Fafd Module Icai

STUDY ON FORENSIC ACCOUNTING
AND FRAUD DETECTION
The Institute of Chartered Accountants of India

(Set up by an Act of Parliament)
New Delhi
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Revised Edition : September, 2017
Committee/Department : Committee on Information Technology
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September/2017/P2177(Revised)
Foreword
Specialization in the areas of Forensic Accounting and Fraud Detection is
more in demand in view of increased incidents of frauds and cyber-crimes.
Forensic accountants with their core understanding of accounting, finance and
laws with added knowledge of investigative techniques will be able to
determine whether an activity is illegal or not. Forensic Accounting and Fraud
Detection (FAFD) involves practice of utilizing accounting, auditing, CAATs/
Data Mining Tools and investigative skills to detect frauds/ mistakes. All
Government bodies, PSUs, Insurance sector, Banks, Investigating agencies
as well as many medium–sized and boutique firms also have specialist
forensic accounting departments engaging Forensic Auditors. Forensic
accountants usually investigate and analyze financial evidence, develop
computerized applications to assist in the presentation and analysis of the
evidence presented, communicate their findings in the form of various reports
and assist in the legal proceedings in court as an expert witness.
In the wake of recent financial and cyber frauds and need for expertise in this
newer area, the Committee on Information Technology (CIT) of the Institute of
Chartered Accountants of India (ICAI) has identified Forensic Audit, Fraud
Detection & Prevention as one of the niche area and has started conduct of
Certificate Course on Forensic Accounting and Fraud Detection.
The Certificate Course on Forensic Accounting and Fraud Detection of ICAI
aims to develop such investigative skills that are required to uncover
corporate/ business frauds, measure resultant damage, provide litigation
support/ outside counsel by applying accounting, auditing principles for the
detection of frauds.
This background material of the Certificate Course contains various practical
aspects, new technologies and case studies related to Forensic Accounting
and Fraud Detection which together will make it a great learning guide and
assist the members in understanding the nuances of this complex subject
thoroughly. I appreciate the efforts put in by CA. Atul Kumar Gupta,
Chairman, CA. Jay Chhaira, Vice-Chairman, other committee members, faculties
and officials of CIT for bringing out this background material.
I am sure that it will be a useful learning material and will fulfill the objectives
for which it has been developed.
Wishing you all the very best in this emerging professional opportunity.
Best wishes,
Place: New Delhi CA. Nilesh Shivji Vikamsey

Date: 21st September 2017 President, ICAI
iv
Preface
Recently, Forensic Accounting (FA) has come into limelight due to rapid
increase in financial frauds and white-collar crimes. The integration of
accounting, auditing and investigative skills creates the specialty, known as
FA. ‘Forensic’ means “suitable for use in a court of law,” and it is to that
standard and potential outcome that forensic accountants generally have to
work. FA uses accounting, auditing, and investigative skills to conduct
investigations, and thefts and frauds cases. No doubt, FA is listed among the
top-20 careers of the future. The job of forensic accountants is to catch the
perpetrators of the financial theft and fraud occurring throughout the World
every year. This includes tracing money laundering and identity theft
activities, as well as, tax evasions.
Forensic accountants will be in high demand because of an increase in
employee and management fraud, theft, embezzlement and other financial
crimes. Growth is also fueled by high-visibility corporate scandals. The
Bureau of Labor Statistics (BLS) USA has predicted 13% job growth for
accountants and auditors by 2022. The growth of all forensic accounting jobs
should correspond with this rate, if not exceed it, due to increasing financial
regulations, with some estimates predicting a 20% growth in demand for
investigative auditors.
This Course is a blend of theoretical and practical training and is intended to
equip the participants with concepts in Forensic Accounting which aims at
sensitizing Fraud Investigators, Auditors, Security Professionals, and IT
executives about the risks and mitigation strategies for an effective business
environment, update members on the developments taking place in the
exciting world of forensic investigation related to finance and Information
Technology sector. It provides an incisive analysis of how fraud occurs within
an organization and explains the latest techniques for fighting it.
This background material is prepared so as to cover all major aspects
applicable to Forensic Accounting and is intended to provide an
understanding about the current state of Frauds, Technologies involved and
their characteristics and give a well-knitted overview & assessment approach
along with that of the prevailing cyber laws/ IT Act.
I would like to express my gratitude to CA. Nilesh Shivji Vikamsey, President ICAI
and CA. Naveen N. D. Gupta, Vice President for their continuous support and
encouragement to the initiatives of the Committee. I must also thank my
colleagues from the Council at the Committee on Information Technology for
providing their invaluable guidance as also their dedication and support to
various initiatives of the Committee.
I would also like to extend my sincere thanks and appreciation to CA Sailesh
Cousik, CA Durgesh Pandey, CA Abhijit Sanzgiri, CA Yogesh Palekar, CA
Shanobar Murali, CA Chetan Dalal, CA Mahesh Bhatki, CA Anand Jangid,
CA M. S. Mehta, Mr. Alok Gupta, CA. Rajiv Gupta, Mr. Prashant Mali,
CA. Ravi Suriyanarayanan, CA T.V.Balasubramaniam, and Dr. Triveni Singh,
who contributed the technical material for this publication brought out by the
Committee on Information Technology. I really appreciate their sincere efforts
and dedication towards the work for the Committee.
I wish to express my thanks to Committee Secretariat in giving final shape to
the publication.
I take pleasure in inviting you all to this Course on Forensic Accounting and
Fraud Detection and I am sure that all the participants will immensely benefit
from this Course.
CA Atul Kumar Gupta

Chairman
Committee on Information Technology
vi
Contents
Foreword ................................................................................................................................... iii
Preface ...................................................................................................................................... v
1. Introduction to Forensic Accounting .................................................................................. 1
2. Where are the Fraud Vulnerabilities and Why Do They Occur .......................................... 7
2.1 Fraud Triangle ....................................................................................................... 7
2.2 Fraud Diamond .................................................................................................... 10
2.3 Fraud Pentagon ................................................................................................... 11
2.4 Fraud Scale ......................................................................................................... 12
2.5 Fraud Circle ......................................................................................................... 12
2.6 Hollinger Clark Theory ........................................................................................ 12
3. Types of Frauds: ............................................................................................................. 14
3.1 Bank Frauds: ....................................................................................................... 14
3.2 Corporate Frauds: ............................................................................................... 15
3.3 Insurance Frauds: ............................................................................................... 18
3.4 Cyber Frauds:...................................................................................................... 19
3.5 Securities Frauds: ............................................................................................... 19
3.6 Consumer Frauds: ............................................................................................... 20
4. Forensic Accounting: Scope ............................................................................................ 21
5. Detecting Red Flags ........................................................................................................ 28
6. Process of Forensic Accounting ...................................................................................... 37
Step 1. Initialization ...................................................................................................... 37
Step 2. Develop Plan.................................................................................................... 37
Step 3. Obtain Relevant Evidence ............................................................................... 38
Step 4. Perform the analysis ........................................................................................ 39
Step 5. Reporting ......................................................................................................... 39
Step 6. Court proceedings............................................................................................ 39
7. Interviewing skills and techniques ................................................................................... 41
7.1 Introduction ......................................................................................................... 41
7.2 Overview of an Effective Interview ...................................................................... 41
7.3 The Interview Process ......................................................................................... 43
7.3.1 Collection of Data .................................................................................... 44
7.3.2 Purpose of Interviewing ........................................................................... 44
7.3.3 Setting of Time and Place ....................................................................... 45
7.3.4 Preparing for an Interview. ...................................................................... 46
7.3.5 Recording of the Interview....................................................................... 46
7.3.6 The Interview ........................................................................................... 47
7.3.7 Types of Questions and Sequence ......................................................... 48
7.3.8 Note-Taking during the Interview ............................................................ 51
7.3.9 How to Conclude an Interview ................................................................. 52
7.3.10 Documenting an Interview ....................................................................... 52
7.4 Common signs of deception and the techniques used to assess them ............... 52
7.5 Admission Seeking Interviews ............................................................................. 54
7.6 Barriers to an effective interview ......................................................................... 58
7.7 Safety Considerations ......................................................................................... 59
7.8 Cases Studies ..................................................................................................... 60
7.9 Summary ............................................................................................................. 67
8 Forensic Audit Techniques .............................................................................................. 69
8.1 General Audit Techniques ................................................................................... 71
8.2 Statistical & Mathematical Techniques ................................................................ 71
8.3 Technology Based/ Digital Forensics Techniques: .............................................. 72
8.4 Computer Assisted Auditing Techniques (CAATs)/ Computer Assisted Audit
Techniques and Tools (CAATT) .......................................................................... 76
8.5 Generalized Audit Software (GAS) ...................................................................... 77
viii
8.6 Common Software Tools (CST) .......................................................................... 78
8.7 Data mining techniques ....................................................................................... 85
8.8 Laboratory Analysis of Physical and Electronic Evidence ................................... 86
9 Using Excel for Forensic Audit ........................................................................................ 87
10 How to write a Forensic Audit Report ............................................................................ 102
11 Digital Forensics ............................................................................................................ 104
11.1 Types of Digital Evidence .................................................................................. 106
11.2 Top 10 Locations for Evidence .......................................................................... 106
11.3 Computer Forensics Methodology ..................................................................... 107
12 Cyber Crime .................................................................................................................. 108
13 Applicable Laws – India ................................................................................................. 112
13.1 The Information Technology Act, 2000, Amended 2008 ................................... 112
13.2 Indian Penal code 1860 ..................................................................................... 114
13.3 Civil Procedure Code 1908 ............................................................................... 116
13.4 Indian Contract Act, 1872 .................................................................................. 116
13.5 Indian Evidence Act, 1872 ................................................................................. 117
13.6 The Prevention of Money Laundering Act, 2002 ............................................... 117
13.7 The Foreign Exchange Management Act, 1999 ................................................ 118
13.8 The Companies Act, 2013 ................................................................................. 119
14 Applicable Laws – Outside India ................................................................................... 123
I. Fraud Act, 2006 – United Kingdom ................................................................... 123
II. Bribery Act, 2010 – United Kingdom ................................................................. 124
III. Foreign Corrupt Practices Act, 1977 – United States of America...................... 126
IV. OECD Anti-Bribery Convention ......................................................................... 126
V. U.N. Convention against Corruption .................................................................. 127
15 Framework on Fraud Deterrence and post event punishment ....................................... 128
16 Fraud Prevention: .......................................................................................................... 133
17 Organizations to Combat Fraud in India and Abroad .................................................... 137
ix
18 Financial Statements Frauds ......................................................................................... 140
19 Opportunities for Chartered Accountants in Forensic Accounting and Fraud
Detection ....................................................................................................................... 211
20 Useful Websites ............................................................................................................ 215
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Chapter 1
Introduction to Forensic Accounting
Forensic
The word forensic comes from the Latin word forēnsis, meaning "of or before the forum."
Means –
• Relating to, used in, or appropriate for courts of law or for public discussion or
argumentation.
• Relating to the use of science or technology in the investigation and establishment of
facts or evidence in a court of law
Forensic Accounting
The integration of accounting, auditing and investigative skills yields the specialty known as
Forensic Accounting. It is the study and interpretation of accounting evidence. It is the
application of accounting methods to the tracking and collection of forensic evidence, usually
for investigation and prosecution of criminal acts such as embezzlement or fraud.
Forensic Investigation
Also known as forensic audit is the examination of documents and the interviewing of people
to extract evidence. Forensic Accounting examines individual or company financial records as
an investigative measure that attempts to derive evidence suitable for use in litigation.
Forensic Accounting can sometimes be referred to as Forensic Auditing.
Purpose can be:
• A forensic audit can be conducted in order to prosecute a party for fraud, embezzlement
or other financial claims
• In addition, an audit may be conducted to determine negligence
Fraud auditing
In a fraud audit one searches for the point where the numbers and/or financial statements do
not mesh. It is a meticulous review of financial documents conducted when fraud is suspected.
Some entities do them as a precaution to prevent fraud from happening and to catch it before
the loss magnifies.
A Fraud Audit however is not an Investigation. Fraud auditing is used to identify fraudulent
transactions, not to figure out how they were created. The auditor simply traces every
Study on Forensic Accounting and Fraud Detection
transaction performed by the company, looking for the one that is fraudulent, if any. A regular
auditor simply checks the numbers for accuracy.
Fraud auditors often go outside the books of accounts to find fraudulent transactions. This
may include reviewing receipts, not only from the company, but from customers as well. Any
inconsistencies in these numbers could help uncover an act of fraud. These auditors also
interview employees, customers and sometimes clients to find out if a fraud has taken place.
How is a forensic accounting analysis different from an audit?
The general public believes that a financial auditor would detect a fraud if one were being
perpetrated during the financial auditor’s audit. The truth, however, is that the procedures for
financial audits are designed to detect material misstatements, not immaterial frauds. While it
is true that many of the financial statements and frauds could have, perhaps should have,
been detected by financial auditors, the vast majority of frauds could not be detected with the
use of financial audits. Reasons include the dependence of financial auditors on a sample and
the auditors’ reliance on examining the audit trail versus examining the events and activities
behind the documents. The latter is simply resource prohibitive in terms of costs and time.
There are some basic differences today between the procedures of forensic auditors and
those of financial auditors. In comparison, forensic accounting and audit differ in specific
ways, as shown below:
Forensic Accounting
• In response to an event
• Financial investigation
• Findings used as evidence in court or to resolve disputes
Audit
• Mandatory
• Measures compliance with reporting standards
• Obtain reasonable assurance that financial statements are free of material
misstatement
In practice, there are differences in mindset between forensic accounting and audit:
• “Investigative mentality” vs. “professional skepticism”. A forensic accountant will often
require more extensive corroboration.
• A forensic accountant may focus more on seemingly immaterial transactions.
A forensic accountant will often look for indications of fraud that are not subject to the scope of
a financial statement audit.
2
Sr. Particulars Other Audits Forensic Audit

No.
1. Objectives Express an opinion as to ‘True Whether fraud has taken
& Fair presentation place in books
2. Techniques Substantive & Compliance. Investigative, substantive
Sample based or in depth checking
3. Period Normally for a particular No such limitations.
accounting period
4. Verification of stock, Relies on the Management Independent verification of
estimation certificate / Management suspected / selected items
realizable value of Representation where misappropriation is
assets, provisions, suspected
liability etc.
5. Off balance sheet Used to vouch the arithmetic Regulatory& propriety of
items (like contracts accuracy & compliance with these transactions /
etc.) procedures. contracts are examined.
6. Adverse findings if Negative opinion or qualified Legal determination of
any opinion expressed with/without fraud impact and
quantification identification of
perpetrators depending on
scope. .
What is Fraud?
Fraud is a type of criminal activity, defined as:
'abuse of position, or false representation, or prejudicing someone's rights for personal gain'.
Put simply, fraud is an act of deception intended for personal gain or to cause a loss to
another party.
The general criminal offence of fraud can include:
• deception whereby someone knowingly makes false representation
• or they fail to disclose information
• or they abuse a position.
Apart from the general meaning let us study some notable definitions of Fraud as per various
statutes and standards. Although definitions vary, most are based around the general theme
mentioned above
3
The Companies Act, 2013 defines Fraud in relation to affairs of a company or anybody
corporate, to include,
(a) any act
(b) omission,
(c) concealment of any fact
(d) abuse of position committed by any person or any other person with the connivance in
any manner
 with intent to deceive
 to gain undue advantage from, or
 to injure the interests of,
 the company or
 its shareholders
 or its creditors or
 any other person
Whether or not there is any wrongful gain or wrongful loss;
• “wrongful gain” means the gain by unlawful means of property to which the person
gaining is not legally entitled
• “wrongful loss” means the loss by unlawful means of property to which the person losing
is legally entitled
Fraud is also defined in Para 11(a) of SA 240 issued by the Institute of Chartered Accountants
of India –“Auditors Responsibilities relating to Fraud in Audit of Financial Statements” as
‘An intentional act by one or more individuals among
• Management
• those charged with governance
• employees or
• or third parties,
Involving use of deception to obtain an unjust or an illegal advantage.”
Similarly Standards on Internal Audit i.e. SIA 11 – “Consideration of Fraud in an Internal
Audit define Fraud as
“An intentional act by one or more individuals among management, those charged with
governance or third parties involving the use of deception to obtains unjust or illegal
4
advantage. A Fraud could take form of misstatement of an information (Financial or otherwise)

or mis-appropriation of assets of that entity”
Another notable definition of Fraud is the one of Indian Contract Act. According to Section 17
of the Indian Contract Act, 1872
‘Fraud’ means and includes any of the following acts committed by
• a party to a contract or
• with his connivance,
• or by his agent,
With an intent to
• Deceive another party thereto or
• His agent or
• To induce him to enter into the contract
1. The suggestion, as a fact, of that which is not true, by one who does not believe it to be
true
2. The active concealment of a fact by one having knowledge or belief of the fact
3. A promise made without any intention of performing it
4. Any other act fitted to deceive
5. Any such act or omission as the law specially declares to be fraudulent
Explanation:
Mere silence as to facts likely to affect the willingness of a person to enter into a contract is
not fraud, unless the circumstances of the case are such that, regard being had to them, it is
the duty of the person keeping silence to speak, or unless his silence, is in itself, equivalent to
speech.
This can be illustrated by way of an example –A sells, by auction, to B, a horse which A knows
to be unsound. A says nothing to B about the horse’s unsoundness. This is not fraud in A
sells, by auction, to B, a horse which A knows to be unsound. A says nothing to B about the
horse’s unsoundness. This is not fraud in A.”
Also Section 25 of IPC defines "Fraudulently” as: A person is said to do a thing fraudulently if
he does that thing with intent to defraud but not otherwise.
The purpose of fraud may be monetary gain or other benefits.
Here is an insight on certain other statutes/standards/circulars/framework principles which
have mentions of frauds and have given a framework with regards to their prevention,
classification, detection and reporting
5
Circular No. IRDA/SDD/MISC/CIR/009/01/2013 date 22nd October 2013 issued by IRDA has
mentions of Fraud in Insurance Sector an act of omission intended to gain dishonest or
unlawful advantage for a party committing the fraud or for other related parties.
Circular No. RBI/2014-15/85 by RBI dated 1st July 2015 on Fraud Classification and
Reporting in Banking Sector – Gives classification of Frauds based on the provisions of the
Indian penal code mainly to have uniformity in reporting.
COSO principle 8 – talks of “Consider potential of Fraud”. It requires identifications of the
opportunities, pressures, incentives, attitudes & rationalizations that may lead stakeholders to
act outside the boundaries of ethical conduct & standards of behaviour.
SA 240This Standard on Auditing (SA) deals with the auditor’s responsibilities relating to fraud
in an audit of financial statements and expands on how SA 315, “Identifying and Assessing the
Risks of Material Misstatement Through Understanding the Entity and Its Environment,” and
SA 330, “The Auditor’s Responses to Assessed Risks,” are to be applied.
SA 315 requires the auditor to identify and assess the risks of material mis statements
whether due to fraud or error in the financial statements.
6
Chapter 2
Where are the Fraud Vulnerabilities and Why
do they Occur
As per a recent study by Assocham and Grant Thornton, the most vulnerable sectors to Fraud
in India are:
The increasing adverse effects of Fraud merit it’s further study and the first step in that study
is understanding as to ‘Why do Frauds Happen’ So let us study some of the
principles/theories which shall help us understand as to why frauds happen.
The most basic of all theories is the Fraud Triangle Theory. The other theories are merely
extension of Fraud Triangle Theory.
2.1 Fraud Triangle
Donald Cressey, a sociologist and criminologist in the 1940s, was one of the first persons to
specialize in the field of understanding fraudsters and why they do what they do. Cressey
wrote "Theft of the Nation," a treatise on La Cosa Nostra- a hierarchically structured view of
the Organizational Crime and he was widely known for his studies in organized crime. Cressey
first gained public recognition in this field while completing his PhD dissertation on
embezzlers, at Indiana University. Cressey interviewed nearly 200 incarcerated individuals
charged with embezzlement. From his research, Cressey developed "The Fraud Triangle”
which was a model he used to explain what caused some people to become fraudsters by
analyzing the circumstances in which the subjects of his research were drawn into fraud
The fraud triangle, developed by Donald Cressey, is a model for explaining the factors that
cause someone to commit occupational fraud. It consists of three components which,
together, lead to fraudulent behavior:
1. Perceived Pressure
2. Perceived opportunity
3. Rationalization
Incentive/ Pressure
Management or other employees may find themselves offered incentives or placed under
pressure to commit fraud. When, for example, remuneration or advancement is significantly
affected by individual, divisional, or company performance, individuals may have an incentive
to manipulate results or to put pressure on others to do so. Pressure may also come from the
unrealistic expectations of investors, banks, or other sources of finance. Certain risk factors
are usefully considered in the evaluation of whether or not the organization is at a greater or
lesser degree of risk, owing to incentives or pressures that could potentially lead to material
misstatements.
Determining the presence and degree of these pressures or incentives is part of the auditor’s
goal in evaluating the risk that misstatements due to fraud may have occurred.
Certain risk factors are usefully considered in the evaluation of whether or not the organization
is at a greater or lesser degree of risk, owing to incentives or pressures that could potentially
lead to material misstatements.
 Financial stability or profitability is threatened by economic, industry, or entity operating
conditions.
 Excessive pressure exists for management to meet debt requirements
 Personal net worth is materially threatened
8
Where are the Fraud Vulnerabilities and Why do they Occur
Attitudes/ rationalization
Some individuals are more prone than others to commit fraud. Other things being equal, the
propensity to commit fraud depends on people’s ethical values as well as on their personal
circumstances. Ethical behavior is motivated both by a person’s character and by external
factors. External factors may include job insecurity, such as during a downsizing, or a work
environment that inspires resentment, such as being passed over for promotion.
Risk factors that fall into this category of rationalization and attitude are typically the least
tangible or measurable, and many are by nature difficult for an auditor to observe or otherwise
ascertain. Fundamentally, rationalization and attitude are functions of the culture of an
organization, the psychology of those who work in it, and the interaction between the two—for
example, the level of employee loyalty to the company. The wider business environment must
also be considered: hard times in an industry or in the overall economy may make it easier for
some individuals to rationalize fraud.
• A history of violations of laws is known
• Little communication and support of the entity’s core values is evident.
• Management has a practice of making overly aggressive or unrealistic forecasts.
• Personal financial obligations create pressure to misappropriate assets.
• Adverse relationships between management and employees motivate employees to
misappropriate assets.
• Disregard for the need to monitor or reduce risk of misappropriating assets exists.
• There is a disregard for internal controls
Some of the commonly given reasons for committing Fraud –
1. Everyone else is doing it
2. I needed the money
3. I meant no harm and did no harm
4. The organization can afford it
5. I was used and needed revenge
6. What I did was entirely right for someone in my position
7. My employer did not compensate me well enough and hence I took what was due to me
8. Bribery is a norm in this type of business
9. I did it to keep the business afloat
10. It was a loan and I would have repaid it
9
Opportunities
Circumstances may exist that create opportunities for management or other staff to commit
fraud. When such opportunities arise, those who might not otherwise be inclined to behave
dishonestly may be tempted to do so. Even individuals under pressure and susceptible to
incentives to perpetrate a fraud are not a grave threat to an organization unless an opportunity
exists for them to act on their need. An opportunity must exist to commit fraud, and the
fraudster must believe the fraud can be committed with impunity.
Opportunities may also be inherent in the nature, size, or structure of the business. Certain
types of transactions lend themselves more than others to falsification or manipulation, as do
certain kinds of balances or accounts.
• There is a presence of large amounts of cash on hand or inventory items.
• There is an inadequate internal control over assets.
• Inadequate segregation of duties.
• Absence of mandatory job rotation and vacations.
2.2 Fraud Diamond
Wolf and Hermanson (2004) introduced the fraud diamond model where they presented
another view of the factors to fraud. The theory adds fourth variable “Capability” to the three
factor theory of fraud triangle. Wolf and Hermanson believed many frauds would not have
occurred without the right person with right capabilities implementing the details of the fraud.
They also suggested four observation traits for committing fraud:
• Authoritative position or function within the organization.
• Capacity to understand and exploit accounting systems and internal control
• Confidence that he/she will not be detected, or if caught, he/she will get out ofit easily.
• Capability to deal with the stress created within and otherwise good person• when he or
she commits bad act.
The Fraud Diamond theory states that all these 3 ingredients are essential but the critical
component in turning the fraud opportunity into reality is “Capability”. The fraudster should
have the necessary traits and abilities to be the right person to pull it off and also the
confidence and ego that he will not be detected or he will be able to talk himself out of trouble
if detected.
10
2.3 Fraud Pentagon

Cressey’s classic fraud triangle helps to explain many situations, but today’s fraudster is more
independent-minded and armed with more information and access than were available to
perpetrators in the 1950s. In addition, few would deny there have been significant cultural
changes in the past 60 years. The fraud triangle can be expanded further to a Crowe
Horwath’s Fraud Pentagon, where an employee’s competence and arrogance are factored into
the 3 conditions generally present when fraud occurs. The two additional aspects in the Fraud
Pentagon are:
1. Competence: It is an extension on the element of opportunity to include an individual’s
ability to override internal controls and to socially control the situation to his advantage
2. Arrogance (lack of conscience): It is an attitude of superiority and entitlement or greed
on the part of the perpetrator who believes that company policies and procedures do not apply
to him.
11
2.4 Fraud Scale

This is another theory on Frauds propounded by Steve Albrecht which states -
• Situational pressures, perceived opportunities& personal integrity are the 3 factors that
lead to frauds–
• When situational pressures & perceived opportunities are high & personal integrity is
low, occupational fraud is much more likely to happen than when the opposite is true.
• It also states that perpetrators hard to profile & fraud difficult to predict.
2.5 Fraud Circle

Another notable theory relating to Fraud is of ‘Fraud Circle’. This theory recognizes the fact
that fraud is Omni-present everywhere and wherever there will be money there will always be
Frauds
2.6 Hollinger Clark Theory
Hollinger and Clark study was based on a total of 12,000 employees of various organizations.
They found that nearly 90% engaged in ‘work place deviance’ which included behavior such
as gold bricking, workplace slowdowns, sick time abuses and pilferage. On top of that, an
astonishing one third of employees actually had stolen money or merchandise on job. The
researchers concluded that the most common reason employees committed fraud had little to
do with opportunity, but more with motivation. The more dissatisfied the employee the more
likely he or she was to engage in criminal behavior. This is described as employees taking
wages in kind.
12
Hollinger and Clark concluded that everyone had a sense of their own worth, if they believe
that they are not being fairly treated or adequately compensated, statistically the organization
is at much higher risk of employee related frauds.
13
Chapter 3
Types of Frauds
Fraud auditing is designed to look for six types of fraud, according to Business Network's
"Recognizing Fraud Indicators." These are embezzling, bribes, stealing, extortion, fictitious
transactions, kickbacks and conflict of interest. Although not all fraud cases can be easily
classified, they will always---at the very least---involve one of these categories. Fraud auditors
are trained to look specifically for indicators to any of these fraud types.
If we classify frauds based on industry, Following are the types of frauds:
1. Bank frauds
2. Corporate frauds
3. Insurance frauds
4. Health Care Frauds
5. Cyber frauds
6. Securities frauds
7. Consumer frauds
3.1 Bank Frauds:
The number of bank frauds in India is substantial. It is in increasing with the passage of time in
all the major operational areas in banking. There are different areas where fraud may exist,
like- Bank-Deposits, Inter-Branch Accounting, Transactions etc.
As a customer you may be seen as a potential target for fraudulent activities. However by
arming yourself with information and tools you can protect yourself from becoming a victim of
fraud. Do you know the four biggest fraud threats you face?
• Electronic fraud
• Identity theft
• Credit/Debit card fraud
• Cheque fraud.
Credit/Debit card fraud
Credit card and debit card fraud is a crime whereby your credit or debit card can be
reproduced in order to use the credit balance to obtain a financial advantage. The creation
and/or alteration of a credit/debit card occurs when the information contained on the magnetic
Types of Frauds
strip is reproduced. This type of crime is known as ‘skimming’.

Credit or debit card fraud can also occur when your card is lost or stolen and used by a third
party to purchase goods with those cards or to remove cash from the cards.
Credit or debit cards can also be intercepted in transit while being sent to you. Your cards can
also be compromised by a dishonest merchant who undertakes unauthorized duplicate
transactions on your card.
Cheque Fraud
Cheque fraud is the use of a cheque to get financial advantage by:
• altering the cheque (payee/amount) without authority
• theft of legitimate cheques and then altering them
• duplication or counterfeiting of cheques
• using false invoices to get legitimate cheques
• depositing a cheque into a third party account without authority
• depositing a cheque for payment knowing that insufficient funds are in the account to
cover the deposited cheque.
3.2 Corporate Frauds
Corporate Frauds can be defined as ‘Activities undertaken by an individual or company that
are done in a dishonest and illegal manner and are designed to give an advantage to the
perpetrating individual or company’ In India, corporate fraud is on a rising trend of45% when
leading Indian business declared that fraud e.g. Satyam Computers stunned the national
financial world. In 2009 Satyam Founder B. Ramalinga Raju declared he had inflated profit
and jacked up the company’s Balance Sheet by more than one billion dollars.
In the Corporate environment frauds which are committed by employees of the organization
are referred to as Occupational or Employee Frauds.
Occupational Fraud is also defined as an employee’s misuse or abuse of his position for his
own enrichment by intentional misappropriation or misuse of company assets. This may
include fraud by an employee, manager or statutory representative.
Occupational Fraud is broadly classified into 3 types
1. Corruption
2. Asset Misappropriation
3. Fraudulent Financial Statements
The FRAUD TREE provides a visual representation of the 3 categories of Occupational Fraud
broken down into various sub-categories.
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Types of Frauds
Classification of Occupational in the Fraud Tree is as follows

Financial Statement Frauds: The least common type of fraud amongst the 3 categories of
Fraud in terms of occurrence is the financial statement fraud. Although it occurs least
frequently, in only 10% of all fraud cases, it is easily the most expensive. The average
financial statement fraud cost to a Company is very high. This type of fraud centers on the
manipulation of financial statements in order to create financial opportunities for an individual
or entity. Stock price, increased year-end bonuses, favorable loan terms, or other indirect
benefits are few of the reasons as to why financial statement frauds are committed Financial
Statement fraud means manipulation, falsification & alteration of accounting records –
(Inventory manipulation, over & under invoicing, Advance billing, Non-impairment of assets,
and use of related party transactions not at arm’s length pricing)
This manipulation could be done by booking fictitious Income or Advance Booking of Income
or non-booking / non-accrual of expenses to increase profits to avail loans / credit or boost
share prices or Reduce Income or inflate Expenses to reduce profits with a view to pay lower
taxes. Alternatively assets like stock or book debts could be inflated to arrive at an inflated
drawing Power to enable more credit to be obtained.
Falsifying documents wholly or in part is termed Forgery
The practice of presenting a rosier picture than what is in reality is also termed as Window
Dressing or Ever Greening.
Corruption: The next most frequently occurring fraud scheme is corruption and bribery, which
is part of about 30% of all fraud that is uncovered. Bribery and corruption include schemes
such as kickbacks, shell company schemes, bribes to influence decision-making, manipulation
of contracts, or substitution of inferior goods. The average bribery/corruption scheme is far
more costly than asset misappropriation but less costly than Financial Statement Fraud.
In ‘Report to the nations on occupational Fraud and Abuse’ ACFE identified the breakdown of
corruption cases by region, along with the respective median losses of those cases (given in
the pictorial format below) TheMiddle East and North Africa had the largest percentage of
reported corruption cases This analysis only represents the cases reported to ACFE by the
CFEs who investigated those cases, and therefore it does not necessarily reflect overall levels
of corruption in each region.
It is also worth noting that Transparency International’s 2013 Corruption Perceptions Index
found these two regions to have amongst the highest perceived levels of corruption in the
world
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Asset Misappropriation: This type is the most common, probably because they are the
frauds that occur most often and are the easiest schemes to understand. An asset
misappropriation might include things like check forgery, theft of money, inventory theft,
payroll fraud, or theft of services. Misappropriation happens in over 91% of fraud
schemes. This easily makes it the most common fraud, but in terms of losses it is the
least expensive per median loss amongst the 3 categories.
3.3 Insurance Frauds
Insurance fraud is any act committed with the intent to obtain a fraudulent outcome from an
insurance process. This may occur when a claimant attempts to obtain some benefit or
advantage to which they are not otherwise entitled, or when an insurer knowingly denies some
benefit that is due. According to the United States Federal Bureau of Investigation the most
common schemes include: Premium Diversion, Fee Churning, Asset Diversion, and Workers
Compensation Fraud. The perpetrators in these schemes can be both insurance company
employees and claimants. False insurance claims are insurance claims filed with the intent to
defraud an insurance provider.
Insurance fraud has existed since the beginning of insurance as a commercial enterprise.
Fraudulent claims account for a significant portion of all claims received by insurers. Types of
insurance fraud are diverse, and occur in all areas of insurance. Insurance crimes also range
in severity, from slightly exaggerating claims to deliberately causing accidents or damage.
Fraudulent activities affect the lives of innocent people, both directly through accidental or
intentional injury or damage, and indirectly as these crimes cause insurance premiums to be
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Types of Frauds
higher. Insurance fraud poses a significant problem and governments and other organizations
make efforts to deter such activities.Such instances of Fraud have been occurring both in the
life and non-life sector. There are significant opportunities for professionals in the field of
forensics and risk management both in the assessment of risk for insurance sector as well as
in determining the veracity of the claims.
According to a survey carried out by E&Y “Fraud risk poses a very big challenge for the
insurance sector. Business leaders are aware of the need to address this risk, but the lack of a
comprehensive and integrated approach to fraud risk management continues to be a concern.
The increasing number of frauds and the growing degree of risk necessitates that insurance
companies regularly review their policies, build in checks and use new and advanced
technology to avoid such issues. However, no system can be foolproof, but a proactive and
dynamic approach can make a company ready to counter fraudsters and gain an edge over its
competitors.”
The key Findings of the survey are still valid today
• There have been increased incidences of fraud over the last one year.
• Fraud risk exposure from claims or surrender is a major concern area for industry
players. They have emphasized the need for increased anti-fraud regulations in the
area of claims management
• Frauds are driving up overall costs for insurers and premiums for policyholders.
• There is a need for a more robust data analytics tools to effectively detect red flags.
• It’s imperative to screen all the key vendors.
3.4 Cyber Frauds
Cyber-crime encompasses any criminal act dealing with computers and networks (called
hacking). Additionally, cyber-crime also includes traditional crimes conducted through the
Internet. For example; hate crimes, telemarketing and Internet fraud, identity theft, and credit
card account thefts are considered to be cyber-crimes when the illegal activities are committed
through the use of a computer and the Internet.
The increasing penetration of e-commerce into consumer population has made this a swiftly
emerging area of practice for forensic accounting professionals
3.5 Securities Frauds
These scams occur because of manipulation of the market by either “insiders” or large players
in the stock market who cause stock prices to fluctuate unusually for their own personal gain,
either through use of “insider” information or through unfair trading practices. As a result
common small investors lose a lot of money as through ignorance they fall into temptation and
invest in stocks which they would not have had they had any idea of how the markets were
being manipulated.
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3.6 Consumer Frauds

Consumer frauds means defrauding consumers of various products and services which do not
perform as advertised. These types of schemes take the form of false advertising, unfair terms
and service conditions, unfair pricing etc.
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Chapter 4
Forensic Accounting: Scope
With India being ranked as the 88th most corrupt nation, the needs for forensic accountants
become all the more profound. A Forensic Auditor is often retained to analyze, interpret,
summarize and present complex financial and business related issues in a manner which is
both understandable and properly supported. Forensic Accountants are trained to look beyond
the numbers and deal with the business reality of the situation.
Forensic Auditors can be engaged in public practice or employed by insurance companies,
banks, police forces, government agencies and other organizations.
A Forensic Auditor is often involved in the following:
• Fraud Detection: Investigating and analyzing financial evidence, detecting financial
frauds and tracing misappropriated funds
• Computer Forensics:Developing computerized applications to assist in the recovery,
analysis and presentation of financial evidence;
• Fraud Prevention: Either reviewing internal controls to verify their adequacy or
providing consultation in the development and implementation of an internal control
framework aligned to an organization’s risk profile
• Providing Expert Testimony: Assisting in legal proceedings, including testifying in
court as an expert witness and preparing visual aids to support trial evidence.
In order to properly perform these services a Forensic Auditor must be familiar with legal
concepts and procedures and have expertise in the use of IT tools and techniques that
facilitate data recovery and analysis. In addition, a Forensic Auditor must be able to identify
substance over form when dealing with an issue.
Fraud Detection
• Review of the factual situation and provision of suggestions regarding possible courses
of action.
• Assistance with the protection of assets and preventing recurrence.
• Co-ordination of other experts, including:
o Private investigators;
o Forensic document examiners;
o Consulting engineers.
• Assistance with the recovery of assets by way of tracing misappropriated funds and
subsequent civil action or criminal prosecution.
Litigation Support
• Assistance in obtaining documentation necessary to support or refute a claim.
• Review of the relevant documentation to form an initial assessment of the case and
identify areas of loss.
• Assistance with Examination for Discovery including the formulation of questions to be
asked regarding the financial evidence.
• Attendance at the Examination for Discovery to review the testimony, assist with
understanding the financial issues and to formulate additional questions to be asked.
• Review of the opposing expert's damages report and reporting on both the strengths
and weaknesses of the positions taken.
• Assistance with settlement discussions and negotiations.
• Attendance at trial to hear the testimony of the opposing expert and to provide
assistance with cross-examination.
Forensic Auditors are retained by:
• Lawyers
• Police Forces
• Insurance Companies
• Government Regulatory Bodies and Agencies
• Banks
• Courts and
• Business Community
Forensic Auditors’ Services
• Crafting questions to be posed
• Responding to questions posed
• Identifying documents to be requested and/or subpoenaed
• Identifying individuals to be most knowledgeable of facts
• Conducting research relevant to facts of the case
• Identifying and preserving key evidence
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• Evaluating produced documentation and information for completeness

• Analyzing produced records and other information for facts
• Identifying alternative means to obtain key facts and information
• Providing questions for deposition and cross examination of fact and expert witnesses
Why are Forensic Auditors required?
They can resolve the matters by combining accounting knowledge & experience with respect
to:
• Fraud Prevention
• Fraud Detection
• Internal Controls Implementation and Review
• Compliance and Regulatory Functions
• Evidence Collection and Analysis
• Risk Management
• Court systems
• Filing requirements
• Investigative methodologies
• Assignments with regulatory agencies like SEBI, RBI. EOW etc.
• Professional body to provide expertise and literature in this fast growing field
• Communicating with audiences from attorneys & judges to victims & suspects
The services rendered by the forensic accountants are in great demand in the following areas:
1. Criminal Investigation
Matters relating to financial implications the services of the forensic accountants are availed
of. The report of the accountants is considered in preparing and presentation as evidence.
2. Cases relating to professional negligence
Professional negligence cases are taken up by the forensic accountants. Non-conformation to
Generally Accepted Accounting Standards (GAAS) or non-compliance to auditing practices or
ethical codes of any profession they are needed to measure the loss due to such professional
negligence or shortage in services.
3. Arbitration service
Forensic accountants render arbitration and mediation services for the business community.
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Their expertise in data collection and evidence presentation makes them sought after in this
specialized practice area.
4. Fraud Investigation and Risk/Control Reviews
Forensic accountants render such services both when called upon to investigate specific
cases as well for a review of or for implementation of Internal Controls. Another area of
significance is Risk Assessment and Risk Mitigation.
5. Settlement of insurance claims:
Insurance companies engage forensic accountants to have an accurate assessment of claims
to be settled.
Similarly, policyholders seek the help of a forensic accountant when they need to challenge
the claim settlement as worked out by the insurance companies. A forensic accountant
handles the claims relating to consequential loss policy, property loss due to various risks,
fidelity insurance and other types of insurance claims.
6. Dispute settlement:
Business firms engage forensic accountants to handle contract disputes, construction claims,
product liability claims, infringement of patent and trade marks cases, liability arising from
breach of contracts and so on.
What characteristics should a Forensic Auditor possess?
• Out of the Box Thinking
• Strong Visualization and Imagination
• Curiosity
• Persistence
• Detail-oriented
• Inquisitiveness
• Creativity
• Discretion
• Skepticism
• Confidence and
• Sound professional judgement.
What Skills should a Forensic Auditor possess?
1. Auditing standards, procedures and related methodologies
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2. Accounting & Business reporting systems

