FRAUD AND IRREGULARITIES IN FORENSIC ACCOUNTING

Written by:

AJASA FADEKEMI

NKIRU EZIKE

UCHENNA CHINWUBA

ABDULWAKIL MUSTAPHA

ALLI AYOKUNNU

CHRISTOPHER OBIANIFE

What Is Fraud?

Sometimes referred to as the fraudulent act, fraud is an act of intentional deception, either by omission or commission that causes its victim to suffer an economic loss and/or the offender to realize a gain. It can simply be defined as “theft by deception”.

Its legal definition is the same whether the offense is criminal or civil; the difference is that criminal cases are accompanied by a higher burden of proof.

What Are The Major Categories Of Fraud?

There are three major categories of fraud, they are explained below;

  1. Asset misappropriations

These involve the theft or mismanagement of an company’s assets. (Common examples of assets misappropriation include skimming revenues, stealing inventory, and payroll fraud.)

2. Corruption

This implies the unlawful or wrongful abuse of influence in a business transaction to get personal benefit, contradicting an individual’s duty to his or her employer or the rights of another. (Common examples of corruption include accepting clandestine payment in return for a favor and engaging in conflicts of interest.)

3. Financial statement fraud

Financial statement fraud and other fraudulent statements involve the intentional misinterpretation of financial or non-financial information to misguide people who are relying on it to make financial decisions. (Common examples of financial statement fraud in an organization include overstating revenues and assets, window-dressing financial statement, Overstating creditors and understating debtors, or making false claims about the safety and prospects of an investment.)

IRREGULARITY

 It is the combination of fraud & error which means the intention and unintentional misrepresentation of facts.

Examples of Irregularity in forensic accounting are

  1. Omission of inventory withdrawn by management which is not disclosed in the financial statement.

 

  1. Understating debtors report in the financial statement

 

  1. Classification of other items as stock which may tend to increase or overstate the value of stock.

 

  1. Not raising credit note for items returned which also tend to undervalue inventory.

 

DIFFERENCE BETWEEN FRAUD AND IRREGULARITY

  1. Fraud is an intentional misstatement/misrepresentation of facts with the intention to make a gain at expense of a company or individual while irregularity is an unintentional

 

  1. An error may be Irregularity while every fraud is an irregularity.

 

REASONS WHY FRAUD AND IRREGULARITY OCCUR

Weaknesses in the corporate structure are the prime driver. C-Suiters, especially in publicly-held firms where they have little skin in the game, have greater incentive to enrich themselves

Fraud can happen when the right conditions intersect. These conditions may include loopholes in a company’s system, temptation on the perpetrator due to personal needs or lack of limits on the authority of employees to transact on behalf of the company.

By a Freudian construct, there are primarily three drivers of fraudulent behavior:

(a) a non-shareable financial problem (pressure/incentives to commit fraud);

(b) knowledge of weaknesses in the structure and workings of a corporation which would allow the perpetrator to commit the fraud and escape detection

 

The Fraud Triangle

Several decades ago, after considerable research, Donald R. Cressey, a well-known criminologist, developed the Fraud Triangle. Interested in the circumstances that led embezzlers to temptation, he published Other People’s Money: A Study in the Social Psychology of Embezzlement.

Cressey’s hypothesis was: “Trusted persons become trust violators when they conceive of themselves as having a financial problem which is non-sharable, are aware this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds or property.

Essentially, the three elements of the Fraud Triangle are: Opportunity, Pressure (also known as incentive or motivation) and Rationalization (sometimes called justification or attitude). For fraud to occur, all three elements must be present.

Opportunity

If one is talking about theft, there must be something to steal and a way to steal it. Anything of value is something to steal. Any weakness in a system—for example, lack of oversight—is a way to steal. Of the three elements of the Fraud Triangle, opportunity is often hard to spot, but fairly easy to control through organizational or procedural changes.

Pressure

Pressure in this case is another way of saying motivation. What is it in one’s life that drives one to commit fraud? Pressure sometimes involves personal situations that create a demand for more money; such situations might include vices like drug use or gambling or merely life events like a spouse losing a job. At other times, pressure arises from problems on the job; unrealistic performance targets may provide the motive to perpetrate fraud.

