1.1 Definition of Fraud Fraud — An act of deception intended to secure personal gain for the person committing the fraudulent act ‘or to cause loss to someone else. Fraud is a criminal activity. Employees may commit fraud to make a dishonest gain from their employer. They may steal items from ‘stocks or make false expense claims. ‘person may commit fraud alone, but it can be more challenging to/detect when two or more people commit fraud together (Collision). This is known as collusion, 1.1.4 Types of Fraud We can divide fraud by employees or managers into two main types. + Asset misappropriation ‘Taking imioney or tier @8S6IS from the business dishonestly, such as making false expense claims. * Misrepresentation ‘Making false statements to deceive and disguise the truth. In particular, it may involve preparing misleading financial statements to deceive shareholders, lenders or regulators. This has happened in the case of several high-profile corporate failures. ‘The difference between fraud and error is: + An @fforis'an Unintentional mistake, usually through negligence or ignorance; whereas + Fraud is an intentional deception.Activity 1 Fraud or Error Classify the actions as fraud or error. Action Fraud or error ‘Alteration, falsification or manipulation of accounting records or documents, Ignorant application of inappropriate accounting policies. Collusion. Mathematical or clerical mistakes in collecting or processing accounting data Unintentional misapplication of accounting policies. Misappropriation of assets (ie. theft). ‘Oversight or misinterpretation of facts resulting in an incorrect accounting estimate. Purposeful recording of transactions without economic substance. ‘Suppression of effects of transactions from records or documents. Action Fraud or error ‘Alteration, falsification or manipulation of accounting records or documents. Fraud Ignorant application of inappropriate accounting policies. Error Collusion. Fraud Mathematical or clerical mistakes in collecting or processing accounting data, Error Unintentional misapplication of accounting policies. Error Misappropriation of assets (ie. theft) Fraud Oversight or misinterpretation of facts resulting in an incorrect accounting Error estimate. Purposeful recording of transactions without economic substance. Fraud ‘Suppression of effects of transactions from records or documents. Fraud4.2 Asset Misappropriation There are various ways in which individuals, acting alone or in collusion with someone else, can commit fraud by taking money or other assets dishonestly from their employer or other people or businesses, receive goods for personal gain Fraudulent activity | Description Example Theft Taking assets trom the Employees may steal cash from the business ‘company for personal gain or other @8Se18 such as materials, inventory or a laptop computer. Overstating COverstating claims to receive | Examples include an employee who claims ‘expense claims ‘more reimbursement than first-class business travel but travels second entitled class or for staying in an expensive four-star hotel but stays in a cheap budget hotel Fictitious customer | Creating fake customers to __| An employee makes a record for a new customer who does not exist and ‘sells’ goods to the ‘customer’ The employee receives the goods, and the Collusion with a customer ‘Working together to receive higher value goods than invoiced, ‘An employee may collude with a customer — for example, by sending an invoice for much less than the value of goods soldCollusion with a Working together with a supplier For example, paying the supplier for goods ‘that have not been delivered and receiving supplier to receive payment for non- existent supplies. part of the payment from the supplier. Disposal of Buying company assets for less | An employee buys an asset from the employer business assets for | than their fair value — such as a company car or a smartphone — less than their value for much less than its actual value ‘Teeming and Lading | Cash for invoice payment is ‘Cash marked for payment of invoice 0001 is taken, and payment to invoices Is delayed to conceal missing funds. stolen by an employee. To hide the fraud, the ‘employee uses money earmarked for payment of invoice 0002 to pay for invoice 0001 ‘The employee informs the customer of invoice (0002 that payment clearance is delayed,Example Teeming and Lading1.3 Misrepresentation of Information \Misrepresentation of information involves preparing misleading financial statements for presentation to the shareholders. Presenting financial statements to make them look better than they are is sometimes known as ‘WinidOW ‘dressing the accounts Management might do this to Banh performanice:telated bOnUSés linked to specific financial statement figures, such as profit or revenue targets. ther reasons to misrepresent financial information include: ‘+ Convince the company’s finance providers ofits creditworthiness to increase borrowing capacity by overstating profits. ‘+ Convince shareholders of the company's future profit potential to raise share price and potential funds from equity issues by overstating profits ‘+ Distract shareholders and those charged with governance with overstated profits to hide fraud For example, when teeming and lading occur, amounts receivable from customers are overstated. + Reduce the tax payable by understating profite 1.3.1 Features of Misrepresentation Misrepresentation Description Overvalue inventory _| It makes the cost of sales