3. Information Technology
4. Data Analytics
5. Criminology
6. Legal Framework
7. Litigation processes & procedures
8. Investigative Techniques
9. Evidence gathering
10. Network of professional contacts in related fields’ viz. enforcement, regulatory bodies,
law, industry, peers etc.
A forensic accountant should possess not only the broad knowledge of accounting principles,
practice and standards but also the knowledge of insurance, banking civil and criminal law and
human psychology.
A Forensic Auditor must be open to consider all alternatives, scrutinize the details and at the
same time see the big picture. In addition, a Forensic Auditor must be able to listen effectively
and communicate clearly and concisely in a timely manner.
Opportunities for Members and Those Involved in Fighting Fraud
Frauds are of such vicissitude and far reaching effects that it would be unthinkable to include
every type or even all major types of frauds. However certain common situations in which
members are likely to find themselves in have been envisaged and briefly described below:
1. Conventional Investigation assignments as a continuation of audits. These are
typical SAP 4 situations where the audit findings have revealed certain anomalies and there is
a suspicion of fraud or error. The management may ask the auditors to extend their audit to
apply such extended or modified procedures as may be necessary to assess, evaluate and
determine the nature and extent of fraud. This kind of assignment is a regular investigation
and needs no elaboration. Such investigations could cover cash embezzlements, asset losses,
revenue leakages through inflated or replicated invoices, suppression of income, inflation of
liabilities, deflation of receivables and the list could go on and on.
2. Investigations by Statutory authorities. Investigations in respect of violations under
any provision under the Income Tax Act, Companies Act, could be required by any of the
respective authorities. Even Police, CBI, CID and the Economic Offences wing could need the
services of chartered accountants. Such services could include determination of claims from
investors of all kinds, assessment of funds lost or misappropriated, non-compliance of
prescribed procedures, bank frauds and any other economic offence where knowledge of
accounting, record-keeping and relevant applicable laws could be useful. In the recent well
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published scams such as Harshad Mehta scam, C R Bhansali, Neek Leeson, and Ketan
Parikh, large number of chartered accountants have been asked to provide valuable insights
as to the nature and methodology of the frauds perpetrated.
3. Bank frauds. This area has the highest potential of fraud. The raw material is money
itself. Frauds can be perpetrated within a bank itself or by outsiders. Insiders may manipulate
funds, loans, and apply teeming and lading between favored accounts. Outsiders could
defraud a bank by furnishing fabricated, duplicated or altered demand drafts, cheques, bills of
exchange, and other negotiable instruments. Apart from these borrowers also often cheat
banks in hypothecation agreements by inflating inventories or even providing substandard or
spurious stocks with little or no value. Chartered Accountants may find themselves as
auditors, investigators, or a part of the inspection team. These days even pre facility audits are
asked to be carried out. These are audits in the garb of investigations to ensure that funds are
going into safe and reliable hands
4. Business risk evaluation. This is another area of professional opportunity for
chartered accountants. Every business venture is always fraught with risks. What varies is the
degree and extent of the risk. Take for example a case where a company has to undertake a
new project for which it requires a large finance say Rs 100 crores. In the current financial
markets there are plenty of consultants offering a plethora of services. Very often such means
of financing are obtained through consultants not very well known to the borrowers and
possibly of dubious credentials. They offer new and untested financing schemes through
banks or financing institutions or IDBI, or RBI, etc. In such situations sometimes upfront or
advance payments are to be made which run in substantial amounts. In such circumstances
either the financial officers of the company who could be chartered accountants or audit firms
may be asked to inquire into the feasibility of the scheme as well as the reliability of the
consultant. Since the stakes involved are generally high, such assignments offer a challenging
opportunity for chartered accountants to earn the appreciation of the clients. Similar situations
could arise when a new vendor, or a new client or a new venture s to be entered into and the
company wants to ensure that there is no risk. In
All such situations the bottom line is to ensure that the client minimizes its chances of being
duped.
5. Insurance claim frauds. Claims for loss of stocks and loss of profits of large values,
particularly exceeding Rs 5 crores are usually surveyed in detail by most insurance
companies. More often than not these claims are inflated, with or without intention. In such
situations as well chartered accountants could be called upon to review, inquire and
investigate into frauds.
6. Compliance verifications. There are so many situations where specific guidelines or
directives have been laid down for use of funds. For example a large trust may be given a
donation of Rs 10 crores for a project say providing for orphans and widows. The donor may
want an assurance that the funds donated have been appropriately used. It is possible that
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this could turn out to be a thriving ground for frauds and misappropriation of funds. Similarly a
hospital may have been given funds for a specific ward with conditions. There could be
misrepresentations and false reports. A business may have a remote site where certain
activities may be in progress. A possibility of misuse of resources is also likely.
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Chapter 5
Detecting Red Flags
The author and creator of Sherlock Holmes [Sir Arthur Conan Doyle] said that "detection is, or
ought to be, an exact science, and should be treated in the same cold and unemotional
way.”Forensic investigation involves looking beyond the obvious. A normal accountant act like
the policeman the forensic investigator role is akin to the CID/CBI and looks for signs which
indicate abnormal and unusual behaviour. Such signs are referred to in forensic accounting
parlance as red flags.
Buddhism refers to three kinds of poisons ‘anger, greed and ignorance’. If not checked they all
eventually lead to wrongdoing. A symptom or a ‘red flag’ will surface in some form or the other
where any of these three evils are present.
Red Flags are sign or warning of any impending danger or inappropriate behaviour. Red
Flags do not necessarily indicate the existence of fraud however are indicators that caution
needs to be exercised while investigating the situations. Red Flags are classified in the
following categories
 Financial performance red flags: Theyinclude aggressive goals and performance
measures, both at the individual and company-wide levels. When a certain level of
performance is mandated, by the boss, Investors, the bank, or otherwise, there can be
a temptation to turn to fraud to meet these goals.
Companies whose financial performance suggests the possibility of fraud might include some
of these signs:
• Significantly outpacing competitors in the industry
• Outstanding results when the rest of the industry has suffered a downturn
• Unusual financial ratios when compared to competitors
• Persistent cash flow problems, even when the company has regularly reported profits
• A pattern of similar audit adjustments proposed year after year
 Accounting system red flags: They refer to the organization of the accounting system
and the level of internal controls that are in place. A good, secure accounting system
cannot exist without internal controls, and the company cannot be free from error and
fraud without such controls.. Some of the basic red flags that might be noted in a
company’s accounting records include:
• Unusual timing of the transaction. This includes the time of day, the day of the
week, or the season.
Detecting Red Flags
• Frequency of transactions. Transactions that are occurring too frequently or not

frequently enough are suspicious. Each company has its own operating patterns,
and the transactions should be booked accordingly.
• Unusual amounts recorded. Take notice of whether an account has many large,
round numbers entered. Consider whether some of the transactions in the
account are far too large or far too small.
• Unusual amounts recorded. Take notice of whether an account has many large,
round numbers entered. Consider whether some of the transactions in the
account are far too large or far too small.
• Questionable parties involved. Payment being made to a related party? Is the
company paying large sums to a vendor whose name is not easily recognizable
or is not a normal vendor of the company
 Operational red flags: They highlight how a company does business each day. Do
things run smoothly, minimizing the chance for errors and problems? Or are things
managed in such a fashion that errors go unchecked and employees do whatever they
want, whenever they want?
 Behavioural red flags: They include behavioural patterns of the employees.
In “Report to the nations on occupational Fraud and Abuse’ by ACFE identified the
behavioural indicators displayed by Fraud Perpetrators. The below figure shows the
distribution of those red flags. Approximately 44% of fraud perpetrators were living
beyond their means while the fraud was ongoing, and 33% were experiencing known
financial difficulties. Other common red flags were an unusually close association with a
vendor or customer (22%), displaying control issues or an unwillingness to share duties
(21%), a general “wheeler-dealer” attitude involving shrewd or unscrupulous behaviour
(18%), and recent divorce or family problems (17%). These six red flags were also the
most common behavioural indicators in each of ACFE’s last three studies.
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 Structural red flags: They relate to the way that a company is set up and the policies
and procedures that are in place. Those very systems create opportunities for fraud
each day. Employees become familiar with operations, and they begin to understand
what accounts are unmonitored, which areas of the company are poorly supervised, and
what size of transaction that creates added scrutiny.
 Personnel red flags: They refer to the employment policies and procedures within a
company, including hiring procedures, advancement policies, employee monitoring
programs, and disciplinary standards.
Appendix 3 of SA 240 ‘THE AUDITOR’S RESPONSIBILITIES RELATING TO FRAUD IN AN
AUDIT OF FINANCIAL STATEMENTS’ contains examples of certain Red Flags i.e. examples
of circumstances that may indicate the possibility that the financial statements may contain a
material misstatement resulting from fraud. They are as follows:
Discrepancies in the accounting records, including:
• Transactions that are not recorded in a complete or timely manner or are improperly
recorded as to amount, accounting period, classification, or entity policy
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Detecting Red Flags
• Unsupported or unauthorized balances or transactions

• Last-minute adjustments that significantly affect financial results
• Evidence of employees’ access to systems and records inconsistent with that necessary
to perform their authorized duties
• Tips or complaints to the auditor about alleged fraud.
Conflicting or missing evidence, including:
• Missing documents
• Documents that appear to have been altered
• Unavailability of other than photocopied or electronically transmitted documents when
documents in original form are expected to exist
• Significant unexplained items on reconciliations
• Unusual balance sheet changes, or changes in trends or important financial statement
ratios or relationships – for example, receivables growing faster than revenues
• Inconsistent, vague, or implausible responses from management or employees arising
from inquiries or analytical procedures
• Unusual discrepancies between the entity's records and confirmation replies
• Large numbers of credit entries and other adjustments made to accounts receivable
records
• Unexplained or inadequately explained differences between the accounts receivable
sub-ledger and the control account, or between the customer statements and the
accounts receivable sub-ledger
• Missing or non-existent cancelled checks in circumstances where cancelled checks are
ordinarily returned to the entity with the bank statement Missing inventory or physical
assets of significant magnitude
• Unavailable or missing electronic evidence, inconsistent with the entity’s record
retention practices or policies
• Fewer responses to confirmations than anticipated or a greater number of responses
than anticipated
• Inability to produce evidence of key systems development and program change testing
and implementation activities for current-year system changes and deployments.
Problematic or unusual relationships between the auditor and management, including:
• Denial of access to records, facilities, certain employees, customers, vendors, or others
from whom audit evidence might be sought
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• Undue time pressures imposed by management to resolve complex or contentious

issues
• Complaints by management about the conduct of the audit or management intimidation
of engagement team members, particularly in connection with the auditor’s critical
assessment of audit evidence or in the resolution of potential disagreements with
management.
• Unusual delays by the entity in providing requested information
• Unwillingness to facilitate auditor access to key electronic files for testing through the
use of computer-assisted audit techniques
• Denial of access to key IT operations staff and facilities, including security, operations,
and systems development personnel
• An unwillingness to add or revise disclosures in the financial statements to make them
more complete and understandable
• An unwillingness to address identified deficiencies in internal control on a timely basis.
Others:
• Unwillingness by management to permit the auditor to meet privately with those
charged with governance
• Accounting policies that appear to be at variance with industry norms
• Frequent changes in accounting estimates that do not appear to result from changed
circumstances
• Tolerance of violations of the entity’s code of conduct.
Red flags that are “Indicia of Fraud” are nothing but symptoms or indicators of situations of
frauds. They do not necessarily indicate the existence of fraud and hence the auditor should
exercise caution in forming an opinion before investigating. The following are some of the red
flags which examiners are likely to come across and understand.
• Lack of Corporate Governance
o Absence of rotation of duties or prolonged exposure in the same area
o no written policies and/or procedures
o lack of Internal Controls or casual approach to reported internal control lapses
o frequent or unusual Related Party transactions ( not arm’s length)
o Close nexus with vendors, clients, or external parties - There would be a conflict
of interests if an employee, particularly at a senior level, were to have close
relations with a client.
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Detecting Red Flags
• Questionable Accounting Activities

o Management override of Internal Controls
o unreconciled subsidiary & General Ledger accounts
o continuous adjustments of book to physical inventories
o topside Journal Entries
o Excessive number of manual checks
 Stale Items in Reconciliations- In bank reconciliations, deposits or checks not
included in the reconciliation could be indicative of theft. Missing deposits
could mean the perpetrator absconded with the funds; missing checks could
indicate one made out to a bogus payee.
 Excessive Voids - Voided sales slips could mean that the sale was rung up,
the payment diverted to the use of the perpetrator, and the sales slip
subsequently voided to cover the theft.
 Excessive Credit Memos - Similar to excessive voids, this technique can be
used to cover the theft of cash. A credit memo to a phony customer is written
out, and the cash is taken to make total cash balance.
 Common Names and Addresses for Refunds - Sales employees frequently
make bogus refunds to customers for merchandise. The address shown for
the refund is then made to the employee's address, or to the address of a
friend or co-worker.
 Increasing Reconciling Items - Stolen deposits, or bogus checks written, are
frequently not removed, or covered, from the reconciliation. Hence, over a
period of time, the reconciling items tend to increase.
 General Ledger Out-of-Balance - when funds, merchandise, or assets are
stolen and not covered by a fictitious entry, the general ledger will be out of
balance. An inventory of the merchandise or cash is needed to confirm the
existence of the missing assets.
 Adjustments to Receivables or Payables - In cases where customer
payments are misappropriated, adjustments to receivables can be made to
cover the shortage. Where payables are adjusted, the perpetrator can use a
phony billing scheme to convert cash to his or her own use.
 Excess Purchases - Excess purchases can be used to cover fraud in two
ways:
• Fictitious payees are used to convert funds
• Excessive purchases may indicate a possible payoff of purchasing
agent
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 Duplicate Payments - Duplicate payments are sometimes converted to the

use of an employee. The employee may notice the duplicate payment, then
he or she may prepare a phony endorsement of the check.
 Ghost Employees - Ghost employee schemes are frequently uncovered when
an auditor, fraud examiner, or other individual distributes paychecks to
employees. Missing or otherwise unaccounted for employees could indicate
the existence of a ghost employee scheme.
 Employee Expense Accounts - Employees frequently conceal fraud in their
individual expense account reimbursements. These reimbursements should
be scrutinized for reasonableness and trends, especially in the area of cash
transactions on the expense account.
 Inventory Shortages- Normal shrinkage over a period of time can be
computed through historical analysis. Excessive shrinkage could explain a
host of fraudulent activity, from embezzlement to theft of inventory.
 Increased Scrap - In the manufacturing process, an increased amount of
scrap could indicate a scheme to steal and resell this material. Scrap is a
favorite target of embezzlers because it is usually subject to less scrutiny
than regular inventory.
 Large Payments to Individuals - Excessively large payments to individuals
may indicate instances of fraudulent disbursements.
 Write-off of Accounts Receivable - Comparing the write-off of receivables by
customers may lead to information indicating that the employee has
absconded with customer payments.
• Sudden Losses. A company doing quite well suddenly makes huge losses. While there
could be genuine reasons, mismanagement of funds and resources are more likely.
These losses are likely to have been there all along simmering under window dressed
accounts.
• TGTBT syndrome. TGTBT stands for Too Good To Be True. This indicates that lovely
glossy report may be furnished whereas in real terms there are gloomy conditions.
• Generation of ‘orphan’ funds. Funds which are held in a fiduciary capacity and for
which there is no accountability are thriving places for frauds. Funds collected by trusts
or donations in cash collection boxes are typical examples where there is no
accountability on either side. Neither does the donor concern himself about the usage of
the funds nor does the beneficiary have a direct claim or even awareness in respect of
such funds. However such funds can Familiarization with Red Flags in Detection of
Frauds.
• Disaster situations: Accidents where books have been lost, or damaged, or
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Detecting Red Flags
catastrophes such as fire, earthquake, floods etc. are other places where fraudsters can
feast.
• Missing Documentation. This is the surest sign of fraud and practically every situation
of missing records either has been created to suppress a fraud or if such a situation
happens to emerge it is used to engineer a fraud.
• Chaotic conditions. As a corollary of disaster situations, conditions where accounts
are in arrears, messy state or unreconciled, by and large are artificially created. The
reason given normally is shortage of staff or resources, but this is more of an excuse.
• Behavioral Issues
o failure to take vacations
o living beyond one’s means
o Insider trading
o early arrival – late departure
o Irrational behavior. Behavior which is not becoming of the employees’ position
and which does not keep in mind the decorum of an office often stems from deep
rooted insecurity which could be symptomatic of fraudulent intentions.
The perpetrator will often display unusual behavior, that when taken as a whole is a
strong indicator of fraud. The fraudster may not ever take a vacation or call in sick in
fear of being caught. He or she may not assign out work even when overloaded. Other
symptoms may be changes in behavior such as increased drinking, smoking,
defensiveness, and unusual irritability and suspiciousness.
• Complaints - Frequently tips or complaints will be received which indicate that a
fraudulent action is going on. Complaints have been known to be some of the best
sources of fraud and should be taken seriously. Although all too often, the motives of
the complainant may be suspect, the allegations usually have merit that warrant further
investigation.
YELLOW FLAGS
These are indications of authorized activities which are flagged because of their unusual
nature. These may be perfectly legitimate activities which are worth checking as they may also
be indications of fraudulent activity. Examples of such activities are
1 Unusually high transactional amounts on a debit credit card transaction
2 Login to a system or application from an unusual IP or Location
Such transactions are used to enforce preventive measures or exception reporting e.g. Banks
now call up the card holder to verify if high volume transactions or transactions from a different
location or a foreign location are genuine before authorization
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GREEN FLAGS
Green Flags are in many ways the converse of Red Flags. They are a part of the TGBT
syndrome referred to earlier. (TOO GOOD TO BE TRUE). Examples include
 Unusually high returns provided by an investment
 High Profit Margins for a company which are way above the industry average
 Specific companies performing very well when the industry is in a slump
Like Red Flags these are only indicators and are not conclusive evidence of fraudulent activity
and need to be investigated before reaching a conclusion.
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Chapter 6
Process of Forensic Accounting
Each Forensic Accounting assignment is unique. Accordingly, the actual approach adopted
and the procedures performed will be specific to it. However, in general, many Forensic
Accounting assignments will include the steps detailed below.
A Forensic Auditor must initially consider whether his/her firm has the necessary skills and
experience to accept the work. Forensic audits are highly specialized, and the work requires
detailed knowledge of fraud investigation techniques and the legal framework.
Step 1. Initialization
It is vital to clarify and remove all doubts as to the real motive, purpose and utility of the
assignment.
It is helpful to meet the client to obtain an understanding of the important facts, players and
issues at hand. A conflict check should be carried out as soon as the relevant parties are
established. It is often useful to carry out a preliminary investigation prior to the development
of a detailed plan of action. This will allow subsequent planning to be based upon a more
complete understanding of the issues.
Fraud audits begin with an initialization process. Internal business owners or managers,
government agencies or other businesses may require a fraud audit on a company.
Reasonable expectation must exist in order to conduct a fraud audit. Fraud auditors will review
each request on a case-by-case basis to determine if circumstances exist whereby fraud may
be going on. Incompetent accounting or handling of financial information does not necessarily
indicate fraud; intent is an essential element for fraud to exist.
Step 2. Develop Plan
The forensic audit team must carefully consider what they have been asked to achieve and
plan their work accordingly. This plan will take into account the knowledge gained by meeting
with the client and carrying out the initial investigation and will set out the objectives to be
achieved and the methodology to be utilized to accomplish them.
Planning a fraud audit will occur if auditors determine enough improprieties exist in a
organization’s financial or business operations. Auditors will gather information about the
organization and begin a review process of the company. Each approach to fraud audits is
different, primarily because fraudulent schemes come in different varieties or situations.
Auditors must also try to determine who is involved in perpetrating the fraud. Gathering
evidence and connecting individuals to specific events can also help auditors develop an audit
plan for fully investigating a company.
The objectives of the investigation will include:

• identifying the type of fraud that has been operating, how long it has been operating for,
and how the fraud has been concealed
• identifying the fraudster(s) involved
• quantifying the financial loss suffered by the client
• gathering evidence to be used in court proceedings
• Providing advice to prevent the reoccurrence of the fraud.
The investigators should also consider the best way to gather evidence – the use of computer
assisted audit techniques, for example, is very common in fraud investigations.
Step 3. Obtain Relevant Evidence
Depending on the nature of the case, this may involve locating documents, economic
information, assets, a person or company, another expert or proof of the occurrence of an
event.
In order to gather detailed evidence, the investigator must understand the specific type of
fraud that has been carried out, and how the fraud has been committed. The evidence should
be sufficient to ultimately prove the identity of the fraudster(s), the mechanics of the fraud
scheme, and the amount of financial loss suffered. It is important that the investigating team is
skilled in collecting evidence that can be used in a court case, and in keeping a clear chain of
custody until the evidence is presented in court. If any evidence is inconclusive or there are
gaps in the chain of custody, then the evidence may be challenged in court, or even become
inadmissible. Investigators must be alert to documents being falsified, damaged or destroyed
by the suspect(s).
Evidence can be gathered using various techniques, such as:
• testing controls to gather evidence which identifies the weaknesses, which allowed the
fraud to be perpetrated
• using analytical procedures to compare trends over time or to provide comparatives
between different segments of the business
• applying computer assisted audit techniques, for example to identify the timing and
location of relevant details being altered in the computer system
• discussions and interviews with employees
• Substantive techniques such as reconciliations, cash counts and reviews of
documentation.
38
Process of Forensic Accounting
Step 4. Perform the analysis

The actual analysis performed will be dependent upon the nature of the assignment and may
involve:
• calculating economic damages;
• summarizing a large number of transactions;
• performing a tracing of assets;
• performing present value calculations utilizing appropriate discount rates;
• performing a regression or sensitivity analysis;
• utilizing a computerized application such as a spread sheet, data base or computer
model; and
• utilizing charts and graphics to explain the analysis.
Step 5. Reporting
Issuing an audit report is the final step of a fraud audit. Auditors will include information
detailing the fraudulent activity, if any has been found. This report provides external business
stakeholders with information regarding the organization’s business operations. Government
agencies may also wish to see the audit report. Significant fraudulent activity may result in civil
or criminal charges against the individuals conducting the fraud.
The client will expect a report containing the findings of the investigation, including a summary
of evidence and a conclusion as to the amount of loss suffered as a result of the fraud. The
report may include sections on the nature of the assignment, scope of the investigation,
approach utilized, limitations of scope and findings and/or opinions. The report will include
schedules and graphics necessary to properly support and explain the findings.
The report will also discuss how the fraudster set up the fraud scheme, and which controls, if
any, were circumvented. It is also likely that the investigative team will recommend
improvements to controls within the organization to prevent any similar frauds occurring in the
future.
The forensic auditor should have active listening skills which will enable him to summarize the
facts in the report. It should be kept in mind that the report should be based on the facts
assimilated during the process and not on the opinion of the person writing the report.
Step 6. Court proceedings
The investigation is likely to lead to legal proceedings against the suspect, and members of
the investigative team will probably be involved in any resultant court case. The evidence
gathered during the investigation will need to be presented at court, and team members may
be called to court to describe the evidence they have gathered and to explain how the suspect
39
was identified. It is imperative that the members of the investigative team called to court can
present their evidence clearly and professionally, as they may have to simplify complex
accounting issues so that non-accountants involved in the court case can understand the
evidence and its implications.
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Chapter 7
Interviewing Skills and Techniques
7.1 Introduction
Interviewing and reporting are critical skills for anti-fraud professionals. Knowing how to
conduct effective interviews and identify deception can make or break a fraud examination.
Reporting the results of an examination clearly and thoroughly supports the credibility of you
and your work, and makes your findings more actionable.
Interviewing and report writing are both critical skills necessary when conducting an internal
investigation.
This chapter explores the strategies necessary to conduct a successful interview, from the
initial planning stages to obtaining signed statement, and handling problems which may arise
during the process.
Effective interviewing is a function of both – a well-structured interview and a well prepared
interviewer. Successful interviewers typically excel in interpersonal relations and can identify
verbal and non-verbal clues of deception.
7.2 Overview of an Effective Interview
In any Fraud investigation, forensic accountants are asked to help management, board of
directors, regulatory authorities, or law enforcement officials to determine the facts regarding
complex financial matters. An effective interview is essential for gathering facts and steering
the investigation in the right direction.
Knowledge of effective interviewing techniques is essential for most types of forensic
investigations. The forensic accountant cannot just rely on paper trails, computer databases,
and documents to provide evidence. In most cases, the accountant must acquire information
from people possessing critical information.
Through interviews the forensic accountant can obtain information that identifies key issues of
a case. Leads can be developed to other sources of evidence.
Interviews are used to obtain information about and to understand the allegations and to verify
facts. These may take the form of formal or informal interviews.
For formal interviews, notes were taken and/or recordings were made. In some instances, the
person is asked to sign the interview notes. If the interview is of importance to a particular
allegation, the interviewee is informed that he or she would possibly have to confirm his or her
statement at a later date.
The investigation team also conducts numerous informal interviews to collect information
relating to documents and activities. Informal interviews were not recorded although hand
written notes may be taken. These interviews are conducted for obtaining background
information, understanding the nature of the fraud, obtaining background information on the
suspected perpetrators, understanding their possible motives and even their behavior
patterns.
Information about the personal backgrounds of those involved can be obtained in interviews.
Interpersonal relationships can be uncovered. Possible motives can be explored. Interviews
can be used to obtain the cooperation of victims and witnesses.
In forensic cases evidence is often gathered piece by piece. Interviewing is often an important
step in putting the pieces together.
To be successful, an interview should be thorough. It requires strategic planning, relevant
questions and an objective interviewer.
Interviewers can enhance their credibility by focusing on information that the interviewee
should know, as opposed to guessing during the interview and thereby wasting the time of the
participants by asking questions that the interviewee could not know. By remaining objective
and fair, the interviewers can better gain the confidence of the interviewee.
An effective interviewer should be an active listener, as well as an active observer. Both are
learned skills that can be studied and improved with practice. Active listening means not only
listening more than talking, but really hearing what is being said and how it is being
communicated. Sometimes what is not being said is equally as important as what has been
said by the interviewee.
It always is recommended that only one person should be interviewed at a time. The
interviews usually should begin with neutral witnesses and move to corroborating witnesses.
The actual suspects of the case normally are interviewed toward the end of the interview
process; however, other options may be considered depending on the nature of the case.
In some circumstances, interviews with suspects may be conducted early in the investigation if
it appears that evidence may be destroyed, if the suspect is leaving the company, or if threats
to other witnesses are being made.
Many other possibilities exist where a suspect (or suspects) may have to be interviewed
before all pertinent documents are obtained and reviewed and before other fact witnesses are
interviewed. In most every organization, there are people who are willing to share information
if they can remain anonymous.
In a number of cases, confidential sources provide information through employee hotlines and
anonymous letters. Additionally, former employees may provide valuable information through
letters of resignation and exit interviews.
Forensic accountants also should consider that confidential sources of information may have a
42
hidden motive for providing information. Former spouses, business partners, employees,
neighbors, and friends may know specific details. However, the reasons for providing such
information may be suspect. The confidential source may be providing information that is
intended to discredit or embarrass the target.
A forensic accountant should weigh the benefits of relying on the evidence against the risk of
potential damage to the case if the information proves false. To the extent possible,
information received from confidential sources should be corroborated through independent
investigation.
An interrogation generally is viewed as a process of questioning with force, moving toward a
denial of the incident or a confession. In many occasions, a simple fact-gathering interview
may evolve into an interrogation with the unsuspected perpetrator of the alleged illicit activity.
The dividing line between interviews and interrogations is not always clear-cut. Interviewers
should be prepared for a wide variety of circumstances in a forensic engagement and should
remain objective, fair and act with integrity.
Practitioners who are not experienced in forensic investigation and who do not consult with
counsel before undertaking an investigation expose themselves to potential ethical violations
and/or serious legal consequences.
Forensic specialists are fact-finders who may appear to lose their objectivity if they assume
the role of interrogator seeking a confession. Although a confession may be elicited based on
the evidence produced by the forensic accountant, interrogation normally is reserved for
experienced specialists such as law enforcement officers.
7.3 The Interview Process
7.3.1. Collection and Collating Data.
7.3.2. Purpose of the interview.
7.3.3. Time and Place for the interview.
7.3.4. Preparation for the interview
7.3.5. Recording the interview
7.3.6. Initiate the interview
7.3.7. Different types of interview questions
7.3.8. Process of taking notes during interviews
7.3.9. Concluding the interview
7.3.10. Documenting the interview
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7.3.1. Collection of Data

The initial steps taken upon the initial discovery of suspected fraud are critical and should be
taken with thoughtful consideration.
Forensic accountants should advise their clients to secure data, documents, and information
before initiating the interview process. Once people learn that an investigation may be under
way, any delay in securing electronic and documentary evidence may result in the alteration,
destruction or deletion of documents or computer data.
Gathering this evidence requires that proper chain of custody procedures be followed to
ensure the integrity of the evidence, especially if such evidence is to be eventually relied upon
in a legal proceeding.
Collection, Organizing and Collating data is the very first step to be taken, even before making
an interview plan. Data is available in various forms and can be gathered from multiple
sources like phone records, CC TV footage, ERP access records, system login details, access
card details and others.
Facts can be derived from business records of parties involved or external sources like
government, industry and market databases. These should be coded andstored in a database
for retrieval. Knowledge of information systems and database management computer
programs can be a valuable aid to a forensic auditor in collecting, organizing, and
summarizing the large volume of facts and related documents.
Financial modeling languages are specifically designed for this purpose andhave many built-in
features to aid the user in developing pro forma financialstatements. Powerful database
software is required for large cases with manydocuments. Sophisticated statistical techniques
are sometimes applied to analyze the data gathered in an investigation. These methods are
more advanced than the basic statistical techniques. With the help of advanced statistical
software, users can employ techniques and analyze the data, financial and non financial to
draw up an effective interview plan.
7.3.2. Purpose of Interviewing
An interview can best be described as a professional conversation conducted with a specific
purpose or goal in mind. The thrust of an effective interview is to gain knowledge and
information that is relevant to the investigation.
The primary purpose of most interviews is to gather evidence through facts and other
information supplied by witnesses. Interviewing is performed throughout an investigation. With
each successive interview, the interviewer should obtain background information about the
witnesses, the subject matter of the investigation, and the potential suspects. Efforts should
be made during the interviews to identify new records and additional witnesses.
Interviews generally should strive to answer basic questions: who, what, where, when, how
and why.
44
An interview plan and theme should be developed before conducting the actual interviews.
Presumably, an investigative plan already exists to outline the nature of the case; list of
potential witnesses; a preliminary order of interviews; key issues to resolve; appropriate data,
documents, and information to obtain; and investigative measures that should be conducted
before interviews begin.
The interview plan should complement the investigative plan. Interviewers should therefore
become familiar with the investigative work already completed, and the Interviewers also
should honestly assess their own strengths and weaknesses to determine if they are properly
prepared and capable of conducting the interviews.
The key elements for an investigative plan are
• The investigative team should develop and agree upon the plan before the first
interview;
• The plan must be flexible enough to incorporate continual changes dictated by
information unearthed at each stage of the engagement; and
• The team should meet regularly during the engagement to consider the possibility of
changes in the interview program.
In terms of developing the interview strategy, an investigator should include the following:
• Whom to interview within the organization, considering both key and non-key personnel;
• Whom to interview outside the organization, considering both key and non-key third-
party individuals;
• Timing of interviews, incorporating time to review documents and other information
discussed and analyzed during interviews; and sequencing of interviews.
While the investigative team members may not want to reveal that they suspect fraud, they
need to provide a reason for wanting to talk with potential interviewees. The reason cited
should be honest but does not necessarily have to disclose concerns of fraudulent activity.
Examples of reasons to undertake these types of interviews include:
• This is part of a special-purpose audit;
• This is part of a process or accounting system improvement study;
• This is connected with an internal control study;
• We need to understand further details about a specific financial transaction; or
• Certain accounting procedures have generated some concerns.
7.3.3. Setting of Time and Place
Many interviews fail to gather enough information to address the issues raised in a forensic
45
matter because of inadequate preparation, or because insufficient time is allowed to complete

the interview.
Normally an interview is scheduled and a fixed time is set for the initiation and completion. If
possible, sufficient time should be allowed to conduct the interview with the time of completion
left open. If a set time is established, the person interviewed may be overly focused on the
ending time, thereby restricting a flow of information.
Ideally, the interview should be conducted as soon as the alleged impropriety has been
discovered.
When arranging an interview, a location should be chosen to ensure privacy and to minimize
interruptions. The use of cell phones should be discouraged.
Care should be taken to ensure that the person being interviewed has access to an exit that
is not blocked by the interviewers. This is a safety consideration, but also may be a
consideration to demonstrate the voluntary nature of statements.
7.3.4. Preparing for an Interview.
What to consider? Depending on the situation, there are many factors that need to be
considered before undertaking an investigation.
Coordination with someone from Human Resources, Security and the Information Technology
departments typically is undertaken before the interview process.
Forensic accountants should resist the temptation to initiate interviews without considering the
significant legal implications that may arise. Working under the direction of counsel protects
the forensic accountants from overreaching or unwittingly crossing the line. For example,
interviews may be protected by legal privilege if the forensic accountant has been retained by
counsel. Privileged conversations are kept confidential and may be protected from further
inquiry or disclosure. Without this protection, forensic accountants may be forced to disclose
inaccurate or slanderous information that may wrongly harm an individual (or individuals),
thereby exposing the forensic accountant to negative legal ramifications.
Each situation presents a different set of circumstances. And each situation presents
complicated legal issues that forensic accountants, by themselves, are not equipped to handle
without legal guidance.
Ideally, interviews should be conducted by two people. And, the plan should outline the goals
of the interview, who will be the lead interviewer, who will be taking notes, the role of the
second interviewer, the subject areas and key points to cover, as well as safety
considerations.
7.3.5. Recording of the Interview
If the decision is made to record interviews, proper and reliable recording equipment is
required and a chain of custody for the recordings will be necessary. If recorded statements
46
are used in a later proceeding, the recordings will have to be authenticated and any
transcriptions will have to be reviewed for accuracy.
While most recording equipment uses a digital format, the digital recordings can easily be
altered. Therefore, the original recordings must be retained where a proper chain of custody
and retention can provide assurances that the original recording has not been changed. Eg
date and time logs.
Extreme care should be taken when making work copies of the original recording.
Surreptitious recordings also are fraught with significant legal issues.
7.3.6. The Interview
The initial contact with the person to be interviewed is the first, but not last, chance to set the
tone of the interview and begin the important rapport-building process.
Introductions should be polite and professional, with appropriate handshakes. Other physical
contact can be easily misinterpreted and should be avoided. The identity of the interviewers
should be disclosed and the identity of the person interviewed and others present should be
confirmed.
During the introductory phase of the interview, interviewers should clearly state the purpose,
preferably in general terms as opposed to specific terms.
The stated purpose should be logical, easy for the respondent to accept, and easy for the
interviewer to explain. It should be stated that the results of the interview may also be
disclosed to third parties.
Once introductions have been made, interviewers should begin with asking simple questions
to put the witness at ease and help to build a rapport. Background questions should include
asking their name, address, phone number, title, how long they have been in that position as
well as what their duties are. During the introductory phase of the interview, sensitive
questions and emotive words should be avoided. Forensic accountants may want to consider
asking the person being interviewed if anyone has talked to them about the reason for the
interview or if allegations have been made.
Depending on the issue being investigated, the interviewer may want to gather information
regarding the target of the investigation. Such information may include work habits, personal
lifestyle, usual activities, as well as any unusual behavior. It also is important for the
interviewer to obtain the interviewee’s basis of knowledge for his/her statements. By
encouraging longer answers, interviewers can better assess the verbal, non-verbal, and
physical reactions of the interviewee in order to gauge baseline reactions. Challenging
information and statements at this point in the process is not recommended.
Interviewers should approach sensitive questions very carefully and should not react to
statements made by the interviewee. Interviewers should not express shock, disgust or similar
emotions. And, interviewers should remain nonjudgmental, fair and objective. While the
47
interviewers are observing the verbal and nonverbal actions of the interviewees, it should be
remembered that the interviewers also can demonstrate powerful messages by their own
verbal, nonverbal and physical actions.
While initial contact should be polite and professional, it is just as important to maintain firm
control over the interview process. The interviewers should be viewed as in charge and with a
mission to accomplish, that is, to resolve the pertinent issues. The topic of the interview
should be controlled to maintain the parameters of the subject matter. Some interviewees may
attempt to wrest control of the interview by omitting key information, offering evasive answers,
or engaging in direct deception.
7.3.7. Types of Questions and Sequence
(a) Informational Questions
Informational type questions are designed to be non-confrontational and non-threatening.
These questions are designed to gather information. Informational questions should be
unbiased in nature. Such questions are used that are unlikely to cause defensiveness or
hostility. These questions should be asked to develop facts in the order of their occurrence.
Only one question should be asked at a time. Interviewers should be asking straight forward
and frank questions while allowing sufficient time for the interviewee to respond. It is
appropriate to assist the interviewee to recall events; however, answers should not be
suggested. To facilitate recall and responses, the interviewers may consider showing the
person copies of data, documents, or information.
Questions can be repeated or rephrased for verification and interviewers should make certain
that the answers are thoroughly understood. The interviewee should be afforded opportunities
to verify and qualify answers.
Interviewers should be attempting to separate facts from inferences in their questioning by
ascertaining the interviewee’s basis of knowledge. In other words, the interviewers will want to
determine whether a person is answering a question based on firsthand observation and
knowledge, or whether the knowledge obtained from other persons (second-hand information).
It also is recommended that interviewers have the interviewee summarize the facts in his or
her own words in order to reduce any misunderstandings.
E.g. Where do you think there is wastage of money in the Company? Do you think there is
abuse of position/authority?
(b) Open Questions
Open questions are questions where yes or no answers are not appropriate, and may need
elaboration. Open questions invite wide ranging answers. Such questions encourage a
monologue and narrative type response. This technique is used to get a quick summary of
what is known about a matter.
48
When an interviewee is offering a narrative or explanation, interviewers should not interrupt

the process. Important clues often are obtained by allowing the interviewee to narrate a series
of events.
In addition, the interviewers can begin the “norming” process by observing how the
interviewee is reacting to the statements. Open-ended questions always are encouraged to
keep people talking; however, most interviews will use a combination of open and closed
questions.
E.g. What do you think is the led to these losses? What is your opinion as to how they could
have been avoided?
(c) Closed Questions
Closed questions are designed to require a precise answer, usually “yes” or “no.” or a one
word answer. As example, closed questions can be used to establish dollar amounts, dates,
times and locations.
Closed questions should be avoided during the informational part in an interview where
rapport building is important. However, such questions can be used extensively during the
conclusion phase of the interview.
Keep in mind that a series of closed questions may tip the hand of the interviewer by revealing
information about the subject matter. An overuse of closed questions also can expose the
knowledge and tactics of the interviewers, which may not be desirable.
E.g. What time did you arrive at the office at the day in question? What day did the particular
incidence take place?
(d) Leading Questions
In contrast, leading questions are questions that contain an answer as part of the question.
Leading questions can be used to confirm facts that already are known.
By answering well-designed leading questions, the interviewee is confirming information by
answering the question. An example of a leading question would be “When you made the
telephone call to your boss, what did he say to you?” Leading questions often are not allowed
in courtroom situations, but they can be an effective technique during the interview process.
A leading question is a question that suggests the answer it wants. Eg. What did you plan to
achieve when you passed that entry? What did you do when you went into that area?
(e) Double Negative Questions
Double-negative questions should be avoided. This is because they are confusing and often
suggest an answer opposite to the correct answer.
E.g. since you did not have the access nor the authority to pass that entry you shouldn’t have
done that should you? You are not aware of his inability to handle this matter effectively, are
you?
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(f) Complex Questions

Complex questions are questions that cover more than one topic. These questions can lead to
confusion and require more than one answer. Therefore, they should also be avoided. It is
also similar to a multi-part question i.e. a question which combines various different shorter
questions into one utterance.
An example of a poorly worded question is: “You went to the data storage room and then you
accessed the particular computer and after you took the data, what did you do?
(g) Attitude Questions
Attitude questions are those in which the attitude of the interviewer is conveyed by the
structure of the question. An example would be: “Can you explain why we have heard
contradicting answers to the same question?”
The attitude of the interviewer can be conveyed by a tone of voice or by intentionally altering
body language exhibited by the interviewers. However, interviewers should not unintentionally
exhibit internal emotions through their own verbal, non-verbal, or physical behavior.
(h) Admission Seeking Questions
These types of probative questions are used for getting an Admission. If decisions are made
to proceed with confronting people with information detrimental to their best interest, the
interview should be conducted with extreme care. In this phase of the interview, accusatory
questions will be asked. The interviewers will use direct accusations in a statement that is not
in the form of question. For example “We know for a fact that you have………..”
(i) Question Sequence
It usually is best to seek general information before seeking details about a matter under
investigation.
A variation of the concept is to reach backward with the questioning. This would mean that
interviewers would begin with known information and then move into that which is unknown.
Skilled interviewers easily will move between combinations of methods. Effective interviewers
will develop skills and confidence to move between open and closed questions to advance the
information gathering process. At the same time, effective interviewers avoid confrontational
and emotive phraseology that may lead to a termination of the interview.
To stimulate a desired answer or impression, an interviewer can direct the interview toward a
specific point using a controlled answer technique. An example would be, “I understand you
were present when …” Another example would be, “Because you were not involved …”
Effective interviewers also will remain impartial and avoid polluting the interview by injecting
their own opinions and emotions.
Plan your questions in advance, beginning with warm up questions i.e.
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1. Establishing some kind of human connect – rapport building – introduction, reason for
the meet etc.
2. Moving on to basic information including confirming known facts – role and
responsibility etc.
3. Soft Questions – Questions that do not challenge or confront. E.g.what is the process
generally followed?
4. Hard Questions – Questions that get to the point of the issue. E.g.why did you not follow
the normal process?
Where relationships are likely to be strained even before you start, keep the initial phase of
the interview short and tight. Right after introduction and common courtesy come swiftly to the
point.
The interview should follow a logical structure establishing first the information you will need to
build more challenging questions later on. Questions should be clear and to the point so that
they are clearly understood. Use short questions instead of long winded and rambling ones
and use each question to build upon for the next in sequence.
7.3.8. Note-Taking during the Interview
It is recommended that each interview is treated separately in the note-taking and report-
writing process.
The lead interviewer should focus on the responses to questions and maintain eye contact to
better assess the verbal and nonverbal responses from the interviewee. The interview partner
should be taking extensive notes and be prepared to ask additional questions.
It is appropriate to carry a list of issues that should be asked and resolved during the
interview. However, using a list of questions usually is not recommended as this would tend to
interrupt the natural flow of the information exchange process. If proper listening and
observation skills are deployed, interviewers will be able to ask logical follow-up questions
upon hearing the responses from, and observing the behavior of the interviewee.
While taking notes, the interviewers should be writing down pertinent facts. If the statement is
relevant, it is appropriate to write the statement made by using quotation marks so as to refer
to it “ad verbatim”. But the note-taking process should not slow the interview process. The
personal opinions of the interviewers should be omitted.
Recording the interview may be appropriate, however the interview should be recorded only
after the same is informed and agreed to by the interviewee. The exact date, time, persons
present and the fact that the interview/recording is not being conducted under duress should
be clearly stated therein.
Digital records can be tampered easily and should be kept in safe custody.
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7.3.9. How to Conclude an Interview

