13.1 Types and Characteristics of Fraud

Fraud comes in many forms, from asset misappropriation to financial statement manipulation. Understanding these types helps auditors spot red flags and prevent costly deception. The fraud triangle explains why people commit fraud, highlighting pressure, opportunity, and rationalization as key factors.

Fraud can devastate organizations, distorting financial statements and deceiving stakeholders. Beyond monetary losses, it can severely damage a company's reputation, leading to lost trust, legal troubles, and even bankruptcy in extreme cases.

Types of Organizational Fraud

Occupational Fraud

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• Involves an employee who misuses their influence in business transactions to gain a direct or indirect personal benefit, often causing detriment to the employing organization
• Three primary categories of occupational fraud:
  • Asset misappropriation
  • Corruption
  • Financial statement fraud

Asset Misappropriation and External Fraud Schemes

• Asset misappropriation schemes involve the theft or misuse of an organization's assets
• Examples of asset misappropriation schemes:
  • Larceny
  • Skimming
  • Check tampering
  • Billing schemes
  • Expense reimbursement schemes
  • Payroll schemes
• External fraud involves schemes perpetrated by individuals outside the victim organization
• Examples of external fraud:
  • Investment scams
  • Ponzi schemes
  • Phishing
  • Identity theft
  • Credit card fraud

Corruption and Financial Statement Fraud Schemes

• Corruption schemes involve an employee misusing their influence in business transactions to obtain an unauthorized benefit contrary to their duty to the employer
• Examples of corruption schemes:
  • Bribery
  • Illegal gratuities
  • Economic extortion
  • Conflicts of interest
• Financial statement fraud schemes are intentional misrepresentations or omissions of material information in the organization's financial reports
• Examples of financial statement fraud:
  • Overstating revenues or assets
  • Understating liabilities or expenses
  • Other misrepresentations in financial statements

Fraud Characteristics and Red Flags

Behavioral and Organizational Red Flags

• Behavioral red flags of fraud:
  • Employee living beyond their means
  • Employee experiencing financial difficulties
  • Employee having an unusually close association with vendors or customers
  • Employee displaying control issues or an unwillingness to share duties
  • Employee exhibiting irritability, suspiciousness, or defensiveness
• Organizational red flags of fraud:
  • Rapid employee turnover
  • Lack of mandatory vacations or job rotations
  • Inadequate internal controls or oversight
  • Unusual or complex transactions
  • Tone at the top that ignores or minimizes ethical behavior

Transactional and Analytical Red Flags

• Transactional red flags of fraud:
  • Missing or altered documents
  • Photocopied or missing receipts
  • Multiple payments to the same vendor
  • Invoices from fictitious vendors
  • Transactions that lack proper authorization or supporting documentation
• Analytical red flags of fraud:
  • Transactions conducted at unusual times or with unusual frequency
  • Unexplained accounting discrepancies or adjustments
  • Inconsistent or nonexistent reporting
  • Significant deviations from predicted amounts or ratios

The Fraud Triangle

Perceived Unshareable Financial Need (Pressure)

• The fraud triangle is a model for explaining the factors that cause an individual to commit occupational fraud
• Consists of three components which, together, lead to fraudulent behavior:
  • Perceived unshareable financial need
  • Perceived opportunity
  • Rationalization
• Perceived unshareable financial need (pressure) refers to the motivation or incentive that leads a person to commit fraud
• Examples of pressures:
  • Personal financial problems
  • Vices (gambling, drugs)
  • Unrealistic performance goals

Perceived Opportunity and Rationalization

• Perceived opportunity refers to the ability to execute the fraud without being caught
• Opportunities often arise from:
  • Weaknesses in internal controls
  • Lack of oversight
  • Fraudster's ability to override controls using their position or influence
• Rationalization is the justification of the fraudulent behavior as acceptable
• Perpetrators often view themselves as ordinary and honest people who are caught in bad circumstances
• Common rationalizations:
  • "I was only borrowing the money"
  • "I was entitled to the money"
  • "I had to steal to provide for my family"
  • "My employer is dishonest and deserves to be fleeced"

Impact of Fraud on Organizations

Financial Statement Distortion and Stakeholder Deception

• Financial statement fraud often results in the overstatement of assets or revenue and the understatement of liabilities or expenses
• Distorts the true financial position and performance of the organization
• Fraudulent financial reporting misleads investors, creditors, and other users of the financial statements
• Leads to inappropriate lending or investing decisions based on inaccurate information

Reputational Damage and Organizational Costs

• Reputational damage from fraud can be severe
• Consequences of reputational damage:
  • Loss of shareholder and stakeholder trust
  • Negative publicity
  • Increased regulatory scrutiny
  • Potential legal action against the organization and its management
• Discovery of fraud can lead to significant costs for the organization:
  • Legal fees
  • Forensic audits
  • Fines and penalties
  • Costs of remediation efforts to improve internal controls and restore reputation
• In extreme cases, fraud can lead to the failure of the organization (Enron, WorldCom, Satyam)
  • Fraudulent financial reporting and other unethical practices led to bankruptcy and dissolution of these companies