lower and profits higher. Alternatively, a company may not write off obsolete inventory. Fictitious sales A company may create fictitious sales to increase reported profits. ‘One way of doing this is to collude with a customer. ‘Near the end of the financial year, goods are sold to the customer, increasing sales and profit for the year. But there is an agreement that the customer will ‘retum the goods afer the year-end and will not pay for them. Understating or Profit may be manipulated by understating or overstating some items of overstating expenses | expense.1.4 Implications of Fraud 1.4.1 Conditions for Fraud Dishonesty a Motivation Opportunity Condition | Description Dishonesty | Fraud can only occur if one or more individuals are dishonest and are prepared to commit, a crime, usually for personal gain. Motivation | Reason for an individual to commit fraud For example, the motivation may be that the individual wants more money. ‘Another important motivating factor, however, is that ifthe individual commits fraud, the risk of being discovered is small - ori found, the threat of severe punishment is minor. Opportunity | The individual must be able to see an opportunity for commiting fraud without being discovered. Even if an individual would like to commit fraud, they can do it only if an ‘opportunity exists,1.4.2 Signs of Potential Fraud ‘Management and supervisors should be alert to signs and risks of possible fraudulent activity. + Secretive behaviour When an employee behaves secretively and does not want colleagues to see what they are doing ‘+ Working long hours and not taking holidays Employees may work long hours and refuse to take holidays so no one else can take over their work and see what they have been doing. + Expensive lifestyle ‘When an employee appears to be living an expensive lifestyle beyond what might be expected of their income. + No segregation of duties Opportunities for fraud are much more significant when there is no segregation of duties and the same individual is responsible for different tasks, such as invoicing, receiving, and recording payments. + Unusual transactions ‘An unusual transaction may be @ cover for fraud. + Poor morale When employees are unhappy and resent the organisation they work for, they may be more motivated to commit fraud + IT system hackers ‘Management must also be aware that the risk of fraud by unauthorised hackers into the organisation's IT systems is high, despite improvements in anti-hacker software such as firewalls.1.5 1g Risk of Fraud The implications of fraud for a business organisation are significant. When fraud occurs, it means that: + The organisation has employed one or more dishonest individuals + Internal controls to prevent fraud are weak because opportunities exist to ignore or avoid those controls + Internal controls to detect fraud, and measures to punish fraud when discovered, are weak or ineffective. ‘The company must have measures to reduce the conditions for fraud. Condition ‘Measures to reduce the condition Dishonesty + Background checks on potential employees + Probationary periods for new employees ‘+ Monitoring + Ethical leadership Motivation + Monitoring + Ethical training + Awareness of the cost and consequences of fraud Opportunity + Effective internal control system + Segregation of duties 1.6 Responsibilities of Management Regarding Fraud Management is responsible for the design and operation of the internal control system, and those, charged with governance (board of directors) are responsible for its effectiveness. They may be assisted by external auditors, internal auditors, and employees. There must be a control environment in which employees are aware of the risk of fraud and are alert to the need to prevent fraud from happening or report their suspicions 1.6.1 Improving Internal control Management should also look for internal control weaknesses that could increase the risk of fraud and should consider improving internal control quality.1.6.2 Employees Employees should be aware of the fraud risks and the consequences of committing fraud on the company, ‘on other employees and themselves. ‘They should be embedded with a moral and ethical obligation not to carry out fraudulent activities, seek ‘opportunities, or encourage others (intemally and externally) to do so.1.7 Whistleblowers Whi leblower ~ An individual that reports a suspicion or case of financial crime or other irregularity Because the board of directors are responsible forthe effectiveness of the internal control system, they may establish an antisaud system that employees can use to bypass management when reporting suspicions of fraud. This is known as a whistleblowing system. 