PwC

“Good” Fraud? Transforming Risk into Opportunity

Jonny FrankFraud Risks & Controls

March 2010

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Should We have Drunk Something Harder than Wine?

Recession Driven Incentives, Pressures and Opportunities

+

Ever Increasing Legal & Regulatory Requirements

+

New Professional Standards and Frameworks

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Market and Management Expectations

=

INCREASED RISK

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Should We be Drinking Champagne?

Maximize Revenue & Reduce Leaks

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Cut Costs

+

Safeguard Assets

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Protect Brand Value and Professional Reputation

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Avoid Criminal, Civil and Legal Liability

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Enhance Finance & Internal Audit Prestige =

INCREASED OPPORTUNITY

Some Numbers to Consider…

• US government admits losing 10% of spending to fraud

• ACFE estimates that companies lose $1 trillion or 7% of revenue to misconduct

• PwC GECS survey–40% increase in fraud - - before the recession–Controls paradox

• Economist Intelligence Unit survey revealed that 85% of companies detected significant frauds over past 3 years

–Small companies - $8.2 million average loss–Large companies - $23 million–10% suffer >$100 million

• Effective fraud management produces an 8:1 ROI for financial services industry (Tower Group)

• US government realizes a $9.75:1 return on fraud management

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Fraud Reporting Trends

Source: PwC Global Economic Crime survey, 2009 Source: ACFE report to the nation (US only), 2008

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Fraud Detection Trends

Source: PwC Global Economic Crime survey, 2009

Fraud Detection:

• Informal Tip offs are the most likely source of detecting fraud

• Only 7% of frauds were detected through formal whistle-blowing procedures

• Internal audit remains another key source for detecting frauds

• Fraud Risk Management programs are becoming increasingly effective in raising fraud awareness and detecting fraud

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Management Response Trends

Management Response:• High reliance on internal audit• Continued focus on control

environment• Low emphasis on forensic technology

Internal Audit's Role in Assessing and Responding to Fraud Risk 7

Reported Fraud by Country or Region

Sources: PwC Global Economic Crime survey, 2009and Transparency International

* the lower the score, the greater the prevalence of corruption in the country

Territories thatreported high levels of fraud (40% or more)

% of Companies surveyed that experienced a fraud event in the last 12 months

TICPI * Score

Russia 71% 2.1

South Africa 62% 4.9

Kenya 57% 2.1

Canada 56% 8.7

Mexico 51% 3.6

Ukraine 45% 2.5

UK 43% 7.7

New Zealand 42% 9.3

Australia 40% 8.7

Territories thatreported high levels of fraud (20% or less)

% of Companies surveyed that experienced a fraud event in the last 12 months

TICPI Score

Italy 19% 4.8

Sweden 19% 9.3

Singapore 18% 9.2

India 18% 3.4

Indonesia 18% 2.6

Switzerland 17% 9.0

Finland 17% 9.0

Romania 16% 3.8

Netherlands 15% 8.9

Turkey 15% 4.6

Hong Kong 13% 8.1

Japan 10% 7.3

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Climate of Risk for Fraud and Waste

If Economic Downturn is the “Perfect Storm” for Fraud and Waste, will an Upturn be Even More Perfect?

Incentives/Pressures• Job security• Bonus and other compensation • Power & prestige

Rationalization• Job dissatisfaction• Family & health priorities• “Everybody else” syndrome• Self-denial about

consequences• Belief that “I won’t get

caught”

Opportunity• Reduced headcount,

travel restrictions and other cost containment measures

• Collusion• Override

Creating Value While Meeting Standards: "Leakage” vs. “Liability” Fraud

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

Assets

Expenditure Leakage

Misappropriation of Assets

Revenue Leakage

Good Fraud = Leakage related activities, that when prevented or detected early, leads to improved financial results

Bad Fraud = Liability related activities, that if not prevented, leads to government sanctions, and damage to brand value and reputation of individual members of the Board and senior management

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Leakage vs. Liability Risk: Revenue Leakage

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

Assets

Expenditure Leakage

Misappropriation of Assets

Revenue Leakage

Illustrations:• Salesperson discounts price in return for

kickback

• Business leader runs parallel business

• Salesperson violates non-compete clause after leaving company

• Salesperson enters side agreement with customer unable to make payment, ultimately resulting in write off of receivable and/or debt

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Leakage vs. Liability Risk: Misappropriation of Assets

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

Assets

Expenditure Leakage

Misappropriation of Assets

Revenue Leakage

Illustrations: • Employee steals liquid assets

• Salesperson steals customer list for use at a competitor

• Event planner receives 15% “commission” on rooms

• HR employees puts shadow employee on payroll

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Leakage vs. Liability Risk: Expenditure Leakage

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

AssetsExpenditure Leakage

Misappropriation of Assets

Revenue Leakage

Illustrations: • Orders from fictitious vendor• Kickbacks in return for allowing supplier

to inflate price• Advertiser charges for advertising not

delivered• Vendors/contractors charge for work not

performed • “Double dips” on p-card and credit card• Salesperson obtains reimbursement for

fictitious travel expenses

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Leakage vs. Liability Risk: Unauthorized Expenses / Disposal of Assets

