ESSENTIALS of Corporate Fraud Tracy Coenen John Wiley & Sons, Inc. Thisbookisprintedonacid-freepaper.(cid:3)1 Copyright#2008byJohnWiley&Sons,Inc.Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedinanyformor byanymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,exceptaspermitted underSection107or108ofthe1976UnitedStatesCopyrightAct,withouteitherthepriorwritten permissionofthePublisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetothe CopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,MA01923,978-750-8400,fax978- 646-8600,oronthewebatwww.copyright.com.RequeststothePublisherforpermissionshouldbe addressedtothePermissionsDepartment,JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030, 201-748-6011,fax201-748-6008,oronlineathttp://www.wiley.com/go/permissions. 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FormoreinformationaboutWileyproducts,visitourwebsiteatwww.wiley.com. LibraryofCongressCataloging-in-PublicationData: Coenen,Tracy,1972- Essentialsofcorporatefraud/TracyCoenen. p.cm.—(Essentialsseries) Includesindex. ISBN978-0-470-19412-6(pbk.) 1. Corporations—Corruptpractices. 2. Fraud. 3. Fraud—Prevention. I.Title. HV6768.C642008 364.1603—dc22 2007045811 PrintedintheUnitedStatesofAmerica 10 9 8 7 6 5 4 3 2 1 Contents Preface xi Acknowledgments xiii 1 TheFraudProblem 1 2 PeopleWhoCommitFraud 25 3 RedFlagsofFraud 47 4 AssetMisappropriation,Bribery,andCorruption 71 5 FinancialStatementFraud 95 6 FraudDetectionandInvestigation 121 7 FraudPrevention 147 8 BestPracticesinFraudManagement 171 9 TheFutureofFraud 189 Index 201 ix Preface C orporatefraudcontinuestofascinatethemasses,yetcompanies as a whole have not been terribly effective in significantly decreasing the occurrence and cost of occupational fraud. While regulations have forced management to review policies and procedures, a wide-scale shift toward proactive fraud prevention has not occurred. Understanding the root causes of fraud and learning about the most effective fraud prevention techniques are critical to reducing theincidenceofcorporatefraud.Along-termreductioninemployee fraud is not achieved easily, yet a company that is committed to improving fraud prevention efforts can begin with some basic improvements. Thisbookisintendedforexecutives,attorneys,andauditorswho need a basic understanding of corporate fraud. It addresses some of thecausesoffraudandthecharacteristicsof thosewhocommitfraud. Thebookexamineswarningsignsoffraudwithincompaniesandthe process of conducting a corporate fraud investigation. It further discussesopportunitiesfor proactivefraudprevention, whichinclude educating employees and implementing polices and procedures spe- cifically designed to prevent fraud. xi Preface Thetopicoffraudisaddressedbroadly,asthebookisintendedto give an overview of fraud methods and results. Companies are best served by involving experienced anti-fraud professionals when they attempt to detect, investigate, and prevent fraud. xii Acknowledgments I offer my thanks to my family, friends, associates, and clients who have extended their support throughout my career. It has been quitearide,andtheyhavesupportedallofmyeffortsatmarketing, public relations, professional development, and growing my fraud investigation practice. Without them, I would not be where I am today, professionallyor personally. Aspecialthanks tothosewho lovemeunconditionallyandcheer meonthroughallof life’schallenges.Youhavemademestrongerand have encouraged me to strive for more. Thank you to Wiley for offering me this opportunity and for making the process so easy and enjoyable. xiii CHAPTER 1 The Fraud Problem After reading this chapter, you will be able to (cid:2) Understandtheresultsoffraudpreventioneffortsover the lastseveralyears. (cid:2) Identifythethreemaincomponentsof anyfraudscheme, traditionallyknownasthefraudtriangle. (cid:2) Discussthevariousactionscompaniestakeagainstthose whoperpetratefraudandthereasonswhytheydonotini- tiatecriminalprosecutions. Internalfraudatcompaniesisabigenoughproblemtobeconsidered an industry unto itself. It is estimated that organizations lose an aver- age of 5% of revenue annually to internal fraud, which equates to $652billioninlosseseachyearjustintheUnitedStates.1 1 The Fraud Problem Peopleoftenwonderwhysomuchfraudoccursandwhyitisnot caught sooner, thereby limiting the losses. The answer is simple. Companies have systems in place to help ensure that accounting transactions are recorded accurately and that proper procedures are followed. Companies have policies to guide the behavior of people whowouldgenerallystrivetoactinanethicalmanner,butoccasion- ally need rules to