1.7.4 Whistleblowing system ‘An effective whistleblowing system must have specific attributes: Attribute Description Reporting channel ‘A whistleblowing system enables an employee to report suspicions of fraud or wrongdoing by others in the organisation, Outside regular lines of reporting ‘The employee can make the report outside their usual line of reporting and does not have to make the report to their boss (who may be involved in the frau). Reports may be made, for example, to the company secretary or the: aut committee Confidentiality ‘The report will be treated in confidence, and the whistleblower's identity will not be revealed (this may not always be possible) Inves The allegation will be investigated by an individual or small committee that can bring independent judgement and objectivity to the investigation,2.1 Definition of Money Laundering Money laundering — Activities intended to conceal the origins of proceeds from cri activity Money laundering is often associated in the public mind with activities that disguise the origins of money eamed by the sale of illegal drugs. Still, applies to all crimes that gain money for the criminal, including financial crimes like asset misappropriation and tax evasion, 2.1.1 Aspects of Money Laundering Money laundering has three stages: a: Layering > eeeeichl Stage Description Example Placement | Introduction of money eamed through crime into the | Deposit criminal proceeds in laundering system. legitimate bank accounts. Exchange criminal proceeds for other assets, such as chips at casinos. Layering | Activities and transactions conceal the money's Moving money between multiple source, making it difficult for investigators to trace. bank accounts, including overseas what has happened to it. banks. Integration | Using laundered money for a legitimate purpose. Buying a car, property, jewellery ate.2.1.2 Other Money Laundering Offenses Offences related to money laundering include: + Tipping off This happens when one person informs another that the other person is being investigated for suspicion ‘of money laundering Tipping off allows the other person to hide the money somewhere else before the investigators can trace itor to escape before they can be captured and arrested. allure to report “Most countries have laws or regulations for dealing with money laundering. Banks and other regulated institutions within the financial system are required to report suspicions of ‘money laundering by their customers to the authoritios. Failure to report suspicions of money laundering is an offence for individuals with regulatory responsibilty for anti-money laundering procedures. 2.2 Anti-Money Laundering Regulations ‘Money laundering is a crime that crosses national boundaries, and the need for international measures to deal with it has been recognised. 2.2.1 Financial Action Task Force (FATF) ‘The interationalant-money laundering inate has been led by an inter-governmental body, the Financial Action Task Force or FATE. ‘The Financial Action Task Force was established in 1989 to Set standards and promote the effective implementation of egal feguetory and operational measures against money laundering, terrorism financing and other related threats tothe integrity ofthe interationa nancial system, FATF has published recommendations about how countries should take measures to combat money. laundering. These are called the FATF Recommendations. ‘One of these recommendations is that money laundering should be a ériminal offence. Other recommendations include guidance on how each country should apply antimoney laundering measures in practice. 2.2.2 National Regulations Countries adopt the FATF Recommendations by producing their anti-money laundering regulations. "National regulations are based on the FATF Recommendations. ‘The anti-money laundering regulations provide for reporting of money laundering activity (including ‘suspicions of money laundering) to a national financial intelligence unit - a government body — for investigation. For example, the UK has enacted the Proceeds of Crime Act to handle money laundering offences.2.2.2 National Regulations Countries adopt the FATF Recommendations by producing their anti-money laundering regulations. "National regulations are based on the FATF Recommendations. ‘The anti-money laundering regulations provide for reporting of money laundering activity (including suspicions of money laundering) to a national financial inteligence unit ~ a government body ~ for investigation. For example, the UK has enacted the Proceeds of Crime Act to handle money laundering offences. 2.2.3 Regulations on Specific Industries ‘The anti-money laundering regulations apply to certain types of organisations but not to others. The laws are also more extensive for some kinds of organisations than for others. For example, banks are subject to extensive anti-money laundering regulation because the banking system Is where most money laundering activity occurs. (Other organisations are also subject to additional money laundering regulations, such as accountants, auditors and tax advisers, casinos, precious metals and jewels dealers, real estate agents and lawyers.2.3 Detecting and Preventing Money laundering ‘Anti-money laundering procedures are used by any organisation subject to anti-money laundering regulations and deal with customers who may be involved in money laundering. ‘Anti-money laundering procedures include: Description ‘An essential anti-money laundering measure is customer due diligence. This means confirming the identity of a new customer before agreeing to make any transactions with or for the customer. ‘This process is also called ‘know your customer’. When the customer is a ‘company, the process involves investigating the identities of the company's directors and its origins and business activites, Dealing with large Large transactions should be referred to a senior manager for approval. The transactions senior manager should be satisfied that the transaction is ‘legitimate’ and that there is no suspicion of money laundering. Staff training Staff should receive regular training to remain alert for money laundering and to report suspicions af money laundering transactions Retaining records ‘The organisation should retain transaction records and the results of customer {due diligence procedures for a specified minimum period, Handling potential tipping-off offences Company staff should be aware that warning customers that they might be reported on suspicion of money laundering is tipping off. Ths is a criminal offence,2.3.1 Reporting Suspicions Organisations must have arrangements that eneble staff to report suspicions of money laundering to ‘someone in authority within the organisation. This arrangement should include preparing a suspicious transaction report by the employee for the Money Laundering Reporting Officer. 