Business & Finance / Audits & Security M Fraud Prevention P oaS rt Lessons can be learned from major fraud cases. Whether the victim is a company, ssscam ah public agency, nonprofit, foundation, or charity, there is a high likelihood that mdle and Detection many of these frauds could have been prevented or detected sooner if early aor ir Red Flag warning signs had been identified and acted upon. Fraud Prevention f and Detection: Warning Signs and the Red Flag System will enable officers and directors, internal and external stakeholders, as well as outside analysts to F Warning Signs and the Red Flag System protect themselves and their organizations against fraud by effectively detecting, r analyzing, and acting on early Red Flag warning signs. Based on an empirically a tested strategy, the Red Flag System reflects the authors’ more than 100 years u combined experience in the investigation of fraud in high-profile, global cases in d North America, Africa, Europe, and the Far East. P Readers of this book will: r • Acquire a general awareness of the nature, characteristics, and e dynamics of fraud v • Understand the process for determining whether a fraud has e been committed n • Develop an understanding of enterprise risk management approaches t for fraud risk management, compliance risk management, and i managing the risk of fraudulent financial reporting—including an o understanding of the limitations inherent in these approaches n • Learn how to find Red Flag indicators of fraud or suspicious transactions in financial statements, budgets, and contracts a n • Know how to ensure that, once a Red Flag has been identified, appropriate action is taken d Fraud can lead to significant financial loss as well as bad press and publicity D with significant reputational impact for officers, directors, corporations, and their e stakeholders. This book’s no-nonsense approach empowers those charged with protecting organizations to stop these frauds before the organization’s livelihood t e is jeopardized or to mitigate damage when fraud has occurred. c Rodney T. Stamler t i o Hans J. Marschdorf K15323 n 6000 Broken Sound Parkway, NW Mario Possamai Suite 300, Boca Raton, FL 33487 ISBN: 978-1-4665-5454-2 711 Third Avenue 90000 New York, NY 10017 an informa business 2 Park Square, Milton Park www.crcpress.com Abingdon, Oxon OX14 4RN, UK 9 781466 554542 w w w. c r c p r e s s . c o m K15323 mech rev.indd 1 2/4/14 1:48 PM Fraud Prevention and Detection Warning Signs and the Red Flag System Fraud Prevention and Detection Warning Signs and the Red Flag System Rodney T. Stamler Hans J. Marschdorf Mario Possamai CRC Press Taylor & Francis Group 6000 Broken Sound Parkway NW, Suite 300 Boca Raton, FL 33487-2742 © 2014 by Taylor & Francis Group, LLC CRC Press is an imprint of Taylor & Francis Group, an Informa business No claim to original U.S. Government works Version Date: 20131112 International Standard Book Number-13: 978-1-4665-5455-9 (eBook - PDF) This book contains information obtained from authentic and highly regarded sources. Reasonable efforts have been made to publish reliable data and information, but the author and publisher cannot assume responsibility for the validity of all materials or the consequences of their use. The authors and publishers have attempted to trace the copyright holders of all material reproduced in this publication and apologize to copyright holders if permission to publish in this form has not been obtained. If any copyright material has not been acknowledged please write and let us know so we may rectify in any future reprint. 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Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com and the CRC Press Web site at http://www.crcpress.com CONTENTS Foreword xiii Bob Lindquist, FCPA, CFE The Authors xv 1 An Introduction to the Red Flag System 1 A Persistent Threat 1 The Red Flags of Fraud 4 Defense in Depth 7 Can You Rely on Regulators or Law Enforcement? 9 About This Book 12 2 Fraud 101: A Primer 15 Introduction 15 What Is Fraud? 15 The Elements of Fraud 16 Criminal Fraud and Civil Fraud 17 What Is Criminal Fraud? 17 What Is Civil Fraud? 18 Conspiracy 19 Conclusion 20 3 The Dynamics and Root Causes of Fraud 21 Introduction 21 Who Commits Fraud? 21 The Fraud Triangle and the Fraud Diamond 22 The Fraud Triangle 22 The Fraud Diamond 23 The Underlying Dynamics of Fraud 23 The Fraudster’s Motivation 24 The Fraudster’s Rationalization 25 Environmental Indicators 25 Conclusion 27 v Contents 4 The Red Flag System 29 Introduction 29 What Is a Red Flag? 29 The Red Flags of Fraud 32 The Four Phases of the Red Flag System 33 Phase 1—Screening for Red Flags 33 Phase 2—Scrutinizing for Red Flags 34 Phase 3—In- Depth Examination 34 Phase 4—Formal Reporting/ Referral 35 Conclusion 35 5 Financial Statement Fraud 37 Introduction 37 What Is Financial Statement Fraud? 37 Scope and Extent of Financial Statement Fraud 38 What Are Financial Statements? 