In closing, the interviewers should try to close an interview on a positive note and leave the
door open for additional contact. Facts should be summarized and the interviewee should be
encouraged to say whatever he/she desires.
Closing questions can be designed to elicit information about other witnesses or documents
that may be useful in the ongoing investigation.
Interviewers should leave a business card and contact information with the witness. That way,
the witness can reach out to the interviewers to mention something they may have forgotten
during the interview or if at a later date they decide to provide additional information. In many
situations, a thorough interview will identify other facts and circumstances requiring further
investigation, which may lead to additional questions that were not covered in the first
interview. Therefore, it is desirable to leave the interview on a positive note so that additional
contact is encouraged.
7.3.10. Documenting an Interview
Written records of an interview should be prepared as soon as possible following the
conclusion of the interview. Original notes should be retained for verification.
It is recommended that narrative reports be written in third person. A third-person account is
where the interviewer is stating his or her recollection of the events of the interview.
The report should contain the date, time, location and persons present during the interview.
An interview log is a good way of recording the times of significant events during the interview.
As an example, the interview log may record when the interview commences, times of
significant events during the interview such as breaks, telephone calls, and refreshments, and
the conclusion of the interview.
Written reports should be thoroughly reviewed and compared to the original notes.
Personal opinions and comments should be avoided. Observations stated should be clear and
relevant and important points highlighted. Breakthrough comments should be quoted verbatim
so as to avoid misinterpretation.
Change in behavior of the interviewee, verbal and non-verbal red flags and other signs of
deception should be detailed.
7.4 Common signs of deception and the techniques used to assess
them
The Interviewer’s role in an interview is normally like a subtle observer. He/She should not
stare at the person being interviewed or call attention to a person’s behavior. Interviewers
should be observing the timing and consistency of behavior and should note clusters of
behavior.
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Caution should be exercised to avoid misinterpretations of behavior because of nervousness

or stress that would be present in a normal interview type situation. Interviewers should also
be aware of cultural differences that may lead to a misinterpretation of verbal and nonverbal
reactions.
In looking for signs of deception, interviewers should be measuring and assessing a person
against themselves. If a baseline of verbal and nonverbal behavior can be obtained, decisions
can be made as to whether physical reactions are signs of deception.
Lying produces stress that is often manifested in involuntary verbal, non-verbal or physical
reactions. In many instances, a person who decides to engage in deceptive answers will begin
with omitting important information, known as lying by omission. Lying by omission produces
less stress and is more difficult to identify though observation.
Deceptive persons may also attempt to mislead interviewers by vagueness, by insincere lack
of memory, or by attempting to move the interviewers into other areas by not directly
answering questions.
If lying by omission or intentional misdirection is identified, interviewers are then challenged to
identify the deception and press for more information. Then, deceptive persons have to make
a decision about continuing the deception, or answering questions truthfully. If a deceptive
path is selected, then stress increases and the chances of identifying verbal, nonverbal, or
physical reactions to stress are increased.
Interviewers should look for involuntary physical actions that may result from the body
relieving itself of stress created by intentional deception. Examples include excessive motions
with their hands, picking lint off their clothing or playing with objects while attempting to
answer questions.
Deceptive behavior may be exhibited by a fleeing position described as the upper body facing
the interviewers while the feet and lower portions point towards the door. There may be
excessive crossing of arms and other physical reactions to evidence being presented by the
interviewers.
Interviewers continually should assess behavior and compare the behavior toward a baseline
established in the early parts of the interview. Other nonverbal clues can include closing the
mouth tightly, pursing lips, covering the mouth with a hand, biting the lips, excessive blinking
of the eyes, and chewing objects. Such persons may sometimes exhibit certain behaviors that
may be an indication of deception. For example, interviewees may make dismissive motions
with their hands in response to key questions, or place their hands over their mouths as if
disguising or hiding the answers.
These concepts reinforce the need to properly prepare for interviews and underscore the
importance of leaving interviews on a positive note to enhance the possibility of further
interviews. On many occasions, the deceptive answers are not discovered until further along
in the investigation.
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Examples of the verbal clues of deception include changes in speech patterns such as
speeding up or slowing down, talking louder, talking softer, coughing or clearing the throat.
People who often make internal decisions about whether to deceive the interviewers will
repeat questions. In addition, and there may be comments regarding the interview such as
complaints as to the location and time of the interview.
Witnesses may provide false oaths of honesty. Examples would be “I swear to God.” Or, they
may offer character testimony such as “You can check with my wife or minister.” A person
engaged in deception may answer a question with another question or may be overly
respectful toward the interviewers.
Other verbal clues of deception may also include a reluctance to terminate the interview. This
is because the interviewee may want to convince the interviewer of their innocence.
If the interviewers come to believe that the interviewee is engaged in deception, efforts should
be made to discover the reason for such deception. Identifying the point in the interview where
the deception started can yield valuable clues as to why a person is choosing deception over
telling the truth. The interviewers should try to identify what triggered the change.
The motive for deception becomes an important issue to resolve with further questioning. It is
possible that the person is being deceptive to aid himself or herself, or it may be possible that
the person is protecting someone else. Other reasons may include that the witness has been
threatened with retaliation, or that the person is hiding certain behavior such as an illicit affair.
More experienced criminals may not exhibit some of the deceptive verbal or nonverbal
behaviors mentioned previously. This is because they may be aware that interviewers are
looking for such indicators of deception.
These days, information can be found on numerous websites by searching terms relating to
deception/ interviews. These websites describe and discuss these same physical, verbal and
non-verbal signs of deception. With this knowledge, it is entirely possible that experienced
criminals can further disguise their activity or even manipulate the interview process.
7.5 Admission Seeking Interviews
Although many white-collar criminals do not equate themselves with common criminals, it is
nonetheless important to get them to admit to the behavior in question. In these instances, it
may be easier to obtain a statement since many white-collar criminals may not believe that
such behavior is criminal. This especially is true if they have not personally or directly
benefitted from committing such acts.
However, if the target personally has benefited from committing the fraud (e.g., in cases where
the target has stolen company funds), obtaining a confession may not be as easy if the target
is an experienced criminal.
Many con artists are eager to talk to interviewers and consider the inevitable interviews as
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additional challenges in their schemes. Their confidence comes from fooling victims and
investigators. Interviewers need to discover information that offers interview leverage over the
con artists. Dealing with experienced con artists presents unique challenges to interviewers.
These people tend to be charming and confident, while exploiting the trust and greed of their
victims. They generally are intelligent, confident and experienced liars. Con artists will be
sizing up the interviewers as well. They will tend to explain their conduct as a
misunderstanding between themselves and the victims. They often use language that
interviewers may not understand, and they do not fear interrogation. They often mix a degree
of truth into their actions and they are familiar with questions that will be asked by the
intended victim. They are able to produce impressive sounding facts and figures while
concealing the fraud.
To meet the challenges of interviewing experienced criminals, forensic accountants should
document and review the details of oral and written representations made to victims, any
audio recordings made and previously existing interviews.
Interestingly, the skills exhibited by con artists to cover up crimes actually create
vulnerabilities that can be exploited by equally skilled forensic accountants. By investigating
and documenting previous crimes and efforts to conceal the crimes, forensic accountants can
begin to establish a pattern of lying and cheating.
Many con artists have committed previous frauds, and they have used similar false
explanations. Therefore, forensic accountants should become very familiar with the con artist
before an interview.
If the suspected con artist is working for a particular organization, employment applications
should be thoroughly reviewed. Employment applications often will contain misrepresentations
that can be used to create interview leverage.
Other sources to be considered are public databases, social networking sites, system login
records etc. If possible, financial transactions should be thoroughly reviewed and investigated
before confronting an experienced con artist. Reviewing public-source information, obtaining
information about previous cases and reviewing prior interviews, can all help a practitioner
begin to establish a pattern of conduct.
Understanding how money was transferred from the victim to the subject and documenting the
paper trail will give the interviewer an advantage. Absent this information, the advantage in the
interview rests with the experienced criminal.
Again, a pattern of fraudulent conduct or a pattern of cheating creates interview leverage
against the con artist. By establishing a pattern of lies, false representations and fraudulent
documents, the forensic accountants can better address the criminal-intent issue.
Many self-confident con artists will want to talk in order to obtain knowledge of how much a
forensic accountants knows. Experienced criminals will be confident in their abilities to
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deceive and engage in their own questioning process to elicit information. In these situations,
the interviewer should be very patient and allow for the subject to offer details in their
explanations. Forensic accountants should not reveal their knowledge in the interview, and
should be thoroughly documenting the representations in the notes.
Interviewers also may want to consider the possibility of multiple simultaneous interviews with
witnesses and potential suspects, as opposed to single interviews. Regardless of well-
intentioned admonishments to the contrary, many people will talk about an interview with
friends and associates.
After the interviewing process begins, those persons who may be engaged in a conspiracy will
want to talk to each other in order to get their stories straight. While manpower intensive,
multiple simultaneous interviews may prevent this occurrence.
Interviewers will need to develop skills to keep the interview moving forward even if deception
is chosen by the interviewee. The deception can effectively be used later as the investigation
progresses and the interviews continue. The self-perceived advantages of the con artist can
then be turned around and used against him or her. The con artist’s self-assurance toward
deceiving victims and investigators can lead to his or her downfall when information is properly
handled by interviewers.
Decisions will have to be made in advance as to whether this interview will be arranged in
advance or will be unannounced. Each procedure has its advantages and disadvantages and
careful consideration should be made when making these decisions. An unannounced
interview can be advantageous because persons will not have had time to prepare responses
to questions. The tactic can be effective with inexperienced persons committing fraudulent
acts. However, experienced criminals have been known to plant their defenses as the
schemes are perpetrated. And, these people often will be well prepared for the confrontational
interview.
Again, safety considerations should be considered when deciding the appropriate approach.
As mentioned previously, interviewers should consult with legal counsel before the interview to
discuss potential legal ramifications. This is especially important when planning to interview a
potential target.
If a person clearly asks for an attorney, the questioning must stop. The exact words used by
the person to ask for counsel and the time of the request should be recorded in the notes.
Desks located between interviewers and interviewees can be barriers to communication.
Under ideal circumstances, the interview room can be arranged so that the entire body of the
person being interviewed is observed. It is generally recommended that the person being
interviewed have access to an exit, as opposed to the exit being blocked by the interviewers.
Keep in mind that the nature of the interview may be reviewed by judges and juries in the
future. For statements to be admitted, a judge will have to be satisfied that the statements
were made on a voluntary basis without threats or coercion. The interviewers may be asked to
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describe the settings of the actual interview in order for other persons to determine if the
questions were obtained voluntarily.
If it appears that a confession is possible, interviewers may want to consider discussing minor
issues discovered during the interview that the interviewee and interviewers can agree about.
It is much easier to confess to minor issues. Afterwards, interviewers can move toward more
significant issues.
In an admission-seeking interview, the interviewers will use direct accusations in a statement
that is not in the form of question. For example, an interviewer may ask: “Our investigations
have established that you ...” At this point, observations are made as to the reaction to the
statement. The interviewers will interrupt alibis and denials offered by the interviewee.
Interviewers may want to establish a rationalization with the person being interviewed and to
take this opportunity to discuss motives being offered. It may be appropriate to display
physical evidence during the admissions-seeking interview and to obtain explanations from the
interviewee. It may be appropriate to discuss other witness statements, to discuss the session
and information uncovered during the interview, and to thereafter present an alternative for
consideration by the person being interviewed.
After covering the explanations offered by the interviewee, interviewers will want to obtain
information about how such acts were perpetrated. The specifics of each offense should be
obtained, and consideration should be given to whether written statements will be prepared.
Interviewers will be looking for a benchmark admission, which would be the first time that a
person is admitting to misconduct. If a benchmark admission is obtained, it should be recorded
during the note-taking process, to be later memorialized in the written report.
At this point, leading questions may be employed to confirm known facts, to reinforce a
rationalization, with the goal of obtaining a verbal confession. If a person begins to confess,
interviewers want to elicit information to demonstrate that the accused person knew that
conduct was wrong at the time of commission.
Sometimes, persons who have been coached will deny that they knew the conduct was wrong
at the time that they were performing the act in question. This knowledge is very important
when trying to establish intent, which is an element of fraud. Without intent, fraud cannot be
committed. The interviewers also will want to obtain facts for independent verification that are
known only to the person.
Proper questioning should establish when the offense was committed, when the offense
ended, other persons involved, and other physical evidence to be obtained. Therefore,
investigators will have established the initial point of fraudulent conduct as well as when the
conduct ended. Interviewers should ask and carefully document the voluntariness of the
confessions.
The interviewers should ask questions concerning the state of mind of the perpetrator at the
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time the offense(s) occurred. Information concerning medical conditions, alcohol use and
abuse, drug use and abuse, depression, and threats or coercion should be documented.
Corroborating evidence and additional interviews may be required to substantiate the
confession.
7.6 Barriers to an effective interview
Interviewing is a type of Communication. Effective communication is possible only if
interviewer understands the psychology of interviewing. The interviewer needs to understand
the elements of conversation that inhibit the interviewee and reduce such inhibitors and use
the elements which facilitate effective communication and enhance the facilitators.
An interview is like a game of poker – avoid revealing one’s hands and predict cards in the
subject’s hands based on his reactions. Each question gives information and reveals its
importance or how critical it is, hence plan line of questioning based on anticipated response.
Information exchange is the central purpose of the interview. Not too much information should
be given but not too little information as to be overly evasive. The tactic of only extracting
information without parting with any, normally does not work.
Inhibitor to conversation is a social –psychological barrier that impedes the flow of relevant
information and makes the respondent unwilling or unable to give the required information.
The respondent may be unwilling due to many reasons such as
Constraint of time – the respondent may not necessarily be uncooperative,he/she may just
feel better use of the time.
Ego – The interviewee feels that it is below his dignity to comment on certain aspects of the
incidence.
Disapproval of interviewer - The interviewee expects to be rebuffed, insulted or embarrassed
by the admission, but if interviewer shows sympathy he may welcome the opportunity to
divulge the information. Accepting attitude elicits candid response.
Loss of status – The fear that the information may become public is a major deterrent and by
giving the required assurance that the information will only be shared on a need to know basis
a lot of hurdles can be overcome.
Etiquette – The interviewee may feel that the disclosure is inappropriate or in poor taste and
avoid embarrassing, threatening or shocking answers for fear of exposing themselves. This
too can be forestalled by appropriate interviewer and venue.
Trauma – The interviewee associates the event, incidence or activity to an acutely unpleasant
feeling or crisis experience and is not willing to divulge due to its sensitivity.
The interviewer should also remember that there is genuine possibility that the interviewer is
willing but really unable to provide the information required by the interviewer.
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Forgetting – The interviewee may be unable to recall the incident unless it is current, memory
fades over time or personal defense system reconstructs or obstructs the information by
addition, distortion or omission.
Confusion - The chronology of events is mixed up or inferential confusion ie based on
induction/generalization or deduction specific examples
Unconscious behavior – customs or habits, settled tendency or usual pattern of behavior,
circular reaction, immediate unwitting response to another person’s, non-verbal clues and
acute emotional crisis – reaction to others special circumstances or emotional trauma.
Repression – repression is a mental process which deals with threat and stress by blocking
experiences that might evoke anxiety or guilt- they may be truthful but actually repress the
memory of the act as it may be against their moral code of ethics.
7.7 Safety Considerations
Recognition and Reduction of risk is a very important aspect of an effective interview. If a
forensic accountant has reason to believe that the interview may become hostile, care should
be taken to ensure that the person being interviewed has access to an exit that is not blocked
by the interviewers. This is a safety consideration. But, it may also be a consideration to
demonstrate the voluntary nature of statements.
It is recommended that someone at the home or office know the date, time, and location of the
interview, who is participating, and the expected time of return
A contact telephone number at the destination with personal cell phone numbers should be left
with someone at the home office.
Avoid situations where you are asked to meet a person alone, particularly if the person is not
well known to you. Having a second person as a witness during an interview is recommended
for practical as well as safety reasons. A coworker as a witness may also reduce the chances
of false accusations of misconduct.
The interview should ideally be conducted in business locations during normal business hours
where other persons are on the premises. In some cases interviews in hotel lobbies may be
appropriate, but interviews in hotel rooms are avoidable. Interviews in bars, parking lots and
private vehicles are not recommended.
If you are unfamiliar with the person being interviewed, ask for a business card. View the
business card carefully and retain it for your records. Always ask for full names, addresses,
contact numbers and job descriptions and try to gather this information in advance when
arranging a date and time for a meeting.
An interviewer and partner always should be appropriately dressed and conduct themselves in
a courteous and professional manner. Avoid disclosing personal information about yourself
during the interview
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Trust your Instincts. While you cannot conduct a thorough background check on the person
being interviewed, a date and location of an interview can be changed if your feelings lead you
to believe that something is amiss. If you’re uneasy, take control of the situation until a
comfort level is reached. It is easy to explain changes by saying that company policy dictates
the circumstances of the interview.
When first entering a room to be used for an interview, take mental notes of the layout. In the
event of a problem, is there a potential escape route available? Try to avoid situations where
an angry person may strike or be in reach of other physical objects that can be used to harm.
During an interview, be aware of behavioral reactions that may indicate stress, uneasiness, or
even anger, these are physical red flags. Increased perspiration, dryness of the mouth, and
cracking of the voice can be indications of internal turmoil as well as other potential signs of
deception.
If you listen carefully, a person under stress may provide clues to potential outbursts. Your
concern should intensify if the person being interviewed makes comments about violence,
excessiveness, drug use, depression, abusive relationships, anger, resentment, financial
problems or threats.
A person confessing to misconduct may view his or her world as falling apart and may see the
persons in the room as bearing some of the blame for the situation. Depression and anger are
common in these circumstances and they may influence the thinking of the person confessing
to improper conduct. Many people have expressed relief while calmly confessing to serious
misconduct, but do not be fooled into complacency. As an example, a person being treated for
depression may have the benefit of powerful drugs to control mood swings. What if the
medication was not taken that day?
Also consider that if you arranged this interview in advance, the person may believe that he or
she will be confronted with incriminating information, thereby raising the interviewee’s anxiety
level. The forensic accountants, as the interviewer, will most likely not know this before arrival.
It is important to trust your instincts. Do not put yourself in situations where you feel
uncomfortable.
7.8 Cases Studies
1. Case Study -Albretch 1995
Many fraud investigation are “blown” because of interviewing mistakes
Case in point: A corporate auditor for a national chain of gas stations uncovered a $58,000
discrepancy in the cash account during the year-end audit. He then solicited explanations for
the discrepancy from both the office manager and the bookkeeper--the two employees in the
best position to steal the company’s cash.
The explanations given for the discrepancy did not satisfy the auditor who then declared, “I’ll
be back first thing in the morning to figure this thing out, and if I can’t find a legitimate reason
for the shortage in the cash account, heads are going to roll!”
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Not surprisingly, that night someone intentionally burned the gas station to the ground. Local
law enforcement officials determined the fire had been intentionally started and had originated
in the office--next to the filing cabinets containing all relevant documents needed to resolve
the discrepancy.
As a result, the auditor was unable to develop a case against the suspected fraudster(s) using
direct evidence since all relevant source documents had literally gone “up in smoke.”
The auditor “blew” this investigation by making two common interviewing mistakes: First, he
attempted to conduct the interviews without adequate preparation.
The proper sequence of events in an investigation should be:
(1) Identify discrepancy or irregularity,
(2) Review source documents and other records relevant to the discrepancy,
(3) Employ other evidence-gathering procedures such as surveillance, net worth analysis of
targets, and interviews of those employees not likely to be responsible for the
defalcation, and
(4) Interview suspect(s).
Mistakenly, the corporate auditor went directly from step one to step four. Consequently, it
was then impossible for him to complete step two.
Second, the auditor approached the targets with an insensitive, “out-to-get-someone” attitude.
An effective interviewer should be sensitive, respectful, and seeking the truth--not trying to
make “heads roll.”
As this example illustrates, the ability to conduct effective interviews is critical to those
responsible for detecting and investigating fraudulent activity.
Case Study
The owner of a medium-sized construction company received a “tip” from a disgruntled spouse
that “Raj”--a highly-trusted, senior project manager--had an ownership interest in two vendors
with which the construction company did business.
Consequently, the owner engaged a forensic auditor to conduct a review of the two vendors
in question. The review revealed that the vendors had only post office box addresses, no
phone numbers listed on the invoices, and did not have taxpayer identification numbers on
file. The payments made to the two vendors totaled Rs. 7,50,000. Neither of the vendors was
listed in the phone book.
Raj, who was also a close personal friend of the owner, had approved the payments. A search
of the local business registrations revealed that both vendors in question had indeed been
created by Raj. After a substantial amount of preliminary investigative work, the auditor
decided to confront Raj with this information and solicit explanations.
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Interview:
Auditor: “Hi, my name is Dilip. (Both shake hands and sit down.) The owner has asked me to
review some of our business practices looking for ways to improve the profitability of the
company. Do you have a few minutes to answer some questions?”
Raj: “Yes.”
Dilip: “I appreciate your willingness to take time to speak with me. Tell me about your duties
and responsibilities with the company.”
Raj: “I’m a project manager. I oversee construction projects, estimate construction costs and
scrutinize tenders, allot job work and approve payments.”
Dilip: “How long have you been with the company?”
Raj: “About 8 years.”
Dilip: “Are you satisfied with the work environment and the compensation you receive?”
Raj: “Yeah, I like working here, it feels like home.”
Analysis: Raj has agreed to answer some questions relevant to improving the profitability of
the company. Dilip does not immediately confront Raj with the incriminating information but
instead tries to put him at ease by asking a series of non-sensitive questions. The purpose of
these non-sensitive questions is to “calibrate” the subject; that is, to establish a baseline for
the subject’s verbal and nonverbal cues when we know he is responding truthfully to non-
sensitive questions. Later in the interview--when the questions move toward more sensitive,
possibly incriminating issues--we will compare the subject’s verbal and nonverbal cues to
those observed during the early part of the interview. This process, called calibration, can be
very effective in determining whether subjects are being truthful or not.
Dilip: “The owner has asked me to look into the possibility of fraudulent activity by
management and employees. Do you think fraud is a problem for business in general?”
Raj: “I have no idea.”
Verbal cues: The interview is now moving toward more sensitive, possibly incriminating
issues. Most informed people would acknowledge that fraud is a problem for business in
general. However, since Raj is actually guilty of fraudulent activity, he is not inclined to
acknowledge that fraud is a problem for business in general and would like to end the
interview as soon as possible.
Dilip: “Do you think that this company has a problem with fraud?”
Raj: “No, not at all.” (Leans back in his chair and looks down at the floor)
Verbal cues: Once again, Raj fails to acknowledge fraud as being a problem. He is now
wondering if Dilip will eventually accuse him of fraudulent activity.
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Nonverbal cues: Raj shifts his body position away from the interviewer and breaks eye
contact, he does not want Dilip to see his discomfiture.
Dilip: “If employees or managers are stealing from this company, why do you think they would
do it?”
Raj: “How should I know? I don’t steal.”
Verbal cues: Even though the question is non-accusatory, Raj feels directly attacked by the
question and responds accordingly. Such “denials” to non-accusatory questions can be good
indicators that the subject has “something to hide.”
Dilip: “I didn’t say you did. If you knew another employee was stealing from the business, what
would you do?”
Raj: “I don’t know, I’ve never really thought about it.”
Dilip: “Do you know of anyone who might be stealing or taking unfair advantage of the
business?”
Raj: “No, sir.”
Dilip: “Suppose someone who worked here decided to steal or commit fraud. How could they
do it and get away with it?
Raj: “They couldn’t get away with it. They’d be caught if they stole.” (Crosses legs, folds arms
and stays locked in this position for some time)
Verbal cues: Raj continues to respond negatively in an effort to end the interview. Also, he
answers too surely concerning whether someone could steal and get away with it. Raj does
not even want to consider the possibility of fraudulent schemes as it is too close to home.
Someone not involved in fraudulent activity generally has no problem verbalizing ways
employees could steal from the company and not be detected.
Nonverbal cues: Raj is feeling personally attacked by this line of questioning and is dealing
with the mounting anxiety by adopting a defensive, rigid and immobile position. It is very
difficult to solicit a confession from a subject while “locked” in this position.
Dilip: “In your opinion, who is beyond suspicion when it comes to committing fraud at this
company?”
Raj: “There is no fraud going on but if there was it could be anybody.” (Looks at floor)
Dilip: “Did you ever think about stealing from the business, even though you didn’t go through
with it?”
Raj: “In all honesty, no.”
Verbal cues: Raj is unwilling to narrow the list of prospective fraudsters; he wants the circle of
suspicion to be as wide as possible. He issued an indirect denial (“There is no fraud going
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on”)--another indicator that he has something to hide. Someone being untruthful tends to use
phrases like “in all honesty,” “to tell you the truth,” or “I swear to God” in an effort to increase
the credibility of their responses. A truthful person tends not to use such phrases.
Nonverbal cues: Raj again breaks eye contact; it is very difficult for most people to lie while
maintaining eye contact.
Dilip: “The owner has asked me to review some vendors which have been used on projects
you supervise. Are you familiar with Shefali Constructron Pvt. Ltd., Chennai?”
Raj: “Vaguely, we did business with them for about three years. We don’t do business with
them anymore.” (Takes off glasses, rubs eyes, lays glasses on the table, recrosses arms and
legs)
Verbal cues: Dilip spends10 -12 minutes asking Raj about vendors known to be legitimate
before asking about the first fictitious vendor. When questioned about legitimate vendors, Raj
was able to recall all pertinent information. However, when questioned about the fictitious
vendors, Raj suddenly had problems remembering anything about them.
Nonverbal cues: In an effort to relieve the stress created by this question, he has shifted his
body position and taken off his glasses. Taking off the glasses is a form of breaking eye
contact.
Dilip: “Which projects did they supply?”
Raj: “I don’t recall.”
Dilip: “What kinds of supplies were typically purchased from them?”
Raj: “I’m not sure. They weren’t a major supplier.”
Dilip: “Who is the sales rep for the company?”
Raj: “I don’t remember.”
Dilip: “Are you familiar with Padman Contracting?”
Raj: “Yes, we do business with them on occasion.”
Dilip: “Where are they located?”
Raj: “I don’t remember.” (Dilip stands up and stretches.)
Dilip: “Why don’t we take a break and stretch for a minute. I’m going to get myself a Coffee,
would you like one?”
Raj: “No thanks, I’m fine.” (Raj stands up to stretch while Dilip exits. Two minutes later Dilip
reenters with Coffee in hand. Before Raj has a chance to get seated, Dilip begins questioning
again.)
Verbal cues: The twofold purpose of this break in the interview is: (1) to get Raj out of the
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“rigid and immobile” position, and (2) to leave Raj in the room alone and allow his anxiety level
to continue to mount. Upon reentering the room, Dilip will issue a direct accusation before Raj
has a chance to rebuild his defenses.
Dilip: “I have reliable information that you are the sole owner of both ShefaliConstructron and
Padman Contracting, both of which are vendors you have approved payments to in the past. Is
this true?”
Raj: (Silence for one long minute.)... “That’s correct.”
Dilip: “What are your reasons for creating and operating these two businesses?”
Raj: “My brother and I started the companies to earn some extra money to pay off some debts.
I knew it was a conflict of interest to authorize purchase orders and approve payments, but
there was nothing fraudulent going on.”
Analysis: Catching Raj “off-guard” Dilip issues a direct accusation which Raj ponders
momentarily before answering.
Dilip: “I didn’t say there was. Did you approve payment of Rs. 140,000/- to Shefali
Constructron Company for this invoice.” (Hands Raj an invoice but Raj puts it on the table,
face down)
Raj: “Yes, but that’s the only one. I closed that company down two years ago.”
Analysis: Raj is more likely to admit to the fraudulent invoices one at a time rather than being
confronted with them all at once. Also, when admitting to fraudulent activity, it is very common
for perpetrators to minimize--and lie about--the magnitude of what they have done.
Nonverbal cues: Raj does not want to look at the incriminating invoice so he puts it face
down on the table. An honest person would want to look at the invoice in question for pertinent
information which might exonerate him.
Dilip: “What service or product did you provide for the rs. 140,000/- you received?”
Raj: (Looks down at the floor.) “Nothing.”
Analysis: Raj just admitted to the fictitious vendor scheme.
Dilip: “How many invoices did you submit from Padman Contracting?”
Raj: “Three or four.”
Dilip: “Tell me about this invoice to XYX Co for 6.10 lacs.” (Hands Raj an invoice but Raj puts
it on the table, face down)
Raj: “Padman Contracting provided materials and labor for a project involving XYZ Co.”
Dilip: “How much was the actual cost of materials and labor?” Raj: “About 1.6 lacs for
materials and 2 lacs for labor.”
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Analysis: Raj is slowly breaking down and admitting to more and more. Raj actually feels
some relief from the intense anxiety by “getting this off his chest.” He likes this feeling and can
extend it by continuing to admit to things. Accordingly, it is imperative that the interview not be
interrupted at this point in the interview.
Dilip: “What happened to the rest of the money?”
Raj: “It went into the checking account I had opened for Padman Contracting.”
Dilip: “What did you do with the ‘profit’?”
Raj: “Paid off credit cards, paid medical bills.”
Analysis: Dilip needs to know what Raj did with the money for two reasons. First, Raj will be
more likely to sign a “statement of admission” if the statement contains his motivations for
“taking” money from his employer. The fact that he had substantial financial pressures on him
that caused him to do something “out of character” for him allows Raj to “save face” and
facilitates his cooperation during the remainder of the investigation. Second, the employee
dishonesty insurance provider will want to know what the target did with the money for
purposes of estimating the probability of recovery.
Dilip: “Were you involved in any other types of unauthorized activities? Kickbacks from
vendors? Selling company materials or scrap?”
Raj: “No, and after the XYZ Co. invoice I was going to quit and never do it again.”
Dilip: “Are you aware of other situations where employees of this company are engaged in
unauthorized or fraudulent activities?”
Raj: “No.”
Analysis: Typically, if one employee is defrauding the company, others within the company
are also engaged in fraudulent activity. Simply inquiring of an employee who has just admitted
to fraud can be very effective in uncovering other fraudulent activity.
Dilip: “Let me summarize what you’ve told me. Due to financial pressures weighing on you
such as credit card debt and medical bills, you set up two companies—Shefali Constructron
and Padman Contracting --to generate some extra money. When you initially set up the
companies, you intended to actually provide some labor and materials for the payments
received, but for one reason or another, you ended up providing little or no materials and
labor. The amount you took in this manner totaled about 7.50 lacs. You knew what you were
doing was wrong but didn’t consider it to be that big a deal. Is my summary of the situation
accurate?”
Raj: “....Yes.”
Analysis: Since Dilip will be converting the content of the “admission-seeking” interview into a
written statement to be signed by Raj, it is important to get all the facts straight. Raj must be
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willing to acknowledge that he knew that what he did was wrong and the written statement
must unambiguously communicate this. Notice the absence of the words “steal” or “fraud” in
Dilip’s summary. The use of such inflammatory terms makes the subject less likely to sign the
written “statement of admission.” Instead of condemning the subject for his/her behavior, allow
the subject to “save face” by focusing on the fraudulent act rather than the person.
Verbally acknowledge to the subject that you understand s/he was under heavy financial
pressure which motivated him or her to do something “out of character.” Such an attitude will
greatly increase the chances of obtaining a signed “statement of admission” from the subject.
The signed statement will greatly facilitate the employee dishonesty insurance claim and any
criminal or civil action resulting from the case.
Dilip: “Here’s my card, let me know if you think of anything else which might be relevant to this
situation. Is there anything else you’d like to say?”
Raj: “Yeah,...What’s going to happen now?”
Dilip: “I’m going to put together a written statement for you to sign. Then I will report my
findings to the owner of the company, and it will be his decision what happens next. (Stands
up, extends hand to Raj). Thanks for taking time with me to resolve this situation. It’s good to
get this all behind us so we can move on. “
7.9 Summary
1. Interview preparation is key. Devote as much time to research, collecting primary
documents, question planning and rehearsal as you can.
2. Set up the interview in a way that suits the story and circumstances.
3. Lose the attitude. Even in interviews that may become adversarial, a calm, neutral
demeanour and questioning style will produce better results.
4. Have a strategy for the whole interview. Always move from warm-up and broad, less
threatening questions towards more precise, focused questions that will allow you to pin
the interviewee down on key aspects.
5. Use data-mapping techniques to pinpoint the areas of short information and
contradiction your interview needs to deal with.
6. Keep questions clear, simple and direct.
7. Establish ground rules and confirm basic information at the start of an interview.
8. Follow-up, re-phrase or reflect back to get answers that are equally clear and direct.
9. Take your time and don’t be scared of silences.
10. Handle reluctant or fearful interviewees kindly and carefully – but don’t let them off the
hook.
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11. Establish support structures and strategies to help you deal with threats and
intimidation.
12. Use covert interviewing techniques only after careful, ethical decision-making – and be
sure you have the technical skills to carry them off.
13. Never take interview answers out of context.
14. Keep in mind safety considerations.
15. Watch, Listen and Observe!
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Chapter 8
Forensic Audit Techniques
Detecting fraud is difficult, especially frauds involving material financial statement

misstatements, which occur only in about 2 percent of all financial statements. Fraud is
generally concealed and often occurs through collusion. Normally, the documents supporting
omitted transactions are not kept in company files. False documentation is often created or
legitimate documents are altered to support fictitious transactions. While fraud detection
techniques will not identify all fraud, the use of sound techniques can increase the likelihood
that misstatements or defalcations will be discovered on a timely basis.
The Seven Recognized Investigative Tools and Techniques Used by Forensic Specialists/
Fraud Examiners
• Public Document Reviews and Background Investigations
o Public Databases
o MCA Website
o Corporate Records
o Internet
• Interviews of Knowledgeable Persons
o Interview /Interrogation
o Continuous process throughout an investigation

o Gain additional information with each interview
o Evidence from witnesses provides additional leads
o May identify additional witnesses
o Interview the target only after completing the interviews of the peripheral
witnesses
• Confidential Sources
o Hotlines
o E-mail
o Letters
o Current Employees
o Former Employees
o Vendors & former vendors
o Customers & former customers
• Laboratory Analysis of Physical and Electronic Evidence
o physical examination
o fingerprint analysis
o forgeries
o ink sampling
o document dating
o Computer Forensics
 hard disk imaging
 E-mail analysis
 search for erased files
 analyze use & possible misuse
 computer software to analyze data
• Physical and Electronic Surveillance
• Undercover Operations
• Analysis of Financial Transactions
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Some of the Techniques that a Forensic Auditor may use are listed below:
• General Audit Techniques
• Statistical & Mathematical Techniques
• Digital/ Electronic Techniques
• CAATT
• Data Mining
8.1 General Audit Techniques
1. Testing Defenses
Most businesses and other organizations have procedures and defenses set up to prevent the
occurrence of fraud. A good initial forensic audit technique is to attempt to circumvent these
defenses yourself. The weaknesses you find within the organization's controls will most
probably guide you down the same path taken by suspected perpetrators. This technique
requires you to attempt to put yourself in the shoes and think like your suspect.
8.2 Statistical & Mathematical Techniques
1. Trend Analysis
Businesses have cycles and seasons much akin to nature itself. An expense or event within a
business that would be analogous to a snowy day in the middle of summer is worth
investigating. Careful review of your subject organization's historical norms is necessary in
order for you to be able to discern the outlier event should it arise within your investigation.
2. Ratio Analysis
Another useful fraud detection technique is the calculation of data analysis ratios for key
numeric fields. Like financial ratios that give indications of the financial health of a company,
data analysis ratios report on the fraud health by identifying possible symptoms of fraud.
Three commonly employed ratios are: -
(a) The ratio of the highest value to the lowest value (max/min);
(b) The ratio of the highest value to the second highest value (max/max2); and
The ratio of the current year to the previous year Using ratio analysis, a financial expert
studies relationships between specified costs and some measure of production, such as units
sold, dollars of sales or direct labor hours. For example, to arrive at overhead costs per direct
labor hour – Total overhead costs might be divided by total direct labor hours. Ratio analysis
may help a Forensic Auditor to estimate expenses.
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8.3 Technology Based/ Digital Forensics Techniques