Rationalization

There are two aspects to rationalization: One, the fraudstar must conclude that the gain to be realized from a fraudulent activity outweighs the possibility for detection. Two, the fraudster needs to justify the fraud. Justification can be related to job dissatisfaction or perceived entitlement, or a current intent to make the victim whole sometime in the future, or saving one’s family, possessions or status. Rationalization is discernible by observation of the fraudster’s comments or attitudes.

The Fraud Diamond

In addition to Opportunity, Pressure (also known as incentive or motivation) and Rationalization (sometimes called justification or attitude), a newer theory of fraud proposed by David T. Wolfe and Dana R. Hermanson, asserts that the fraudster’s capability must also be taken into account. This gave rise to the Fraud Diamond.

Capability

The Fraud Diamond, a newer theory of fraud proposed by David T. Wolfe and Dana R. Hermanson, asserts that the fraudster’s capability must also be taken into account. The fraudster, it is said, must have the required traits (e.g., greed, weakness of character, excessive pride, dishonesty, etc.) and abilities (e.g., knowledge of processes and controls) to actually commit the fraud. It can be argued, however, that traits are components of pressure and that abilities are opportunity factors.

 

10-80-10 Rule*

The 10-80-10 Rule supports the general assumption of capability by breakdown of the population and the likelihood of fraud occurrences. Essentially:

  • 10 percent of the population will NEVER commit fraud. This is the type of person that will go out of their way to return items to the correct party.
  • 80 percent of the population might commit fraud given the right combination of opportunity, pressure, and rationalization.
  • 10 percent of the population are activelylooking at systems and trying to find a way to commit fraud.

*Source: National Association of State Auditors, Comptrollers and Treasurers (NASACT) and the Oregon State Controller’s Division

PREVENTION OF FRAUD AND IRREGULARITY

Fraud and irregularities can be prevented in so many ways but in the course of this paper we shall alight few ways in this menace can be curbed:

  1. Sound and strong corporate governance tends to reduce fraud but when it is weak fraud cases persist.

 

  1. Good internal control system should be put in place to checkmate financial and non financial   activities of individuals.

 

  1. Asset Verification exercises should be conducted regularly.

 

  1. Recommendation and compliance should be adhered to strictly.

 

  1. Strong audit system should be put in place.

 

 

ROLE OF FORENSIC ACCOUNTANTS IN FRAUD DETECTION

 

WHAT IS FORENSIC ACCOUNTING

Forensic Accounting is essentially a financial service that specializes in the identification and prevention of fraud in a business. Forensic Audits are done by forensic accountants who can identify the ways in which a particular business is susceptible to fraud.

 

Any business which has in its employ accountants and other professionals who have access to the business funds runs the risk of being a fraud victim. All businesses are actually vulnerable to fraud, in some degree or the other.

 

Forensic accounting is one of the ways in which embezzlement and skimming can be found out. Forensic accounting integrates investigative, accountancy, and communication skills.

Crumbley, Heitger, and Stevenson Smith in their book Forensic and Investigative Accounting, Second Edition define forensic accounting as:“the action of identifying, recording, settling, extracting, sorting, reporting, and verifying past financial data or other accounting activities for settling current or prospective legal disputes or using such past financial data for projecting future financial data to settle legal disputes”.

Forensic accounting is an investigative methodology to follow money or proceeds, conducted under the premise that the results of the investigation may be used in a court of law. Regardless of the purpose of your engagement — civil or criminal — forensic accounting is usually all about following the money.

 

What Forensic Accountants Do

Forensic accountants use their auditing abilities combined with investigative skills to determine what causes suspicious financial activity. Businesses use this information as credible evidence in trials and/or to recover losses from a scam.

 

Forensic accountants examine data to determine where missing money has gone and how to recover it. They may also present reports of their financial findings as evidence during hearings, where they often testify as expert witnesses. This work serves an important purpose at public accounting and consulting firms, law firms, law enforcement agencies, and insurance companies.

 

What is financial forensics?

