CHAPTER 10

IDENTIFYING AND PREVENTING FRAUD

Fraud & their Prevention in
Business
• Fraud is an intentional act by one or more individuals among
management, those charged with governance, employees or third
parties, involving the use of deception to obtain an unjust or illegal
advantage.
• For example, managers may deliberately select inappropriate
accounting policies.
• Employees may seize the proceeds of cash sales and omit to enter the
sale into the accounting records.
• Third parties may send bogus (fake) invoices to the company, hoping
that they will be paid in error.
The prerequisites of fraud
• There are three prerequisites for fraud to occur: dishonesty,
opportunity and motive.
• All three are usually required – for example an honest employee is
unlikely to commit fraud even if given the opportunity and motive.
• Fraud is more likely to occur in a business environment with poor or
no controls.
• If the control environment is soft and management has implemented
few specific control activities, then the potential for fraud is high.
Factors that might increase the
risk of fraud and error:
• management domination by one person, or a small group of people
• unnecessarily complex corporate structure
• high turnover rate of key accounting personnel
• personnel who do not take leave/holidays
• understaffed accounting department
• volatile business environment
• inadequate working capital
• deteriorating quality of earnings
• inadequate segregation of duties
• lack of monitoring of control systems
• unusual transactions – in cash, or direct to numbered bank accounts
• payments for services disproportionate to effort
• significant transactions with related parties
• inadequate IT systems.
Example of fraud by
management
• Financial statement fraud, e.g. ‘window dressing’ and ‘cooking the
books’
• * Window Dressing/Cooking the books are the deceptive practices of
using accounting “tricks” to make a company's balance sheet and
income statement appear better than they really are.
• Misappropriation of assets – stealing physical assets or selling
property
• False insurance claims
• Using the company’s assets for personal use.
 Example frauds by employees
• Sales ledger fraud – ‘teeming and lading’
• * Teeming and lading is a type of fraud normally on the sales ledger
whereby the receipts of later debtors are allocated to pay off earlier
debtors
• Purchase ledger fraud
• Skimming schemes
• * Skimming schemes is when the fraudster diverts small amounts from a
large number of transactions, believing that no one will bother to
investigate the small differences individually, although in the aggregate
they can total to a worthwhile sum.
• Payroll fraud.
 Example frauds by third parties
• False billing fraud – third parties sending bogus invoices to the company
• Bank account fraud
• Advance fee fraud
• * Advance fee fraud is a trick where a company is invited to pay a
modest fee up front in the promise of being paid a large amount in the
future.
• Ponzi/Pyramid schemes
• * Ponzi/Pyramid schemes are fraudulent investments offers that involve
paying abnormally high returns to early investors out of the new money
paid in by subsequent investors, rather than from any genuine
underlying business.
The possible implications of
fraud to the company
• There is a spectrum of implications of fraud, including:
• Misuse of assets
• Loss of assets
• Financial difficulties
• Collapse of the company
THE FRAUD DETECTION AND
PREVENTION PROCESS
The duties to prevent and detect fraud can be split between:
• the duties of the board of directors
• the duties of the audit committee
• the duties of employees generally (including senior employees below
board level).
The duties of the board of
directors
• The board of directors is required by the Combined Code to maintain
a sound system of internal control.
• At least annually, the board should conduct a review of the
effectiveness of the internal control system and should report to
shareholders.
The duties of the audit
committee
• The audit committee is required by the Combined Code to monitor
and review the company's internal control and risk management
systems.
• This should ensure the continuing effectiveness of the controls in
preventing and detecting fraud.
The duties of employees
• The specific duties of employees are set out in their contract of
employment and in what they are told to do by their supervisors, but
there will always be an implied duty to act honestly and to report
suspected or actual frauds encountered to supervisors.
• Fraud prevention and detection is the responsibility of every
employee in a company, not just the board of directors.
Illegally-Obtained Money
• Money laundering
• is the practice of covering the origins of illegally-obtained money.
• Ultimately, it is the process by which the proceeds of crime are made to
appear legitimate.
• Laundering allows criminals to transform illegally obtained gain into
seemingly legitimate funds.
• It seems to be a worldwide problem.
• Criminals want their illegal funds laundered because they can then move
their money through society freely, without fear that the funds will be
traced to their criminal deeds.
• In addition, laundering prevents the funds from being confiscated by the
police.
Money laundering usually
consists of three steps
These are:
• Placement,
• Layering and
• Integration
• Placement
• Putting illegal funds from the illegal activity into apparently legitimate
business activity or property
• e.g. Open a cash sales business (Hair dressing) and put the illegal
funds in to the bank account there as a cash income.
• Layering
• Involves the wire transfer of funds through a series of accounts in an
attempt to hide the funds' true origins.
• Integration
• involves buying of legitimate goods, using the cash after the layering
stage
 REPORTED TO THE
APPROPRIATE AUTHORITIES
• Today, most financial institutions globally, and many non-financial
institutions, are required to identify and report transactions of a suspicious
nature to the financial intelligence unit in the respective country.
• For example, a bank must perform due diligence by verifying a customer's
identity and monitor transactions for suspicious activity.
• To do this, many financial institutions utilize the services of special software
to gather information about high risk individuals and organizations.