Every transaction leaves a digital footprint in today's computer-driven society. Close scrutiny
of relevant emails, accounting records, phone logs and target hard drives is a requisite facet
of any modern forensic audit. Before taking steps such as obtaining data from email etc. the
forensic auditor should take appropriate legal advice so that it doesn’t amount to invasion of
privacy. Digital investigations can become quite complex and require support from trained
digital investigators. However, many open-source digital forensics tools are now available to
assist you in this phase of the investigation.
Forensic Computing is the process of identifying, preserving, analyzing, and presenting digital
evidence in a manner that is legally acceptable in a court of law.
Digital Crime Scene Investigation involves determining what fraud events occurred by using
digital evidence and has broad stages:
• Preserve & Document Scene
• Analyze/Search & Document Data
• Reconstruct & Document Fraud Event
1. Cross-drive analysis
A forensic technique that correlates information found on multiple hard drives. The process,
still being researched, can be used to identify social networks and to perform anomaly
detection.
2. Live analysis
The examination of computers from within the operating system using custom forensics or
existing sysadmin tools to extract evidence. The practice is useful when dealing with
Encrypting File Systems, for example, where the encryption keys may be collected and, in
some instances, the logical hard drive volume may be imaged (known as a live acquisition)
before the computer is shut down. (Sysadmin - A system administrator, or sysadmin, is a
person who is responsible for the upkeep, configuration, and reliable operation of computer
systems; especially multi-user computers, such as servers. The system administrator seeks to
ensure that the uptime, performance, resources, and security of the computers he or she
manages meet the needs of the users, without exceeding the budget.)
3. Deleted files
A common technique used in computer forensics is the recovery of deleted files. Modern
forensic software have their own tools for recovering or carving out deleted data. Most
operating systems and file systems do not always erase physical file data, allowing
investigators to reconstruct it from the physical disk sectors. File carving involves searching
for known file headers within the disk image and reconstructing deleted materials.
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4. Stochastic forensics
A method which uses stochastic properties of the computer system to investigate activities
lacking digital artifacts. Its chief use is to investigate data theft.
Physical systems in which we are uncertain about the values of parameters, measurements,
expected input and disturbances are termed Stochastic Systems.
5. Steganography
One of the techniques used to hide data is via steganography, the process of hiding data
inside of a picture or digital image. An example would be to hide pornographic images of
children or other information that a given criminal does not want to have discovered. Computer
forensics professionals can fight this by looking at the hash of the file and comparing it to the
original image (if available.) While the image appears exactly the same, the hash changes as
the data changes.
6. EnCase
EnCase from Guidance Software is a Windows-based comprehensive and complete forensic
application. EnCase is recognized as a court-validated standard in computer forensics
software. Encase can have the following functionalities.
1. File signature analysis
2. Filter conditions and queries
3. View deleted files and file fragments in unallocated or slack space
4. Folder recovery
5. Log file and event log analysis
6. File type search
7. Registry viewer, external file viewer WinHex Tool: WinHex is a universal hex editor,
particularly helpful in computer forensics, data recovery, low-level data editing.
• Reduces internal investigation costs
• Platform independent
• Automated analysis saves time
• Supports electronic records audit
• Creates logical evidence files — eliminating need to capture entire hard drives
• Previews computers over the network to determine whether relevant evidence
exists:
o Unallocated/allocated space
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o Deleted files
o File slack
o Volume slack
o File system attributes
o CD ROMs/DVDs
o Mounted FireWire and USB devices
o Mounted encrypted volumes
o Mounted thumb drives
7. MD5
• Message Digest – a hashing algorithm used to generate a checksum
• Available online as freeware
• Any changes to file will change the checksum
• Generate MD5 of system or critical files regularly
• Keep checksums in a secure place to compare against later if integrity is
questioned
8. Tracking Log Files
9. PC System Log
10. Free Log Tools
A. Hidden data analysis: In storage media Suspects can hide their sensitive data in various
areas of the file system such as Volume slack; file slack, bad clusters, deleted file
spaces.
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Hard Disks: The maintenance track / Protected Area on ATA (Advanced Technology
Attachment) disks are used to hide information. The evidence collection tools can copy
the above contents.
File System Tables: A file allocation table in FAT and Master File Table in NTFS are
used to keep track of files. These entries are manipulated to hide vital and sensitive
information.
B. File Deletion: When a file is deleted, the record of the file is removed from the table,
thereby making it appear that it does not exist anymore. The clusters used by the
deleted file are marked as being free and can now be used to store other data.
However, although the record is gone, the data may still reside in the clusters of the
hard disk. That data we can recover by calculating starting and end of the file in Hex
format and copy it into a text file and save with corresponding extension.
Recover a JPEG file
• Open file in the hex format
• Check the file signature
• Copy From starting signature upto ending signature.
For example (JPEG/JPG/JPE/JFIF file starting signature is FF D8 FF E1 XX XX 45 78
69 66 00 (EXIF in asci Exchangeable image file format trailer is FF D9). Open the file
with corresponding application.
C. Partition Tables: Information about how partitions are set up on a machine is stored in a
partition table, which is a part of the Master Boot Record (MBR). When the computer is
booted, the partition table allows the computer to understand how the hard disk is
organized and then passes this information to the operating system. When a partition is
deleted, the entry in the partition table is removed, making the data inaccessible.
However, even though the partition entry has been removed, the data still resides on
the hard disk.
D. Slack space: A file system may not use an entire partition. The space after the end of
the volume called volume slack that can be used to hide data. The space between
Partitions is also vulnerable for hiding data. File slack space is another hidden storage.
When a file does not end on a sector boundary, operating systems fill the rest of the
sector with data from RAM, giving it the name RAM slack. When a file is deleted, its
entry in the file system is updated to indicate its deleted status and the clusters that
were previously allocated to storing are unallocated and can be reused to store a new
file. However, the data are left on the disk and it is often possible to retrieve a file
immediately after it has been deleted. The data will remain on the disk until a new file
overwrites them however, if the new file does not take up the entire cluster, a portion of
the old file might remain in the slack space. In this case, a portion of a file can be
retrieved long after it has been deleted and partially overwritten.
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E. Free space: When a file is moved from one hard disk or partition to another, it is
actually a multistep process of copying and deleting the file. First, a new copy of the file
is created on the target partition. After the file has been copied, the original file is then
deleted. This process also requires some housekeeping in the FAT or MFT tables. A
new entry is created in the table on the partition where it has been copied, whereas the
record for the deleted file is removed from the table on its partition. When a file get
deleted, that space considered as free space, there also criminal can hide sensitive
information.
F. Faked Bad Clusters: Clusters marked as bad may be used to hide data. In NFTS, bad
clusters are marked in metadata file called $BadClus, which is in MFT entry 8.
Originally, $BadClus is a sparse file which file size is set to the size of entire file
system. When bad clusters are detected, they will be allocated to this file. The size of
data that can be hidden with this technique is unlimited. Suspects can simply allocate
more clusters.
8.4 Computer Assisted Auditing Techniques (CAATs)/ Computer
Assisted Audit Techniques and Tools (CAATT)
Audit in general and fraud investigation in particular is getting complex day by day primarily
due to migration to non-paper based systems. Processes and workflows are system driven
and generally the entire control revolves around the computerized environment. Therefore,
there is a clear trend that auditors would have to churn voluminous digitalized data as
auditable records. Needless to say, auditors would therefore have to devise ways and means
of verification that is commensurate with the changing times. The challenges are to examine
various databases generated from different systems which may or may not be integrated.
Changing patterns of businesses, regulatory framework, scarcity of resources at auditors’
disposal on one side and the ever increasing mountainous data on other hand is making audit
a complex process. Use of CAATTs is, thus, indispensable to the Auditors and forensic
auditors.
Computer-assisted audit techniques (CAATs) or computer-assisted audit tools and techniques
(CAATTs) are computer programs that the auditors use as part of the audit procedures to
process data of audit significance contained in a client’s information systems, without
depending on him. CAAT helps auditors to perform various auditing procedures such as:
(a) Testing details of transactions and balances
(b) identifying inconsistencies or significant fluctuations
(c) Testing general as well as application control of computer systems
(d) Sampling programs to extract data for audit testing, and
(e) Redoing calculations performed by accounting systems.
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CAATTs, as the name suggests, deals with two aspects -- the CAT-Tool and CAT-Technique.
While the CAT-Tool refers to use of software tool, the CAT technique insinuates enhancing the
effectiveness and efficiency of audit to work with the CAT-Tool on the auditable database.
Thus both are integrated part of each other like a sides of scissors and one will not be able to
work without the other. Needless to say both sides have to work in tandem to be able to cut
through the complex data. CAT-Tool is all about learning the syntax of a software application
and will also entail a need to know about the database architecture. It deals with ‘How-to’ work
on the database. Whereas the CAT-technique is all about the auditor’s judgment to apply
procedures on the database knowing auditee’s environment vis-a-vis the underlying audit
objective. This part deals with What-to-do with the database.
Computer Aided Audit Tools or CAATs can be broadly divided into
• Generalized Audit Software’s (GAS) or
• Common Software Tools (CST)
CAATs include tools that range from basic word processing to expert systems. Computerized
audit techniques range from procedures as simple as listing the data in a given file to the use
of Artificial Intelligence tools to predict financial failure or financial statement structures. For
instance, general productivity software such as Microsoft Word, MS Excel and MS Access can
be used to support audit work including text processing, spreadsheet analysis and graphics.
MS Access and other general purpose databases and data analysis tools including Oracle,
Statistical Analysis Software (SAS), Structured Query Language (SQL), Crystal Report and
PowerBuilder can be used as forms of generalized retrieval software (GRS) or for more
sophisticated data analysis tools. Embedded Audit Modules (EAMs) are a class of CAATs that
are integrated within the entity’s application systems and which support real time or quasi-real
time monitoring of transactions within the accounting information system.
8.5 Generalized Audit Software (GAS)
Generalized Audit Software (GAS) is a class of CAATs that allows auditors to undertake data
extraction, querying, manipulation, summarization and analytical tasks. Arguably the most
widely deployed class of CAATs is Generalized Audit Software (GAS). These packages are
computer programs that contain general modules to read existing computer files and perform
sophisticated manipulations of data contained in the files to accomplish audit tasks. They have
a user-friendly interface that captures users’ audit requirements and translates those user
instructions or queries into program code. This is undertaken by interrogating the client’s file
systems or database and performing the necessary program steps. As compared to
embedded audit modules, they do not require a certain level of programming expertise to
design and implement the audit queries.
These are specialized software’s designed for accountants fostered with audit architecture in
mind. The user interface is very simple for users to follow and with that objective, GASs very
often have out-of-box-integration with leading accounting / other systems. However simple it
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may sound, it needs some training and experience to use them and some people do find it
complex to operate.
GAS focuses on the fully exploiting the data available in the entity’s application systems in the
pursuit of audit objectives. GAS support auditors by allowing them to examine the entity’s data
easily, flexibly, independently and interactively in data based auditing. Using GAS, an auditor
can formulate a range of alternative hypotheses for a particular potential misstatement in the
subject matter and then test those hypotheses immediately. “What if” scenarios can be
developed with the results and the auditors can examine the generated report rapidly.
Currently, the latest versions of GAS include the Audit Command Language (ACL), Interactive
Data Extraction and Analysis (IDEA) and Pan audit.
Audit Command Language -ACL
ACL is the market leader in computer-assisted audit technology and is an established
forensics tool. It is a computer data extraction and analytical audit tool with audit capabilities
like Statistics, Duplicates and Gaps, Stratify and Classify, Sampling, Benford Analysis, using a
GAS such as ACL means the auditor does not review a sample of the data, but rather reviews
or examines 100 percent of the data and transactions.
8.6 Common Software Tools (CST)
Due to shortcomings of GASs, CSTs have become popular over a period. Spreadsheets (like
MS Excel, Lotus, etc.), RDBMS (like MS Access, etc.) and Report writers (like Crystal reports,
etc.) are few examples of CSTs. Their widespread acceptability is due to its instant availability
and lower costs. While spreadsheets may be extremely easy to use due to its simplicity and
versatility, other CSTs may need some practice.
Whether one uses GAS or CST, it is imperative that the auditor is aware about the manner
and processes that have led to the data generation, the control environment revolving around
the data and the source from where the data samples are imported into the GAS/CST.
As a part of computer-aided audit, an auditor needs to do one or more of the following.
1. Check Missing
2. Check Duplicates
3. Round Numbers
4. Repetitive Odd-Numbers
5. Classification
6. Stratification
7. Single Transactions
8. Isolated Outliers
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(i) Check Missing: Here we basically try to identify the gaps in any workflow that has serial
control mechanism. For example, missing cheques numbers, insurance policies
numbers, and bank fixed deposit receipts, good received notes, cash receipt numbers,
etc. Depending upon the availability of data vis-a-vis audit objectives, an appropriate
data attribute (data field) may be selected to run this check. Missing gaps can be
filtered for auditee’s explanations.
(ii) Check Duplicates: the serial control numbers which ought not to be repeated are
checked for duplicates. Thus all the documents (that have serial control), mentioned in
the above paragraph can be checked for replication. Duplicated numbers could throw
up serious gaps in the sourcing of these documents or in case they have been
generated using some computerized system could mean a software bug. All such
duplicated numbers need thorough detailed review to dispel any wrong doing
(iii) Round Numbers: Basically there is nothing wrong with Round numbers and it is not
unusual to see many round number transactions in any commercial deals. However,
sometimes round numbers are symptomatic of mysterious deals. Therefore the auditor
should use some judgement to eliminate possible round number cases. For example, it
is quite natural to generally spot round number transactions in monthly rentals,
professional fees, audit remuneration, etc. - these transactions could be filtered out
from the list of transactions with round numbers.
(iv) Repetitive Odd-Numbers: This is converse of Round-numbers. Unlike the round
numbers, repetition of odd numbers (particularly repetitions at decimals levels) are very
rare coincident. Unless of course there is apparent reasons say, like for Telco having
promotional offer of Rs 199/- prepaid packs - but in that case, the repetitions will be by
volumes and not a few stray incidences here and there. Repeated oddnumber
transactions can be filtered for detailed verification and most often these will throw up
some irregularities.
(v) Classification: Classification is a process of arranging data into homogenous group or
classes according to some common characteristics present in the data. This analysis
aid the Auditor in getting a bird’s eye view to see a panoramic whole of how the data is
dispersed or where the concentration lies. Classification can be combined with other
appropriate CAATT checks to enable more penetrative tests.
(vi) Stratification: Stratification is a derivative of classification which involves grouping of
large data into ‘strata’. Strata means levels, bands or groups. Thus it involves dividing
or rearranging the data within the Strata and then overviewing it to decipher the latent
configuration of the database.
(vii) Single Transaction: This is self-explanatory and may need little explanation. As the
name suggests, this check basically filters all the single transactions in a database.
These single records could be bonafide cases or just a stray transaction inserted by
opportunist beneficiary. Generally vendor account, employee account, customer
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account, etc. should have multiple transactions since everyone wants regular business.
Solitary transaction could be vouchsafe to exonerate sketchiness if any.
(viii) Isolated Outliers: An Isolated outlier is an observation in a data set which is far extreme
in value from the others in the data set. It is an unusually large or an unusually small
value compared to the others. Any database will be vitiated by incongruent records or
contaminated transactions which will stick out as outliers. That happens because of its
inherent nature that impedes its blending with the others in the group and will be clearly
isolated with the remainders.
(a) A word of caution -- there could outliers that would creep in any database as
deviations which happens in normal course and may not always mean a fraud or
an error. However, as an auditor s/he will be concerned about these outliers and
should review these transactions as part of audit plan.
(b) There are various ways to spot the Isolated Outliers as discussed below.
(c) Simple Charting Options
(d) Relative Size Factor
(e) RSF is the ratio of Largest Number to the Second Largest Number of a relevant
set.
i. RSF = Largest Number
1. Second Largest Number
(f) For example, if we have following bank payment vouchers of Vendor XYZ
(ix) Voucher No. (x) Rs.

(xi) SB-211 (xii) 50,000
(xiii) SB-642 (xiv) 5,00,000
(xv) SB-547 (xvi) 5,00,000
(xvii) SB-1864 (xviii) 20,000
(xix) SB-4755 (xx) 23,000
(xxi) SB-8347 (xxii) 8,500
(a) The Largest value in above table = Rs 5,00,000/- and the second largest
value = Rs 50,000/-. Therefore the RSF in this case = 10 that is Rs
5,00,000 Lacs divided by Rs. 50,000/-. Per RSF theory generally any
transactions where RSF > 10 are the cases of isolated outliers.
(b) Relevance of RSF:
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(c) Scrutiny of individual parties account is humanly ineffective and now with
most of the data available digitally how does one scrutinize the ledgers?
RSF theory comes in very handy here, instantly one can calculate RSF and
take sample for verification. This tool finds focus and meaning to the
scrutiny. It highlights all unusual fluctuations which may be stemming from
frauds or errors.
Application of RSF theory in audit
• Any set of transactions generally take place in certain range or limits. Thus there is a
certain pattern of financial limits peculiar to each vendor, customer, employee, etc.
These limits may not be defined, but the data can be analyzed to view a pattern. RSF
captures this pattern as ratio.
• For example in case of vendor X the normal invoicing range, say is Rs. 20k to 50k per
bill. If there is any stray instance of single transaction which is way beyond the normal
range than that ought to be looked into. That is, in the instant case, if there is bill of Rs.
5 lacs than it naturally concerns the auditor to have a look at.
• RSF is above case will give a ratio of 10. That is. ratio of
• Rs. 5lacs (largest value) to Rs. 0.50 lacs (second largest value)
• This single instance could be case where there is some foul play or error in punching of
the data (due to additional zero at the end).
Case study on use of RSF
ICE, a large multinational white goods company had set up operations in India in the year
2000 by acquiring a small local manufacturing company and expanded its operations
countrywide. The investigators were called in the year 2003 / 2004 pursuant to allegations
contained in an anonymous letter against the Plant Manager. Initial engagement discussion
revealed that the ICE’s outflows mainly comprised of labor payments, power, Capex, raw
materials, job-works, R&M, etc.
The investigator first ran a check of RSF on the vendor data and got the following parties
where the RSF exceeded 10.
Vendor Max_Val 2nd Max_ Val RSF > 10

WAP Systems LLC 25,748,906 2,059,912 12.50
Indergoll Rand Ltd 206,788,550 13,586,007 15.22
Difel Inc. 96,574,432 3,094,148 31.21
Ajmera Constructions 45,659,440 1,551,753 29.42
A-Technologies Ltd 13,478,523 705,870 19.09
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A drill-down on the voucher level details of the above vendors revealed following information
Name Doc Ref Date Rs. Particulars

No. Of Cases
WAP Sys 17089343 31-Mar-01 25,748,906 WAP -ERP 14 Capitalised
System
WAP Sys 18088874 06-May-02 WAP- 14 for 2 years
2,059,912 system-AMC
Indergoll 17089352 31-Mar-01 SW, PS, 22
206,788,550 Asly-line Capitalised
Indergoll 17089353 31-Mar-01 P&M 22
13,586,007 Erection and Comm.Chgs
Difel 17089355 31-Mar-01 Foaming 16
96,574,432 System Capitalised
Difel 18089983 05-Jun-01 3,094,148 Foaming 16 Capitalised
cryst s/w
Ajmera 17069323 15-Jan-01 45,659,440 FacBldg., Admn
Ajmera 17070222 02-Feb-01 1,551,753 Wing, Stores, FGStore
Interiors-Office, 18
Mng.,Conf.,Canteen
A-Techn 37852344 25-Mar-03 13,478,523 Mould qty1 - 4,586 4011 Stellar
SKE
A-Techn 18088874 21-Jan-03 705,870 Mould Job 4,586 HDL-5004 -
wrk 15000 nos.
Considering the information obtained, the RSF of M/s. WAP, Indergoll, Difel, Ajmera were
explainable since they had basically supplied capital items which was one time large cost and
subsequent bills would be for supply of services/ spares etc. and hence the cost would be
much lower. However, A-Tech was a job worker and had issued over 4,500 bills. So the
pattern of his general transactions were in range of 50,000 to 7,00,000/-, thus the off-beat
transaction of Rs 1.34 Crores needed a review.
The investigator made inquiries of the transaction for Rs. 1.34 Cr and learnt that it was
towards the cost of mould purchased from A-Tech. General review of accounting documents
and supporting showed everything to be in order. He was explained that generally moulds are
procured from another vendor but this one was purchased since ATech was L1. The
investigator reviewed the quotes received, bid comparison, etc. and noted that indeed A-tech
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was lowest. He also noted that the next bid value was about Rs 3 Crores that is more than
double then the quote of A-Tech. This raised a red-flag that how was A-Tech able to supply
the same mould in less than half of its competitor. He decided to inspect the asset. To cut the
long story short, when he investigated into the procurement, it was found that the mould
actually belonged to the ICE only which was not in use and had been discarded by the
previous management of ICE and later sold as scrap to A-tech. The plant manager in
connivance with the A-tech created the need for a mould which was little bit modified and put
to use. The mould was however sold back to the company at much higher profit.
How to calculate RSF in MS Excel
Given data of about 1000 records extracted from Account payable system. The data consists
of following relevant fields.
• Voucher No.
• Voucher Date
• Vendor Name
• Bill Amount
• Bill Number
The objective is to find out the RSF for each vendor in following format
Vendor Max_Val 2nd Max_Val RSF

Col _A Col_B Col_C Col_D
Summarized Steps
Step 1 : Extract the maximum value for each vendor and store in a column of the work sheet -
say col. B
Step 2 : Extract the second maximum value for each vendor and store in another column say
col. C
Step 3 : Divide Col. ‘B’ by ‘C’ to get RSF Ratio and store result in Col. ‘D’
Step 4 :Filter Col. ‘D’ for results where RSF is more than say 10.
Step 5 : Filter records from Database for the above results as audit sample.
Detailed Steps
Step 1 : To obtain the largest or maximum value from the data
• Use Pivot Table Function to classify the bill-amount field of data.
• The classification criteria will be vendor name
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• Classification of Bill amount field will be for “Max. Value”

Step 2 : To obtain the 2nd maximum value from the data
• To obtain the 2nd max value, it will be necessary to nullify the max. values obtained in
Step 1 above. This can be done as follows.
• Extract results obtain from the first step to append to the data with the maximum value
for the each respective vendor. This can be done by using ‘Vlookup’ Function.
Formula = Vlookup (Criteria Cell Ref, Data Source, Offset)
• Nullify the effect of the bill amount if the respective bill value is equal to the Max.
value. Using the ‘If’ function.
Formula = If (BillValueCellRef = MaxValueCellRef, 0, BillValueCellRef.)
[The above formula will add to the existing database, a field with bill amount which is
not a MAX.Value.]
• Repeat The First Step again to obtain the max value from the field created above. The
max value now will be actually the 2nd Max. value.
Step 3 : Divide the Max Value with 2nd max Value
• This is a simple divide function Formula = MaxValueCellRef
2nd MaxValueCellRef
• The result obtained is RSF
Step 4 : Filter the RSF col. to extract where RSF is more than say 10
• This can be done using the Auto Filter Command of excel sheet by customizing the
limits.
• The result obtained are data where RSF is more than 10.
Step 5 : Filter records from Database for the above results.
• This is same as filter command used in Step 4, except that now the filter is set on the
main database.
• This data is records where the max value of bills exceeded the 2nd max value over five
times.
Benford’s Law
This is revolutionary theorem pro-founded by Dr. Frank Benford, an American Electrical
Engineer and Physicists. Benford’s Law is also popularly known as the first digit law. The law
is about statistical statement regarding occurrence of numerical digits. Dr. Benford observed
that in any large database generated through a ordinary process, the natural numbers
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(numbers which are not limited by boundaries or non-serial nos.) follow a count of its first-left-
most digit which is not in consonance with the law of probability. He asserted that the first-
leftmost-digit (e.g. it is “1” in a number 1,2,3,4,5,6,7,8”) follows a pattern of appearance where
the lower numbers have more chance of appearing as compared to the higher numbers.
According to him the appearance of first left most digit has the following frequency.
Digit 1 2 3 4 5 6 7 8 9
Frequency (%) 30.1 17.6 12.5 9.7 7.9 6.7 5.8 5.1 4.6
Thus numbers deviating from the above principle would be transactions that could are
isolated outliers.
This table was compiled after sheer hard work on widely disparate populations such as a
day’s stock quotations, a tournament’s tennis scores, the numbers on the front page of The
New York Times, the populations of towns, electricity bills in the Solomon Islands, the
molecular weights of compounds, the half-lives of radioactive atoms and much more.
How does this help auditors? The one word answer for this is ‘phenomenally’. The application
of this law in auditing can lead to amazing discoveries in terms of errors or frauds. Data
validation and analysis of a new dimension is now possible. Most accountants or embezzlers
would not know that any error or fraud is very likely to be caught or trapped by digital
analysis using this amazing theorem. This is because a material error or a fraud, influences a
natural number population and consequently the data set loses its digital properties as
predicted by Benford and a digital analysis would easily throw up the anomalies for an auditor
to concentrate upon. Thus this law facilitates an auditor to virtually focus his attention directly
on fraud or error prone areas. Research studies have shown that a digital analyses are
successful about 68 % of the time with the limited knowledge that humans possess as of
date, as regards this law and its potential.
8.7 Data mining techniques
It is a set of assisted techniques designed to automatically mine large volumes of data for
new, hidden or unexpected information or patterns.
• If You Know Exactly What You Are Looking for, Use Structured Query Language (SQL).
• If You Know Only Vaguely What You Are Looking for, Turn to Data Mining.
Data mining techniques are categorized in three ways: Discovery, Predictive modeling and
Deviation and Link analysis. It discovers the usual knowledge or patterns in data, without a
predefined idea or hypothesis about what the pattern may be, i.e. without any prior knowledge
of fraud. It explains various affinities, association, trends and variations in the form of
conditional logic. In predictive modeling, patterns discovered from the database are used to
predict the outcome and to guess data for new value items. In Deviation analysis the norm is
found first, and then those items are detected that deviate from the usual within a given
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threshold (to find anomalies by extracted patterns). Link discovery has emerged recently for
detecting a suspicious pattern. It mostly uses deterministic graphical techniques, Bayesian
probabilistic casual networks. This method involves “pattern matching” algorithm to ‘extract’
any rare or suspicious cases.
Data mining commonly involves four classes of task:
• Classification - Arranges the data into predefined groups with the help of algorithms
• Clustering - Is like classification but the groups are not predefined, so the algorithm will
try to group similar items together
• Regression - Attempts to find a function which models the data with the least error. A
common method is to use Genetic Programming.
• Association rule learning - Searches for relationships between variables.
8.8 Laboratory Analysis of Physical and Electronic Evidence
 Computer Forensics
 hard disk imaging
 E-mail analysis
 search for erased files
 analyze use & possible misuse
 computer software to analyze data
 Protection/Validation of Evidence
 Federal Rules of Evidence
 Chain of Custody
 Altered & Fictitious Documents
 physical examination
 fingerprint analysis
 forgeries
 ink sampling
 document dating
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Chapter 9
Using Excel for Forensic Audit
MS Excel software needs no introduction; it’s a simple application which most of us use every
day -time-in and out. The versatile spreadsheet is available almost on all machines and
seldom one will find an accountant / auditor not using it. While mostly it is popular for making
statements, charts, etc., it can conveniently be also used as CAAT. This article is to facilitate
to make best use of whatever little is known by user about MSExcel.
Some of the important MSExcel-functions that are useful as CAAT for audit / investigation are
described below.
• ‘IF’
• ‘IF’ in combination with ‘AND’
• ‘IF’ in Combination with ‘AND’ & ‘OR’
• ‘CountIF’ and ‘SUMIF’
• ‘SUMIFS’
• ‘VLOOKUP’
• Pivot Table Function
• Formula Auditing
Note: The above list is not exhaustive but is only an illustrative one. There are many other
useful functions and the users may develop skills once he/she starts practicing them. Also it
needs to be noted that there are several ways in MS Excel to achieve the same results;
therefore this article attempts to only explain a few of them.
The above functions are explained in detail with its corresponding application in audit / fraud
investigations.
The ‘IF’ Function
The IF Function along with its derivative usage with ‘AND’ / ‘OR’ can be useful for:
• Detecting Gaps
• Finding Duplicates
• Locating Multiple Records
• Flagging Records
• Ageing Analysis or Advance Analysis

• Extracting Records meeting certain criteria (Combination with filter commands or with
Pivot Table commands)
Example of ‘IF’ Function:

The given data is list of cheques issued and the objective is to determine gaps of missing
cheque numbers.
For complex operations, another ‘IF’ function can be used within an ‘IF’ function. This is known
as Nested-IF function which is explained as follows :
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The Nested ‘IF’ functions

That is using IF within IF Function.
Here we use multiple tests (queries/ questions) in serial order and depending upon the
response of preceding test another logical test follows. The nested-IF function can be
explained as follows:
Syntax of Nested IF
= IF (Test1,
if true IF [Test2, if true,if false], if false IF [Test 3,
if true, if false] )
There can be maximum of 64 nested ‘IF’s
Example of Nested-IF function
The given data is list of sales team with their date of joining, years of experience and sales
achieved during a period. A salesman is entitled to promotion depending upon his/her
experience and sales achieved. If his experience in under 3 years, he/she is eligible if the
sales are over $ 3mn and for others the eligibility sales criteria is $ 5mn. The objective is to
flag ‘Eligible’ status in Col-F
The Eligible and Not-Eligible employees can be filtered separately to check with the
promotions given.
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Using ‘IF’ function in combination with ‘AND’/ ‘OR’

Sometimes we need to have two or more tests that needs simultaneous confirmation for
logical actions, this can be done by using the ‘AND’ or ‘OR’ with the ‘IF’ function. These
results can also be achieved using the Nested-IF functions, however sometimes it may be
easier to use ‘AND’/’OR’ functions. The ‘IF’ in combination with ‘AND’/’OR’ are explained
below:
Syntax of ‘IF’ function used in combination with ‘AND’

=IF(AND(Test1,Test2)=Result,IfTrue,If False)
Example of ‘IF’ function used in combination with ‘AND’ :
The given data is a list of payments stating details of cheque nos., bills reference (against
which the payments are made) and the name of vendor with the amounts. Here is order to
establish multipayments, one need to compare the vendor names and the bills numbers.
When there is match for both criteria (Name and Bill No.) then double payment flag is set.
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Syntax of ‘IF’ function used in combination with ‘OR’

=IF(OR (Test1,Test2) = Result, If Either True, If Both False)
Example of ‘IF’ function used in combination with ‘AND’ + ‘OR’
Continuing with the same example as above, it can be seen that we are able to flag only one
of the two records of double payments. On applying filters, though we have details of the
double payments, we cannot show both the records. It happens because we are comparing
the record on current line with a below-line item (in above example Row27 is compared with
Row28).Therefore to flag both the records (or if there more than 2 than all the records), we
need to compare the current line item with line-item above and line-item below. That is, say for
record at Row28, we need to check Row28-with-Row29 AND Row28-with-Row27. If either
combination matches then that record needs to be flagged for “DblPymnt”.
To simplify (at Record at Row28) we need to :
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On filtering the “DblPymnt” records, we are able to get all the bills that are paid more than
once.
The ‘COUNTIF’ Function
This function counts the Tnumber of records satisfying user criteria.
This function is extremely useful in analysis of master databases (vendors, customers,
employees, etc.) to determine whether there is nexus between them. For example common
telephone numbers, fax nos., contact person references, email_ids., etc. can give a clue of
linkages. This function can be coupled with ‘filter’ command to give instant results.
cSyntax Of ‘COUNTIF’ Function:
= COUNTIF (criteria_range, criteria,) Example Of ‘COUNTIF’ Function:
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The given data is of vendors details -Vendor_name, city, fax-nos. and telephone nos.
By using the ‘Countif’ function we can count (say for Row2) how many times the fax number
(in cell C2) is repeated in the entire Col-C (the count is stored in Col-D).
Similarly we can also count how many times the tel_no. (in cell E2) is repeated in the sentire
Col-E (the count is stored in Col-F).
Thereafter set filters for:
• fax-counts more than 2 and
• tel-counts more than 2 following result is obtained….……the linakages bet’ the parts are
highlighted.
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The filtered records can be copied on another sheet and sorted on fax_no. / tel_no to get the
proper result :
The ‘SUMIF’ Function this is an extension of widely used ‘Sum’ function but here the ‘SUM’ is
combined with ‘IF’. Thus summation can be obtained of selected records satisfying user
defined criteria. This function operates the same way as Pivot Table Command. However,
Pivot Table function is not on real-time basis (one need to refresh to get updated results);
‘SUMIF’ function on other hand works on real-time basis (changes in data instantly updates
this formula) Syntax of the Sum IF function is as follows:
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Example of the Sum IF function:

Given data is of quantities of fruits sale with summary of total quantities (kgs.) sold. To check
the summary calculation, the SUMIF function can be easily used. Say for fruit-Dates, we take
sum” of Col-D only for the records where ‘Dates” appear in Col-
C. Therefore criteria range will be the Fruit-name (C19:C40), Criteria = C45 (“Dates”) and sum
range is quantities in Col D (D19:D40). It needs to be noted that the criteria range (19:40)
matches with sum range (19:40). The calculated numbers can be compared with the given
quantities to show the differences.
The ‘VLOOKUP’ Function

This function is extremely useful in linking two databases. This can be however, only done if
there is a common unique reference (generally referred to as’ primary key’) between the two
databases. All databases built-up on RDBMS work on this prime principle and hence generally
it is easy to generate a primary key. There can be several applications of ‘V Lookup’ function.
A few examples could be:
• To verify the rates billed with standard rate-card prices,
• To confirm proper application of interest rates charged for bank advances.
• To vouchsafe whether all dispatches are billed or vice-versa. Similarly vendor-bills can
be checked with the Inventory receipts.
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• Quantities, rates, etc. in purchase orders can be compared with the vendor bills. Or
even the rates charged can be analyzed by comparing multi- vendors or same vendor
over different period.
• Multi-years Inventories records can be compared.
• Employee payroll can be compared over the period or with master records.
• Tax rates for employees (withholding tax) , invoices, etc. can bechecked.
• Production records can be checked to inventories and vice-versa.
• The list can be endless and an effective use can be made depending upon the
circumstances and subject matter of the audit / investigation.
Example of VLOOKUP
Given two databases (i) data of sales (marked with green frame) and (ii) data of standard rate
card prices (marked with yellow frame). In practice usually the databases are in different
worksheets or workbooks, but here it is shown in same worksheet for easy understanding.
However the principle is same. The objective is to check whether the correct rates are
invoiced to the customer. Using VLOOKUP function, the rates (in Col. D) of rate card
(B23:D36) is extracted in Col-Q. The formula is explained in figure below. The difference
between rates invoiced (Col. M) and rates chargeable (Col-Q extracted as aforesaid) can be
compared.
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The Col-R can be filtered for non-zero to list the differences which is list where the rates are
charged higher or lower for further investigation.
This function quickly summarizes large data by:

• Querying the data in many user-friendly ways.
• Subtotaling and aggregating numeric data, summarizing data by categories, and
subcategories, and creating custom calculations and formulae. Besides summing (sum),
it can also find average, max, min, etc.
• Expanding and collapsing levels to focus on results, drilldowns to details from the
summary
• Moving rows to columns or vice-versa; see different summaries using various scenarios.
• Filtering, sorting, grouping, etc.
Application of Pivot Table function:
There can be several uses of the Pivot table function, a few examples can be as follows :
• Stratification / Classification of Data – period-wise, party-wise, assets-wise, etc.
• Creating various scenarios with if-then categories, using with filters it is possible to
expand and collapse levels. For example in data of vendor bills, a pivot can be created
to see Vendor-wise +Item_wise summary or Item-wise + Vendor_ wise summary.
• Create Trial Balance of General Ledger, Accounts Payable, Accounts Receivable, Bank
Account balances, etc.
• Inventory Summary, Slow Moving / Non-moving Stock, etc.
• Digital Analysis e.g. Benfords Law, Relative Size Factor (RSF), etc.
• How to apply the Pivot Table.
Unlike many formulae, the Pivot function does not begin with a ‘=’ sign. This is more of a
command and hence not a formula. Therefore this command needs to refresh from time to
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time to obtain correct results. If there is need for an update on real-time basis, one can use
SUMIF, COUNTIF, etc.
To apply the Pivot command, in the insert tab select the PivotTable icon and one needs to
navigate throughthe interactive dialogue box. Select the appropriate data range and where
you need to place the output (the appropriate choice generally should be ‘in new sheet’ since
that will not conflict with your data).Select the appropriatefields for the vertical andhorizontal
crosstabs as Rowlabels and Column labels. The data to be summarized should be placed in
the ‘value’ section. Here by selecting the ‘value field settings’, one can select the sum, count,
average, max, min, product, etc.Cosmetic touch can be given to the table by selecting
appropriate formats or charts.
Example of Pivot Table:
Given data is of sales during a period giving details of Bill No., Customer name, Product_Id,
Quantity billed, etc. The objective is to summarize the quantity product code wise. Applying
the Pivot Table the pivot table / charts can be obtained as shown below:
In principle however complex queries and charts can be generated for different scenarios to
give much more insights into the data.
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Formula Auditing
Very often some excel sheets are very complicatedly built-up -- there are many variables
spread across multiple sheets and complex formulae make it difficult to audit. Most often such
sheets are verified based on rebuild-and-compare method. This can sometime take enormous
effort and hence may not be viable. This is where the Formula Auditing options come handy.
This is an in-built tool in MSExcel to quickly spot errors / omissions by locating inconsistencies
in data having regard to surrounding region. A check run is conducted for:
• Cell containing formula that result in error
• Inconsistent calculated column in tables
• Cell containing years represented as two digits
• Numbers formatted as text
• Formulae inconsistent with other formulae in the region
• Formulae which omitted cells in a region
• Unlock cells containing formulae
• Formulae referring to empty cells
• Data entered in a table is invalid
How to use the Formula Auditing Options
• Click on the ‘Formula’ tab and then select the ‘Formula Auditing’ section as shown in
figure below. There are different audit tools available, a combination of which can throw
up exceptions. Since this does not change the data, there no fear for data modification.
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• Trace dependent and precedents diagrammatically show various relationship between

the cells. Repeatedly pressing these commands shows a pattern of linkages (see the
linkages in blue arrows in the figure below); one can easily spot variations (marked in
red circle) if any.
• As the name suggests, the ‘Show Formula’ tab quickly converts the entire sheet from
value to the formula as shown below so that one can spot any glaring errors, e.g. direct
numbers entered (see the yellow highlighted cell in fig. below) as against expected
formula or vice versa, some extra numbers inserted in cell along with formulae, etc.
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• Error checking commands works like a spell-check command. It basically checks all the
possible errors and shows the errors in a dialogue box (as shown below) giving the cell
numbers with possible error and explanation. The user can then correct the errors as he
deems fit.
• Also one can use the green-corner sign (see adjacent screen shot) to spot errors. This
is similar to the error checking. In error checking explanation is given, while in green-
corner is just flagged (this is like the red line shown from wrong spelling in word file).
This can be done by enabling the configuration settings in the as shown below.
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Chapter 10
How to Write a Forensic Audit Report
“A Report is a statement of collected & considered facts, so drawn up as to give clear and
concise information to persons who are not already in possession of the full facts of the
subject matter of the report.”
The Forensic Audit Report is nothing but statements of observation gathered & considered
while proving conclusive evidence. It is a medium through which an auditors expresses his
opinion under audit. It is an important part of the audit as it provides the results of the audit
conducted by the auditor.
Points to Remember:
• Clear thinking :
 To whom the report is directed
 Purpose and aim
 Cool and calm thinking to have logical and coherent presentation
 Pattern of presentation
• Keep the reader uppermost in mind
 Translate technical matters to layman’s language
 To visualize the reader’s viewpoint
• Unbiased approach
 To mention the view point of the auditee
• Impact of the report
 What be the probable reaction to reporting whether action or decision will follow
in quickest possible time or to be treated as of academic interest only.
 To remember the universal saying – “don’t jump to conclusions”
• Facts and figures to be in proper sequences
The main factors to go into the consideration for the various ways of presentations of
written reports are:-
• Nature of business of the organization
• Nature of subject or aspect appraised
How to Write a Forensic Audit Report
• For whom the report is intended

• Purpose for which the report is prepared
• Management attitude, directives and needs.
• Forensic auditor’s approach and caliber.
• Extent of details required by auditee and management
A sample Table of Contents of a Forensic Audit Report may include the following:
1. EXECUTIVE SUMMARY
1.0 Background
1.1 Origin of the Audit
1.2 Audit Objective
1.3 Proposed Audit Outputs
1.4 Audit Implementation Approach
2. RISK ANALYSIS
2.1 Internal Environment Risk
2.1.1 Financial Management
2.1.2 Customers, Products and Competitors
2.1.3 Information technology
2.1.4 Business Process
2.1.5 Human Resource Management
2.2 External Environment Forces
2.2.1 Influence of Economics and relevant Market
2.2.2 Political and Legal Scenario
2.2.3 Technology in the Sector
3. AUDIT PROCESS
3.1. Preliminary understanding of scope and incident coverage
(i) Identification of all related data elements
(ii) Preparation of a List of “persons of interest” for interview
(iii) Obtain management approval for scope
3.2. Collect Evidence
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3.3. Conduct Interviews

3.4. Analyze findings
3.5. Validate Inferences and conclusions
4. EVIDENCE OF RISK EVENTS
4.1 Conflicts of interest
4.2 Bribery
4.3 Extortion
4.4 Theft
4.5 Fraudulent transactions
4.6 Inventory frauds
4.7 Misuse of assets
4.8 Financial Statement frauds
5. AUDIT RECOMMENDATIONS
5.1 Logical Framework Approach
5.2 Preconditions and Risks
6. GOVERNANCE ON RECOMMENDATION IMPLEMENTATION
6.1 Stakeholders
6.2 Budget Considerations
LIST OF ANNEXURES
Annex 1: Members of the Interviews
Annex 2: Organization Chart of Auditee organization
Annex 3: Financial Performance (YYYY to YYYY)
Annex 4: Audit Recommendation Logical Framework
Annex 5: Analysis of Key Risk Events
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Chapter 11
Digital Forensics
Digital forensics has been defined as the use of scientifically derived and proven methods
towards the preservation, collection, validation, identification, analysis, interpretation and
presentation of digital evidence derived from digital sources for the purpose of facilitating or
furthering the reconstruction of events found to be criminal or helping to anticipate the
unauthorized actions shown to be disruptive to planned operations. It is the application of
proven scientific methods and techniques in order to recover data from electronic / digital
media. Digital Forensic specialists work in the field as well as in the lab.
In the early 1980s personal computers became more accessible to consumers, leading to their
increased use in criminal activity (for example, to help commit fraud). At the same time,
several new "computer crimes" were recognized (such as hacking). The discipline of computer
forensics emerged during this time as a method to recover and investigate digital evidence for
use in court. A computer forensic investigator follows certain stages and procedures when
working on a case. First he identifies the crime, along with the computer and other tools used
to commit the crime. Then he gathers evidence and builds a suitable chain of custody. The
investigator must follow these procedures as thoroughly as possible. Once he recovers data,
he must image, duplicate, and replicate it, and then analyze the duplicated evidence. After the
evidence has been analyzed, the investigator must act as an expert witness and present the
evidence in court. The investigator becomes the tool which law enforcement uses to track and
prosecute cyber criminals. Forensic investigator follows all of these steps and that the process
contains no misinformation that could ruin his reputation or the reputation of an organization.
Stages of Forensic Investigation in Digital forensics includes Assessing, preserving, collecting,
confirming, identifying, analyzing, recording, and presenting crime scene information.
1. Assess the Crime scene
To conduct a computer investigation, first one need to obtain proper authorization. That
process begins with the step of assessing the case, asking people questions, and
documenting the results in an effort to identify the crime and the location of the evidence.
Review the organization’s policies and laws and build a team for the investigation.In this
investigators prioritize the actions and justify the resources for the internal investigation.
2. Collection phase
The first step in the forensic process is to identify potential sources of data and acquire
forensic data from them. Major sources of data are desktops, storage media, Routers, Cell
Phones, Digital Camera etc. A plan is developed to acquire data according to their importance,
volatility and amount of effort to collect
Evidence is most commonly found in files and Databases that are stored on hard drives and
storage devices and media. Finding the evidence, discovering relevant data, preparing an
Order of Volatility, eradicating external avenues of alteration, gathering the evidence, and
preparing a chain of custody are the main steps in the collection phase. Maintaining the chain
of custody is the important step. Identification of the evidence must be preserved to maintain
its integrity.
3. Analysis phase
This involves examining the collected data/files and finding out the actual evidence. The
computer forensic investigator must trace, filter, and extract hidden data during the process.
4. Report phase
The audience will be able to understand the evidence data which has been acquired from the
evidence collection and analysis phases. The report generation phase records the evidence
data found out by each analysis component. Additionally, it records the time and provides
hash values of the collected evidence for the chain-of-custody.
Chain-of-custody and Documentation
Documentation is essential to the investigation. For evidence to be reliable in court, integrity
has to be preserved. Safe storage and tamper protection is needed, so is also the
documenting of handling, i.e. who has accessed the evidence while it was in custody. Chain of
custody prevents accusation in court that the evidence has been tempered with. Evidence
need to be identified and labelled as soon as it is collected. All actions performed by the
investigator should be documented, including the reasons for doing so. In digital forensics, this
means logging all actions and integrity checks.
11.1 Types of Digital Evidence
• PERSISTANT DATA - Meaning data that remains intact when the computer is turned
off. E.g. hard drives, disk drives and removable storage devices (such as USB drives or
flash drives).
• VOLATILE DATA - Which is data that would be lost if the computer is turned off. E.g.
deleted files, computer history, the computer's registry, temporary files and web
browsing history.
11.2 Top 10 Locations for Evidence
• Internet History Files
• Temporary Internet Files
• Slack/Unallocated Space
• Buddy lists, personal chat room records, P2P, others saved areas
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Digital Forensics
• News groups/club lists/posting