1. An employee prepares a suspicious transaction report on a due dligence check of a customer or a large- sized transaction that a customer wants to make. 2. The suspicious transaction report is submitted to a Money Laundering Reporting Officer within the organisation. 3. The Money Laundering Reporting Officer considers the report and decides whether or not it should be reported tothe authorities. 4. Suspicious transactions considered by the Money Laundering Reporting Officer to be potentially a money laundering activity should be reported to the government's official investigation unit. This unit then investigates the report. 2.3.2 Implications of Money Laundering on the Accountant ‘Money laundering is a serious offence; involverent will have severe professional and criminal consequences for an accountant Doing due diligence on customers, ensuring staff are well trained, keeping detailed records of transactions and reporting suspicious activity to the Money Laundering Reporting Officer are ways in which an accountant can ensure they do not become involved.3.1 Handling Client Money Professional firms such as accountants or lawyers sometimes act on behalf of a client, for example, to assist them with investing in the stock market. Law firms help clients with property purchases, and insurance brokers help clients to buy insurance policies. ‘To carry out these tasks for clients, the firm will need some money from the clients to pay for what they want. Effective policies and procedures must be implemented for handling client money: ‘+ Reduce the risk of involvement in financial crime (fraud and money laundering) ‘+ Ensure client funds are not misspent or misappropriated, ‘+ Ensure client funds are correctly accounted for. 3.1.1 Definition of Client Money Client money is money held by a firm that belongs to a client. It is not money paid by the client forthe firm's. professional services. It is the client's money that the firm may be required to spend on the client's behalf 3.1.2 Risks of holding Client Money ‘risk with client money is that the firm will mix it up with its cash and cannot separate the two. ‘As a result, the firm might spend client money for its benefit. Or i the firm gets into financial trouble, it may Use client money to rescue itself. There is also a risk that the firm may be implicated in financial crime, especially ifthe client's money is discovered to be proceeds of criminal activity. 3.1.3 Reducing Risks of Holding Client Money ‘+ Keep client money segregated from the firm’s funds, either physically (cash) or in separate bank accounts, In some countries, this is a legal requirement ‘+ Account for client money separately from the firm's funds, with separate accounts for each client. In the case of client money held by business organisations, the risk of improper use of cient money by a firm is reduced by the existence of regulations and the threat of criminal and professional sanctions if cient. money is improperly used (in other words, used by the firm to pay its expenses rather than those of the client). Internal controls over authorising access to and using funds also help reduce risk.Syllabus Coverage This chapter covers the following Learning Outcomes. C. Business functions, regulation and technology 3. Regulation and financial crime 4) Explain the circumstances under which fraud is likely to arise, €) Identify different types of fraud in the organisation. ) Explain the implications of fraud for the organisation. 9) Explain the role and duties of individual managers in the fraud detection and prevention process. h) Explain why itis important to adhere to policies and procedures for handling clients’ money. i) Define the term money laundering, j) Give examples of recognised offences under money laundering regulations. k) Identify methods for detecting, preventing and reporting money laundering. Summary and Quiz ‘+ Fraud — An act of deception intended to secure personal gain for the person committing the fraudulent ‘act or to cause loss to someone else. Types of fraud are: © Asset misappropriation © Misrepresentation ‘+ Conditions for fraud are: © Dishonesty © Motivation © Opportunity + Management is responsible for the design and operation of the internal control system, and those charged with governance (board of directors) are responsible for its effectiveness. ‘+ Whistleblower — An individual that reports a suspicion or case of financial crime or other irregularity. ‘+ Money laundering — Activities intended to conceal the origins of proceeds from criminal activity. It has three stages: © Placement © Layering © Integration ‘+ Money laundering offenses include: © Tipping off © Failure to report ‘+ Money laundering is crime that crosses national boundaries, and the need for international measures to deal with it has been recognised. + Effective policies and procedures must be implemented for handling client money.