Genesis of a Fraud Investigation and Major Types of Fraud

Detecting Fraud

Most fraud or forensic investigations begin with a suspicion of wrongdoing. The suspicion may be the result of a tip provided through a fraud reporting portal, an unexpected financial occurrence, a person internal to the Company (such as an owner, director or manager), or the result of an external audit. Steps will normally be taken to conduct a preliminary internal investigation. The purpose of the investigation is to determine whether there are fact patterns that indicate there may have been wrongdoing in the area(s) suspected, determine the possible method(s) employed, and attempt to quantify the questionable amounts involved.  It is shortly after the point of the preliminary internal investigation that we are typically called in for assistance. We are engaged to help prove a fraud for prosecutorial and recovery purposes, as well as to help defend an alleged fraud to eliminate or mitigate the monetary implications of any fraudulent activity.

Although many of the fact-finding steps performed are somewhat similar, it is important to differentiate the various types of frauds. The three major types of frauds, described below, are: (1) asset misappropriation, (2) financial statement misrepresentation, and (3) corruption or other illegal acts. Please keep in mind that one single fraud scheme may include all three major types of fraud.

Asset Misappropriation

Asset misappropriation refers to theft, embezzlement, or wrongful use of assets. Typically, it involves vendors and other third parties, as well as management and other employees entrusted to manage Company assets who abuse their position to steal through one or more fraudulent schemes.

In many cases, asset misappropriation is accounted for appropriately in the financial statements and does not result in financial statement misrepresentation. For example, inventory theft would likely be caught during variances identified during inventory counts. The inventory balance would be adjusted accordingly, and the financial statements would not be misstated. To the extent that the misappropriation becomes material, and remains unaccounted for in the accounting records, misappropriation may cause the financial statements not to be fairly presented in conformity with generally accepted accounting principles (GAAP).

Some of the more common types of fraud schemes involving asset misappropriation we have investigated include the following:

• Embezzlement (skimming, larceny, vendor fraud, investor fraud, ghost employees, kickback arrangements, employee expense reimbursements)
• Ponzi schemes
• Corruption or bribery schemes

Financial Statement Misrepresentation

Another area in which we may provide forensic accounting services is in the investigation of alleged financial statement misrepresentations. Different from other fraud schemes in which assets are suspected to have been misappropriated, financial statement misrepresentations may not have resulted in the loss of company assets or the addition of company liabilities. The losses generally associated with financial statement misrepresentations are those that may be claimed by lenders, creditors, investors, or shareholders who placed assets or loans with a company based on misrepresentations in the financial statements (or disclosure omissions). Another common damage related to financial statement misrepresentations may be in the form of additional compensation (bonuses) paid to executives because of meeting certain performance metrics that are ultimately found not to have been met.

Most of financial statement misrepresentation matters involve companies with financial statements that had been audited by an external independent audit firm. Many involve public companies, whose financial statements are required to be filed with the U.S. Securities and Exchange Commission (SEC).  Many investigations regarding claimed financial statement misrepresentation are initiated through inquiries or investigations (or both) conducted by the SEC or Department of Justice. Regardless of the initiation of the investigation, we may be retained by one or more parties to assist with the fact finding, data gathering and investigative analysis. Frequently, the external auditors will deploy a group to participate in the investigation in a “shadow” role. The shadow role exists so that the audit team receives satisfactory information about the investigation process and results to enable reliance as part of audit evidence. The external auditor does not typically lead the investigation due to the potential impairment of independence.

Generally, the misrepresentations are claimed in one or more of the four areas described as follows, although they may affect multiple areas:

• Income statement (misstated revenue, expenses, net income).
• Balance sheet (asset valuation, misstated liabilities, fictitious assets).
• Cash flow statement (misclassified finance versus operating cash flows).
• Notes to the financial statements, contingent liabilities, pending litigation, variable-interest entities, related party transactions).

Corruption and Other Illegal Acts

Corruption and other illegal acts include all other violations of laws or governmental regulations not covered in asset misappropriation or financial statement misrepresentation. There has been a new focus on corporate governance and enforcement of enacted legislation including the Foreign Corrupt Practices Act (FCPA), the Dodd-Frank Act, and the UK Bribery Act to cite a few. As forensic accountants we may serve several roles related to the prevention, monitoring, or investigation of claims related to corruption and bribery.

Some illegal acts may have a direct and material effect on the determination of financial amounts, such as payments of bribes to foreign officials in violation of the FCPA. Such payments may be mischaracterized in a company’s books and records as “consulting fees” or “”commissions” to conceal their illegal nature. Companies may also improperly deduct bribe payments for tax purposes in violation of US or foreign tax laws, resulting in the understatement of tax provisions and overstatement of reported net income. Failure to disclose material effects of bribe payments on a company’s revenues and profits may also violate other securities laws. Other illegal acts may be far removed from the books and records supporting the financial statements, such as violations of antitrust law. Such illegal acts could result in enforcement proceedings that prevent an organization from doing business in a market, region or service line. Although this type of enforcement action is further removed from the financial statements, it may represent a serious threat to the continued profitability and projected result of the business.

Proving Fraud

Our work in a forensic engagement does not include making a legal conclusion as to the existence of fraud or determining the liability for fraud. While we understand the legal elements, our work is based on an objective evaluation of evidence gathered. That evidence is presented to the client, insurance company or a trier-of- fact who may make legal conclusions as to the existence of fraud.

In proving fraud, the following primary elements must exist:

• Misrepresentation of a material fact,
• Knowledge that a statement is false,
• An act done with the intent to deceive,
• Reliance was placed on the false representation, and
• Damage was sustained as a result.

Preventing Fraud

There are many roles and services that we may provide in matters related to fraud prevention and corporate governance. Because of our specialized skills, experience, education, and training, we can provide valuable consulting services in this arena.  Corporate governance-related services include consulting related to the following:

• Fraud risk assessments.
• Fraud prevention through enhancements to the systems of internal controls.
• Development of anti-fraud programs.
• Monitoring and enhancing established compliance programs.
• Implementation of fraud reporting portals and other reporting systems.