• Settings, folder structure, file names
• File Storage Dates
• Software/Hardware added
• File Sharing ability
• E-mails
11.3 Computer Forensics Methodology
• Shut Down the Computer
• Document the Hardware Configuration of The System
• Transport the Computer System to A Secure Location
• Make Bit Stream Backups of Hard Disks and Floppy Disks
• Mathematically Verify Data on All Storage Devices
• Document the System Date and Time
• Make a List of Key Search Words
• Evaluate the Windows Swap File
• Evaluate File Slack
• Evaluate Unallocated Space (Erased Files)
• Search Files, File Slack and Unallocated Space for Key Words
• Document File Names, Dates and Times
• Identify File, Program and Storage Anomalies
• Evaluate Program Functionality
• Document Your Findings
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Chapter 12
Cyber Crime
• Computer or computer networks are used as a tool or a target or a place of criminal
activity
• First recorded Cyber Crime took place in the year 1820 in France.
• Unauthorized access to computer system, data destruction, data alteration, theft of
intellectual property.
• Most important revenue sector for global organized crime
• Easy to learn how to commit
• Require few resources relative to potential damage caused
• Can be committed in a jurisdiction without being physically present in it
• Are often not clearly illegal
• Problematical
• Any crime where computer is a tool, target or both
• Offences against computer data / systems
• Unauthorized access, modification or impairment of a computer or digital system
• Offences against the confidentiality, integrity and availability of computer data or
systems
The first recorded cyber-crime took place in 1820. That is not surprising considering the fact
that the abacus, which is thought to be the earliest from of a computer, has been around since
3500 B.C.
In India, Japan and China, the era of modern computer, however, began with the analytical
engine of Charles Babbage. The first spam email took place in 1978 when it was sent out over
the ARPANT. The first virus was installed on an Apple computer in 1982 when a high school
student, Rich Skrenta, developed the EIK Cloner.
Categories of Cyber Crime
We can categorize cyber-crime in two ways
• The computer as a target: - using a computer to attacks other computer, e.g. Hacking,
virus/worms attacks, Dos attack etc.
Cyber Crime
• The computer as a weapon: - using a computer to commit real world crime e.g. cyber
terrorism, credit card fraud and pornography etc.
Types of Cyber Crime
HACKING: Hacking, in simple terms means illegal intrusion of information non a computer
system and /or network. Government websites are the hot target soft he hackers due to the
press coverage it receives. Hackers enjoy the media coverage. Motive behind such crimes are
greed, power, publicity, revenge, adventure, desire to access for bidden information etc.
Law & Punishment: Under Information Technology (Amendment) Act, 2008, Section 43(a)
read with section 66 is applicable and Section 379 & 406 of Indian Penal Code, 1860 also are
applicable. If crime is proved under IT Act, accused shall be punished for imprisonment, which
may extend to three years or with fine, which may extend to five lakh rupees or both. Hacking
offence is cognizable, bailable, compoundable with permission of the court before which the
prosecution of such offence is pending and triable by any magistrate
DATA THEFT: Data theft is growing problem, primarily perpetrated by office workers with
access of technology such computers, laptops and hand-held devices, capable of storing
digital information such as flash drives, iPods and even digital cameras. The damage caused
by data theft can be considerable with today’s ability to transmit very large files via e-mail, web
pages, USB devices, DVD storage and other hand-held devices. According to Information
Technology (Amendment) Act, 2008, crime of data theft under Section 43 (b) is stated as - If
any person without permission of the owner or any other person, who is in charge of a
computer, computer system of computer network - downloads, copies or extracts any data,
computer data base or information from such computer, computer system or computer network
including information or data held or stored in any removable storage medium, then it is data
theft.
Law & Punishment: Under Information Technology (Amendment) Act, 2008, Section 43(b)
read with Section 66 is applicable and under Section 379, 405 & 420 of Indian Penal Code,
1860 also applicable. Data Theft offence is cognizable, bailable, compoundable with
permission of the court before which the prosecution of such offence is pending and triable by
any magistrate.
E-MAIL SPOOFING: E-mail spoofing is e-mail activity in which the sender addresses and
other parts of the e-mail header are altered to appear as though the e-mail originated from a
different source. E-mail spoofing is sending an e-mail to another person in such a way that it
appears that the e-mail was sent by someone else. A spoof email is one that appears to
originate from one source but actually has been sent from another source. Spoofing is the act
of electronically disguising one computer as another for gaining as the password system. It is
becoming so common that you can no longer take for granted that the e-mail you are receiving
is truly from the person identified as the sender.
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Email spoofing is a technique used by hackers to fraudulently send email messages in which
the sender address and other parts of the email header are altered to appear as though the
email originated from a source other than its actual source. Hackers use this method to
disguise the actual email address from which phishing and spam messages are sent and often
use email spoofing in conjunction with Web page spoofing to trick users into providing
personal and confidential information.
Law & Punishment: Under Information Technology (Amendment) Act, 2008, Section 66-D and
Section417, 419 & 465of Indian Penal Code, 1860 also applicable. Email spoofing offence is
cognizable, bailable, compoundable with permission of the court before which the prosecution
of such offence is pending and triable by any magistrate.
IDENTITY THEFT : Identity theft is a form of fraud or cheating of another person’s identity in
which someone pretends to be someone else by assuming that person’s identity, typically in
order to access resources or obtain credit and other benefits in that person’s name.
Information Technology (Amendment) Act, 2008, crime of identity theft under Section 66-C,
whoever, fraudulently or dishonestly make use of the electronic signature, password or any
other unique identification feature of any other person known as identity theft.
Identity theft is a term used to refer to fraud that involves stealing money or getting other
benefits by pretending to be someone else. The term is relatively new and is actually a
misnomer, since it is not inherently possible to steal an identity, only to use it. The person
whose identity is used can suffer various consequences when they are held responsible for
the perpetrator’s actions. At one time the only way for someone to steal somebody else’s
identity was by killing that person and taking his place. It was typically a violent crime.
However, since then, the crime has evolved and today’s white collared criminals are a lot less
brutal. But the ramifications of an identity theft are still scary.
Law & Punishment: Under Information Technology (Amendment) Act, 2008, Section 66-C and
Section 419 of Indian Penal Code, 1860 also applicable. Identity Theft offence is cognizable,
bailable, compoundable with permission of the court before which the prosecution of such
offence is pending and triable by any magistrate.
CHILD PORNOGRAPHY: The Internet is being highly used by its abusers to reach and abuse
children sexually, worldwide. As more homes have access to internet, more children would be
using the internet and more are the chances of falling victim to the aggression of Pedophiles.
How Do They Operate: How do they operate Pedophiles use false identity to trap the children,
Pedophiles connect children in various chat rooms which are used by children to interact with
other children.
DENIAL OF SERVICE ATTACKS: This is an act by the criminals who floods the bandwidth of
the victim’s network or fills his E-mail box with spam mail depriving him of the service he is
entitled to access or provide. Many DOS attacks, such as the ping of death and Tear drop
attacks.
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Cyber Crime
VIRUS DISSEMINATION: Malicious software that attaches itself to other software. VIRUS,
WORMS, TROJAN HORSE,WEB JACKING, E-MAIL BOMBING etc.
COMPUTER VANDALISM: Damaging or destroying data rather than stealing or misusing
them is called cyber vandalism. These are program that attach themselves to a file and then
circulate.
CYBER TERRORISM: Terrorist attacks on the Internet is by distributed denial of service
attacks, hate websites and hate E-mails, attacks on service network etc.
SOFTWARE PIRACY: Theft of software through the illegal copying of genuine programs or
the counterfeiting and distribution of products intended to pass for the original.
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Chapter 13
Applicable Laws– India
• The Information Technology Act, 2000
• Indian Penal code 1860
• Civil Procedure Code 1908
• Indian Contract Act, 1872
• Indian Evidence Act, 1872
• The Prevention of Money Laundering Act, 2002
• The Foreign Exchange Management Act, 1999
• The Companies Act, 2013
• RBI - Master Circular on Frauds- Classification and Reporting
13.1 The Information Technology Act, 2000, Amended 2008
The IT Act recognizes offences related to fraud such as tampering with computer source
documents, hacking computer systems, creating, publishing, or otherwise making available
digital signature for any fraudulent purpose. The Act also provides legitimacy to electronic
records and approvals and recognizes the evidential value electronic records, emails and
electronic approvals and allows them to be used instead of paper documents subject to them
meeting the guidelines provided in the Act.
The intent of the Act is to provide legal recognition for the transactions carried out by means of
electronic data interchange and other means of electronic communication, commonly referred
to as "Electronic Commerce", which involve the use of alternatives to paper based methods of
communication and storage of information , to facilitate electronic filings of documents with the
Government agencies and further to amend the Indian Penal Code, Indian Evidence Act,
1872,, The Bankers' Books Evidence Act, 1891, and the Reserve Bank of India Act, 1934 and
for matters connected therewith or incidental thereto.
The Act brings focus to digital signatures and data privacy as well as defines the use of
intermediaries and sets up a structure to ensure compliance. A copy of the Act is provided as
part of the material for this course and the candidates would be well advised to review and
familiarize themselves with the content.
The Act also sets up Indian Computer Emergency Response Team to serve as national
agency for incident response which shall serve as the national agency for performing the
following functions in the area of Cyber Security,-
(a) Collection, analysis and dissemination of information on cyber incidents

(b) Forecast and alerts of cyber security incidents
(c) Emergency measures for handling cyber security incidents
(d) Coordination of cyber incidents response activities
(e) Issue guidelines, advisories, vulnerability notes and white papers relating to Information
security practices, procedures, prevention, response and reporting of Cyber incidents
(e) Such other functions relating to cyber security as may be prescribed
(f) The fraud related offences and their relevant punishments included in the IT Act are as
follows:
Section Nature of Offense Penalty and /or Fine
No.
65 Tampering with the Penalties: Imprisonment up to 3 years and / or
computer source documents Fine: Two lakh rupees.
66 Hacking with computer Penalties: Punishment: Imprisoned up to three
system years and
Fine: which may extend up to two lakh rupees or
with both.
67 Publishing of information Penalties: Punishment: (1) On first conviction ---
which is obscene in imprisonment which may extend up to five years.
electronic form Fine: up to on first conviction which may extend to
one lakh rupees.
(2) On second conviction ---- imprisonment up to
which may extend to ten years and Fine which may
extend up to two lakh rupees.
71 Misrepresentation Penalties: Punishment: imprisonment which may
extend to two years
Fine: may extend to one lakh rupees or with both.
72 Breach of confidentiality and Penalties: Punishment: term which may extend to
privacy two years.
Fine: one lakh rupees or with both.
73 Publishing false Digital Penalties: Punishment imprisonment of a term of
Signature Certificate which may extend to two years.
Fine: fine may extend to 1 lakh rupees or with both.
74 Publication for fraudulent Punishment: imprisonment for a term up to two
purpose years.
Fine: up to one lakh or both.
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13.2 Indian Penal Code 1860

Indian Penal Code is the main criminal code of India. It is a comprehensive code intended to
cover all substantive aspects of criminal law.
There is no separate legislation dealing with fraud as in the United Kingdom or the USA.
Fraudulent activities are covered by the Indian Penal Code. The word ‘fraud’ is not defined in
Indian Penal Code; instead what constitutes doing a thing fraudulently is explained. Section 25
defines the expression ‘fraudulently’ – ‘a person is said to do a thing fraudulently if he does
that with intent to defraud but not otherwise’. The expression fraudulently occurs in Sections
206, 207, 208, 242, 246, 247, 252, 253, 261, 262, 263 and Sections 421 to 424.
Sections 24 and 23 define expressions ‘dishonestly’ and ‘wrongful gain and wrongful loss.
‘Wrongful gain’ is gain by unlawful means of property which the person gaining is not legally
entitled. ‘Wrongful loss’ is the loss by unlawful means of property to which the person losing it
is legally entitled. Whoever does anything with the intention of causing wrongful gain to one
person or wrongful loss to another person, is said to do that thing ‘dishonestly’.
Indian Penal Code recognizes the following acts as fraud:
(a) Impersonation
(b) Counterfeiting
(c) Wrong weighing and measurement
(d) Misappropriation
(e) Criminal breach of trust
(f) Cheating
(g) Dishonest dealing in property
(h) Mischief
(i) Forgery
(j) Falsification
(k) Possessing stolen property
(l) Concealment
(m) Some of the important provisions of the IPC in this regard are discussed hereunder-
(n) (a) Section 403 of IPC-Dishonest misappropriation of property: According to this
provision, whoever dishonestly misappropriates or convert to his own use, any movable
property, shall be punished with imprisonment for a term which may extend to two years
or with fine or with both.
(o) For example, A takes B’s property in good faith believing that the property belongs to
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himself. A is not guilty of misappropriation. But even after discovering his mistake, A
dishonestly misappropriates the property to his own use, he is guilty of an offence under
this section.
(p) Explanation 1 to the section states that a dishonest misappropriation for the time being
only is a misappropriation within the meaning of this section. For example, A finds a
property and takes it with the intention of restoring it to the owner, A is not guilty of
offence. But if he appropriates it for his own use without using reasonable means to
discover the owner, he is guilty of the offence.
(q) (b) Section 405 of IPC-Criminal breach of trust: According to this provision, anybody
entrusted with the property dishonestly misappropriates or converts to his own use or
dishonestly uses or disposes of that property in violation of any 3 direction of law
prescribing the mode in which such trust is to be discharged, or of any legal contract,
which he has made touching the discharging of such trust, commits criminal breach of
trust.
(r) For example, A, an executor of a will, dishonestly disobeys the law which directs him to
divide the property according to the Will and appropriate the same to his own use, A
has committed criminal breach of trust. Section 406 prescribes punishment for criminal
breach of trust which is imprisonment extending to three years or fine or both. Section
409 of IPC prescribes higher imprisonment of upto ten years in respect of criminal
breach of trust by a public servant or by a banker or merchant or agent.
(s) (c) Section 415 of IPC –Cheating : According to this provision, whoever, by deceiving
any person, fraudulently or dishonestly induces the person so deceived to deliver any
property, to any person, or to consent that any person shall retain any property or
intentionally induces the person so deceived to do or omit to do anything which he
would not do or omit, if he were not so deceived, and which act or omission causes or is
likely to cause damage or harm to that person in body, reputation or property, commits
cheating. Examples: (a) A, by falsely pretending to be in civil service, intentionally
deceives B and thus dishonestly induces B to let him have on credit goods for which he
does not mean to pay, A cheats. (b) A, by putting a counterfeit mark on an article,
intentionally deceives B into a belief that this article was made by a certain celebrated
manufacturer, and thus dishonestly induces B to buy and pay for the article, A cheats.
(t) (d) Section 463-Forgery: It is defined as- “ Whoever makes any false document or
false electronic record or, part of a document, or electronic record, with intent to cause
damage or injury, to the public or to any person, or to support any claim or title, or to
cause any person to part with property, or to enter into express or implied contract, or
with intent to commit fraud or that fraud may be committed, commits forgery”. 4 The
Madras High Court in AIR 1968 Mad 349 held that in order to constitute an offence
under this section, the document must be false and it must have been made dishonestly
or fraudulently and it must have been made with one of the intention specified in section
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463. In AIR 1979 SC 1890, Supreme Court held that mere presenting a lottery ticket to
the state authority which later on was detected as a forged one does not by itself
amount to forgery. The knowledge of forged document is a necessary requirement.
Section 465 prescribes a punishment for forgery which is imprisonment for a term which
may extend to two years or with fine or with both.
13.3 Civil Procedure Code 1908
Civil procedure is the body of law that sets out the rules and standards that courts follow when
adjudicating civil lawsuits (as opposed to procedures in criminal law matters). These rules
govern how a lawsuit or case may be commenced, what kind of service of process (if any) is
required, the types of pleadings or statements of case, motions or applications, and orders
allowed in civil cases, the timing and manner of depositions and discovery or disclosure, the
conduct of trials, the process for judgment, various available remedies, and how the courts
and clerks must function.
13.4 Indian Contract Act, 1872
Under the Indian Contract Act, 1872, Sec.17 defines fraud.
“Fraud means and includes any of the following acts committed by a party to a contract, or
with his connivance, or by his agents, with intent to deceive another party thereto his agent, or
to induce him to enter into the contract;
(1) The suggestion as a fact, of that which is not true, by one who does not believe it to be
true;
(2) The active concealment of a fact by one having knowledge or belief of the fact;
(3) A promise made without any intention of performing it;
(4) Any other act fitted to deceive;
(5) Any such act or omission as the law specially declares to be fraudulent.
Explanation.—Mere silence as to facts likely to affect the willingness of a person to enter into
a contract is not fraud, unless the circumstances of the case are such that, regard being had
to them, it is the duty of the person keeping silence to speak, or unless his silence, is, in itself,
equivalent to speech.”
Section 19 ‘Voidability of agreement without free consent’ states ‘When consent to an
agreement is caused by coercion, fraud or misrepresentation, the agreement is a contract
voidable at the option of the party whose consent was so caused’;
‘A party to a contract whose consent was caused by fraud or misrepresentation, may, if he
thinks fit, insist that the contract hall be performed and that he shall be put in the position in
which he would have been if the representations made had been true.’
Hence the section seeks to provide protection to the defrauded party as the contract which is
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entered into by fraud is voidable at the option of the defrauded contracting party. Further it
also grants the defrauded party an option in form of a right of enforcement of the contract and
indemnity against the loss caused to him on account of such fraud which he would not have
been subject to had the contact been entered into by proper representation.
The only cases which are outside the purview of section 19 are those in which the defrauded
party could have obtained the knowledge of fraud by due diligence and where he failed to
apply such due diligence.
13.5 Indian Evidence Act, 1872
The Indian Evidence Act, originally passed by the Imperial Legislative Council in 1872, during
the British Raj, contains a set of rules and allied issues governing admissibility of evidence in
the Indian courts of law.
Section 44 in the Indian Evidence Act, 1872
Fraud or collusion in obtaining judgment, or incompetency of Court, may be proved.—Any
party to a suit or other proceeding may show that any judgment, order or decree which is
relevant under section 40, 41 or 42 and which has been proved by the adverse party, was
delivered by a Court not competent to deliver it, or was obtained by fraud or collusion. tc "44.
Fraud or collusion in obtaining judgment, or incompetency of Court, may be proved.—Any
party to a suit or other proceeding may show that any judgment, order or decree which is
relevant under section 40, 41 or 42 and which has been proved by the adverse party, was
delivered by a Court not competent to deliver it, or was obtained by fraud or collusion."
13.6 The Prevention of Money Laundering Act, 2002
The Prevention of Money Laundering Act, 2002 (PMLA) forms the core of the legal framework
put in place by India to combat money laundering. PMLA and the Rules notified there under
came into force with effect from July 1, 2005. Director, FIU-IND and Director (Enforcement)
have been conferred with exclusive and concurrent powers under relevant sections of the Act
to implement the provisions of the Act.
The PMLA and rules notified there under impose obligation on banking companies, financial
institutions and intermediaries to verify identity of clients, maintain records and furnish
information to FIU-IND. PMLA defines money laundering offence and provides for the freezing,
seizure and confiscation of the proceeds of crime.
PMLA empowers certain officers of the Directorate of Enforcement to carry out investigations
in cases involving offence of money laundering and also to attach the property involved in
money laundering. PMLA envisages setting up of an Adjudicating Authority to exercise
jurisdiction, power and authority conferred by it essentially to confirm attachment or order
confiscation of attached properties. It also envisages setting up of an Appellate Tribunal to
hear appeals against the order of the Adjudicating Authority and the authorities like Director
FIU-IND.
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13.7 The Foreign Exchange Management Act, 1999

The Foreign Exchange Management Act, 1999 (FEMA) is an Act of the Parliament of India "to
consolidate and amend the law relating to foreign exchange with the objective of facilitating
external trade and payments and for promoting the orderly development and maintenance of
foreign exchange market in India". It was passed in the winter session of Parliament in 1999,
replacing the Foreign Exchange Regulation Act (FERA). This act seeks to make offenses
related to foreign exchange civil offenses. It extends to the whole of India. It enabled a new
foreign exchange management regime consistent with the emerging framework of the World
Trade Organization (WTO). It also paved way to Prevention of Money Laundering Act 2002,
which was effected from 1 July 2005.
FEMA permits only authorized person to deal in foreign exchange or foreign security. Such an
authorized person, under the Act, means authorized dealer, money changer, off-shore banking
unit or any other person for the time being authorized by Reserve Bank. The Act thus prohibits
any person who:-
• Deal in or transfer any foreign exchange or foreign security to any person not being an
authorized person;
• Make any payment to or for the credit of any person resident outside India in any
manner;
• Receive otherwise through an authorized person, any payment by order or on behalf of
any person resident outside India in any manner;
• Enter into any financial transaction in India as consideration for or in association with
acquisition or creation or transfer of a right to acquire, any asset outside India by any
person is resident in India which acquire, hold, own, possess or transfer any foreign
exchange, foreign security or any immovable property situated outside India.
Main Features
• Activities such as payments made to any person outside India or receipts from them,
along with the deals in foreign exchange and foreign security is restricted. It is FEMA
that gives the central government the power to impose the restrictions.
• Restrictions are imposed on residents of India who carry out transactions in foreign
exchange, foreign security or who own or hold immovable property abroad.
• Without general or specific permission of the MA restricts the transactions involving
foreign exchange or foreign security and payments from outside the country to India –
the transactions should be made only through an authorised person.
• Deals in foreign exchange under the current account by an authorised person can be
restricted by the Central Government, based on public interest.
• Although selling or drawing of foreign exchange is done through an authorized person,
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the RBI is empowered by this Act to subject the capital account transactions to a
number of restrictions.
• Residents of India will be permitted to carry out transactions in foreign exchange,
foreign security or to own or hold immovable property abroad if the currency, security or
property was owned or acquired when he/she was living outside India, or when it was
inherited by him/her from someone living outside India.
• Exporters are needed to furnish their export details to RBI. To ensure that the
transactions are carried out properly, RBI may ask the exporters to comply with its
necessary requirements.
13.8 The Companies Act, 2013
Comprehensive explanation of term Fraud is given in Explanation to Section 447(1) of The
Companies Act, 2013 as follows:
“Fraud” in relation to affairs of a company or any body corporate, includes
(a) Any act,
(b) Omission,
(c) Concealment of any fact or
(d) Abuse of position committed by any person or any other person with the connivance in
any manner, -
• with intent to deceive,
• to gain undue advantage from, or
• to injure the interests of,
o the company or
o its shareholders or
o its creditors or
o any other person,
Whether or not there is any wrongful gain or wrongful loss;
• “Wrongful gain” means the gain by unlawful means of property to which the person
gaining is not legally entitled;
• “Wrongful loss” means the loss by unlawful means of property to which the person
losing is legally entitled.
Statutory provisions of Fraud and Fraud Reporting under The Companies Act, 2013
Section 447 of the Companies Act, 2013 often now referred as one of the draconian section of
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the new Act deals with provision relating to punishment for fraud. It reads as: “Without
prejudice to any liability including repayment of any debt under this Act or any other law for the
time being in force, any person who is found to be guilty of fraud, shall be punishable with
imprisonment for a term which shall not be less than 6 months but which may extend to 10
years and shall also be liable to fine which shall not be less than the amount involved in the
fraud, but which may extend to 3 times the amount involved in the fraud.
Where the fraud in question involves public interest, the term of imprisonment shall not be less
than 3 years”.
The Companies Act, 2013 has provided punishment for fraud as provided under section 447 in
around 20 sections of the Act e.g. u/s 7(5), 7(6), 8(11), 34, 36, 38(1), 46(5), 56(7), 66(10), 75,
140(5), 206(4), 213, 229, 251(1), 266(1), 339(3), 448 etc. for directors, key managerial
personnel, auditors and/or officers of company. Thus, the new Act goes beyond professional
liability for fraud and extends to personal liability if a company contravenes such provisions.
Under section 140 the auditors and their firm would be jointly liable for any frauds in the books
of accounts and many auditors are likely to become forensic accountants in the days to come
to avoid being caught on the wrong foot.
The Companies Act, 2013 via Section 143 has cast a responsibility of reporting the Frauds to
the Central Government on the Auditors.
Who has to Report?
1. The Statutory Auditor including Joint Auditor , and also the Auditor in the course of
providing attest services like
(a) Clause 41 of the Listing Agreement with Stock Exchanges requires the statutory
auditor to perform limited review/audit of the quarterly financial results published
by the listed companies
(b) the auditor may also be engaged by the Board of directors of the company to
carry out the audit of interim financial statements prepared by the management
as per Accounting Standard 25 and report on such interim financial statements to
the Board of Directors
(c) the auditor may also perform Tax Audit under the Income-tax Act
(d) the auditor may be engaged to issue certificates
2. The Cost Accountant conducting cost audit under Section 148 of the Act
3. The Company Secretary in practice, conducting secretarial audit under Section 204 of
the Act,
4. The Branch Auditors appointed under Section 139 of the Act with respect to the branch.
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What Frauds need to be reported?

Section 143 includes only fraud by officers or employees of the company and does not include
fraud by third parties such as vendors and customers. The fraud needs to be reported only if
the auditor is the first person to identify/note such fraud. In case a fraud has already been
reported or has been identified/detected by the management or through the company’s
vigil/whistle blower mechanism and has been/is being remediated/dealt with by them and such
case is informed to the auditor, he will not be required to report the same.
The Companies Act, 2013 has included a comprehensive definition of fraud and stringent
provisions regarding punishment for such frauds. Moreover, independent professionals shall
also be held liable for action and proceeded against under the Act.
Section 447 of the Companies Act now referred to as the draconian section which deals with
provisions relating to punishment for fraud.
What is the penalty for violation?
I. Imprisonment: [6 months to 10 years] & In cases where fraud involves public interest,
term of imprisonment not to be less than 3 years
II. Fine: Not less than amount involved in the fraud and extending to three times the
amount in certain casesThe below table includes certain sections that attract liability u/s
447 of the Companies Act. These are cognizable offences and the person accused of
any such offense shall not be released on bail or on his or her own bond, unless subject
to exception provided /s 212(6)
Section Fraud w.r.t. Who will be penalized
7(5) Registration of a company A person furnishing false information or
suppressing any material information of
which he or she is aware
36 Inducing persons to invest money The person doing so
75(1) Acceptance of deposit with intent to Every officer of the company who
defraud depositors or for any accepted deposit
fraudulent purpose
206(4) Conducting business of a company for Every officer of the company who is in
a fraudulent or unlawful purpose default
213 OTHER CASES Every officer of the company who is in
 Business of a company being default and the person(s) concerned in
conducted with intent to defraud the formation of the company or
its creditors management of its affairs
 Fraud, misfeasance or other
misconduct of the company or any
of its members, or
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 Company withholding information

from members with respect to its
affairs, which they may
reasonably expect
229 Furnishing false statement or Person required to provide an
mutilation or destruction of documents explanation or make a statement during
the course of inspection, inquiry or
investigation, or the officer or other
employee as required
251(1) Application for removal of name from Persons in charge of management of
register with the object of evading the company
liabilities/intent to deceive
339(3) Conducting business of company with Every person who was knowingly a
intent to defraud its creditors, any other party to the business in the aforesaid
persons or for any fraudulent purpose manner
448 Making a false statement in any return, Person making such a statement
report, certificate, financial statements
or other document required by or for
the purpose of any of the provisions of
this Act or the rules made thereunder
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Chapter 14
Applicable Laws – Outside India
I. Fraud Act, 2006 – United Kingdom

The Fraud Act came into force on the 15th January 2007. By introducing a general offence of
“fraud”, the aim was to simplify the law by replacing the various deception offences under the
Theft Act, 1968. This new general offence of fraud is set out in section 1 of the Act. It can be
committed in three ways:
• Fraud by false representation;
• Fraud by failing to disclose information;
• Fraud by abuse of position.
A person who is guilty of fraud is liable on conviction on indictment to imprisonment for a term
not exceeding 10 years or to a fine (or both).
Each offence in the Fraud Act 2006 is a conduct offence, complete on the accused's acts
notwithstanding any result caused. So there is no need to prove a result of any kind, it is
sufficient that the person intends to cause loss or make a gain.
• "Fraud by false representation" is defined by Section 2 of the Act as a case where a
person makes "any representation as to fact or law ... express or implied" which they
know to be untrue or misleading.
• "Fraud by failing to disclose information" is defined by Section 3 of the Act as a case
where a person fails to disclose any information to a third party when they are under a
legal duty to disclose such information.
• "Fraud by abuse of position" is defined by Section 4 of the Act as a case where a
person occupies a position where they are expected to safeguard the financial interests
of another person, and abuses that position; this includes cases where the abuse
consisted of an omission rather than an overt act.
In all three classes of fraud, it requires that for an offence to have occurred, the person must
have acted dishonestly, and that they had to have acted with the intent of making a gain for
themselves or anyone else, or inflicting a loss (or a risk of loss) on another.
A "gain" or a "loss" is defined to consist only of a gain or a loss in money or property (including
intangible property), but could be temporary or permanent. A "gain" could be construed as
gaining by keeping their existing possessions, not just by obtaining new ones, and loss
included losses of expected acquisitions, as well as losses of already-held property.
The Act will establish two "supporting" offences, these being the possession of articles for use
in frauds (Section 6) and the making or supplying of articles for use in frauds (Section 7).
Section 11 of the Act makes it a statutory offence to obtain services dishonestly; meaning that
services which were to be paid for were obtained with the knowledge or intention that no
payment would be made. A person found guilty of this will be liable to a fine or imprisonment
for up to twelve months on summary conviction (six months in Northern Ireland), or a fine or
imprisonment for up to five years on conviction on indictment.
In regard to the fraudulent behavior of companies, the existing offence of participating in
fraudulent business carried on by a company, provided for by the Companies Act 1985, was
amended by Section 10 - bringing the maximum penalty from 7 years imprisonment to 10
years [And/or a fine] - and a new offence of participating in fraudulent business carried on by a
sole trader was established by Section 9.
Section 12 of the Act provides that where an offence against the Act was committed by a body
corporate, but was carried out with the "consent or connivance" of any director, manager,
secretary or officer of the body - or any person purporting to be such - then that person, as
well as the body itself, is liable.
II. Bribery Act, 2010 – United Kingdom
The Bribery Act 2010 was introduced to update and enhance UK law on bribery including
foreign bribery in order to address better the requirements of the 1997 OECD anti-bribery
Convention. It is now among the strictest legislation internationally on bribery. Notably, it
introduces a new strict liability offence for companies and partnerships of failing to prevent
bribery.
The introduction of this new corporate criminal offence places a burden of proof on companies
to show they have adequate procedures in place to prevent bribery. The Bribery Act also
provides for strict penalties for active and passive bribery by individuals as well as companies.
The crime of bribery is described in Section 1 as occurring when a person offers, gives or
promises to give a "financial or other advantage" to another individual in exchange for
"improperly" performing a "relevant function or activity".
The Bribery Act creates four prime offences:
• Two general offences covering the offering, promising or giving of an advantage, and
requesting, agreeing to receive or accepting of an advantage;
• A discrete offence of bribery of a foreign public official ; and
• A new offence of failure by a commercial organisation to prevent a bribe being paid to
obtain or retain business or a business advantage (should an offence be committed, it
will be a defence that the organisation has adequate procedures in place to prevent
bribery).
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The Bribery Act is legislation of great significance for companies incorporated in or carrying on
business in the UK. It presents heightened liability risks for companies, directors and
individuals. To avoid corporate liability for bribery, companies must make sure that they have
strong, up-to-date and effective anti-bribery policies and systems.
The Bribery Act unlike previous legislation places strict liability upon companies for failure to
prevent bribes being given (active bribery) and the only defence is that the company had in
place adequate procedures designed to prevent persons associated with it from undertaking
bribery.
The Bribery Act has extra-territorial reach both for UK companies operating abroad and for
overseas companies with a presence in the UK.
UK companies doing business overseas -
Companies registered in the UK must take note of the extra-territorial reach of the Bribery Act.
A company can commit an offence under section 7 of failure to prevent bribery if an employee,
subsidiary, agent or service provider (‘associated persons’) bribes another person anywhere in
the world to obtain or retain business or a business advantage.
A foreign subsidiary of a UK company can cause the parent company to become liable under
section 7 when the subsidiary commits an act of bribery in the context of performing services
for the UK parent. If the foreign subsidiary were acting entirely on its own account it would not
cause the UK parent to be liable for failure to prevent bribery under section 7 as it would not
then be performing services for the UK parent.
However, the UK parent might still be liable for the actions of its subsidiary in other ways such
as false accounting offences or under the Proceeds of Crime Act 2002.
Foreign companies with operations in the UK -
The Bribery Act has important implications for foreign companies which do business in the UK
as its territorial scope is extensive. The corporate offence set out in Section 7 of failure to
prevent bribery in the course of business applies to any relevant commercial organization
defined as a body incorporated under the law of the United Kingdom (or United Kingdom
registered partnership) and any overseas entity that carries on a business or part of a
business in the United Kingdom.
A foreign company which carries on any part of its business in the UK could be prosecuted for
failure to prevent bribery even where the bribery takes place wholly outside the UK and the
benefit or advantage to the company is intended to accrue outside the UK.
Section 11 explains the penalties for individuals and companies found guilty of committing a
crime. If an individual is found guilty of a bribery offence, tried as a summary offence, they
may be imprisoned for up to 12 months and fined up to £5,000. Someone found guilty on
indictment, however, faces up to 10 years' imprisonment and an unlimited fine. The crime of a
commercial organization failing to prevent bribery is punishable by an unlimited fine. In
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addition, a convicted individual or organization may be subject to a confiscation order under

the Proceeds of Crime Act 2002, while a company director who is convicted may be
disqualified under the Company Directors Disqualification Act 1986.
(The Proceeds of Crime Act 2002 (c.29) (POCA) is an Act of the Parliament of the United
Kingdom which provides for the confiscation or civil recovery of the proceeds from crime and
contains the principal money laundering legislation in the UK.)
III. Foreign Corrupt Practices Act, 1977 – United States of America
The Foreign Corrupt Practices Act of 1977 (FCPA) is a United States federal law known
primarily for two of its main provisions, one that addresses accounting transparency
requirements under the Securities Exchange Act of 1934 and another concerning bribery of
foreign officials.
The Act was signed into law by President Jimmy Carter on December 19, 1977, and amended
in 1998 by the International Anti-Bribery Act of 1998 which was designed to implement the
anti-bribery conventions of the Organization for Economic Co-operation and Development.
IV. OECD Anti-Bribery Convention
http://www.oecd.org/daf/anti-bribery/anti-briberyconvention/
The OECD Anti-Bribery Convention (officially Convention on Combating Bribery of Foreign
Public Officials in International Business Transactions) is a convention of the OECD aimed at
reducing corruption in developing countries by encouraging sanctions against bribery in
international business transactions carried out by companies based in the Convention member
countries. Its goal is to create a truly level playing field in today's international business
environment.
Countries that have signed the convention are required to put in place legislation that
criminalizes the act of bribing a foreign public official. The OECD has no authority to
implement the convention, but instead monitors implementation by participating countries.
Countries are responsible for implementing laws and regulations that conform to the
convention and therefore provide for enforcement. The OECD performs its monitoring function
in a two-phased examination process. Phase I consists of a review of legislation implementing
the conventions in the member country with the goal of evaluating the adequacy of the laws.
Phase 2 assesses the effectiveness with which the legislation is applied.
The Convention is open to accession by any country which is a member of the OECD or has
become a full participant in the OECD Working Group on Bribery in International Business
Transactions. As of May 2013, 40 countries have ratified or acceded to the convention:
Presently India is not a member of the OECD Anti-Bribery Convention.
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V. U.N. Convention against Corruption

The United Nations Convention against Corruption (UNCAC) is a multilateral convention
negotiated by members of the United Nations. It is the first global legally binding international
anti-corruption instrument. In its 71 Articles divided into 8 Chapters, UNCAC requires that
States Parties implement several anti-corruption measures which may affect their laws,
institutions and practices. These measures aim at preventing corruption, criminalizing certain
conducts, strengthening international law enforcement and judicial cooperation, providing
effective legal mechanisms for asset recovery, technical assistance and information exchange,
and mechanisms for implementation of the Convention, including the Conference of the States
Parties to the United Nations Convention against Corruption (CoSP).
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Chapter 15
Framework on Fraud Deterrence and Post
Event Punishment
In the current world where frauds and the financial and the other ancillary losses due to
frauds are on rise India as a country needs to have a pragmatic and strict approach towards
fraud prevention, detection and timely and punishment to the fraudster which is commensurate
with the nature and the scale of his offence. Fraud Deterrence is the key here as a significant
amount of work gets done if the fear of consequence hovers around the head of person
perpetrating a fraud .If a person fears the consequences of the act he shall have very serious
thought before going ahead with the act and until now India as a country has taken very few
steps in this regard. Unlike other countries like United States, Canada and United Kingdom to
name a few, India does not have a separate legislation which deals with punishment of the
fraudster.
Banking Sector
Perpetrators of frauds in banking transactions are liable to be prosecuted under the criminal
law of the country for which adequate provisions of punishment have been prescribed under
the Indian Penal Code, 1860.
Circular No. RBI/2014-15/85 by RBI dated 1st July 2015 on Fraud Classification and
Reporting in Banking Sector – Gives classification of Frauds based on the provisions of the
Indian penal code mainly to have uniformity in reporting.
As mandated Bank have to submit details of the Faraud in the return to RBI for cases which
involve amounts of greater than Rs.1 lakh.
Insurance Sector
Circular No. IRDA/SDD/MISC/CIR/009/01/2013 dated 21st January 2013 on Insurance Fraud
Monitoring Framework issued by IRDA mentions Fraud in Insurance Sector
The Guidelines mandate insurance companies to put in place, as part of their corporate
governance structure, Fraud detection and mitigation measures; and to submit periodic reports
to the Authority in the formats prescribed herein.
Securities and Exchange Board of India (SEBI)
Securities And Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices
Relating to Securities Market) Regulations, 2003 deals with the frauds in case of Securities.
The regulation recognizes the following cases as frauds
Framework on Fraud Deterrence and Post Event Punishment
• Indulging in an act which creates false or misleading appearance of trading in the

securities market;
• Dealing in a security not intended to effect transfer of beneficial ownership but intended
to operate only as a device to inflate, depress or cause fluctuations in the price of such
security for wrongful gain or avoidance of loss
• Advancing or agreeing to advance any money to any person thereby inducing any other
person to offer to buy any security in any issue only with the intention of securing the
minimum subscription to such issue
• Paying, offering or agreeing to pay or offer, directly or indirectly, to any person any
money or money’s worth for inducing such person for dealing in any security with the
object of inflating, depressing, maintaining or causing fluctuation in the price of such
security
• Any act or omission amounting to manipulation of the price of a security
• Publishing or causing to publish or reporting or causing to report by a person dealing in
securities any information which is not true or which he does not believe to be true prior
to or in the course of dealing in securities
• Entering into a transaction in securities without intention of performing it or without
intention of change of ownership of such security
• Selling, dealing or pledging of stolen or counterfeit security whether in physical or
dematerialized form
• An intermediary promising a certain price in respect of buying or selling of a security to
a client and waiting till a discrepancy arises in the price of such security and retaining
the difference in prices as profit for himself
• An intermediary providing his clients with such information relating to a security as
cannot be verified by the clients before their dealing in such security
• An advertisement that is misleading or that contains information in a distorted manner
and which may influence the decision of the investors
• An intermediary reporting trading transactions to his clients entered into on their behalf
in an inflated manner in order to increase his commission and brokerage
• An intermediary not disclosing to his client transactions entered into on his behalf
including taking an option position
• Circular transactions in respect of a security entered into between intermediaries in
order to increase commission to provide a false appearance of trading in such security
or to inflate, depress or cause fluctuations in the price of such security
• Encouraging the clients by an intermediary to deal in securities solely with the object of
enhancing his brokerage or commission
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• An intermediary predating or otherwise falsifying records such as contract notes