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

Assets

Expenditure Leakage

Misappropriation of Assets

Revenue Leakage

Illustrations: • Payments to public officials for permits

• Payments to public officials for patents

• Gifts to public officials to evade taxes

• Payments to agents to facilitate sales

• Illegal political contributions

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Leakage vs. Liability Risk: Unauthorized Receivables / Acquisition of Assets

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

Assets

Expenditure Leakage

Misappropriation of Assets

Revenue Leakage

Illustrations:• Overbilling customers

• Antitrust and restraint of trade

• Improperly obtaining rebates

• Marketing devices for off label use

• False marketing statements

• Overcharging customers

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Leakage vs. Liability Risk: Financial Reporting & Disclosure Manipulation

Financial Reporting & Disclosure

Manipulation

Unauthorized Receivables / Acquisition of

Assets

Unauthorized Expenses / Disposal of

Assets

Expenditure Leakage

Misappropriation of Assets

Revenue Leakage

Illustrations:• Improper revenue recognition

• Manipulation of significant management estimates

• Inconsistent or improper accounting of intercompany transactions to improve operating performance of business units.

• Transactions with related parties on non-arms length terms

• False statements in MD&A

• Deceptive marketing

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So, What Steps are Organizations Taking to Maximize Opportunities & Minimize Risk?

People Build three lines of defense – business, finance and internal audit/complianceProcess Identify significant risks, evaluate vulnerability to collusion, monitor/audit for

red flags

Technology Disaggregate schemes into key risk indicators, develop data analytics, maximize available technology

• Board oversight• Codes of ethics/conduct• Anonymous reporting• Other entity level activities

Control environment

Entity and business process level control activities

Develop new/enhance existing controls

Validateoperatingeffectiveness

Evaluatecontrolsdesign

Monitoring activities

• Monitor fraud risk factors & indicators

• Audit for ‘Red flags’

Continuousreassessment

Develop a risk response

Fraud event identification and risk assessment

Conduct self-assessment at function & local businessunit levels

Assesslikelihood& impact

Identity entitylevel scheme& scenario risks

Incident response & remediation

• Investigate• Perform root cause analysis• Search for other misconduct• Enhance controls

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Identifying and Responding to High Impact Risks & Opportunities

Create

Inventory

Design & Operating Effectiveness

Monitor & Audit

Likelihood &

Significance

Factors &

Indicators

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Significant on-line reporting with drill-down capabilities

The Future of Fraud Management is Advanced Data Analytics and Forensic Technology

Suggested Next Steps

Everybody:• Play “Angels v. Demons” or host “A Perfect Crime Dinner”, and• Contact me for Fraud Case Digest.

Practitioners:• Assess how organization addresses fraud risk,• High impact “good” and “bad” fraud risks, and• Develop a strategy to identify, maximize and mitigate.

Students:• Consider a career in fraud auditing or forensic accounting,• Take specialized courses, e.g., Baruch Forensic Accounting

Certificate, and• Consider fraud aspects of courses in traditional curriculum.

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Questions & Discussion

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Facilitator Contact & Biographical Information

Jonny J. Frankjonny.frank@us.pwc.com

1.646.471.8590

Jonny Frank has over 30 years public and private sector experience and over 20 years university teaching experience in preventing, detecting and investigating business irregularities. He is an award winning author of over 30 articles and book chapters, including the IIA's Thurston Award for outstanding scholarship. Jonny earned his LLM from Yale Law School in 1983 and his JD from Boston College Law School in 1980, where he ranked no.1 in a class of 250 and graduated summa cum laude.

Executive Assistant United States Attorney, Eastern District of New York Jonny began his professional career as a Federal prosecutor in the early 1980s in the U.S. Department of Justice, where he served for 12 years. His prosecutorial career included investigating and prosecuting over 1,000 economic crimes cases involving Fortune 500 companies across every business sector. In the mid-1990s, the Justice Department appointed Jonny to serve as Special Counsel to the New York City Mayoral Commission on Police Corruption. He also led trips to train former Soviet bloc prosecutors and judges on the investigation of economic crime.

Co-founder, PwC Investigations PwC recruited Jonny to join the firm as a partner in 1997 to help develop and lead the firm's investigations practice. Leveraging this public sector experience, Jonny developed a global practice, focusing on investigation and remediation of fraud and corruption. Jonny led over 1000 engagements during his five years as practice leader.

Founder, PwC Fraud Risks & Controls (FR&C)Following Enron, PwC appointed Jonny to build and lead a practice devoted to prevention, detection, and remediation. The practice has professionals in Africa, Canada, Central, Eastern & Western Europe, India, South America, and the United Kingdom.

In 2003, Jonny pioneered PwC's "scheme and scenario" fraud risk assessment framework, which the SEC, AICPA, IIA, and COSO have embraced. FR&C have embedded this framework at numerous internal audit departments and finance functions, in addition to using it on over 1500 PwC audits.

Jonny also developed a fraud auditing training methodology, comprised of classroom and on-the-job coaching. PwC applied this methodology to train over 350 experienced audit managers to serve as fraud specialists on their engagements.

Yale School of Management, Fordham University, Brooklyn Law SchoolSimultaneous to his DOJ and PwC career, Jonny has taught for over 20 years at the professional school level. He serves as an Adjunct Professor of Law at Fordham University Law School (1988 – present) (ranked no. 3 nationally in evening law programs) and previously taught at Yale School of Management (Senior Faculty Fellow 2003 – 2006) and Brooklyn Law School (1089 – 2004).

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