Kranacher, Riley, and Wells defines financial forensics as follows:

Financial forensics is the application of financial principles and theories to facts or hypotheses at issue in a legal dispute and consists of two primary functions:

  1. Litigation advisory services, which recognizes the role of the financial forensic professional as an expert or consultant
  2. Investigative services, which makes use of the financial forensic professional’s skill and may or may not lead to courtroom testimony.

 

Financial forensics is the intersection of financial principles and the law and, therefore, applies the:

 (1) technical skills of accounting, auditing, finance, quantitative methods, and

certain areas of the law and research;

(2) investigative skills for the collection, analysis,

and evaluation of evidentiary matter; and

 (3) critical thinking to interpret and communicate the results of an investigation.2

 

What are the techniques of forensic accounting?

The accountant may also interview management and employees. The Indirect Method has many forensic accounting techniques that fall under its name — including the Cash T Method, the Source and Application of Funds Method, the Net Worth Method and the Bank Deposit Method.

 

What are forensic accounting tools?

Since forensic accountants are both accountants and investigators, they use tools applicable to both. These include bookkeeping and accounting software, computer forensic tools like data-mining applications, and statistical principles like Benford’s Law.

What is Forensic investigation

It is a part of a forensic accounting engagement. Forensic investigation is the process of gathering evidence so that the expert’s report or witness statement can be prepared. It includes forensic auditing, but incorporates a much broader range of investigative techniques, such as interviewing witnesses and suspects, imaging or recovering computer files including emails, physical searches of premises etc.

 

What is Forensic auditing

It is the application of traditional auditing procedures and techniques in order to gather evidence as part of the forensic investigation.

 

Application of forensic accounting

The major applications of forensic accounting include fraud investigations, negligence cases and insurance claims.

The need for a forensic accountant may also arise because two parties cannot agree on the amount owed by one party to another, and the accountant is engaged to provide an expert valuation, of a business for example.

This might be the case in a matrimonial dispute, where a divorcing couple whose assets include shares in a company or partnership, engage a forensic accountant to value the company so that a settlement can be reached.

 A similar process might apply in partnerships, when one partner wishes to leave the partnership and is being bought out by the remaining partner(s). 

However, not all forensic engagements will require evidence to be submitted to a court. Often, the engagement will simply require a report for the client’s own purposes or sometimes a report for use by the insurer.

Forensic accounting Planning

Forensic accounting engagements are agreed-upon procedures engagements, not assurance engagements. The forensic accountant will not provide an assurance opinion – that is the role of the auditor when reviewing the amount of loss included in the financial statements.

Remember that a forensic accountant is just that; an accountant! Their role is to provide an accountant’s expert opinion or analysis of the facts. They are not the law-enforcer, prosecutor or judge.  

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To what extent is the audit considered capable of detecting irregularities, including fraud

In determining what information the auditor should include in the auditor’s report, the auditor may consider the extent to which the following aspects of the auditor’s approach affected the auditor’s capability to detect irregularity (this is not an exhaustive list):

  1. The auditor’s assessment of the susceptibility of the entity’s financial statements to material misstatement, including how fraud might occur.
  2. Which laws and regulations the auditor identified as being of significance in the context of the entity.
  3. How the auditor obtained an understanding of the legal and regulatory framework applicable to the entity and how the entity is complying with that framework.
  4. How the auditor obtained an understanding of the entity’s policies and procedures on compliance with laws and regulations, including documentation of any instances of non-compliance.
  5. How the auditor obtained an understanding of the entity’s policies and procedures on fraud risks, including knowledge of any actual, suspected or alleged fraud.
  6. The engagement partner’s assessment of whether the engagement team collectively had the appropriate competence and capabilities to identify or recognise non-compliance with laws and regulations, details of those matters about non-compliance with laws and regulations and fraud that were communicated to the engagement team, and any discussions with specialists on areas of the financial statements particularly susceptible to fraud.
  7. In the case of a group, how the auditor addressed these matters at both the group and component levels.
  8. Communications with component auditors to request identification of any instances of non-compliance with laws and regulations that could give rise to a material misstatement of the group financial statements.
  9. In the case of a regulated entity, how the auditor obtained an understanding of the entity’s current activities, the scope of its authorisation and the effectiveness of its control environment

What is financial fraud?