• An intermediary buying or selling securities in advance of a substantial client order or
whereby a futures or option position is taken about an impending transaction in the
same or related futures or options contract
• Planting false or misleading news which may induce sale or purchase of securities
The step which comes ahead of Fraud Deterrence or Prevention is Fraud Detection. In India
there are several governmental as well as non-governmental organizations which are dealing
with Fraud Detection.
• Serious Fraud Investigation Officer (SFIO)
• Central Bureau of Investigation (CBI)
• Enforcement Directorate (ED)
• Financial Intelligence Unit – India (FIU-IND)
• Private Organizations
• Fraud Containment Units
Serious Fraud Investigation Officer (SFIO)
The Serious Fraud Investigation Office (SFIO) is a multidisciplinary organization to
investigate serious financial frauds. India. It is under the jurisdiction of the Government of
India. The SFIO is involved in major fraud probes and is the coordinating agency with the
Income Tax and CBI. The Serious Fraud Investigation Office is a multi-disciplinary
organization having experts from financial sector, capital market, accountancy, forensic audit,
taxation, law, information technology, company law, customs and investigation. These experts
have been taken from various organizations like banks, Securities & Exchange Board of India,
Comptroller and Auditor General and concerned organizations and departments of the
Government. The Government approved setting up of this organization on 9 January 2003 on
the basis of the recommendations made by the Naresh Chandra Committee which was set up
by the government on 21 August 2002 on corporate governance.
Central Bureau of Investigation (CBI)
The Central Bureau of Investigation (CBI) is the foremost investigating police agency in
India, an elite force which plays a role in public life and ensuring the health of the national
economy. The CBI is responsible for investigation of cases which involve cases of bribery and
corruption too notably 2G Scam, Coal Allocation Scam, Bofors Case etc. It is under the
jurisdiction of the Government of India. The CBI is involved in major criminal probes, and is
the Interpol agency in India. The CBI was established in 1941 as the Special Police
Establishment, tasked with domestic security. It was renamed the Central Bureau of
Investigation on 1 April 1963. Its motto is "Industry, Impartiality, Integrity".
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Framework on Fraud Deterrence and Post Event Punishment
Agency headquarters is in the Indian capital, New Delhi, with field offices located in major
cities throughout India. It is headed by a Union Minister who reports directly to the Prime
Minister. While analogous in structure to the Federal Bureau of Investigation in the United
States of America, the CBI's powers and functions are limited to specific crimes by Acts.
Enforcement Directorate (ED)
The Directorate General of Economic Enforcement is a law enforcement agency and economic
intelligence agency responsible for enforcing economic laws and fighting economic crime in
India. It is part of the Department of Revenue, Ministry of Finance. The origin of this
Directorate goes back to 1st May, 1956, when an ‘Enforcement Unit’ was formed, in
Department of Economic Affairs, for handling Exchange Control Laws violations under Foreign
Exchange Regulation Act, 1947.
The prime objective of the Enforcement Directorate is the enforcement of two key Acts
namely, the Foreign Exchange Management Act 1999 and the Prevention of Money
Laundering Act 2002
The main functions of the Directorate are as under
• Investigate contraventions of the provisions of Foreign Exchange Management Act,
1999(FEMA) which came into force with effect from 1.6.2000. Contraventions of FEMA
are dealt with by way of adjudication by designated authorities of ED and penalties upto
three times the sum involved can be imposed.
• Investigate offences of money laundering under the provisions of Prevention of Money
Laundering Act, 2002(PMLA) which came into force with effect from 1.7.2005 and to
take actions of attachment and confiscation of property if the same is determined to be
proceeds of crime derived from a Scheduled Offence under PMLA, and to prosecute the
persons involved in the offence of money laundering. There are 156 offences under 28
statutes which are Scheduled Offences under PMLA.
• Adjudicate Show Cause Notices issued under the repealed Foreign Exchange
Regulation Act, 1973 (FERA) upto 31.5.2002 for the alleged contraventions of the Act
which may result in imposition of penalties. Pursue prosecutions launched under FERA
in the concerned courts.
• Sponsor cases of preventive detention under Conservation of Foreign Exchange and
Prevention of Smuggling Activities Act, 1974(COFEPOSA) in regard to contraventions
of FEMA.
• Render cooperation to foreign countries in matters relating to money laundering and
restitution of assets under the provisions of PMLA and to seek cooperation in such
matters.
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Financial Intelligence Unit – India (FIU-IND)

• Financial Intelligence Unit – India (FIU-IND) was set by the Government of India vide
O.M. dated 18th November 2004 as the central national agency responsible for
receiving, processing, analyzing and disseminating information relating to suspect
financial transactions. FIU-IND is also responsible for coordinating and strengthening
efforts of national and international intelligence, investigation and enforcement agencies
in pursuing the global efforts against money laundering and related crimes. FIU-IND is
an independent body reporting directly to the Economic Intelligence Council (EIC)
headed by the Finance Minister.
Private Organizations
Private Fraud Detection Organizations including CA Firms also play a vital role in investigating
and detecting frauds for their respective clients. Such non-governmental organizations provide
services flexible to the need of their clients. In additions several large organization have fraud
prevention and deterrence departments which are include as part of the organizational
structure. Some of these are headed by very senior personnel with exposure to both IT as well
as the business. In organizations where data security and cyber threats are critical these
positions may even report to the CEO to allow independent functioning
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Chapter 16
Fraud Prevention
Fraud prevention is a topic applicable to many industries including banking and financial
sectors, insurance, government agencies and law enforcement, and more. Fraud attempts
have seen a drastic increase in recent years, making fraud prevention more important than
ever. Despite efforts on the part of the institutions, hundreds of millions of rupees are lost to
fraud every year.
An important early step in fraud prevention is to identify factors that can lead to fraud. What
specific phenomena typically occur before, during, or after a fraudulent incident? What other
characteristics are generally seen with fraud? When these phenomena and characteristics
are pinpointed.
While Fraud may not be prevented altogether the focus of all prevention systems is three fold
(i) Making it as difficult as possible for frauds to occur. Here the mandate would be that all
reasonable controls commensurate with the size and nature of the business would be in
place
(ii) Definition of an exception reporting system and a compensatory control mechanism
which ensures triggers and alerts in the event unusual behavioural or transactional
patterns are observed
(iii) Verifying that the exceptions are reviewed by Management and the actions taken reflect
that the reports are being followed up until a satisfactory explanation is obtained or
investigative processes initiated
Effective Internal Controls
There are several keys to effective fraud prevention, but some of the most important tools are
strong internal controls. Equally important, though, are the entity’s attitude towards fraud,
internal controls and an ethical organizational culture.
According to the Committee of Sponsoring Organizations (COSO), Internal control is broadly
defined as a process, effected by an entity's board of directors, management and other
personnel, designed to provide reasonable assurance regarding the achievement of objectives
in the following categories:
(i) Effectiveness and efficiency of operations,
(ii) Reliability of financial reporting
(iii) Compliance with applicable laws and regulations.
Internal controls should not be thought of as "static." They are a dynamic and fluid set of tools
which evolve over time as the business, technology and fraud environment changes in
response to competition, industry practices, legislation, regulation and current economic
conditions.
While no entity, even with the strongest internal controls, is immune from fraud, strengthening
internal control policies, processes and procedures definitely makes them a less attractive
target to both internal and external criminals seeking to exploit internal control weaknesses.
Strengthening internal controls is seldom accomplished by enhancing one process; rather it
involves a comprehensive review of the risks faced, the existing internal controls already in
place and their adequacy in preventing fraud from occurring. An internal control review may be
conducted corporate-wide or on a location by location basis, or broken down to the individual
business unit level. Generally, a review of this nature involves an in depth examination of
people, processes and technology. However, there are other intangibles that organizations
can not afford to overlook.
Audit Interaction
The first part of strengthening internal controls involves changing the attitude some employees
have towards auditors. While it is easy to view auditors as the police department's "Internal
Affairs" group—whose sole responsibility it is to ferret out wrongdoing—identifying employees
who are breaking the rules, personal and professional success is to be had by viewing
auditors as key partners and allies in the battle against fraud. This is further reinforced as the
auditor's role ensures that he or she is always at the forefront of corporate policies, practices,
procedures, technology, new products and services, making auditors a valuable source of
corporate information
Secondly, part of strengthening internal controls is simply a matter of defining, or clarifying,
ownership roles and responsibilities.
A common misperception among corporate employees is that internal controls are solely the
responsibility of the company's Audit Department. While internal auditors measure the
effectiveness of internal control through their efforts, they don't generally assume ownership.
They assess whether the controls are properly designed, implemented and working effectively
and make recommendations on how to improve internal control.
According to the Institute of Internal Auditors (IIA), "responsibility for the system of internal
control within a typical organization is a shared responsibility among all the executives, with
leadership normally provided by the CFO."
Systems Security Audits
With the growing need for security measures and the limited number of technical staff to meet
the demands for the ever-increasing threat of unauthorized intrusion into an organization’s
networking system, security audits have become one of several lines of defense employed to
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Fraud Prevention
help mitigate such action. According to Haynes (2003), a security audit is a process that can
verify that certain standards have been met and identify areas in need of remediation or
improvement. Dark and Poftak (2004) add that a computer security audit involves a
systematic, measurable technical assessment of how the organization’s security policy is
employed at a specific site or location.
Haynes (2003) further explains that a security audit is a policy-based assessment of the
procedures and practices of a site, assessing the level of risk created by these actions. A
security audit comprises a number of stages. You can choose to focus the audit on different
areas, such as the firewall, host, or network. However, a security audit will address issues with
your systems, including software and hardware, your infrastructure, your procedures, your
business processes, and your people. Information is the key. Once the audit has been
completed you will have information on the compliance level of the users and systems under
your control, with an idea of the risk exposure and security level of these systems. In some
cases management may choose to carry out an audit internally or use an external contractor.
Whoever carries out the audit, those personnel should have the relevant technical expertise
and ability to communicate the findings of the audit. Even authorized system users can be the
source of a security breach, therefore identifying possible lapses that could allow this is just as
important as preventing external attack. It is important to understand that information security
or computer security audits must move beyond information technology audits, which are
concerned with ideas of auditing what is on the computer system and how it is being used.
Instead security audits must also move past the review of programs and hardware, to the level
of verifying that programs are operation with full integrity as they are intended to operate. .
Security audits also must encompass components that ensure the data and information are
reliable, as well as to verify that the information has not been compromised.
Security audits can be part of an information technology audit conducted by a team of
professionals with expertise not only in the theoretical underpinnings of information systems,
but also in the computer or networking system being audited. In addition, security audits must
go beyond the annual financial audits and physical inventory audits to the data and content,
which are standard processes in most businesses.
Methods for Performing Security Audits
When performing a security audit, one must perform the audit though personal interviews,
vulnerability scan examination of operating system settings, analyses of network shares, and
historical data. Those who conduct the audit should be concerned primarily with how security
policies, the foundation of any effective organizational security strategy, are actually applied
and implemented. According to Haynes (2003), there are a number of key questions that
security audits should attempt to answer concerning the audit:
• Are passwords difficult to crack?
• Are there access control lists (ACLs) in place on network devices to control who has
access to shared data? Are there audit logs to record who accesses data?
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• Are the audit logs reviewed?

• Are the security settings for operating systems in accordance with accepted industry
security practices?
• Have all unnecessary applications and computer services been eliminated for each
system?
• Are these operating systems and commercial applications patched to current levels?
• How is backup media stored? Who has access to it? Is it up to date?
• Is there a disaster recovery plan? Have the participants and stakeholders ever
rehearsed the disaster recovery plan?
• Are there adequate cryptographic tools in place to govern data encryption, and have
these tools been properly configured?
• Have custom-built applications been written with security in mind?
• How have these custom applications been tested for security flaws?
• How are configuration and code changes documented at every level? How are these
records reviewed and who conducts the review?
• What is the mechanism for providing data for testing? Are masking techniques used for
maintaining data privacy
• How frequent and effective are the log reviews for
o Databases
o Applications
o Network
o Server activities
o Intrusion Detection Systems wherever deployed
• What controls and measures are in place for misuse of admin passwords? Does the
sensitivity of operations required a Privileged Account Management System.
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Chapter 17
Organizations to Combat Fraud in India and
Abroad
List of institutional framework in India to combat fraud in India

(i) Serious Fraud Investigation Office (SFIO)
(ii) Public Accounts Committee - examines the appropriateness of the expenditure incurred
by the government as presented in the accounts, the reported cases of losses, financial
irregularities in the government, and so on.
(iii) Comptroller and Auditor-General - the constitutional authority charged with the
responsibility of auditing all receipts and expenditure of the Union Government and that
of the States and Union Territories and agencies under them.
(iv) Chief Secretary - the highest administrative authority dealing with complaints of
misconduct and fraud committed by any Department of the State.
(v) Crime Investigation Department (CID) - white collar crime and larger issues like scams
and frauds are dealt by the Crime Investigating Department.
(vi) Economic Offences Wing - investigates cases pertaining to misappropriation, cheating,
forgery, counterfeit currency, cybercrimes and major frauds, scams and other white
collar offences.
(vii) Central Vigilance Commission (CVC) - The Central Vigilance Commission supervises
corruption cases in governmental departments. It has supervisory powers over the CBI
but does not have authority to prosecute individuals.
(viii) State vigilance Commission
(ix) Lokayuktha & UpaLokayuktha
(x) Central Bureau of Investigation (CBI) – it is a Governmental organization which
normally investigates and prosecutes cases of serious fraud or cheating that may have
ramifications in more than one state. It also investigates corruption cases.
(xi) Central Economic Intelligence Bureau (CEIB) - The Central Economic Intelligence
Bureau monitors economic offences and co-ordinates co-operation with international
agencies in relation to economic offences
(xii) Directorate of Enforcement (DOE) - Enforcement of Foreign Exchange Management Act
1999 and the Prevention of Money Laundering Act 2002. The organization falls under
the Ministry of Finance and is headquartered in New Delhi
(xiii) Economic Intelligence Council (EIC) - Established under the Ministry of Finance to
facilitate co-ordination among the enforcement agencies dealing with economic
offences.
List of institutional framework outside India
(i) Serious Fraud Office (United Kingdom) - http://www.sfo.gov.uk/
The Serious Fraud Office (SFO) is an independent UK Government department that
investigates and prosecutes serious or complex fraud and corruption. Accountable to the
Attorney General, it has jurisdiction over England, Wales and Northern Ireland and assists a
number of overseas investigations by obtaining information from UK sources. Section 2 of the
Criminal Justice Act, 1987 grants the SFO special compulsory powers to require any person
(or business/bank) to provide any relevant documents (including confidential ones) and
answer any relevant questions including ones about confidential matters.
The SFO is also the principal enforcer of the Bribery Act 2010, which has been designed to
encourage good corporate governance and enhance the reputation of the City of London and
the UK as a safe place to do business.
The SFO is a specialist organization that investigates only the most serious types of economic
crime. As a result a potential case must meet certain criteria before it is taken on.
(ii) National Fraud Authority (NFA) - https://www.gov.uk/government/organisations/
national-fraud-authority
The National Fraud Authority is an executive agency of the United Kingdom Home Office
responsible for increasing protection for the UK economy from the harm caused by fraud. The
NFA works with a wide range of partners with the aim of making fraud more difficult to commit
in the UK. Formerly the National Strategic Fraud Authority, it was set up in October 2008 in
response to the government's Fraud Review in 2006.
The NFA works to tackle frauds across the spectrum, but also works on fraud types and fraud
issues that are a notable problem. The NFA also produces the Annual Fraud Indicator, which
estimates the cost of fraud.
Action Fraud is the UK's national fraud reporting service, run by a private sector company
called bss for the National Fraud Authority. Action Fraud is the place to go to get information
and advice about fraud, as well as to report fraud. UK citizens can report fraud online (such as
forwarding scam emails for inspection) or by telephone. When a fraud is reported to Action
Fraud, victims are given a crime reference number and their case is passed on to the National
Fraud Intelligence Bureau (NFIB), which is run by the City of London's police service. The
Action Fraud website also has an A-Z of fraud describing different types of fraud, and offers
prevention advice.
The National Fraud Authority publishes the Annual Fraud Indicator every year, which is the
UK's comprehensive estimate of how much fraud costs the UK.
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Organizations to Combat Fraud in India and Abroad
(iii) CIFAS - The UK's Fraud Prevention Service –http://www.cifas.org.uk/

CIFAS is a not-for-profit membership association representing the private and public sectors.
CIFAS is dedicated to the prevention of fraud, including staff fraud, and the identification of
financial and related crime. CIFAS operates two databases:
• National Fraud Database (NFD
• Staff Fraud Database (SFD)
CIFAS has 290 Member organizations spread across various business sectors. These include
financial services, retail, telecommunications, customer service centres, call centres and
public services. Although at present CIFAS Members are predominantly private sector
organizations, public sector bodies may also share fraud data reciprocally through CIFAS to
prevent fraud.
Members share information about confirmed frauds in the fight to prevent further fraud.
CIFAS is unique and was the world's first not-for-profit fraud prevention data sharing
organization. Since CIFAS was founded, CIFAS Members have prevented fraud losses to
their organizations worth over £8 billion by sharing fraud data.
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Chapter 18
Financial Statements Frauds
1. Introduction and Background

Fraud is a global phenomenon affecting all sectors of the economy. Fraud encompasses a
wide-range of illicit practices and illegal acts, consisting of intentional deception or
misrepresentation.
A fraud can be defined as “a deception or misrepresentation, knowingly or intentionally, made
by an individual or entity, knowing that the misrepresentation could result into some
unauthorized gains to the individual or to the entity or some other party”.
1.1. Mistakes are different from Frauds
It may be stated that there is difference between mistakes and frauds and the mistakes are
not fraud. Mistakes are unintentional acts, which may not results into losses to others or gains
to the maker of mistakes.
Following items or issues could be broadly termed as mistakes and not frauds:
a. An unintentional mistake in processing or gathering the information, based on which the
financial statements are prepared,
b. An incorrect accounting estimates arising due to oversight or mis-representation of
facts,
c. A mistake in application of accounting principles relating to recognition, classification,
presentation or disclosure.
1.2. Characteristics of Fraud
1.2.1. Misstatements in the financial statements can arise either from a fraud or an error. The
distinguishing factor between the fraud and error is “whether the underlying action that results
into the misstatement of the financial statements, is intentional or unintentional”.
1.2.2. Although the term “fraud” is a broad legal concept, for the purposes of the Standard on
Audit”, the auditor is concerned with fraud that results into a material misstatement in the
financial statements. Two types of intentional misstatements are relevant to the auditor– (a)
Mis-statements resulting from fraudulent financial reporting and (b) Mis-statements resulting
from misappropriation of assets. Although the auditor may suspect or, in rare cases, identify
the occurrence of fraud, the auditor does not make legal determinations of whether fraud has
actually occurred.
2. Issue and Purpose

The main issue and purpose is to understand the nature of financial statements frauds (who
does them - types of persons committing frauds), why do they do - purpose behind committing
frauds, how they do - modus-operandi, etc.):
2.1. A Financial fraud can be broadly defined as a wilful or an intentional act, with the intention
to deceive someone involving financial transactions, for certain personal gains. As such, a
fraud could be essentially termed as a crime, and is also a violation of civil law. A number of
fraud cases, involving complicated financial transactions, were committed by so called 'white
collar criminals', such as, business professionals, who have specialized knowledge and a
criminal intent.
2.1.1. Corporate financial frauds result into a deep rooted negative impact on the sentiments
of investors and also the capital markets, in general. It is noted that the efforts being made in
the direction of detection and also prevention of frauds at present, are considered to be
grossly inadequate or rather insufficient for identification of all such occurrences in a timely
manner.
2.1.1. Unscrupulous individuals (as they commit frauds intentionally for their personal gains)
manipulate, or influence the activities of a business, with the intention of making money, or
obtaining gains through illegal or certain unfair means. Fraud deceives the organization of its
legitimate income and results into a loss of money, even goodwill and reputation. In frauds,
the doers employ illegal and immoral, or unfair means.
It is essential that in order to protect the entities from becoming victims of frauds, entities take
steps to develop certain processes, procedures and controls that prevents the employees from
committing frauds and that effectively helps in detecting fraudulent activity, if it occurs. The
fraud involving persons from the leadership level is known under the name “managerial fraud”
and the one involving only entity’s employees is named “fraud by employees’ association”.
3. Who Commits Frauds?
3.1. Every day, there are news or reports about entities or corporations behaving in
discreditable ways. Generally, there are three groups of business people, who commit
financial statement frauds. They range from (a) Senior Management; (b) Middle and Lower-
level Management and (c) Organizational criminals.
3.1.2. Senior Management commits accounting frauds so as to conceal true business
performance and also to preserve their personal status and control and also to maintain
personal income and wealth. Mid and lower-level employees tend to falsify financial
statements related to their area of responsibility (for example, subsidiary, division or other unit
with which they are associated) so as to conceal their poor performance and/or to earn
performance-based bonuses.
Organizational criminals also falsify financial statements for obtaining loans, or they artificially
inflate value of stock, which they plan to sell in a “pump-and-dump” scheme. While many
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changes in financial audit processes have stemmed from financial statement frauds or
manipulations, history and related research repeatedly demonstrates that a financial audit
simply cannot be relied upon to detect fraud at any significant level.
3.1.3. Frauds like any other crimes, could be best explained by three factors:
(a) Supply of motivated offenders,
(b) Easy availability of suitable targets and
(c) Absence of capable guardians, control systems.
Therefore, a fraud typically includes three characteristics, which are known as “fraud triangle.”
4. What is a Financial Statement Fraud?
4.1. Financial statement frauds usually involve activities such as Manipulation of Financial
Statements with an intent to defraud the readers thereof. By manipulation, the financial
position of the Company or Corporation, appears to be sound, though the actual position is not
so. In the process of manipulation, there is either overstatement of the assets, revenues and
profits on one side or an understatement of liabilities, expenses and losses on the other side.
However, the overall objective of the manipulation may sometimes even require the opposite
action, e.g., concealing higher-than-expected revenues or profits in a good year, so as to help
in the subsequent year, which is expected to be a tougher year.
4.1.2. As such, the financial statement frauds are deliberate and intentional misrepresentation
of the financial condition of an enterprise, which is carried out through the intentional
misstatement or omission of amounts or disclosures in the financial statements, so as to
deceive the users of the financial statements and hide the true picture thereof.
4.1.3. When the books are cooked so as to suit the needs, what it means is that the fraudsters
are trying to "buy more time" so as to fix the business problems that prevent their entities from
achieving its expected earnings or complying with the loan covenants. Cooking of the books
may also be done with an intent to obtain new or additional finances on renewal of the
facilities that would otherwise not be granted or would be lower, if true and honest financial
statements were provided to the lenders.
4.1.4. People intent on profiting from crime may commit financial statement fraudsso as to
obtain loans, which they can later siphon off either for personal gains or to inflate the price of
the company's shares, allowing them to sell their holdings or exercise stock options at a profit.
However, in many past cases of financial statement frauds, the doers of frauds have hardly
gained or even nothing personally in financial terms. Instead the focus appears to have been
preserving their status as market leaders - a status that might have been lost had the real
financial results been published promptly.
4.1.5. A financial fraud is commonly defined as "intentional misrepresentation that an
individual or entity makes knowing that the misrepresentation could result into some
unauthorised benefit to the individual or to the entity or some other party."
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5. Causes or reasons for Financial Frauds or Why Financial Frauds do

take place?
5.1.1 Greed for money and work pressure, are the most common factors compelling
management to commit financial frauds and deceive investors and creditors.
5.1.2. Some examples of pressures on the managerial persons generally include following
factors:
• For obtaining finance at favourable terms or in the case of existing finance, negotiating
the same for still more favourable terms;
• Encouraging investment through Sale of Stock;
• Demonstrating increased earnings per share (EPS) or increased Year-on-Year (Y-on-Y)
or Q-on-Q profits, thus allowing dividends or distribution pay-outs financial statement
fraud;
• Dispelling negative market perceptions or sentiments;
• Obtaining a higher purchase price for acquisitions or sales;
• Demonstrating compliance with financing covenants;
• Meeting projections set for performance and investor expectations, receiving
performance-related bonuses;
• • An overwhelming desire for personal gains;
• • High personal debts;
• • Feeling that their pay is not commensurate with responsibility;
• • Strong challenge to beat the system.
5.1.3. As stated earlier, the opportunity to commit and conceal the fraud often involves either
complete absence of oversight or inadequate oversight by the Board of Directors or Audit
Committee, weak or non-existent internal control measures, existence of unusual or complex
transactions, accounting estimates that require significant subjective judgment by
management, and ineffective internal audit staff. If there are reasons present that make it
appear to be relatively easy to commit and conceal the fraud, the likelihood of occurrence of
frauds are very high.
5.1.4. If top management is not committed to observing high standards of integrity and ethical
values, the ability to rationalize dishonest behaviour will be greatly increased. Top
management is responsible for establishing the environment within which all operations are
conducted. Management’s commitment to integrity and ethical values is perhaps the most
important factor in minimizing the ability to rationalize dishonest behaviour. Ethical values and
honesty must be stressed and top management must display these qualities.
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The Management cannot just expect everyone else to display these qualities, until they
themselves abide by these values and set examples for others to follow. A commitment to
enforcing integrity and ethical values will greatly reduce the ability to rationalize the dishonest
behaviour.
6. Financial Statement Frauds
6.1. Financial statement fraud can take many different forms, but there are several methods
that are considered most common.
These include fictitious revenues, timing differences, concealed liabilities or expenses,
improper disclosure, related-party transactions and improper asset valuations.
6.2. From the accounting perspective, typically revenues, profits or even assets are
overstated, while on the other side, losses, expenses, or liabilities are understated.
Overstating revenues, profits or assets makes a financially weak company to look stronger (as
against its actual financial position), while understating losses, expenses and liabilities results
into increased net worth and equity. Understating revenues or overstating expenses is also an
indicative of management’s efforts to reduce tax liability.
6.2.1. Another alternative to financial statement fraud involves cookie-jar accounting practices,
wherein a firm would understate its revenues in one accounting period and maintain them as a
reserve for future periods, when there are worse performances. Such a practice irons out or
removes the appearance of volatility from the operations.
6.2.2. It is evident that improper revenue recognition, including fictitious revenues and timing
differences, accounts for majority of all financial statement frauds. Fictitious revenues are
entails recording transactions or figures, such as sales that are yet to take place. This involves
creation of fictitious or manipulated transactions with the intent to enhance the reported
earnings. It is also a form of fabrication.
6.2.3. Fabrication of revenue typically involves creating fake or phantom customers and sales.
Artificial sales could also involve legitimate customers — by creating phony invoices or
increasing quantities or prices.
In such a method, the fictitious transactions are reversed in the subsequent period or period.
There are several ways in which such fabricated revenues can be detected. Knowledge of the
business and the industry is critical to understand the organization’s financial statements and
what may have occurred.
6.3. Timing differences is another method of creating fictitious revenues. It involves recording
of revenues and/or expenses in the improper or wrong period. Recognizing revenues early,
much before it is earned, will immediately increase the organization’s income using legitimate
sales, rather than creating phony sales. Recording expenses in the unrelated or wrong period
or periods is another way of increasing the income, which means that expenses are either
postponed or they are recorded incorrectly.
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Expenses are either typically capitalized or recorded in the subsequent period or periods, so
the effects are not taken into the income statement. Depreciating or amortizing assets too
slowly is another method of delaying recognition of expense. If the objective is to decrease
income so as to minimize the tax liabilities, it might accelerate expenses in the current period.
This could involve increasing the rate of depreciation or amortization on assets. It could also
include treating expenses of capital nature as revenue expenditures.
6.4. Thus, a financial statement frauds could be termed as a deliberate or intentional mis-
representation, misstatement or omission of some factual or material financial statement data,
with sole motive to mislead the readers for the purpose of creating a false impression (better
financial health than the actual position) of an organization's financial strength.
6.5. Often business houses resort to financial statements frauds with a motive to evoke
investor’s interest or for the purpose of obtaining bank approvals for financing, or as a
justification for bonuses or increased salaries or to meet expectations of shareholders.
Top Management is generally the centre point of such frauds in the financial statements, as
fraudulent financial statements are prepared and finalised the Top Management level or at the
whims and fancy of the Top Management.
7. Different types of Financial Statement Frauds
7.1. The following are examples of different types of Financial Statement Frauds:
(a) Fictitious revenues
(b) Fabricating revenue
(c) Inadequate provisions for sales and returns
(d) Sales with conditions
7.2. Revenue in order to be recognised as income or earnings must be “earned” and also must
be either “realized” or be “realizable”, before it could be recognized in the financial statements.
Revenue is considered as having been “earned”, only if the entity or corporate has
substantially completed what it must have done, so as to be entitled to the benefits under the
contract. Putting it in other words, the entity or corporate should have fulfilled substantially all
its obligations to the customer. Revenue is considered “realizable” only when the related
assets so received are readily convertible into cash or claims to cash.
7.2.1. Revenue is generally earned and realized or stands as realizable, when all of the
following criteria have been met:
(i) There is an evidence that an arrangement exists between two parties. The requirement
that persuasive evidence of an arrangement exists is intended to ensure that there is an
understanding between two parties about the specific nature and terms of a transaction,
which has been finalized. Determining the proper accounting treatment for a transaction
depends on evidence of the final understanding between two parties, because a change
in terms could lead to a different conclusion regarding the revenue recognition model to
apply.
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(ii) Delivery of goods has taken place or completed or where services are involved, such
services have been rendered. Unless delivery of the goods has taken place or services
have been rendered, as the case may be, the seller cannot be treated as having
completed his obligations under the terms of the arrangement, and therefore, the
revenue should not be recognized. Delivery is generally deemed to have occurred when
the customer gets title and assumes the risks and rewards of the ownership of such
goods or services.
(iii) The price of goods or services between the sellers to the buyer is fixed or
ascertainable. Whether the price is fixed or determinable, could depend on several
factors, including payment terms, discounts, and rebates, which could vary from
contract to contract or arrangement to arrangement. In determining whether the price is
fixed or ascertainable or determinable, entities are supposed to evaluate all elements of
the arrangement so as to ensure that amounts recognized as revenue are not subject to
refund or adjustment.
(iv) Another important factor is “collectability of the amount” under the agreement or
contract and should be reasonably assured. If the collection of sale proceeds, service
charges or fees in an arrangement is not reasonably assured, the general principle of
being realized or realizable is not met, and revenue recognition is precluded until
collection is reasonably assured.
7.2.2. Revenue from a service transaction is subject to the same revenue recognition
requirements as applicable to a transaction under product sales. Regarding the delivery
requirement, if the service has been performed, it is considered as having been “delivered.”
Non-refundable up-front fees are normally recognized over contract terms, not immediately.
Inconsequential or perfunctory services can often be ignored.
7.2.3. In some cases, recognition of revenue is deferred until even the final lap of service has
been performed, where execution of the final lap of acts is a critical event. In other situations,
the scenario of “proportionate performance” is used. As such, it is absolutely important that
the time of recognition of revenue is properly ascertained or determined. For example, in
cases of sales of goods, when should the revenue be recognized; viz., on receipt of the
customer order or on completion of production or on the date of shipment or on actual delivery
of goods to the customer? The decision as to when and how revenue should be recognised
has a significant impact on the determination of net income for the year (i.e., the “bottom line”)
and thus, it is a critical element in the preparation of the financial statements. Revenue earned
is often considered as crucial to the users of financial statements in assessing the
performance and future prospects.
7.3. The main objectives of revenue recognition are to:
(a) Removal of inconsistencies and weaknesses in the existing revenue recognition
standards by providing clear principles for revenue recognition in a robust manner;
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(b) Provide a uniform revenue recognition model, which will improve comparability over a
range of industries, companies and geographical boundaries; and
(c) Simplify the preparation of financial statements by reducing the number of requirements
to which preparers must refer.
7.3.1. The key principles on which the issue is based – revenue is recognized upon transfer to
the customer, measured at transaction price – are consistent with much of current practice.
Under the asset-and-liability approach, revenue is recognized by direct reference to changes
in assets and liabilities that arise from an entity’s contract with a customer, rather than by
direct reference to critical events or activities as in the earnings process approach. The idea is
that where an entity has a legally enforceable, non-cancellable contract, it should begin to
recognize the assets and liabilities inherent in that contract.
While this approach does not change the final profit or loss on the completed contract, it
opens up the issue of the timing of recognition, moving from the end of the transaction, where
recognition has traditionally taken place, to the moment when an executory contract comes
into existence, and then re-measuring as the transaction moves or progresses towards
completion.
7.3.2. The key concepts underlying the proposed standard include the following:
(a) A contract-based revenue recognition principle will be employed. The underlying
principle is that revenue recognition should be based on accounting for a contract with a
customer. A contract with a customer is viewed as a series of enforceable rights and
performance obligations - obtained rights to payment from the customer and assumed
obligations to provide goods and services to the customer under that contract.
(b) Revenue will be recognized when and as performance obligations in the contract are
satisfied. Revenue arises from increases in an entity’s net position (a combination of
rights and obligations) in the contract with a customer as a result of the entity satisfying
its performance obligation under the contract.
(c) The entity satisfies a performance obligation when goods or services are transferred to
a customer. Revenue is recognized for each performance obligation when an entity has
transferred promised goods or services to the customer. It is assumed that the entity
has transferred that good or service when the customer obtains control of it.
(d) Revenue recognized is the amount of the payment received from the customer in
exchange for transferring an asset to the customer. Consequently, the transfer of goods
or services is considered to be the transfer of an asset.
(e) The amount of revenue will be measured based on an allocation of the customer’s
consideration. An entity transferring goods or services at different times needs to
allocate total consideration received to each performance obligation. At inception, the
transaction price is allocated between the performance obligations on the basis of the
relative stand-alone selling prices of the associated goods or services.
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(f) Re-measurement of performance obligations should take place when they are deemed
“onerous.” The carrying amount of an onerous performance obligation is increased
based on the entity’s expected costs of satisfying that performance obligation, and a
corresponding contract loss is recognized.
7.3.3. There are five steps in applying the core principle of the proposed standard:
(a) Identify the contract(s) with the customer: An entity should combine contracts with the
same customer and account for them together, if they are entered into at or near the same
time, and one or more of the following criteria are met:
(i) The contracts are negotiated as a package with a single commercial objective.
(ii) There is price interdependence between the contracts - i.e., the consideration in one
contract depends on the other contract; or
(iii) The goods or services in the contracts are interrelated in terms of design, technology or
function.
(b) Identify the separate performance obligations within the contract: As defined, a
performance obligation is a promise in a contract with a customer to transfer goods or services
to the customer. Performance obligations include promises that are implied by an entity’s
business practices, published policies, or specific statements if those promises create a valid
expectation that the entity will fulfil. When an entity promises to provide a bundle of goods or
services, the entity should account for it as a single performance obligation, if the goods or
services are highly interrelated and the contract includes significant integration of those goods
or services into an item, for which the customer has contracted.
An example is when an entity provides materials and services in constructing a building.
Otherwise, the entity should account for a promised goods or services as a separate
performance obligation, if both of conditions below are met:
(i) The good or service is distinct, and
(ii) The pattern of transfer of the good or service is different from that of other promised
goods or services in the contract.
A good or service is distinct if either:
(i) The entity regularly sells the good or service separately, or
(ii) The customer can use the good or service either on its own or together with resources
that are readily available to the customer. Readily available resources include goods or
services that are sold separately by the entity or another entity, or resources that the
customer has obtained from previous transactions or events.
(c) Determine the transaction price: As defined, the transaction price is the amount of
consideration an entity receives, or expects to receive, in exchange for transferring goods or
services to a customer, excluding amounts collected on behalf of third parties, such as taxes.
This definition reflects uncertainty and implicit financing.
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When determining the transaction price, the objective is to estimate the total amount of
consideration to which the entity will be entitled under the contract. The estimate of the total
consideration can be based on a probability-weighted amount or the most likely amount,
depending on which method is most predictive of the amount to which the entity is entitled.
An entity should recognize the revenue allocated to a satisfied performance obligation if the
entity is reasonably assured that it will be entitled to that amount. The issue of collectability is
closely related to the measurement of the transaction price.
Customer’s credit risk should be accounted for separately and should not impact the
measurement of the transaction price. Therefore, an entity should recognize revenue based
on the stated contract price allocated to a satisfied performance obligation. The entity should
also recognize an allowance for the expected impairment loss from contracts with customer, to
be shown as a contra revenue line item in the income statement. An entity should adjust the
contract amount to reflect the time value of money if the contract includes a financing
component that is significant to that contract. To determine if a contract has a significant
financing component, an entity should consider various factors, including:
(i) The amount of cash to be paid at the time of transfer of the goods or service;
(ii) The timing difference between the transfer of goods or services and customer payment;
and
(iii) The interest rate within the contract, whether explicit or implicit. If the period between
customer payment and the transfer of goods or services to the customer is less than a
year, an entity does not need to assess if a contract has a significant financing
component.
(d) Allocate the transaction price to the separate performance obligations: An entity
should allocate to each separate performance obligation the consideration it expects to
receive in exchange for satisfying that performance obligation on a relative standalone selling
price basis. If the standalone selling price of a good or service is highly variable, the entity
should estimate a standalone selling price using a residual technique, i.e., taking the total
transaction price and deducting the standalone selling prices of other goods or services in the
contract.
Conversely, an entity should allocate a portion of the transaction price entirely to one
performance obligation, if both of the following conditions are met:
(i) The contingent payment terms of the contract relate specifically to the entity’s efforts to
satisfy that performance obligation or a specific outcome from satisfying that separate
performance obligation; and
(ii) The amount allocated to that particular performance obligation is reasonable, relative to
all of the performance obligations and payment terms, including other potential
contingent payments in the contract.
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(e) Recognize revenue when a performance obligation is satisfied: An entity should

recognize revenue when it satisfies a performance obligation by transferring the promised
good or service to the customer. This is when the customer obtains control of the promised
good or service, which is defined as being when it has the ability to direct the use of, and
receive the benefits from, the good or the service.
This is based on the premise that the continuous transfer of control is different between goods
and services. For goods, the performance obligation is satisfied at a point in time.
The indicators that the customer has obtained control of a good include:
(i) The customer has an unconditional obligation to pay;
(ii) The customer has legal title;
(iii) The customer has physical possession; and
(iv) The customer has the risks and rewards of ownership of the good.
For services, an entity is considered to have satisfied a performance obligation over time, if at
least one of the following two criteria is met:
(i) The entity’s performance creates or enhances an asset that the customer controls, as
the asset is created or enhanced; or
(ii) The entity’s performance does not create an asset with alternative use to the entity and
at least one of the following is met:
(a) The customer receives a benefit as the entity performs each task;
(b) Another entity would not need to re-perform the task(s) performed to date if that
other entity were to fulfil the remaining obligation to the customer without the
benefit of any inventory controlled by the entity; or
(c) The entity has a right to payment for its performance to date. If an entity promises
to transfer both goods and services, the entity should first determine whether the
goods and services are separate performance obligations. If they are separate,
the entity should account for them as such. Otherwise, the entity should account
for the bundle of goods and services as a service.
7.4. Contract acquisition costs should be capitalized to the extent that they are recoverable.
Contract acquisition costs are such costs that the entity would not have incurred if the contract
had not been obtained. The capitalized contract acquisition costs are to be presented
separately on the statement of financial position and subsequently amortized on a systematic
basis consistent with the pattern of transfer of the goods or services to which the asset
relates. Concerning testing for onerous contracts, an entity will be required to recognize a
liability and an expense if the remaining performance obligations in a contract are deemed to
be onerous. The remaining performance obligations in a contract are onerous if the costs that
relate directly to satisfying those remaining obligations exceed the amount of the transaction
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price allocated to those performance obligations. This situation must be reassessed at each
financial reporting date. This standard will add to the already-extensive set of required
disclosures to be made in the financial statements. In order to assist the users of financial
statements to understand the amount, timing and uncertainty of revenue and cash flows, the
enhanced disclosures under the revised standard include information about contracts with
customers and information about various judgments and changes in those judgments effected
during the reporting period. Regarding the former category, this will include, as may prove
useful, a disaggregation of revenue; maturity analysis of specific remaining performance
obligations; and reconciliation from opening to closing total contract balances. Concerning the
latter group, this will include information about judgments and changes in judgment about the
timing of revenue recognition and determining and allocating the transaction price.
7.4.1. Companies can use numerous methods to engage in premature or fictitious revenue
recognition. Following are the most common techniques:
Agreements or policies which grant liberal return, refund or exchange rights;
Side agreements;
Channel stuffing;
Early delivery of product
Contracts with multiple deliverables;
Soft sales;
Partial shipments; and
Up-front fees;
Bill and hold transactions;
Recording false sales to existing customers and false sales to fictitious customers;
Round tripping
Other forms of improper recognition:
Recognizing revenue on disputed claims against customers;
Holding the books open past the end of a period;
Recognizing income on consignment sales or on products shipped for trial or evaluation
purposes; and
Improper accounting for construction contracts ; and
Sham related party transactions.
7.5. The following paragraph seeks to address the major classes of fraud, as well as innocent
errors involving revenue recognition.
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Revenue Timing:
7.5.1. Recording a revenue intentionally in the wrong accounting period, is a management
technique, whereby the management manipulates the timing of the revenue for possibly a
number of reasons. These reasons could include meeting performance levels and also to
achieve target bonus levels for the top management, as well as boosting stock values for
holders of shares and possibilities of options on shares.
7.5.2. Although the revenue is real, by recognizing it in the wrong accounting period or in a
different time cycle, i.e., in the earlier period it can be used to project a healthier growth than
the real trend, projecting future continued success, which in fact can often be maintained only
by continued, ever-growing fraudulent acceleration of revenue.
By “borrowing forward” from future revenues creates what is ultimately an unsustainable aura
of growth. When this is no longer possible to continue such a practice, the fraud gets exposed,
usually with disastrous consequences for the stock price and for the management. Holding the
books open for a few extra days at year-end, until enough sales have actually occurred to
meet whatever target was being aimed for, has a long history.
7.5.3. There can be no justification for this action. This is a financial reporting fraud. One
variation on this scheme involves a so-called “bill and hold” arrangement, whereby customers
are encouraged to place larger-than-needed orders, usually near the end of a reporting period.
The sales are recorded, but the goods are held by the reporting entity for release to the
customer in later periods. The customer is not obligated to make immediate payment for the
goods, so in effect this becomes similar to a consignment arrangement, which is not
recognizable as a sale as per generally accepted accounting principles.
7.5.4. Sometimes the goods are actually delivered, but with side agreements permitting
abnormal levels of returns for unsold goods. In other cases, delivery is made, not to the
ostensible customer, but instead to a warehouse or other facility controlled by the seller, which
typically is done to deceive auditors examining shipping documents to find support for
purported revenue transactions.
Yet another situation or variation arises when though the revenue is recorded but the
significant uncertainties still remain. Going by the accepted accounting principles, the revenue
should not be recognised until the uncertainties are resolved completely, although this
deception may not always be apparent, particularly to the auditors, who only sample test
transactions and may not fully appreciate the conditions stipulated in each sales transaction.
However, cash collections from such sales will, upon closer inspection, seemingly lag behind
the normal pattern, because the customer will pay only when all agreed-to conditions have
been met.
7.5.5. For a seller of goods, premature revenue recognition also requires that cost of goods
sold be manipulated, so that a normal or expected relationship between sales and costs can
be maintained during the pendency of the fraud. In many instances where premature or
fictitious revenue methods have been employed, this aspect has been overlooked.
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In these cases the fraud becomes more obvious, particularly when auditors examine
disaggregated information, such as quarterly or monthly accounting data, where end-of-period
anomalies will tend to be more visible.
7.5.6. In the case of service transactions, the same general principle holds, but may be more
difficult to detect, as margins may vary to a somewhat greater extent from one transaction to
the next, compared with multiple transactions in uniform goods. Recording revenue when
services are still due is a fraud intended towards jacking up the revenues, but may be difficult
to detect, and this will persist as a problem. Unless services have been rendered completely,
the accounting principles prohibit booking the revenue.
However, it is too common for companies to (1) ignore percentage-of-completion contracts by
taking the cash payments into income, (2) fail to record offsetting accruals for services paid for
in advance, and (3) record refundable deposits as income.
7.6. Fictitious recognition of revenue
An even more fundamental form of revenue fraud involves booking entirely fictitious revenue.
The objective is similar - namely, (a) to exaggerate current period revenues and profits, or (b)
to distort growth or profitability patterns, thereby impacting stock valuation, executive bonuses,
and so forth.
7.6.1. In this situation, bogus (not just premature) receivables are recorded and as such
receivables are never collectable, such receivables are bogus. Concealing fictitious revenue
will later on necessitate reversal or elimination of such fabricated receivables.
Such receivables will inevitably draw audit attention and auditors would seek for recognition of
such receivables as bad debts, thereby bringing reduction in earnings, even if the auditors do
not detect the actual fraud.
7.6.2. Achieving a successful fictitious revenue fraud will often involve “refreshing” the old
receivables by transferring the balances to other, equally fictitious customers. In this way the
age of the bogus customer obligations can be maintained within a historically normal range for
such receivables. Transferring bad receivables balances to substitute customers will require
non-cash entries, usually made in the general journal, where they should draw auditors’
attention. An alternative is to engage in “lapping” the receivables, or crediting collections on
real receivables against the bogus ones. This leads to a never-ending pattern of applying later
collections to cover prior misapplications of collections to the fraudulent receivables. Here,
too, the need to continue this practice over an extended period increases the likelihood of
eventual discovery, again with probable disastrous consequences.
7.7. Accounting Polices and Customer Contracts
Inquiries into alleged improper revenue recognition usually begin with a review of the entity’s
revenue recognition policies and customer contracts. The auditor considers the
reasonableness of the company’s normal recognition practice and whether the company has
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done everything necessary to comply with. For example, if the company customarily obtains a
written sale agreement, the absence of a written agreement becomes a “red flag”.
The review should begin with a detailed reading of the contract terms and provisions.
Particular attention should be focused upon terms governing
(i) payment and shipment,
(ii) delivery and acceptance,
(iii) risk of loss,
(iv) terms requiring future performance on the part of the seller before payment,
(v) payment of up-front fees, and
(vi) other contingencies. The auditor must consider timing – particularly as it relates to the
company’s quarter and year-end periods. In which periods were the sales agreements
obtained? When was the product or equipment delivered to the buyer’s site? When did
the buyer become obligated to pay? What additional service was required of the seller?
In the absence of a written agreement, the auditor should consider other evidences of the
transaction, e.g. purchase orders, shipping documents, payment records, etc.
7.8. Improperly deferring earned revenue
7.8.1. If a company’s earned revenue significantly exceeds estimates for a reporting period,
the company may improperly defer recording some of the earned revenue until a future
unfavourable reporting period. This is a variation on the common “cookie jar reserves” fraud,
whereby unwarranted expenses are accrued currently, depressing current period profits, only
to be reversed in later, less profitable periods. Although deferring revenue is less commonly
observed than is accelerated recognition, and may be improperly defended using the often-
misunderstood accounting concept of conservatism, it is nonetheless still financial reporting
fraud. Detection is somewhat more difficult, but can often be identified using the same
approaches as are useful in uncovering premature revenue recognition frauds – namely, by
examining disaggregated data and closely studying key financial ratios. There is little reason
to expect that the incidences of such frauds will be altered when the new revenue recognition
standards becomes effective, given the underlying motivations to smooth earnings and meet
announced targets.
7.8.2. In summation, the history of financial reporting frauds has been filled with a wide range
of creative devices to either accelerate revenue recognition or to outright fabricate revenues.
Thus, preparers, auditors and users of financial statements should be prepared to devote time
and attention to this markedly new mode of accounting.
8. Revenue Recognition Vs. Fraud
8.1. Improper recognition of revenue - either prematurely or of fictitious revenue – is the most
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common form of displaying wrongful earnings (either inflated or otherwise). Premature

