Fraud Examination, 3E

Chapter 5: Recognizing Symptoms of Fraud

COPYRIGHT © 2009 South-Western, a part of Cengage Learning

Learning Objectives• Understand how symptoms help in the

detection of fraud.• Identify and understand accounting

symptoms of fraud.• Describe internal controls that help detect

fraud.• Identify and understand analytical

symptoms of fraud.

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Learning Objectives• Explain how lifestyle changes help detect

fraud.• Discuss how behavioral symptoms help

detect fraud.• Recognize the importance of tips and

complaints as fraud symptoms.

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Symptoms of FraudCan be separated into six groups: 1.Accounting anomalies2.Internal control weaknesses3.Analytical anomalies4.Extravagant lifestyle5.Unusual behavior6.Tips and complaints

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Elgin Aircraft CaseAccounting Anomalies– result from unusual processes or procedures

in the accounting system

Example:– the 22 phony doctors – checks were sent to the same two common

addresses

Why?– managers trusted the perpetrator completely – auditors merely matched claim forms with

canceled checks5

Elgin Aircraft CaseInternal Control WeaknessesExample:– Manager had not taken a vacation in 10 years– Employees never received payment

confirmations– Payments to new doctors were never

investigated or cleared

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Elgin Aircraft CaseAnalytical Anomalies– relationships in financial or nonfinancial data

that do not make sense

• 12 million be paid to only 22 doctors over a period of four years

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Elgin Aircraft CaseLifestyle SymptomsThe manager…– took the employees to lunch in a limousine,– lived in a very expensive house,– drove luxury cars,– wore expensive clothes and jewelry,– was “independently wealthy,”– inherited a large sum of money,– yet never took a vacation!

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Elgin Aircraft CaseBehavioral Symptoms– The manager had a “Dr. Jekyll and Mrs. Hyde”

personality– Her highs and lows had become more intense

and more frequent in recent months

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Accounting AnomaliesCommon anomaly frauds involve:• Irregularities in source documents • Faulty journal entries • Inaccuracies in ledgers

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Accounting AnomaliesIrregularities in Source DocumentsInclude the following:– Missing documents– Stale items on bank reconciliations– Excessive voids or credits– Common names or addresses of payees or

customers– Increased past-due accounts– Increased reconciling items– Alterations on documents

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Accounting AnomaliesIrregularities in Source DocumentsInclude the following (cont.):– Duplicate payments– Second endorsements on checks– Document sequences that do not make sense– Questionable handwriting on documents– Photocopied documents

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Faulty Journal EntriesFraud is hidden by using accounting language

Legal Expense .....................5,000Cash ...................……………5,000

English:“An attorney was paid $5,000 in cash”

Accounting:“Debit Legal Expense; Credit Cash”

Was the attorney really paid $5,000? 13

Faulty Journal EntriesFraud is hidden by increasing the expense account

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Assets = Liabilities + Owner’s Equity

Stock

Dividends

Revenues

Retained Earnings

Net Income

Expenses

Faulty Journal EntriesCommon journal entry fraud symptoms:• Journal entries without documentary

support• Unexplained adjustments to receivables,

payables, revenues, or expenses• Journal entries that do not balance• Journal entries made by individuals who

would not normally make such entries• Journal entries made near the end of an

accounting period 15

Inaccuracies in LedgersFraud symptoms relating to ledgers:• Ledger that does not balance– the total of all debit balances does not equal

the total of all credit balances• Master (control) account balances do not

equal the sum of the individual customer or vendor balances

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Internal Control WeaknessesInternal control fraud symptoms include :• Lack of segregation of duties• Lack of physical safeguards• Lack of independent checks• Lack of proper authorization• Lack of proper documents and records• Overriding of existing controls• Inadequate accounting system

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Analytical Fraud SymptomsAnalytical Fraud symptoms include:• Unexplained inventory shortages or

adjustments• Deviations from specifications• Increased scrap• Excess purchases• Too many debit or credit memos• Significant increases or decreases in

account balances, ratios, or relationships

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Analytical Fraud Symptoms• Physical abnormalities• Cash shortages or overages• Excessive late charges• Unreasonable expenses or reimbursements• Excessive turnover of executives• Strange financial statement relationships,

such as:– Increased revenues with decreased inventory– Increased revenues with decreased receivables

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Analytical Fraud Symptoms• Strange financial statement relationships,

such as (cont.):– Increased revenues with decreased cash flows– Increased inventory with decreased payables– Increased volume with increased cost per unit– Increased volume with decreased scrap– Increased inventory with decreased

warehousing costs

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Extravagant LifestylesExampleKay…• Embezzled $3 million from her employer• Bought a $500,000 or more home• Bought five luxury cars• Filled home with artwork and glass• Bought a boat• Paid cash to have yard landscaped• Served lobster flown in from the east coast

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Unusual Behaviors

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Guilt

Fear

Stress

Behavior Changes

• Insomnia• Increased drinking• Taking drugs• Unusual irritability and suspiciousness• Inability to relax• Lack of pleasure in things usually enjoyed• Fear of getting caught• Inability to look people in the eyes• Showing embarrassment around friends,

co-workers, and family• Defensiveness or argumentativeness• Unusual belligerence in stating opinions• Confessing (either to a religious leader,

psychologist, or other professional)

• Obsessively contemplating possible consequences

• Working standing up• Sweating• Increased smoking

Tips and Complaints

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Theft Act

Concealment Conversion

The Fraud Element Triangle

Who is in the best position to recognize fraud in each of these elements—Auditors or Company Employees? Company Employees

Tips and ComplaintsWhy are tips and complaints just symptoms?– Many tips and complaints turn out to be

unjustified– Difficult to know what motivates a person to

complain or provide a tip• Customers may feel taken advantage of• Employee may have malice, personal problems, or

jealousy• Spouses and friends may be motivated by anger,

divorce, or blackmail

– Individuals should always be considered innocent until proved guilt

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Tips and ComplaintsWhy people are hesitant to come forward:– Impossible to know for sure that a fraud is

taking place– Fear of being the whistle-blower– Intimidation by the perpetrator– Feel that squealing on someone is wrong– Not easy to come forward

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