dictate their behavior. Those systems, procedures, and policies often work to catch errors and honest mistakes in the accountingprocess. However, when an employee is committing fraud, he or she is deliberately trying to thwart those systems and policies. The person is purposely circumventing the system, while at the same time at- tempting to conceal his or her actions. While systems, policies, and procedures may be reasonably good at bringing errors to light, they typically cannot and do not expose fraud. Fraud constitutes a pur- poseful disregard for the system and a deliberate attempt to violate that system for personal gain, and most companies’systems aren’t de- signedtostopthis. Therearealsothecompaniesthathaveinadequateor nonexistent systems to ensure accurate accounting records and financial state- ments. Those companies can barely keep adequate and reliable re- cords, even with honest employees. But if they can’t even ensure a basic level of accuracy, management will hardly be able to prevent, detect,andstopfraudfromwithin. Internal fraud itself is troubling. Companies entrust their emp- loyees with assets, information, and customers. Business cannot be done unless companies put trust in people to sell their products or services, deliver them, collect the money, and keep accurate records. 2 Progress? Employees must be charged with growing and managing the busi- ness, as well as doing what is in the best interest of the owners and the rest of the company. When those trusted people steal, it can be disheartening. Maybe even more troubling is the fact that so little of theproceedsoffraudareever recovered. A2006fraudsurveybyKPMG2foundthatin42%ofmajorfrauds, noneofthestolengoodsor moneywasrecovered.None.TheAssoci- ation ofCertified Fraud Examiners (ACFE) foundequally disappoint- ing results in its 2006 survey of fraud examiners. In 42% of internal fraud cases, there was no recovery of money or assets, and in 23% of cases, the recovery amounted to 25% or less of what was stolen.3 As bothofthesestudiesshow,closetohalfofinternalfraudvictimscannot count on recovering any of the proceeds of fraud, and another one- fourthwillrecoveronlyafractionofwhatwasstolen.Clearly,compa- niescannotandshouldnotexpecttorecoverfraudproceeds. P rogress? With the focus on fraud since the big cases of Enron, WorldCom, and Tyco, an important question is whether or not companies are making any progress in the fight against fraud. Has the focus on the fraud issue caused them to tighten controls and take swift action against perpetrators, or have companies remained largely complacent infightingfraud? The general consensus seems to be that companies have made some progress in protecting themselves against fraud, but still there hasnotbeenanoticeabledecreaseinfraudoverall.Somemightargue that the progress has not been swift enough, and that is why no real 3 The Fraud Problem results have been seen. It also may be that companies have been so focused on compliance with Sarbanes–Oxley, that most of the meas- urestakenaremerelyfor thesakeofcomplianceandnotdesignedfor true fraud prevention. Companies may think that they have im- proved in terms of fraud prevention and detection, but that self- assessment can often be overlyoptimistic. Until a marked decrease in fraud is seen worldwide, the idea that companies have been effective atreducingfraudisdubious. The ACFE conducted studies on fraud detection, investigation, andpreventionin1996,2002,2004,and2006.Ineachofthesestud- ies, Certified Fraud Examiners were asked to estimate the amount of revenue companies lose each year to internal fraud. In the 1996, 2002, and 2004 reports, Certified Fraud Examiners estimated that 6%ofrevenueswouldbelostbycompaniesasaresultofoccupational fraud and abuse. When applied to the U.S. gross domestic product, thatwouldtotal$600billionin20024and$660billionin2003.5 Fivepercentofrevenueswereestimatedtobelosttointernalfraud in2006,6a1%decreasefrompreviousestimates.Whenappliedtothe 2005U.S.grossdomesticproduct,thisisanestimated$652billionlost tooccupationalfraud.It’simportanttorememberthattheseparticular figures are all estimates and there is much room for error. The most important conclusion we can draw from these surveys is that profes- sional fraud investigators don’t think the instance of employee fraud hasdecreasedtoanygreatextentduringthepastseveralyears. And let us not forget that anyestimate of the total cost of fraud is justthat—an estimate.Thereisnowayforanyonetoknowtheexact total impact offraud, becausewe knowthat alot offraud goes unde- tected. All we are left to do is make educated guesses about the total 4