40 What Are the Most Frequent Types of Financial Reporting Fraud? 41 What Is the Motivation for Financial Reporting Fraud? 42 How Is Financial Reporting Fraud Usually Perpetrated? 42 Introduction 42 How Are Net Assets Typically Manipulated? 43 How Are Fixed Assets Typically Manipulated? 43 How Is Inventory Typically Manipulated? 46 How Are Accounts Receivable Typically Manipulated? 47 How Is “Cash in the Bank” Typically Manipulated? 47 How Are Liabilities and Accrued Liabilities Typically Manipulated? 48 How Are Sales Typically Manipulated? 49 How Are Expenses Typically Manipulated? 50 How Are Notes to Financial Statements Typically Manipulated? 50 How Are Management Discussion and Analysis Reports Typically Manipulated? 50 Conclusion 51 6 Red Flags for Financial Statement Fraud 53 Introduction 53 Types of Financial Statement Fraud Red Flags 53 Behavioral Red Flags 54 Situational Red Flags 54 vi Contents Organizational Red Flags 55 Financial Red Flags 56 Transactional Red Flags 56 Empirical Evidence: Red Flags in Financial Statement Fraud Cases 57 Prevention versus Detection 58 Preventing Financial Statement Fraud 58 Reduce the Situational Pressures That Encourage Statement Fraud 60 Reduce the Opportunity to Commit Financial Statement Fraud 61 Reduce Rationalization of Fraud—Strengthen Employee Personal Integrity 61 Conclusion 62 7 Procurement Fraud 63 Introduction 63 Overview of Procurement Fraud 63 Types of Contracts 64 Competitive and Noncompetitive Contracts 65 Methods for Pricing Procurement Contracts 66 Procurement Methods 66 Stages of Procurement Contracts 67 Requirements Definition Stage 67 Key Control Features for the Requirements Definition Stage 68 Bidding and/ or Selection Stage 68 Key Control Features in the Bidding and/ or Selection Stage 69 Contract Performance and Evaluation Stage 69 Key Control Features in the Performance and Evaluation Stage 70 Conclusion 70 8 Procurement Fraud Methods and Red Flags 71 Introduction 71 Procurement Fraud and Its Red Flags 71 Procurement Manipulation Schemes 72 Collusive Bidding or Bid Rigging 72 Red Flags of Collusive Bidding or Bid Rigging 73 Red Flags Indicating Corruption and Bribery in the Collusive Bidding Process 74 Contract Splitting 79 Contract Bundling 80 Red Flags That Identify Billing Schemes Suggesting Corruption, Fraud, and Theft in the Procurement Process 81 vii Contents False Representations 83 Front- End Loading or Advance Payment Fraud 84 Information Theft 84 Local Purchase Order or Split Purchases 85 Phantom Contractor 85 Product Substitution 86 Progress Payment Fraud 86 Purchases for Personal Use 86 Time Limitations and Restricted Advertising 86 Unnecessary Purchases 87 Conclusion 88 9 Bribery and Corruption 89 Introduction 89 Economic Impact of Bribery 90 Negative Impact of Corruption at the Global Level 90 Negative Impact of Corruption—Internal 91 Bribery of Public Officials 92 Components of Antibribery Laws 94 Bribery as a Criminal Offense 94 Corporate Criminal Liability versus Individual Criminal Liability 95 Legal Entity View versus Conglomerate View 96 Criminalization of Facilitation Payments 96 Application of Antibribery Laws 96 Definition of a Public Official 97 Extent of Monetary Penalties 97 Money Laundering to Conceal Corrupt Payments 99 Secret Commissions or Bribes to Nonpublic Officials 100 Secret Commissions as a Criminal Offense 102 Schemes Used to Pay Unlawful Benefits 104 Bribes Paid with Funds under Direct Control of the Corporation— Using Secret Off- Book Funds 106 Using Lawyers to Channel Corrupt Payments to Public Officials or Private- Sector Decision Makers 108 Arrangements with Foreign Agents and Consultants 112 Using Local Importers in Foreign Jurisdictions 113 Bribes Paid with Funds under the Control of Intermediaries 114 Using Foreign Subcontractors or Joint Venture Partners to Pay the Bribe 114 viii Contents Directors’ Obligations 115 Conclusion 116 10 Fraud and Money Laundering 117 Introduction 117 The Koop Fraud 117 Development of Money Laundering Laws 118 What Is Money Laundering? 121 Fraud and Money Laundering 123 Creating and Operating Undisclosed or Offshore Corporations 124 Creating and Operating Undisclosed or Offshore Trusts 124 Creating and Operating Undisclosed or Offshore Bank Accounts 124 Undisclosed Insider Beneficial Relationships 125 Creating Fictitious Records to Enhance this Offshore Activity 125 Conclusion 125 11 High- Risk Corporate Activities and Market Manipulation 127 Introduction 127 High Risk with Start- Up Corporations 127 Market Manipulation 128 Market Manipulation and Start- Up Corporations—Red Flags 133 Conclusion 134 12 Pyramid Schemes 135 Introduction 135 Charles Ponzi 136 Bernard L. Madoff 138 Holiday Magic 139 Kubus 140 The Bennett Funding Group 141 Why Pyramid Schemes Are a Concern 141 Red Flags—Pyramid Schemes 142 13 Fraud and the Absence of Good Governance 145 Introduction 145 Governance and Good Governance 146 ix