recognition of revenue involves the recording of revenue generated through legitimate means,
at any time prior to the time when it would be legitimately allowed. Premature recognition
should be distinguished and understood separately from recognition of fictitious revenue
derived from false sales (which have not taken place, but have been reflected in the
accounting books as such) or to false customers (who do not exist at all and would later on
necessitate reversal thereof).
8.1.2. According to AS 18, revenue from the sale of goods shall be recognised when all the
following conditions have been satisfied:
(a) the entity has transferred to the buyer the significant risks and rewards of ownership of
the goods;
(b) the entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to the
entity; and
(e) the costs incurred or to be incurred in respect of the transaction can be measured
reliably.
As such, the revenue is to be recognized only after the earnings process is completed and the
rights of ownership have passed from seller to buyer. Examples of rights of ownership include:
possession of an unrestricted right to use the property, title, assumption of liabilities and
transferability of ownership, insurance coverage and risk of loss. How revenue is actually
defined is a highly complex issue, but fraud is not so complicated. It involves purposeful
attempts to deceive, not good-faith disagreements on accounting treatments. The auditor will
normally find that revenue recognition frauds can be sub-divided into three categories viz., (i)
holding the books open past the end of the accounting period, (ii) recording revenue when
services are still due and (iii) shipping merchandise before the sale is final.
8.2. Playing with time
Probably the most common method to illegally recognize revenue early is to hold the books
open even after the end of the accounting period in order to accumulate more sales. Proper
accounting cut-off tests prevent most of these problems, but not all.
8.3. Recording revenue when services are still due or yet to be completed
Unless services have been rendered completely, the accounting principles prohibit booking
the entire revenue amount. But it is all too common for companies to (1) ignore percentage-of-
completion contracts by taking the cash payments into income, (2) fail to record offsetting
accruals for services paid for in advance, and (3) record refundable deposits as income.
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8.4. Shipping merchandise even before the Sale is final

Often merchandise sent on consignment basis is counted as having been sold. In more than a
few cases, companies—around the time of an audit—have shipped merchandise to private
warehouses for storage and counted those shipments as sales.
9. Timing differences
Early revenue recognition
Recording expenses in the wrong period
9.1. Frauds due to timing differences
When management is required to show year on year improved performance, they generally
either tend to show inflated earnings or resort to reduced expenses or losses. Sometimes the
Top Management even resorts to fraudulent timing differences in order to show unrealistic and
phony profits.
There are five basic methods Companies generally employ to reflect bogus or unrealistic
profits. One of them is fraud in timing differences, also called as a cut-off date fraud. It
normally involves one of two basic techniques: recording revenues early and/or postponing
recording of expenses and liabilities.
9.1.1. A Checklist for Detecting Timing Differences
This checklist will help determine the risk that an entity’s financial statements are overstated
due to timing differences. The more of “yes” answers, the higher the risk.
(a) Compared with previous periods, have sales increased materially? Have product lines
changed?
(b) Is the company trying to raise capital or borrow money?
(c) Whether the earnings of key management personnel substantially depend on or
determined by the company revenues or sales?
(d) Has the company delayed or denied access to original records?
(e) Do cut-off tests show that the books were held open beyond the end of the accounting
period so as to accumulate more sales? Have some of the sales been reversed in
subsequent periods?
(f) Have unusually large sales have taken place or been reflected within a few weeks of
the end of the accounting period?
(g) Were sales to customers towards the end of the accounting period that were on unusual
or extremely favourable conditions?
(h) In the last month of the accounting period, are there material unsupported revenue
entries in the sales journal?
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(i) When compared with previous periods, is there any significant reduction in the cost of
sales?
Does the company have any history of employing aggressive or dubious accounting
practices?
(J) Concealed liabilities and expenses
Instances of omission of liability and/or expenses,
Omission of liability on account of warranty or product liability
10. Understatement Liabilities and Expenses
10.1 Understating liabilities and expenses mirrors overstating income and assets - both serve
to inflate artificially earnings and/or strengthening the company’s financial condition.
Auditors can use various analytical indicators to search for such schemes, including:
An increasing current ratio (current assets/current liabilities) or quick ratio (cash + marketable
securities + net receivables/current liabilities) from one period to the next;
Unexpected improvements in gross margins from one period to the next;
Change in inventory with no simultaneous increase in accounts payable or accrued expenses
between periods; and
A comparison of the percent change in the accrued expense account with revenues reveals
that revenue is increasing faster than accrued expense payable.
10.2. In addition to the above analytical procedures, an auditor should also inquire accounting
personnel so as to if they have ever been asked to postpone expenses until a subsequent
period. Finally, the auditor should also:
Review expense ledger and perform cut-off test to ensure that expenses are recorded in
proper period and not postponed until a subsequent period;
Review prior years expenses and liabilities and look for unusual trends;
Perform current or quick ratio analysis which may indicate the concealment of liabilities;
Examine account detail looking for unusual debits to liabilities which would have the effect of
reclassifying an expense to the balance sheet and also improving the current ratio (certain
levels of current ratio may be required for debt covenant compliance);
Consider performing data mining procedures to identify significant payments for further review
to determine whether the payment should have been capitalized;
Review internal controls to ensure expenses are recorded in proper accounting period and not
postponed until a subsequent period; and
Review expenditures to determine whether they are more appropriately classified as
expenses.
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11. Overstatement or Assets or Understatement of Liabilities

Improper reporting of assets is another way for companies to overstate or inflate their
earnings. A direct relationship exists between overstatement of assets and understatement of
liabilities on the balance sheet and the inflated earnings.
In many cases, perpetrators are looking for a place on the balance sheet to place the debit.
Overstating an asset or understating a liability usually occurs in this situation. Accounts, such
as inter-company and foreign currency exchange gain/ loss should not be overlooked, as
these are potential places to hide the debits.
11.1. Common asset overstatement fraud schemes include:
Creating fictitious assets;
Manipulating balances of legitimate assets with the intent to overstate value;
Understating liabilities or expenses, including failing to record (or deliberately under
estimating) accrued expenses, environmental litigation liabilities and other business problems;
Misstating inter-company expenses; and
Manipulating foreign currency exchanges.
11.1.2. An auditor can often become alert to the possibility of fictitious or over-inflated assets
by inquiring as to whether the entity intends to secure financing. If the answer is yes and if
that financing is contingent on the value of particular assets, such as receivables or inventory,
that should lead the auditor to ask more questions and perform additional procedures to verify
the existence, and location and value of these assets. As with certain other schemes, the
auditor can most often detect these schemes by observing the company’s operations and
inquiring as to unusual items.
11.1.3. Users of financial statements tend to look unfavourably at companies with significant
amount of debts. When liabilities or expenses are concealed, the company’s equity, assets,
and/or net earnings are inflated. Understating liabilities involves not recording accounts
payable or accrued liabilities, recording unearned revenues as earned, not accounting for
warranty or service liabilities, not recording loans or keeping liabilities off the books and not
recording contingent liabilities. Detecting concealed liabilities or expenses can be
accomplished using several different methods.
11.1.4. Perform a search for unrecorded liabilities by completing a cut-off test that compares
vendors’ invoices, receiving documents, and cash disbursements to determine when the
liability was actually incurred. Trace amounts to the accounts payable sub-ledger on the
balance sheet date. Examine the open invoice file to see if all open invoices are recorded.
Examine subsequent disbursements to determine whether disbursements were made for
liabilities that were not recorded. Confirm liabilities with vendors. Examine the minutes of
board meetings, contracts and loan or lease agreements to ascertain whether there are
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liabilities or covenants that are not being properly disclosed. Identify related parties and check
that liabilities have not been “pushed” over to them. Calculate the current ratio of the
company. If it is unusually high, it may be indicative of hidden liabilities.
12. Improper disclosures
Liability omissions
Significant events
Management fraud
Related-party transactions
Changes in accounting policy
12.1. Improper and Inadequate Disclosures
12.1.1. Financial statement fraud is not just limited to numbers. A company can also
misrepresent the financial condition of the company through misstatements and omissions of
the facts and circumstances behind the numbers. Improper disclosures can take various forms
notably, misrepresentations, intentional inaccuracies, or deliberate omissions in:
Descriptions of the company or its products, in news reports, interviews, annual reports,
websites, etc.
Management discussions and other non-financial statement sections of annual reports, other
reports; and
Footnotes to the financial statements.
12.1.2. In all these instances, management has perpetrated a fraud on the readers of the
financial statements by not providing sufficient information required to make an informed
decision regarding the financial position of the company.
Non-disclosure or inadequate disclosure of facts that have severe impact on the financials and
operations of the organisation. In such cases, the management avoids disclosure of certain
events, more particularly those events that have occurred after the date of balance sheet, but
have significant impact on the financial position. These events have taken place after the date
of balance sheet, but before the issuance of the financial statements and if reported in the
financial statements, it would have adverse impact on the users’ sentiments or perceptions.
For example, fire occurred in the factory premises and destroying substantial portion of assets
like factory machineries and building, resulting into stoppage of production activities.
Restoring of the factory would need substantial resources and time. Since the event is
substantial and hence needs to be reported in the financial statements, but reporting could
adversely affect the investors or market sentiments about the organisation.
As such, the management would try to hide such incidence and try that the auditors do not
report the facts in the financial statements.
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12.1.3. It was noted that the management had instructed the employees and other related staff
members to:
• Omit the disclosure from the financial statements.
• Destroy any documentation related to the contamination. The auditors informed senior
management about the line items that will require adjustment to the financial
statements.
12.2. General Comments/Lessons Learned: The omission of disclosure of subsequent
events occurring after the balance sheet date and issuance date of the financial statements
could mislead the reader who is otherwise unaware of those events.
Accounting Standard (AS) 4 (equivalent to IAS 10) on “Contingencies and Events Occurring
After the Balance Sheet Date” that an entity shall recognize in the financial statements the
effects of all subsequent events that provide additional evidence about conditions that existed
at the date of the balance sheet, including the estimates inherent in the process of preparing
financial statements. The auditor will need to review the figures within the financial statements
and the disclosures and other information contained within them in order to form an opinion on
whether the financial statements, as a whole, give a true and fair view of the agency’s
financial position.
13. Improper asset valuations
Inventory
Accounts receivable
Fixed assets
Business combinations
Fictitious or Inflated Investments
13.1 Inventory Schemes
Fraudulent asset valuations comprised nearly half of the cases of financial fraud statements.
Misstatements of inventory, in turn, comprised the majority of asset valuation frauds.
Generally, when inventory is sold, the amounts are transferred to cost of goods sold and
included in the income statement. An overvaluation of ending inventory will understate cost of
goods sold and in turn, overstate net income.
13.1.1. Inventory schemes can generally fall into three categories:
Artificially inflating the quantity of inventory on hand;
Inflating the value of inventory by
Postponing write-downs for obsolescence;
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Manipulating unit of measurement to inflate value;

Under-reporting provisions for obsolete inventory, especially in industries where products are
being updated or have a short shelf life; and
Changing between inventory reporting methods (average costing, last invoice price, LIFO,
FIFO, etc.);
Fraudulent or improper inventory capitalization.
13.2. Following are indicators an auditor can look for to detect possible inventory
manipulation:
A gross profit margin, which is higher than expected;
Inventory that increases faster than sales;
Inventory turnover that decreases from one period to the other;
Shipping costs that decrease as a percentage of inventory;
Inventory as a percentage of total assets that rise faster than expected;
Decreasing cost of sales as a percentage of sales;
Cost of goods sold per the books that do not agree with the company's tax return;
Falling shipping costs while total inventory or cost of sales have increased; and
Monthly trend analyses that indicate spikes in inventory balances near year-end.
Inflating Inventory Quantity (Fictitious Inventory)
The simplest way to overstate inventory is to add fictitious items to inventory. Companies can
accomplish this by creating fake or fictitious:
Journal entries;
Shipping and receiving reports;
Purchase orders; and
Quantities on cycle counts or physical counts.
Some companies even go as far as maintaining empty boxes in a warehouse.
The most effective way to confirm the inventory balance is to carry out physical verification of
the client’s inventory, particularly at such times when an inventory count is being performed. In
fact, the auditors should physically observe, test and inquire as to the amount of inventory on
hand so as to satisfy themselves with respect to the methods of inventory taking and the
measure of reliance placed upon the client’s representations about the quantities and physical
condition of inventories. When the auditor cannot be satisfied as to the inventories, he or she
must physically count the inventory and test transactions in that account. Where inventory is
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stored outside the company site, such as public warehouses, auditors should conduct
additional procedures to confirm balance.
The auditor should look for the following operational factors may arouse suspicions of fictitious
inventory:
Inventory that cannot be easily physically inspected;
Unsupported inventory, cost of sales or accounts payable journal entries;
Unusual or suspicious shipping and receiving reports;
Unusual or suspicious purchase orders;
Large test count differences;
Inventory that does not appear to have been used for some time or that is stored in unusual
locations;
Large quantities of high cost items in summarized inventory;
Unclear or ineffective cut-off procedures or inclusions in inventory of merchandise already sold
or for which purchases are not recorded;
Adjusting entries which have increased inventory over time;
Material reversals of entries to the inventory account after the close of the accounting period;
Inventory that is not subject to a physical count at year end;
Improper or “accidental” sales that are reversed and included in inventory but not counted in
physical observation (for example a company “accidentally” delivers a specifics product to a
customer, tells the customer it was a mistake and requests the customer to send the product
back); and
Excessive inter-company and interplant movement of inventory with little or no related controls
or documentation.
13.3. Even physical observation, however, is not fool-proof. Even when an auditor can
observe inventory, a company can still perpetrate fraud by:
Following the auditor during the course of the count and adding fictitious inventory to the items
not tested;
Obtaining advance notice of the timing and location of the inventory counts thereby permitting
the company to conceal shortages at locations not visited;
Stacking empty containers at the warehouse, which are not checked during the count;
Entering additional quantities on count sheets, cards, scanners, etc. that do not exist or
adding a digit in front of the actual count;
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Falsifying shipping documents to show that inventory is in transit from one company location
to another;
Falsifying documents to show that inventory is located at a public warehouse or other location
not controlled by the company;
Including consigned items as part of the inventory count; and
Including items being held for customers as part of the inventory count.
13.4. To deter management from inflating inventory during physical counts, the auditor should
consider:
Reviewing company policy for inventory counts (frequency and procedures);
Inquiring as to whether all inventory shrinkages have been reported;
Inquiring and observe inventory at third-party locations/off-site storage locations;
Observing a physical inventory unannounced; and
Conducting physical inventories for multi –locations all on the same date.
13.5. Inflating Inventory Value
13.5.1. In terms of applicable Accounting Standards (AS-2), inventories are to be reported at
the lower of replacement cost or market value (i.e., net realisable value or current replacement
cost). Companies tend to inflate inventory value for a variety of reasons other than to boost
earnings. For instance, a common reason to inflate the value of inventory is to obtain higher
finance from banks using the inventory as a security. Higher the value of the inventory, the
more the money the company will be able to obtain in the form of financing.
13.5.2. Inflating inventory value achieves the same impact on earnings as manipulating the
physical count. Management can accomplish this simply by creating false journal entries
designed to increase the balance in the inventory account. Another common way to inflate
inventory value is to delay the write-down of obsolete or slow moving inventory, since a write
down would require a charge against earnings.
Auditors, thus, should be fully aware of the items comprising inventory and their life cycles,
particularly as it relates to that industry. In addition, during the physical observation of the
inventory, the auditor must look for and inquire about older items that appear to be obsolete.
Few or no write-downs to market or no provisions for obsolescence in industries where there
have been changes in product lines or technology or rapid declines in sales or markets
warrant further investigation as to why the company has not accounted for such declines even
when the inventory in question may be relatively new.
13.5.3. When a potential inventory valuation problem is detected or suspected, the auditor
should consider:
Inquiring of accounting personnel as to the company’s inventory pricing policy and how they
identify net realizable value mark-downs;
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Inquiring of management, accounting and finance personnel as to whether the company has
shown historical patterns in the past of over valuation (i.e., prior year write down which
became value impaired);
Inquiring of accounting personnel as to whether they have ever been requested to delay
inventory write downs due to obsolescence etc.;
Touring the warehouse looking for items which appear to be old or obsolete and asking
warehouse personnel if stock is slow moving, damaged or obsolete;
Inquiring of accounting personnel if they are aware of any items being sold below cost; and
Inquiring of industry experts whether the products are saleable and at what cost.
13.6. Fraudulent or Improper Inventory Capitalization
With respect to inventory fraud however, companies will sometimes seek to inflate inventory
by capitalizing certain expenditures associated with inventory, such as selling expenses and
general and administrative overhead. Amounts that are actually expenses but have been
improperly reported as additions to the asset balance, thereby artificially increasing inventory
value.
Auditors and investigators need to be cognizant of the company’s capitalization policies, as
well industry practice with respect to the expenses in question. Moreover, the auditor should
consider whether past accounting policies have been aggressive with respect to capitalization,
which would tend to indicate the need for further investigation. Finally, the auditor should look
for changes to standardized cost amounts that increase the amounts capitalized to inventory.
13.7. Misappropriation of Inventory
Inventory fraud in its most basic definition is the misappropriation of inventory from a
business. There are three basic ways that inventory is stolen:
Physical removal of the inventory from the company location either after it has been
purchased and delivered and without manipulation of the books and records or after it has
been purchased but before delivery to the client;
False write offs or other credits to inventory;
Recording false sales of inventory.
13.7.1. Anyone with access to inventory can engage in misappropriation - - the difference
between the schemes lies in how the theft is concealed. A purchasing officer, for example,
will usually not be able to adjust inventory records, so those types of frauds will not be
available to him. A sales person has access to sales records and this will cover his theft
differently than the purchasing officer.
13.8. Conversion of Inventory
The most basic form of inventory theft is the physical conversion of existing stock. Adequate
physical security, which is beyond the scope of this chapter, is the obvious solution.
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Conversion of inventory before it has reached the company is more sophisticated. This form
of conversion occurs by the perpetrator who has authority to order inventory without
supervision and authorization. Once the inventory is ordered, the perpetrator can direct the
location to which it is delivered. Prevention of this scheme requires stringent controls
regarding the ordering and approval functions. All orders should also require adequate
documentation including shipping records to verify that the inventory was actually delivered to
the company location.
13.9. False Write-offs and Other Debits to Inventory
Employees with the authority to write off inventory as damaged or scrap (or lack adequate
supervision) often perpetrate false write-off schemes. The company will not detect that the
inventory is missing once it is written off in the books and records.
Companies can institute controls to deter inventory manipulation. In addition to adequate
physical security, controls include independent verification of records and separation of
incompatible functions such as purchasing as writing off of inventory. Inventory counts should
be performed by people independent to the inventory records department, or by independent
third parties. The supervisor should verify all write offs and monitor disposal. All entries on the
perpetual system should be referenced to a purchase, sale, or other record. Periodic checks
should be performed on those records.
13.10. False Sales of Inventory
False sale frauds are very similar to recording a fictitious sale in the inventory records of the
business. The false sale is never recorded as a sale in the sales records, which are usually
kept independently from the inventory records. As there is no sale and no amount to collect or
bank, the “sale” is never recorded and thus never missed. Alternatively, the false credit sale
may be recorded (probably under a false name) but the amount never collected and eventually
written off. A variation of the scheme is for the perpetrator to skim the proceeds of a valid sale
to a real purchaser and not record the sale and the payment for the sale that is
misappropriated.
Sales frauds, like other misappropriation frauds, occur due to a lack of controls or a
breakdown of the controls in the sales process. Sales department employees should be
monitored. All sales should require appropriate authorization in addition to sufficient
documentation to support the sale. Furthermore, the individuals in the sales department
should not be in charge of monitoring or writing off receivables and should have no influence
over that department.
The auditor should perform observations of physical inventory and compare the inventory
account for discrepancies between physical inventory and books. The auditor should
determine whether inventory purchases are properly authorized, reconciled, and in possession
of the company. Independent departments should authorize sales, write offs and, other debits.
Inventory data should be entered completely, accurately, and only once. Finally, the auditor
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should ensure that spot checks verifying the existence of inventory are performed on a regular
basis by departments’ independent of the purchasing and sales departments or by
independent third parties
14. Investment Schemes
Fraudulent investment schemes provide another method for a company to overstate assets.
Similar to schemes relating to inventory and receivables, management can create fictitious
investments or deliberately over-value existing ones.
As discussed below, the auditor must first be familiar with all of the entity’s investments and
understand their classifications. This knowledge is necessary to spot the red flags of potential
fraudulent accounting practices. The auditor must also be aware of the current market status
of all investments and must confirm that the entity’s books and records reflect all increase or
decreases in such status. In addition, the auditor should question all classifications of
securities to ensure that they are indeed classified in a manner that is consistent with the
company’s intentions and not just done to recognize gain or forgo recognizing loss. The
auditor should be also wary of losses on securities held as available for sale that are
accumulating in the other comprehensive income account. The company must eventually take
a charge for these losses either through a sale or through a permanent write down. Evidence
of accumulating losses may lead the auditor to conclude that management is intentionally
delaying the recognition of such a loss.
14.1. Fictitious Investments
Fictitious investments are similar to the creation of other fictitious assets. Indicia include:
Missing supporting documentation;
Missing brokerage statements; and
Unusual investments (i.e., gold bullion) or ones held in remote locations or with obscure third
parties.
14.2. Follow up procedures an auditor can conduct include:
Confirming the existence of the investment by physical inspection or by confirmation with the
issuer or custodian;
Confirming unsettled transactions with the broker-dealer;
Reviewing the minutes of board of directors meetings and the company’s Treasury policies to
ensure that all investments were authorized by the Board and that company policy was
followed in the trading of and investment in securities; and
Reviewing internal controls to ensure that the duties of purchasing, recording, and custody are
adequately segregated.
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14.3. Manipulating the Value of Investments

Companies can also manipulate their financial statements by inflating the value of investments
by misclassifying them or failing to record unrealized declines in market value for those
investments.
According to AS 13, investments are classified as long term investments and current
investments. Current investments are in the nature of current assets, although the common
practice may be to include them in investments.
Investments other than current investments are classified as long term investments, even
though they may be readily marketable.
14.3.1. Carrying Amount of Investments: The carrying amount for current investments is the
lower of cost and fair value. In respect of investments for which an active market exists,
market value generally provides the best evidence of fair value. The valuation of current
investments at lower of cost and fair value provides a prudent method of determining the
carrying amount to be stated in the balance sheet.
14.3.2. Valuation of current investments on overall (or global) basis is not considered
appropriate. Sometimes, the concern of an enterprise may be with the value of a category of
related current investments and not with each individual investment, and accordingly the
investments may be carried at the lower of cost and fair value computed category-wise (i.e.
equity shares, preference shares, convertible debentures, etc.). However, the more prudent
and appropriate method is to carry investments individually at the lower of cost and fair value.
14.3.3. For current investments, any reduction to fair value and any reversals of such
reductions are included in the profit and loss statement.
Investments classified as trading includes such investments which are bought and held
principally for sale in the near term. Investments not classified as trading or as held-to-maturity
are classified as available-for-sale securities.
Trading and available for sale securities are reported at fair market value and must be
periodically adjusted for unrealized gains and losses to bring them to fair market value.
Unrealized gains or losses from trading securities are included in income for the period.
Unrealized gains or losses from changes held as available for sale are reported as a
component of other comprehensive income.
Equity securities (i.e., common or preferred stock) on the other hand, can be classified only as
trading or available for sale. Unrealized gains or losses from changes in fair market value are
reported in earnings for trading securities and as a component of other comprehensive income
for securities held as available for sale.
14.3.4. Long-term investments are usually carried at cost. However, when there is a decline,
other than temporary, in the value of a long term investment, the carrying amount is reduced
to recognise the decline. Indicators of the value of an investment are obtained by reference to
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its market value, the investee’s assets and results and the expected cash flows from the
investment. The type and extent of the investor’s stake in the investee are also taken into
account. Restrictions on distributions by the investee or on disposal by the investor may affect
the value attributed to the investment. 18. Long-term investments are usually of individual
importance to the investing enterprise. The carrying amount of long-term investments is
therefore determined on an individual investment basis.
14.3.5. Where there is a decline, other than temporary, in the carrying amounts of long term
investments, the resultant reduction in the carrying amount is charged to the profit and loss
statement. The reduction in carrying amount is reversed when there is a rise in the value of
the investment, or if the reasons for the reduction no longer exist.
14.3.6. The transfer of a security between different categories of investments is required to be
accounted for at fair value. Securities transferred from the trading category will already have
had any unrealized holding gain or loss reflected in earnings. For securities transferred into
the trading category, the unrealized holding gain or loss as on the date of the transfer are to
be recognized in earnings immediately. For securities transferred into the available-for-sale
category from the held-to-maturity category, the unrealized holding gain or loss at the date of
the transfer must be reported in other comprehensive income. Securities transferred from
available for sale to held to maturity report unrealized holding gain or loss as at the date of the
transfer as a separate component of other comprehensive income and amortized to interest
income over the remaining life of the security.
14.4. Generally, with respect to investments, auditors should consider inquiring of:
Management as to company policies regarding the recording of unrealised gains or losses on
trading and available for sale securities; and
Accounting personnel as to they have been asked to:
Record held to maturity securities at anything but amortized cost;
Not record all unrealised gains and losses in available for sale and trading securities have
been recorded and if not the reason; and
Postpone a write down of a debt security.
14.5. Misclassification of Investments
Investments are classified as long term investments and current investments. Current
investments are in the nature of current assets, although the common practice may be to
include them in investments.
Investments other than current investments are classified as long term investments, even
though they may be readily marketable.
Companies can manipulate financial statements by intentionally misclassifying securities or
transferring securities to a class that would trigger the recognition of gain or conversely
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postpone the recognition of a loss. For example, a company might misclassify a security as
held to maturity in order to avoid recognizing a decline of value in the current period. Similarly,
transferring a security from held to maturity to either trading or available for sale, would permit
the recognition of gains that had not been previously recognized.
The Treasury function most commonly decides the classification at the time that the security is
acquired. Auditors should review any changes in classification for possible abuse.
14.6. Recording Unrealized Declines in Fair Market Value
Deciding whether to write down a security due to a permanent decline in value is highly
subjective and ordinarily left to the discretion of management. Accepting a write down results
in a charge against net income. The auditor, thus, should consider whether management has
inappropriately failed to or delayed a write down an impaired security to inflate income.
15. Accounts Receivable Schemes
15.1. Companies can manipulate accounts receivable with the same techniques that they can
manipulate inventory; that is, by creating:
Fictitious receivables; and
Inflating the value of receivables.
15.2. Analytics that may assist in detecting overstated receivables include:
A decrease in the company’s quick or current ratio;
Unexplained decrease in accounts receivable turnover
Unexplained increase in days sales outstanding; and
An increase of the ratio of credit sales to cash sales.
15.3. Creating Fictitious Receivables
Fictitious receivables are generally similar to those in our discussion of fictitious earnings:
Unexpected increases in sales and corresponding receivables by month at period end;
Large discounts, allowances, credits or returns after the close of the accounting period;
Large receivable balances from related parties or conversely from customers with unknown
names or addresses or which have no apparent business relation to the business;
Outstanding receivable increasing faster than sales;
Organizations that pay commissions based on sales, rather than the collection of the
receivable;
Increased receivable balances accompanied by stable or decreasing cost of sales and
corresponding improvement in gross margins;
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Lengthening of aging of receivables or granting of extended credit terms;

Excessive write offs of customer receivable balances after period end;
Re-ageing of receivables;
Excessive use of account called “miscellaneous/unidentified customer”
Large unapplied cash balance;
Increased trend of past due receivables; and
Lack of adequate controls in the sales and billing functions.
15.4. As part of the inquiry process, the auditor should:
Inquire of finance personnel and management as to whether the company is trying to obtain
financing secured by its receivables;
Inquire of sales personnel as to whether they have been pressured to create fictitious or
fraudulent sales invoices;
Inquire of accounting or sales personnel as to whether they have been pressured to:
Overstate the value of receivables;
Create fictitious journal entries or invoices for the sales of inventory or assets; and
15.5. Inquire whether customers have been pressured to accept large volume orders close to
the end of period. Fictitious receivables schemes can also often involve related parties, as
related parties are more likely to assist in collusion and providing of false information to the
auditor. Auditors should inquire into the legitimacy of receivables if they appear to involve a
related party.
15.6. Inflating value of Receivables
15.6.1. Inflating the value of legitimate receivables has the same impact as creating fictitious
ones. Accounting Principles require accounts receivable to be reported at the net realizable
value. Net realizable value is the gross value of the receivable less an estimated allowance for
uncollectible accounts. It requires companies to estimate the uncollectible portion of a
receivable to determine the net realizable value of receivables. The preferred method to
determine uncollectible receivables is to periodically record the estimate of uncollectible
receivables as a percentage of sales, outstanding receivables, or based on an aging of
outstanding receivables.
15.6.2. Under the allowance method bad debt provisions are recorded as a debit to bad debt
expense (an income statement account) and a credit to allowance for doubtful accounts (a
balance sheet contra receivable account). When all or a portion of the receivable becomes
uncollectible, the uncollectible amount is charged against the allowance account. When
receivables are recorded at their true net realizable value, the recording of a bad debt
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provision decreases accounts receivable, current assets, working capital and most
importantly, net income.
Companies circumvent these rules by underestimating the uncollectible portion of a
receivable. Underestimating the value of the provision (i.e., the amount deemed uncollectible)
artificially inflates the value of the receivable and records it at an amount higher than net
realizable value.
15.6.3. Overvaluing receivables also serve to understate the allowance account, such that the
provision is insufficient to accommodate receivables that in fact become uncollectible.
A related scheme is not writing off (or delaying the write-off) of receivables that have in fact
become uncollectible. These schemes are relatively easy to execute given the subjectivity
involved in estimating bad debt provisions.
15.6.4. Potential auditing procedures include:
Spending adequate time to review and understand the provision;
Inquiring of management and accounting personnel as to the reasoning behind the amount of
the provision; and
Determining the reasonableness of the provision in relation to the true facts surrounding the
receivables.
15.6.5. Indications of the potential overvaluation of receivables include:
Minimum bad debt provisions or reserves that appear to be inadequate in relation to prior
periods;
A history of extending payment terms to customers with limited ability to repay;
A history of inadequate reserves for uncollectible receivables;
Deteriorating economic conditions, e.g., declining sales;
Deteriorating accounts receivable days outstanding;
Untimely reconciliations and/or reconciliations that are “back of the envelope”;
History of inadequate reserves for uncollectible receivables;
Net receivables (i.e., net of the allowance for doubtful account) which are increasing faster
than revenues;
Uncollectible accounts which have been on the books for extended periods of time but have
not been written off; and
Recorded disputes with a customer that may potentially threaten ability to collect.
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15.6.6. Follow up procedures include inquiring of:

Company changes to its credit policy and the reason for such changes;
Management as to the reason for any change in the reserve rates or policy for reserves in
accounts receivable;
The sales force and Credit Department about whether they have been pressured or requested
to grant credit to customers who are not credit worthy;
The Credit Department if they have been requested to extend payment terms for certain
customers;
The Credit Department to determine whether certain sales people have instructed them to
approve a customer and to avoid/circumvent the normal approval process; and
The nature and details surrounding any disputes with customers.
16. Software Development
Costs associated with developing new software are to be treated as expenses until the point
of technological feasibility. Technological feasibility is established upon completion of a detail
program design or, in its absence, completion of a working model. Once the technological
feasibility is established, all software production costs must be capitalized and subsequently
reported at the lower of unamortized cost or net realizable value.
Whether technological feasibility has been reached is a subjective decision and thus subject to
abuse. By arbitrarily determining technological feasibility, management can manipulate income
by increasing or decreasing the amount capitalized or expensed. Auditors should consult with
the company’s technical personnel (i.e., engineers, programmers) in reviewing management’s
assertions that technological feasibility has been achieved.
17. Research and Development (“R&D”)
In accordance with AS 26, no intangible asset arising from research (or from the research
phase of an internal project) should be recognised.
Expenditure on research (or on the research phase of an internal project) should be
recognised as an expense when it is incurred.
17.1. This Standard takes the view that, in the research phase of a project, an enterprise
cannot demonstrate that an intangible asset exists from which future economic benefits are
probable. Therefore, this expenditure is recognised as an expense when it is incurred.
17.2. Examples of research activities are:
(a) activities aimed at obtaining new knowledge;
(b) the search for, evaluation and final selection of, applications of research findings or
other knowledge;
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(c) the search for alternatives for materials, devices, products, processes, systems or
services; and
(d) the formulation, design, evaluation and final selection of possible alternatives for new or
improved materials, devices, products, processes, systems or services.
17.3. Development Phase:
An intangible asset arising from development should be recognised if, and only if, an
enterprise can demonstrate all of the following:
(a) the technical feasibility of completing the intangible asset so that it will be available for
use or sale;
(b) its intention to complete the intangible asset and use or sell it;
(c) its ability to use or sell the intangible asset;
(d) how the intangible asset will generate probable future economic benefits. Among other
things, the enterprise should demonstrate the existence of a market for the output of the
intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset;
(e) the availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset; and
(f) its ability to measure the expenditure attributable to the intangible asset during its
development reliably.
17.4. In the development phase of a project, an enterprise can, in some instances, identify an
intangible asset and demonstrate that future economic benefits from the asset are probable.
This is because the development phase of a project is further advanced than the research
phase.
17.5. Examples of development activities are:
(a) the design, construction and testing of pre-production or pre-use prototypes and
models;
(b) the design of tools, jigs, moulds and dies involving new technology;
(c) the design, construction and operation of a pilot plant that is not of a scale economically
feasible for commercial production; and
(d) the design, construction and testing of a chosen alternative for new or improved
materials, devices, products, processes, systems or services.
The acquirers tend to classify a large part of the acquisition price as in process research and
development (“R&D”), thereby allowing the entity to immediately expense the costs. This
practice allows the entity to write off the R&D in a single chunk in the year of acquisition itself
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and not burdening future earnings with amortized R&D charges. This type of practice also
involves the creation of liabilities for future operating expenses.
18. Start-up Costs
Similar to R&D, all start-up costs to be expensed or charged as revenue expenses in the year
of expense itself. However, many entities will label start up activities as other costs, thereby
attempting to capitalize them.
19. Interest Costs
19.1. According to Ind AS 23, an entity shall capitalise borrowing costs that are directly
attributable to the acquisition, construction or production of a qualifying asset as part of the
cost of that asset.
As such, the entity shall recognise other borrowing costs as an expense in the period in which
it incurs them.
19.2. Where borrowing costs are directly attributable to the acquisition, construction or
production of a qualifying asset are included in the cost of that asset. Such borrowing costs
are to be capitalised as part of the cost of the asset, when it is probable that they will result in
future economic benefits to the entity and the costs can be measured reliably.
19.3. Capitalization of Interest Costs, requires the capitalization of interest costs incurred
during the acquisition and construction of an asset. The interest cost capitalized are added to
the cost of acquiring the asset and then amortized over the useful life of the asset. The total
interest cost capitalized in a period may not exceed the interest cost incurred during that
period.
Capitalization is no longer allowed when the cost of the asset exceeds its net realizable value.
One potential scheme in this area is for the company to continue capitalizing interest after
construction has been completed.
20. Improper Capitalization of Expenses
Capitalization of company expenditures is another fertile area for abuse. The most common
way is to record expenditures as capital items rather than ordinary expenses. This technique
allows the company to capitalize and amortize the expense over many periods rather than
recognize it in its entirety in the current period.
The start of any audit with respect to questionable capitalization policies should be the
company’s accounting policy with respect to this area in addition to the policies of other
entities in the industry. Is the company being overly aggressive with its policies as compared
to other companies? Due consideration must also be given to management’s reasons for
selecting the policy. The auditor will also want to consider whether the costs in question are
providing future benefit thereby warranting capitalization. Detecting capitalization policies can
often be achieved by considering or reviewing the following items:
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Is there a heavy capitalization of fixed assets?