Sometimes referred to as the fraudulent act, fraud is an act of intentional deception, either by omission or commission, that causes its victim to suffer an economic loss and/or the offender to realize a gain. It can simply be defined as “theft by deception”.

 

THE RISK OF MATERIAL MISSTATEMENT
The SAS describes two types of fraud that may result in financial statement misstatements:

  • Fraudulent financial reporting. An example of fraudulent financial reporting is a company that ships customers goods that have not been ordered and then records the revenue as if it met all the criteria for revenue recognition. In other cases involving new high technology products, company personnel may have provided customers with a side agreement granting right of return for any reason or made payment for the goods contingent on receipt of funding or some other event. In such cases the side agreement typically is not disclosed to the auditor because the underlying transaction would not meet the criteria for revenue recognition under generally accepted accounting principles.

 

  • Misappropriation of assets. Examples of misappropriation of assets are thefts of cash, inventory or securities. Small practitioners specifically asked for guidance in this area because they were more likely to encounter misappropriations than fraudulent financial reporting. Auditors from larger firms were more concerned about fraudulent financial reporting from a materiality standpoint but also thought guidance on misappropriations would be helpful.

Some practitioners questioned the auditors responsibility to detect certain significant defalcations, such as at a retailing company where thefts are reflected in cost of goods sold after inventories are adjusted to actual quantities on hand. While the answer depends on the actual facts and circumstances involved, many believe the auditor should have a feel for when inventory shrinkage is not in line with other entities in the industry. Although some argue the amount attributed to a defalcation should be shown on a line labeled “theft expense,” there is no such requirement under GAAP.

SAS no. 82 requires the auditor to specifically assess the risk of material misstatement of the financial statements due to fraud in every audit. The auditor is not expected to assess the risk of fraud as high, medium or low, as might be the case in assessing control risk. Rather, SAS no. 82 asks the auditor to consider risk factors relating to fraudulent financial reporting and misappropriation of assets in each of the categories shown in paragraphs 16 and 18 of the statement. The auditor then needs to consider that risk assessment in designing the audit procedures he or she will perform. In the context of this statement, risk assessment is a process rather than a rating or a score.

Characteristics of Fraud
The commonest fraud that is committed happens to be embezzlement. Employees who indulge in embezzlement are experts in choosing the time and the amount of money, which is in small amounts such that they are not detected. A forensic audit can help to stop embezzlement which if left unchecked would have continued for many years to come and caused significant losses and damage to the company or business. While performing the forensic audit, the forensic accountant carefully studies the financial history of the company and the records to try and spot “patterns” that are indicative of embezzlement and fraud. Background checks, thorough in nature are done for every employee to rule out the possibility of a known fraudster joining the company ranks.

Fraud Detection
A forensic audit is by nature a very thorough and detailed examination of each and every facet of a business’ history and financial activities. One could say that forensic auditors don a detective’s hat when they get working. The fraudsters involved are in general a tricky and slimy lot, who are intelligent to boot. They take every possible measure to avoid getting caught and cover their tracks quite well. It takes all the skill and expertise of a forensic auditor to nail a fraudster.

Fraud Prevention
Apart from fraud detection, forensic audits can also help a business to identify the inherent vulnerabilities it possesses. At the end of the day, the forensic specialist team lists a recommendation to mitigate those risks completely or to a minimum.

Management integrity or otherwise concludes it is not possible to address the level of risk on the engagement, he or she should consider withdrawing from the audit, with appropriate communications to the entity’s audit committee.

 

CONCLUSION

The prevalent increases in financial fraud have affected many corporate organizations in the world. This stirred the need for forensic accounting investigation to uncover fraud and any other corporate financial irregularities. It has been shown by many studies that forensic accounting investigation has a significant effect in detecting financial fraud in organizations and the results strongly support the use and application of forensic accounting investigation towards detecting financial fraud in Nigeria. In view of this, it is suggested that the ICAN and ANAN as the professional accounting bodies should encourage specialization on forensic accounting service among the professional accountants as provided in the U.S. by incorporating the service of CFEs members to deliver forensic accounting services. The government should also develop an interest to encourage forensic accounting specialization and awareness on the effect of fraud as this could allow strong monitoring of any fraudulent activities in both public and private organizations.