by top management and spoke to analysts, investment bankers, and other market contributors, with subsequent pressure from these groups.
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With concern to the risk of material misstatement due to ill use of assets, the risk factors are:
Individual financial problems that might boost an individual to misuse assets
Adverse relationships between the entity and its employees, which might generate feelings of hatred or unfaithfulness. Individual pressures have increased meaningfully in recent decades as stock opportunities turn into a common way of compensating and encouraging management.
Defining the existence and degree of these pressures or motivations is part of the auditor's aim in assessing the risk that misstatements in line for to fraud may have occurred. Remember that some people will go to surprising lengths to satisfy their needs. The capability to satisfy those desires through incorrect measures is increased if the other constituents of the fraud triangle are present.
Conditions may be present that make opportunities for management or other employee to commit fraud. When such chances arise, those who might not otherwise be motivated to behave deceitfully may be drawn to do so. Even characters under pressure and prone to incentives to commit a fraud are not a serious danger to an organization except when a chance exists for them to act on their need. A chance must be present to commit fraud, and the cheater must believe the fraud can be committed with freedom. Absent or unsuccessful controls, lack of command, or inadequate assignment of responsibilities may offer such opportunities.
Chances may also be present in the nature, size, or structure of the business. Specific types of transactions provide themselves more opportunities than others to misrepresentation or manipulation, as do certain types of balances or accounts. There are certain corporate and group structures that may be more vulnerable and susceptible to abuse. And certain types of asset are more likely to be misuse. Risk factors revealing the opportunities that could lead to material misstatements as a result of falsified economic reporting comprise:
Aspects related to the type of the industry in which the object is working, the nature of the object's business and the transactions it enters into, and the way in which they are recorded in the profit-and-loss account or balance sheet.
The kind of the object's dealings with clients and suppliers and its position in its markets: the capability to control or order terms may create the opportunity for incorrect or non-arm's-length transactions.
The extent of judgment involved in defining the level of income or expenses or the estimation of assets or responsibilities: Normally, a higher amount of judgment will give rise to a greater opportunity for thoughtful manipulation.
The extent and efficiency of administration of senior management by liberated corporate governance functions such as the nonexecutive directors, audit committee, and administrative boards.
The grade of complexity and constancy of the object or group.
The general control environment, containing the continuity and efficacy of internal audit, information technology, and accounting employees as well as the efficacy of accounting and reporting structures.
In numerous large financial statement fraud cases, opportunity is present by advantage of administration's role in the internal control structure and its capacity to dominate or avoid existing controls. With concern to the risk of material misstatement resulting from stealing of assets, the risk factors best characterized as related to opportunity can be concise as follows:
Vulnerability of fixed assets, records, or other assets to misuse, depending on such variables as value, demand, transportability, and convertibility
Flaws in the controls designed to protect assets, such as command, assignments of duties, employee screening, physical controls, settlements, and other accounting controls
Rationalization and Attitude
Some individuals are more susceptible to than others to do fraud. Other things being equal, the tendency to commit fraud depends on people's moral values as well as on their personal surroundings. Ethical behaviour is inspired both by a person's character and by external influences. External factors may comprise job insecurity, such as during a economizing, or a work environment that inspires offense, such as being neglected for promotion. The external environment also includes the attitude at the top-the approach of management toward fraud risk and management's responses to actual occurrences of fraud. When fraud has happened in the past and management has not reacted properly, others may interpret that the matter is not taken seriously and they can take advantage of it.
Risk factors that included into this type of justification and attitude are typically the least noticeable or determinate, and many are by nature difficult for an auditor to observe or otherwise discover. Basically, rationalization and attitude are purposes of the culture of an organization, the mind-set of those who work in it, and the statements between the two-for example, the level of employee devotion to the company. The wider business environment must also consider: hard times in a company or in the overall economy may make it easier for some individuals to justify fraud. Risk factors to look for, in this slightly vague but critically significant category, include:
Lack of clearness or communication about corporate principled values or occasional communication and strengthening of such values
Ignore for the risk of fraud-or useless measures when fraud rises
Lack of practicality in budgeting and estimating and in communicating expectations to third parties
Frequent efforts by management to defend incorrect accounting or disclosure strategies and practices on basis of materiality or other grounds
Difficult relationships with the entity's auditors: a victimization attitude, obligation of unreasonable time pressure, or restrictions on access to relevant audit evidence
Most frauds are started small and build with time. Most of the people can easily justify small violations such as using the office phone for private long-distance phone calls or supplying their home with goods from the company supply cabinet-and the auditor will definitely come into contact with individuals who are capable of these explanations. These justifications can be simple, even for a complicated financial crime.
Some of the most frequent rationalizations are the following:
• It is just temporary.
The firm will do better in next session and the act can be reversed. Nobody will ever know.
It is actually not a fraud, if I change this record one month and then reverse it the next? At the end, it will be cleared and no one's hurt. The organisation stays in compliance with debt contracts, and we make our bonus payments.
• Management does not care.
Management does not truly observe internal controls.
Management does not correct known shortages in controls.
Management does not correct this kind of conduct.
• Management take part in, expects, and rewards this kind of behaviour.
Management has pass in into certain transactions only for the purpose of meeting particular reporting purposes.
Management traditionally uses forceful accounting policies, and we need to remain steady with prior periods.
The individuals being promoted helped the company accomplish its purposes without concern to the means of reaching there.
Risk taking is being rewarded. We are cowboys-but nobody is permitted to say that anymore.
• No one is offended and the company is helped.
It is not significant to the company as a whole. But it makes a vast difference to our takings from the public offering.
• I deserve this.
I was appropriate for the promotion I earned.
I'm paid at less than the market rate for my responsibilities and the price I provide.
The company has no faithfulness to its employees; I'm likely to be put down soon.
This is in favour for the benefits the company.