Are capitalized costs that are increasing faster than revenue over lengthy periods?
Are repair and maintenance expenses (or other operating expense) dropping out of line with
operations (indicating these are possibly being capitalized instead of expensed?
With respect to construction contracts, does interest expense properly increase when
construction and capitalization of expenditures has ceased?
Have prior accounting policies have been aggressive with respect to capitalization?
21. Advertising Costs
Reporting on Advertising Costs, provides that all advertising expenses must be expensed as
incurred unless there exists persuasive historic evidence that allow the entity to make a
reliable estimate of future revenue to be obtained as a result of the advertising in which case
the expenditures are allowed to be capitalized.
22. Recording Fictitious Fixed Assets
Similar to the concept of recording fictitious sales or receivables, entities will record fictitious
assets to improve the balance sheet which, as previously discussed, inflates earnings as well.
22.1. Fictitious assets include:
Fixed assets on books and records which do not have an apparent relation to the business;
Lack of a subsidiary ledger to record additions and retirements;
Lack of adequate policies and procedures to determine whether property and equipment are
received and properly recorded;
Lack of procedures to account for fixed assets that may have been moved from one facility to
another;
Existence of a second-hand storage facility for fixed assets that may still have useful life but
for some reason are not being used;
Lack of adequate written policies and procedures concerning the recording, retirement and
disposition of fixed assets; and
Sub-ledgers that do not reconcile to the general ledger.
22.2. Follow up procedures to consider if any of these indicia are present include:
Tour of the client’s facility to review fixed assets: select certain fixed assets from the fixed
asset listing (especially new, significant additions), physically confirming that the fixed asset
exists and physically inspecting the asset’s serial number if applicable;
Determine that retired assets are no longer included in financial statements; and
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Review internal controls to ensure that there are written policies covering retirement
procedures which include serially [sequentially] numbered retirement work orders, reasons for
retirement and all necessary approvals.
23. Depreciation & Amortization Schemes
An easy way to inflate the value of an asset is to extend its depreciable/amortizable life so that
it is carried on the books for a longer period. Depreciation is another area in which
management is given leeway to choose any method so long is that method allocates the costs
in a “rational and systematic manner.”
Detection of these schemes begins with a review of the company’s depreciation policy. Most
companies have written policies for depreciating assets. Lack of a written policy heightens the
potential for abuse as it enables management potentially to record depreciation on an ad hoc
basis with no particular rational. Similarly, recent changes to the entity’s depreciation policy
should be scrutinized for both their purpose and effect on the entity’s assets.
23.1. Auditors who have suspicions should consider:
Reviewing the records of depreciable assets for unusually slow depreciation or lengthy
amortization periods;
Comparing prior years depreciation charges with current year for reasonableness;
Identifying changes in policy which may affect the rate of depreciation that appears to boost
earnings;
Inquire into historical depreciation policies to determine the extent of their aggressiveness;
and
Reviewing a detailed list of fixed assets as well as the assigned lives of the assets and then
randomly selecting certain fixed assets and recalculating the net book value at reporting date
based upon the recorded life of the asset.
24. Establishing Off-Balance Sheet Entities
24.1.The Enron scandal highlighted the practice of fraud by using “off-balance sheet” vehicles
to transfer and conceal debt.The fraud occurs when companies use them to, for example,
conceal debts, thereby misleading investors about the risks and rewards of a transaction,
particularly when inadequate or misleading disclosure are provided. Off-balance sheet
transactions also have an income statement impact as well.
24.2. With an off-balance sheet transaction, a company’s “investment” account on the income
statement will reflect the relevant proportion of net profit or loss that results from operation of
the underlying net assets. In other words, the effect of non-consolidation should leave income
the same as if the off-balance sheet investment had been consolidated. However, the
individual line items composing that net income or loss are not explicitly shown. A
consolidation treatment conversely, would show individual revenue and expense line items.
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24.3 Off-Balance Sheet Treatment V/s Consolidation

Off-balance sheet transactions are transactions wherein a company retains the benefits of
assets in a corporate vehicle not consolidated for financial accounting purposes. These
investments can typically appear in the asset section of the balance sheet as a single net line
item, titled variously as an “investment in affiliate”, “retained interest in securitization”, etc.
Off-balance sheet transactions enable the company to avoid showing the individual asset of
the off-balance sheet vehicle in the balance sheet, and more importantly, the associated debt
used to acquire the off-balance sheet vehicle’s assets. In other words, the company executing
the transaction reports only its proportion of the net assets of the off balance sheet vehicle as
an asset, rather than reporting the gross assets of the vehicle, including the vehicle’s total
debt and outside interests held by other parties. While this form of reporting technically would
not change the net equity of the company executing the transaction, the consolidated balance
sheet would show greater total assets and greater total debt. Thus, in executing an off-
balance sheet transaction, the company looks more financially attractive. In addition, there is
an impact upon balance-sheet dependent financial ratios; for instance, it is likely that debt to
equity ratios will be higher, and therefore less favourable, under consolidation treatment as
compared to non-consolidation.
Off-balance sheet treatment has historically been used for among other things:
Securitization transactions - financial assets such as receivables are sold to an off-balance
sheet vehicle while the seller retains a subordinated interest in that entity;
Leasing transactions – long-lived assets are acquired by an off-balance sheet entity. The use
of the assets is conveyed to a third party via an operating lease; and
Non-controlling investments: assets or businesses are held by an entity that does not convey
control back to the investors. One simple example is a jointly controlled joint venture. The
assets and debt of that venture remains off-balance sheet for at least one of the
partner/investors involved.
25. Overstatement of Liability Reserves (“Cookie Jar Reserves”)
25.1. While most fraud schemes are geared toward inflating the current financial position,
companies sometimes overstate the amount of provisions to cover the expected costs of
liabilities such as taxes, litigation, bad debts, job cuts and acquisitions. In doing so,
management will establish inflated accruals in those years where the company is extremely
profitable and doing well and can afford to incur larger expense amounts. These “cookie jar
reserves” are then tucked away for management to reach into and reverse in future years
where the company is unprofitable or marginally profitable when a boost to earnings would be
beneficial.
25.2. Company managers estimate reserves. The outside auditor judges whether the reserves
are reasonable. Generally, it is difficult for auditors to challenge company estimates because
there are no clear accounting guidelines. This creates a ripe environment for abuse.
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26. Materiality
26.1. No discussion of financial statement fraud is complete without a discussion on
materiality. Companies (and sometimes auditors) dismiss improprieties, because they are not
considered as “material” to the financial statements.
26.2. An information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.
Materiality, therefore, relates to the significance of transactions, balances and errors
contained in the financial statements. Materiality defines the threshold or cut-off point, after
which financial information becomes relevant to the decision making needs of the users.
Information contained in the financial statements must, therefore, be complete in all material
respects in order for them to present a true and fair view of the affairs of the entity.
26.3. Materiality is relative to the size and particular circumstances of individual companies.
Example - Size
A default by a customer who owes only Rs. 1000/- to a company having net assets of worth
Rs. 10 million, is immaterial to the financial statements of the company.
However, if the amount of default was, say, Rs. 2 million, the information would be material to
the financial statements, omission of which could cause users to make incorrect business
decisions.
Example - Nature
If a company intends to curtail its operations in a geographic segment, which has traditionally
been a major source of revenue for the company in the past, then this information should be
disclosed in the financial statements, as it is by its nature material to understanding the
entity's scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:
(a) Relevance: Material information influences the economic decisions of the users and is
therefore relevant to their needs.
(b) Reliability: Omission or mis-statement of an important piece of information impairs
users' ability to make correct decisions taken on the basis of financial statements
thereby affecting the reliability of information.
(c) Completeness: Information contained in the financial statements must be complete in all
material respects in order to present a true and fair view of the affairs of the company.
26.4. Over time, companies and their auditors have also developed certain “rules of thumb” to
assist them in determining when a matter might be deemed material. One frequently used
rule of thumb is that a misstatement or omission that is less than 5% of some factor (i.e., net
income or net assets, etc.) is not material.
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While there should not be any objection to the use of the 5% threshold as a preliminary
assessment of materiality, but exclusive reliance on quantitative benchmarks, such as the 5%
rule can only be the beginning of a materiality analysis and not a substitute for a full analysis
of one Examples of qualitative factors to be considered include whether the misstatements:
Arise from imprecise estimates;
Mask changes in earnings trends;
Cause financial statements to meet analysts’ expectations;
Would change a loss to income or vice versa;
Affect compliance with regulations or contracts;
Affect management compensation; or
Arise from illegal acts.
Thus, it is clear that numerical tests also will no longer satisfy a materiality analysis and that
the auditor must question the facts and circumstances surrounding all suspicious transactions
and cannot simply pass on them if they are deemed financially immaterial.
27. Misappropriation of Cash
Cash schemes are the most common form of misappropriation of assets. The major categories
include: (i) skimming and larceny of cash and (ii) fraudulent disbursements. Fraudulent
disbursements include: (i) billing schemes, (ii) payroll schemes, (iii) expense reimbursement
schemes, (iv) check theft and tampering of checks and (v) register disbursement schemes.
27. 1 Skimming of Cash
Unrecorded or Understated Sales or Receivables- (Failure to record the full amount of sales or
other items of income)
27.2. Many asset misappropriation schemes start at the entry point of the sale. An employee
can embezzle monies by not recording the sale or full amount of the monies received.
Deterrence of skimming activities requires adequate segregation of duties among the
individuals recording the sales, receiving the monies, and recording the sales in the books. In
addition, particular attention must be paid to those individuals, such as consultants and sales
people, who handle cash in offsite locations. These individuals often operate without sufficient
controls governing their conduct that can lead to the perpetration of this scheme.
27.3. Special attention should also be given to payments made on the account. Perpetrators
can convert the cash and then either wait for an alternative source of funds to make up for the
replace the funds converted (This practice, more commonly known as lapping, will be
discussed in detail below). The perpetrator may simply not record the payment against the
customer’s account at all. The customer’s receivable balance will remain unchanged or slightly
changed despite the fact that they have been making payments. After the receivable has aged
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significantly, the perpetrator writes off the receivable balance as unpaid. Adequate
segregation of duties again is key. The same individual should not be in charge of recording
and monitoring receivables in addition to being given the responsibility of authorizing and
recording write offs.
27.4. The auditor should review the customer complaint log for complaints regarding the
misapplication or lack of payment to their receivable account balance and follow-up on any
recorded complaints with both management and the customer to see what the nature of the
problem was, how it was resolved, by whom within the organization and finally whether the
problem occurred subsequently.
27.5. The auditor should also consider performing certain analytics and noting particular
trends such as:
Cash that is decreasing in relation to total current assets;
Cash that is decreasing in relation to credit sales;
Decrease in sales accompanied by an increase in cost of sales;
Current ratio which has decreased significantly from prior periods;
Decreasing gross margins from the prior to the current period;
Cash collections which are significantly less than reported revenues;
Significant amount of write offs in the current period as compared to the previous period; and
Decreasing trend of payments on accounts receivable.
27.6. Other indications of the existence of this scheme include:
Lack of segregation of duties between the sales, receipts and recording functions;
Poor controls over the completeness of recording sales;
Sharp increase in the average length of time that customer cash receipts are maintained in an
account before being applied to customer’s outstanding balance;
Periodic or large or numerous debits or other write offs to aged accounts;
Recorded customer complaints regarding misapplication of payments to their account;
Forced account balances such as overstatements of cash balances that are made to match
the accounts receivable balance;
Numerous or significant reversing entries or other adjustments been made which have caused
the books or register to reconcile to the amount if cash on hand; and
Large or numerous suspicious debit adjustments to aged receivable accounts.
27.7. Finally, an auditor confronted with these high risk factors should consider:
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Inquiring of management or internal audit group whether there ever been previous problems
with employee theft of incoming cash receipts;
Inquiring as to the company’s policy for monitoring off site sales people (if applicable) or rental
properties that generate cash flows for the company;
Inquiring on how reconciling items or discrepancies are treated and reviewed by management;
Inquiring of management and sales personnel regarding customer complaints about billing
and/or payments not being applied to their accounts;
Following up with customers regarding any recorded complaints; and
Inquiring of management and others whether they are aware of any employees having
financial difficulties.
28. Channel Stuffing
Channel stuffing refers to the practice of offering deep discounts, extended payment terms or
other concessions to customers to induce the sale of products in the current period, when they
would not have not been otherwise sold until later periods, if at all.
Channel stuffing often is indicated by an increase in shipments, which is usually accompanied
by an increase in shipping sold at steep discount costs, at or near the end of period. Where
these circumstances occur, the auditor or auditor should (i) inquire whether the goods were
sold and (ii) review customer contracts and side agreements for unusual discounts in
exchange for sales and rights of return provisions. The auditor should also inquire of sales
personnel and shipping personnel regarding management influence to alter normal sales
channel requirements.
In addition, customers offered deep discounts often purchase inventory in excess of required
needs to take advantage of the reduced prices. This excess, inventory is often returned by the
customer after the close of the period as it cannot be resold. The auditor thus should consider
the amount of returns shortly after the close of a period as compared to prior periods and
margins on sales recorded immediately before the end of a reporting period.
Early Delivery of Product
Shipping unfinished or incomplete products to customers, or at a time prior to when customers
are ready to accept them;
Engaging in “soft sales” (shipping of products to customers who have not agreed to purchase);
Recognizing the full amount of revenue on contracts where services are still due to the client,
and/or
Recognizing the full amount of revenue on fees collected up front.
Income should not be recognized under these circumstances because delivery has not
actually occurred.
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Customers on the other side of early delivery schemes often return the unfinished product or
demand more completion before payment is rendered.
Analytics that may reveal the existence of an early delivery scheme include:
Comparing returns in the current period and prior periods;
Comparing shipping costs in current period and prior periods; and
Comparing shipping costs as a percentage of revenue in the current period and prior periods.
29. Lapping
Lapping generally involves converting one customer’s payment and then using a subsequent
payment, usually from another customer, to cover the payment converted from the previous
customer's account. For example, the perpetrator steals the payment intended for customer
A’s account. When a payment is received from customer B, the thief credits it to A’s account.
And when customer C pays, that money is credited to B.
Lapping tends to increase at exponential rates and lapping schemes often tend to reveal
themselves because the employee is unable to keep track or obtain additional payments to
cover up the prior skimming.
The controls, analytical and other indicators that apply to skimming also apply to lapping.
However, one of the most effective ways to control a potential lapping scheme is to require a
daily bank deposit in addition to an independent confirmation that the deposit was properly
made. Additionally, the auditor be aware, pay attention and inquire into any delays in the
processing of payments to customer’s accounts and inquire as to the reason for those delays.
30. Fraudulent Disbursements
Cash schemes involve the theft of revenues before they have been recorded in the books and
records of the company. Fraudulent disbursement schemes, on the other hand, involve theft of
funds already entered into the books and records. Fraudulent disbursement schemes
generally fall into five main categories:
Billing schemes;
Theft of company checks;
Payroll schemes;
Expense reimbursement schemes; and
Register disbursement schemes.
These five categories in turn can be broken down further to include a host of other individual
schemes many which, like the cash skimming schemes discussed above are similar in their
nature and means of detection.
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30.1. Billing Schemes - Creation of Fictitious Vendors or the Use of Shell Companies to
Convert Monies
A common billing scheme is the creation of fictitious vendors or shell companies.
The perpetrator will create a fictitious vendor, usually a company owned by him or herself, and
then have the fictitious bill the entity for goods or services it does not receive. Alternatively,
the perpetrator can create a shell company to purchase goods or services, which are then
marked up and sold to the employer through the shell. This scheme is most easily
accomplished when one or few individuals maintain control over multiple functions and duties
such as purchasing, selecting vendors, and receiving, and approving payments. Lack of
adequate written cash disbursement procedures, such as requiring independent approval for
disbursements over a particular amount, also heightens the risk of this scheme.
30.2. Third party vendor diligence is a useful prevention and detection technique. Such
diligence should include:
Verification of the name and address of the new vendor by obtaining and maintaining on file
copies of corporate records and other relevant documents evidencing its existence (and not
simply a shell);
Obtaining credit references from reputed sources;
Requesting the vendor to furnish credit and other references establishing its identity; and
Checking the vendor address against the employee database to ensure that it does not match
the known addresses of any employees or to determine whether any other relations exist
between employees and the vendor. In addition, the auditor should be alert for addresses that
are P.O. boxes. These should be considered as instant red flags of the existence of a fictitious
vendor.
30.3. Once the new vendor has been approved, he or she should be entered into a master
vendor database to which only a select few individuals have authority to enter into and
change. These changes should be made in accordance with written procedures requiring
proper authorization. An independent third party should periodically audit the database to
ensure that the listed vendors are indeed still active and not being used to process fictitious
invoices.
Once the company commences business with the vendor, an appropriate independent person
should approve all purchase orders prior to being processed. In addition, adequate supporting
documentation including an original invoice from the supplier, and a receipt to indicate that the
product was delivered, should be requested and reviewed to support all cash disbursements.
The same person should not be able to both request and approve purchase orders.
Likewise, only designated check signers should be able to disburse payment.
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30.4. New accounts should also be monitored for some time for:
Increases in the amount or frequency of billings;
Variances from budgets or projections;
Discrepancies between the vendor’s prices and those charged by other sources; and
Frequent or sizeable price increases by certain vendors with no explanation.
30.5. Billing Schemes - False Credits, Refunds, Rebates and Kickbacks
These fraudulent disbursement schemes require collusion between an internal employee and
a third party to issue false rebates, discounts or credits. These schemes can occur with
suppliers, as well as customers.
Deterrence and detection begin with the company’s process for issuing and reviewing refunds,
credits, rebates and discounts. Does the credit/refund/rebate process contain sufficient levels
of review by independent supervisory authority? Do cash register employees possess
authority to void their own transactions? Are only selected individuals authorized to offer
rebates/discounts to vendors and customers? Do the appropriate people verify the
rebate/credit transactions or are they merely “rubber stamped”? Is there adequate
segregation of incompatible functions such as approval of vendors, maintaining the vendor
master file, purchasing, processing of payments, and issuing and authorizing disbursements?
Is there an adequate segregation of duties between individuals authorized to process checks
and those in supervisory role? Is access to cash, checks, or purchase orders, shared by
many employees?
30.6. Potential red flags for this scheme include:
Duplicate or multiple large amounts of refunds, credits or rebates, issued just under the review
limit or in round numbers to the same vendor;
Excessive number of “voided” purchase or sales transactions for which no supporting
documentation is found;
Unusual reconciling items or lack of timely resolution of reconciling items;
Large or numerous payments to particular vendors for which there is little or no supporting
documentation or where the documentation contains discrepancies between the payment
information and the back-up documentation;
Supporting documentation that contains anomalies such as invoices from several suppliers
with different names but with the same address or which are signed by the same person or
which return to a post office number; and
Sales contract specifications, purchase orders and invoices that are vague in nature;
30.7. The auditor can employ many of the procedures outlined in the fictitious vendor
discussion above. In addition, the auditor should consider whether to:
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Review outgoing credits and rebates to ensure that such payments are made in accordance
with company rules and that any discount terms are accurately recorded;
Review and question supporting documentation for voided or refunded sales transactions;
Determine whether certain vendors are receiving preferential treatment with respect to credits
and rebates; and
Inquire of personnel in the purchasing and cash departments whether they are aware of any
vendors who maintain any sort of relationship with other personnel in the company.
Finally, as a note, whether searching for red flags or trying to actually detect the existence of
this scheme, the auditor must always be cognizant of the existence of related parties whom
the perpetrator may be using to commit this scheme.
30.8. Billing Schemes - Over Billing
An over billing scheme also involves collusion between an employee and third party. These
generally involve extra illegitimate charges to a legitimate business expense or trade payable.
This scheme is similar to false credits schemes and shares the same indicators. The auditor
should be particularly wary of invoices carrying “extra” or “special” charges as well as
discrepancies between the purchase order and invoice amount.
30.9. Billing Schemes - Pay and Return Scheme
Pay and return schemes involve employee perpetrators, who improperly pay a vendor or pay
an invoice twice. The employee calls the vendor and requests return of the improperly issued
or duplicate check. The employee then intercepts and converts the incoming check to his own
use. This scheme is similar to unrecorded sales schemes and can be deterred and detected
by techniques discussed in that section above.
30.10. Fraudulent Disbursements – Theft of Company Cheques
Cash larceny occurs when the perpetrator steals currency from the company. The theft can be
of cash or its equivalent including cheques, CDs etc. Theft of company chequesis a common
and easy way to accomplish cash larceny particularly when there is a clear lack of controls
and segregation of duties in incompatible functions. Another basic but effective control is the
maintenance of pre-numbered cheques. Thus, any check out of sequence will be easy to
identify and investigated immediately.
30.11. In addition to the risks identified throughout this section, the auditor should be aware of
the following factors that may facilitate the perpetration of this scheme:
Lack of adequate physical safeguarding of cash or incoming cheques;
Excessive amounts of voided cheques;
Numerous cheques payable to employees other than regular payroll cheques;
Excessive soft expenses (advertising, legal consulting etc.) or unexpected trends in expenses;
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and
Cheques payable to “cash” or “bearer.”
30.12. Once the auditor has detected the possible existence of this scheme, there are various
procedures he or she can perform to confirm this possibility. The starting point should be to
review bank accounts established by company to ensure that they have been properly
authorized and that only authorized personnel are drawing on them. Concurrent with such
review, the auditor should also ensure that the company is maintaining policies and
procedures which ensure that access to cash and bank accounts is maintained by select
authorized employees and further that all assets including company cheques are adequately
safeguarded and that access is restricted to a few select employees. The next step should be
to perform reconciliations of various accounts looking for shortages or overages and reviewing
bank reconciliations for old outstanding cheques that have not been followed up on. Other
potentially helpful procedures include selecting sample cheques for review of various potential
indicators including:
Evidence of alterations or other tampering;
Reviewing the endorsements to ensure that endorsements have been made by proper parties
and cheques are deposited into authorized bank accounts; and
Reviewing endorsements for evidence of forgery, altered terms or other forms of tampering
30.13. Finally, if a perpetrator is going to steal cheques he will likely write them to either
himself or to entities or individuals related to him or herself. Thus, the auditor should look for
cheques with payments to “cash”, “bearer”, or unknown vendors. Similarly, the auditor should
review the list of vendors for shell companies or for companies with no apparent business
purpose to determine if the vendor is linked to employees in any manner. In this regard, any
payments of excessive “soft” expenses to such vendors might be made with stolen cheques.
The auditor should also review bank deposits to ensure that that the control total of cheques
received matches the cheques withdrawn.
31. Payroll Fraud
Fewer and fewer companies pay employees in cash and many hire third parties to process
payroll. Ironically, while these changes have simplified the processing of payroll, they also
have increased the risk of payroll fraud.
Payroll fraud schemes generally occur in two major forms: the creation of fictitious employees
and the padding of hours to cheat on time cards. Other payroll frauds include inflated overtime
claims, the use of incorrect hourly rates, and overpayment of expenses or underpayment of
deductions.
These schemes have different indicators and different means by which they are perpetrated.
The intent of both is essentially the same; to defraud the corporation and steal from it.
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31.1. Payroll Fraud - Ghost Employees

Ghost employee schemes involve payments to fictitious employees. Computerized payrolls,
absent adequate controls are highly vulnerable to these schemes, as the computer does not
know whether the employee is real or fictitious. A related scheme is to simply not remove
former employees from the payroll.
Segregation of the duties of hiring, payroll processing and disbursement is essential to
mitigating this risk. This helps to ensure that those in charge of processing employees into the
payroll system do not get involved in disbursing cheques to fictitious employees they have
created. Other significant controls include adequate procedures governing the hiring and firing
process, and controls to ensure that new hires are adequately screened and that rigorous
background checks are performed on them. Once entered into the payroll system, there must
be checks and audits to ensure that the payroll, or individual records on it, cannot generate
more than one payment for each period. Additionally, there should be checks to ensure that
all payroll data is entered promptly, accurately and only once and in the proper accounting
period. Finally, all employees who have been terminated or have otherwise left the firm
should be promptly removed from the payroll system.
31.2. Procedures the auditor can perform to try to detect this scheme include:
Comparing a list of current and former employees to the current payroll list to search for and
verify additions to payroll;
Matching master information from the payroll file with the organization’s personnel file to
determine whether there are "ghost" employees on the payroll;
Comparing suspected employee’s social security numbers against list of valid numbers and
test for duplicate employees on the entire payroll file (appending or joining payroll files if
necessary.);
Reviewing direct deposit account numbers to look for duplicate deposits;
Randomly selecting employees and trace hours worked to time sheet (to ensure that all hours
are approved by supervisor for hourly employees) and obtain employee file to ensure all
proper documentation validating hiring of the employee is in place;
Ensuring that changes to payroll are adequately documented and supported;
Comparing the payroll file at two dates (i.e., beginning and end of a month) to determine
whether recorded starters and leavers (hires and terminations) are as expected and if any
employees have received unusually large salary increases;
Ensuring each employee's salary is between the minimum and maximum for his/her position or
grade; and
Comparing holidays and sick leave taken to the limits for a particular grade or position and if
there is a high rate of absenteeism for sickness analysing by department to identify problem
areas
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31.3. Payroll Fraud - Falsified Hours

Cheating on hours worked is a very easy way to steal from an employer, as it is very difficult
to validate the hours an employee spends on a given assignment. To guard against this
practice, an employer must establish strong internal controls that encompass some or all of
the following procedures:
Maintain checks to ensure that all payroll data is entered promptly, accurately and only once
and in the proper accounting period;
Require that all sales commission claims be made in writing;
Ensure that all claims are checked to vouchers and any other supporting documentation prior
to authorisation;
Establish procedures to check claims to ensure that the correct reimbursement rates have
been used;
Establish procedures to ensure that all alterations to claim forms are countersigned; and
Establish procedures to ensure that signatures of authorised counter-signatories are checked
before payment is made.
31.4. The auditor in turn can attempt to detect this by:
Reconciling time cards/sheets (with approved supervisor signature and employee signature) to
pay cheque; and
Recalculating commissions by testing sales invoices, back to sales orders, shipper, and
customer receipt.
32. Sham Related Party Transactions
32.1. Sham related party transactions are transactions between related parties, where either
little or no consideration is given for the product or service. The existence of related party
transactions does not meet that there be persuasive evidence of an arm’s length arrangement.
Sales transactions should stem from express or implied contracts and represent exchanges
between independent parties at arm’s-length prices and terms. Accordingly, arms-length
transactions cannot be achieved in those situations, where the parties are related or where
one party can exercise substantial control over the other.
32.2. Related party transactions carry the presumption that one or both parties have received
a benefit that they would not have otherwise received had the transactions been truly arm’s
length.
Transactions between related parties are often difficult to audit, as these transactions are not
always accounted for in a manner that communicates their substance and effect with
transparency. The possibility of collusion always exists, given that the parties arerelated.
Internal controls, moreover, might not identify the transactions as involving related parties.
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32.3. An auditor may encounter related parties that are known by some members of the
company; however, the relationships are not properly disclosed in the books and records. The
auditor should inquire as to outside business interests and then try to determine whether they
are properly disclosed, and the volume of transactions, if any, that are occurring between the
entities.
Auditors should also focus on the relationship and identity of the other party to the transaction
and whether the transaction emphasizes form over substance. Common indicators of such
related party, sham transactions include but are not limited to:
Borrowing or lending on an interest-free basis or at a rate of interest significantly above or
below market rates;
Selling real estate at prices that differ significantly from appraised value;
Exchanging property for similar property in a non-monetary transaction;
Loans with no scheduled terms for when or how the funds will be repaid.
Loans with accruing interest differing significantly from market rates;
Loans to parties lacking the capacity to repay;
Loans advanced for valid business purpose and later written off as uncollectible;
Non-recourse loans to shareholders;
Agreements requiring one party to pay the expenses on the other’s behalf;
Round tripping sales arrangements (seller has concurrent obligation to purchase from the
buyer);
Business arrangements, where the entity pays or receives payments of amounts at other than
market values;
Failure to adequately disclose the nature and amounts of related party relationships and
transactions as required by Accounting Standards;
Consulting arrangements with directors, officers or other members of management;
Land sales and other transactions with buyers of marginal credit risk;
Monies transferred to or from the company from a related party for goods or services that were
never rendered;
Goods purchased or sent to another party at less than cost;
Material receivables or payables from to or from related parties such as officers, directors and
other employees;
Discovery of a previously undisclosed related party;
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Large, unusual transactions with one or a few other parties on or at period end; and
Sales to high-risk jurisdictions or jurisdictions where the entity would not be expected to
conduct business.
If related party transactions are detected or suspected, the auditor should consider further
inquiry, including:
Conducting public records searches/background investigations on customers, suppliers and
other individuals to identify related parties and confirm legitimacy of business;
Performing data mining to determine whether transactions appear on computerized files;
Performing document review of identified transactions to obtain additional information for
further inquiry;
Searching for unusual or complex transactions occurring close to the end of a reporting
period;
Searching for significant bank accounting or operations for which there is no apparent
business purpose;
Reviewing the nature and extent of business transacted with major suppliers, customers,
borrowers and lenders to look for previously undisclosed relationships;
Reviewing confirmations of loans receivable and payable for indications of guarantees;
Performing alternative procedures if confirmations are not returned or returned with material
exceptions;
Reviewing material cash disbursements, advances and investments to determine if the
company is funding a related entity;
Testing related party sales to supporting documentation (i.e., contract and sales order) to
ensure appropriately recorded;
Discussing with counsel, prior auditors and other service providers the extent of their
knowledge of parties to material transactions; and
Inquiring about side agreements with related parties for right of return or contract cancellation
without recourse
33. How to detect premature Revenue Recognition
33.1. Technique used to detect premature revenue recognition are textbook audit procedures.
The trick is to apply the proper degree of professional skepticism in interpreting the results. A
lack of diligence in employing reasonable and necessary techniques like the ones described
below can easily lead to an audit failure.
33.2. If one employee processes the same transaction from beginning to end, premature
revenue recognition is easier to accomplish. Adequate internal controls involve the following
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segregation of duties: order entry, shipping, billing, accounts receivable detail and general
ledger. Even adequate internal controls can be overridden by management, so be alert to the
indicators that controls are not being followed. If sales or shipping invoices are out of a
numerical sequence, check to see if the documentation has been hidden.
33.3. In premature revenue recognition cases, goods are often billed before they are actually
shipped, so quantities of goods shipped will not reconcile to the goods billed. Check the
reconciliations for accuracy. Select a sample of sales transactions from the sales journal,
obtain the supporting documents and:
(a) Inspect the sales order for approved credit terms.
(b) Compare the details among sales orders, shipping documents and sales invoices for
inconsistencies.
(c) Compare the prices on sales invoices against published prices.
(d) Re-compute the extensions on sales invoices.
33.4. When merchandise is shipped early, the shipping costs near the end of the accounting
period could be higher. Compare shipping costs to previous periods for reasonableness.
Moreover, conduct a standard cut-off test by selecting invoices from the end of the previous
period and those from the beginning of the next period. Examine the invoices to make sure
they are recorded in the proper period. When in doubt, verify major sales through
confirmations or by telephone. Look for discrepancies in sales records.
By recording expenses belatedly, a company can fraudulently inflate its net income. (A
variation of this technique is failing to record returns and allowances in the proper period).
33.5. Most frequently, accounts payable personnel are told to hold all unpaid bills until the
beginning of the next accounting period. Often, the unpaid invoices are simply secreted in a
desk or filing cabinet, out of sight of the auditors. Ask those responsible for recording liabilities
whether they have been instructed to hide unpaid bills. Document the inquiry in your
workpapers.
34. Remember the Motive
34.1. To determine how much pressure is on management to show high levels of earnings,
find out whether the company is attempting to raise additional funds through stock issues or
borrowings. If these risk factors or similar others are present, recognize this reality.
Companies can and do significantly influence income, expense and profits by manipulating the
cut-off time. As an auditor, considering this fact as a part of the risk equation will help keep
you from being fooled by fake cut-offs.
34.2. Ask the Right Questions
34.2.1. A third lesson is specific to auditors of manufacturing, wholesale and retail firms—
those with a loading dock. Every inventory item eventually finds its way to the loading dock,
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either coming or going. As a result, key shipping and receiving personnel know if financial
shenanigans are occurring in inventory. For example, the warehouse becoming too full of
junked merchandise and that off-site storage had to be rented. The loading dock employees
knew shipping documents had been backdated and that consignment merchandise had been
counted as sales.
In a thorough audit involving inventory, the auditor should ensure that he or she spends
enough time on the loading dock. In addition to the normal audit steps, the auditor should
make diligent inquiries. Asking tough questions is not hard if you do it right. Here is an
example: “Mr. Warehouseman, as you know, part of my job as an auditor is to detect fraud. As
a result, I will need to ask you and other people I talk to some specific questions about fraud
and abuse. Do you understand?”
When you have broken the ice, ask the following:
Has anyone in the company ever asked someone on the loading dock to misstate the amount
of merchandise the company ships or receives?
Are you aware of anyone in the company asking someone on the loading dock to destroy,
conceal, backdate or postdate documents?
Has anyone in the company asked you to do anything else you thought was illegal or unethical
with respect to your job?
If you receive answers that make you pause, assess the risk of material financial statement
fraud in light of other relevant information. Don’t be reluctant to ask penetrating (but non-
accusatory) questions. You may be surprised at what people will tell you and the mere fact
that employees understand that auditors are looking for fraud can be a significant deterrent.
35. The Acid Test
Nonetheless, before the auditor signs off on the engagement, he or she should use an acid
test to evaluate the analytical review, reflecting on this question: If management was
attempting to conceal a material financial statement fraud, where would it show up? By
thinking of fraud as a “worst-case” scenario, you will find your focus quickly sharpen and the
degree of your professional skepticism should rise.
The auditor who uses these techniques will find they can pay big dividends. Any legitimate
client will appreciate your anti-fraud efforts. After all, fraud costs money. And if a client resists
or restricts your efforts to detect and deter fraud, that should raise a big red flag.
36. Opportunities
The following opportunities may result into financial statements frauds:
(a) Absence of oversight by the Board of Directors or by Audit Committee;
(b) Weak or non-existent Internal Control methods;
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(c) Where financial statements require significant judgement;

(d) Significant related party transactions;
(e) Highly complex transactions and also complex organisational structure.
37. Detecting Financial Statement Frauds:
37.1 Looking back at Enron, perhaps the company best known for committing accounting
fraud, one can see the different methods that were utilized so as to fraudulently improve the
appearance of its financial statements. Through the use of off balance sheet, the firm
continued to hide its liabilities and inflate its earnings.
37.2. In 1999, limited partnerships were created for the purpose of purchasing Enron shares,
as a mean of improving performance of its stock. That year, the company returned 56% to its
shareholders, which was followed by another 87% appreciation at the onset of the new
millennium. As Enron's aggressive accounting practices and financial statement manipulation
began to spiral out of control, the scandal was eventually uncovered by the complex
accounting fraud such as that practiced at Enron is usually extremely difficult for the average
retail investor to discover. However, there are some basic red flags that help during the
preliminary stages of the investigation. Despite passage of SOX (Sarbanes-Oxley), financial
statement fraud remains too common an occurrence, often damaging people's retirement and
educational savings.
Being first on the scene to uncover a fraudulent company can be very lucrative from a short
seller's perspective and can be rather beneficial to a skeptical investor, who is weighing in the
overall market sentiments?
38. Financial Statement Fraud Red Flags
38.1. Financial statement red flags provide a general overview of the warning signals investors
should take note of. These red flags do not necessarily indicate an undoubted occurrence of
financial statement fraud, but merely a signal that further in-depth investigation must be
carried out, so as to assess the validity of the corporate documents.
Creditors would find such information useful for ensuring that the loans are not provided to
firms operating with high and increased amount of risk.
38.2. Investors, on the other hand, may want to take note of the following factors to discover
new shorting opportunities. Government regulators, however, aim to catch and punish fraud to
ensure the transparency and reliability of the financial markets.
38.3. Five basic types of financial statement fraud exist:
Fictitious sales (Goods not yet sold, recorded as sales)
Improper expense recognition (meaning that not in accordance with applicable Accounting
Standards)
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Incorrect valuation of Assets (Not charging correct value of depreciation in the revenue
statements)
Hidden Liabilities (Means Liabilities not reflected at their true and fair value), and
Unsuitable or inadequate disclosures in the Financial Statements.
39. Misappropriations
39.1. One of the most serious forms of financial statement fraud is when statements are
altered so as to mask the theft or embezzlement. This can be done in a number of ways, such
as (a) through double-entry bookkeeping or (b) the inclusion of fictitious expenses. In this
case, the fraud is generally committed for purely personal gains, and not through an interest in
altering public perception of the company,
39.2. Another way of financial statement fraud could be in the form of making Assets appear
as more valuable than they actually are. This is done either by adding fictitious assets and
charging lower amount of depreciation. Although the entries in the financial statements may
be true, the appraisals that led to these statements being written are incorrect. For example, if
an oil company deliberately appraises a non-producing well as worth the same as one that
produces oil, and include this valuation on its financial statement, this is a form of fraud.
40. Overstatement of Revenue
One of the most basic forms of financial statement fraud is the overstatement of revenue. In
this form of fraud, a company states that it took in more money in a certain period of time than
was the case. This may be done for several reasons, all related to creating the perception that
the company is worth more than it is.
40.1. Recording Uncertain Sales: Another form of financial statement fraud is to record sales
that have not yet gone through as sales that have already been transacted. This can take
several forms, including sales that are currently being negotiated or sales that are expected
for the next quarter. This form of fraud is closely related to the recording of false revenues.
Like false revenues, this form of fraud is designed to make the company appear more
profitable than is the case.
40.2. Concealment of material facts: Concealment of Material facts, which have bearing on
Financial Statements, is another form of fraud, wherein certain liabilities, expenses or even
other critical disclosures, that could impact the financial results of the company, are not
disclosed in the financial statements. For example, if the company took on a number of
liabilities, such as by taking out a loan or issuing debt, this will generally need to be recorded.
By keeping such disclosures off the financial statements, the company looks in better financial
shape, than is the case.
41. How to prevent financial statements frauds
41.1. A long time trusted employee has confessed having misappropriated company funds.
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Unfortunately, business owners are often engrossed in managing employees, customer

service and putting out daily fires that a majority of the financial responsibilities are entrusted
to someone else. However, once an entrepreneur has become the victim of fraud, he searches
for answers to prevent the situation in the future. A strong system of internal controls helps
companies deter employees from committing fraud. Following are the some steps that need to
be taken in the matter:
Step 1
41.2. Educating the Management about different indicators of fraud. According to the
Association of Certified Fraud Examiners, financial statement fraud involves intentional
publishing of false information in any portion of a financial statement.
To prevent fraudulent activities, management must implement internal controls, or structure,
and know what situations to look for.
Individuals commit fraud when (i) under situational or financial pressure, (ii) when the
opportunity to commit fraud is present and (iii) when the perpetrator easily rationalizes the
fraudulent activity.
Step 2
41.3. Segregation of accounting functions:
One of the main factors of an effective internal control system is Segregation of Duties. The
opportunity to commit fraud, is reduced when accounting functions are separated. The act of
segregating duties separates the recordkeeping, authorization and review functions in the
accounting process.
To segregate duties, involve more than one person in the financial statement preparation
process. Therefore, for fraud to occur two employees must collude to perpetrate the crime.
Step 3
41.4. Establish a strong control environment:
Establishing a strong control environment, also known as a strong tone at the top, involves
enlisting management to demonstrate ethical behaviour. It may be noted that whatever tone
management sets, will have a trickle-down effect at the bottom level. A strong tone is
developed by establishing and complying with a written set of policies and procedures. The
policies must be concise and must include consequences when procedures are disobeyed. In
addition, one of the easiest ways to establish a strong moral tone for an organization is to hire
morally sound employees.
Step 4
41.5. Initiate Annual examinations of Financial Statements:
41.5.1. Annual audit of the financial statements by an external and independent party. In many
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cases, management is the party to the frauds. Management may feel pressure to meet
financial goals for the company or may receive incentives, if certain goals are achieved.
41.5.2. To help prevent management from engaging in adjustments to the financial
statements, it is desirable to engage an independent party to examine financial statements on
an annual basis. Engaging an auditor to perform a financial statement review or audit, deters
employees from knowingly presenting incorrect financial statements.
Effectively spotting these fraudulent disclosures involves keeping an open eye for the most
common financial statement fraud red flags:
An eye on the accounting anomalies, for example growing revenues not supported by
corresponding growth in cash flows.
Sales are much easier to manipulate than cash flow, but the two should move more or less in
tandem over time.
Reporting of consistent growth in sales, whereas other established competitors are
experiencing periods of weak performance. This situation should work as eye opener to the
Management. However, actual reasons need to be looked into, whether the consistent growth
in the sales is on account of high quality of products manufactured by the company supported
with efficient after sales service. In such as a situation, this is called as growth due to efficient
business operations rather than any fraudulent activity.
A rapid but unexplainable rise in the number of day's sales in receivables in addition to
growing inventories. This suggests rise in obsolete goods for which the firm has been
recording fictitious future sales.
A significant surge in the company's performance within the final reporting period of fiscal
year. The company may be under immense pressure to meet analysts' expectations.
The company maintains consistent gross profit margins, while its industry is facing pricing
pressure. This can potentially indicate failure to recognize expenses or aggressive revenue
recognition.
A large build-up of fixed assets: An unexpected accumulation of fixed assets can flag the
usage of operating expense capitalization, rather than expense recognition.
Depreciation methods and estimates of assets' useful life that do not correspond with the
industry standards. An overstated life of an asset will decrease the annual depreciation
expense.
A weak system of internal control. Strong corporate governance and internal controls
processes minimize the likelihood that financial statement fraud will go unnoticed.
Outsized frequency of complex related-party or third-party transactions, many of which do not
add to any tangible value.
The firm is on the brink of breaching their debt covenants. To avoid technical default,
management may be forced to fraudulently adjust its leverage ratios.
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The auditor was replaced, resulting in a missed accounting period. Auditor replacement can
signal a dysfunctional relationship while missed accounting period provides extra time to "fix"
financials.
A disproportionate amount of managements' compensation is derived from bonuses based on
short term targets. This provides incentive to commit fraud.
42. Financial Statement Fraud Detection Methods
42.1. Spotting red flags could be extremely challenging, as corporates engaged in the
fraudulent activities, would make all possible attempts to portray good image about the
financial stability and normal business operations.
42.2. Vertical and horizontal financial statement analysis introduces a straight-forward
approach to fraud detection. Vertical analysis involves taking every item in the income
statement, as a percentage of revenue and comparing the year-over-year (YoY) trends that
could be a potential flag cause of concern. A similar approach can also be applied to the
balance sheet, using total assets as the comparison benchmark, to monitor significant
deviations from normal activity. Horizontal analysis also implements a similar approach,
whereby financial information is represented as a percentage of the base years' figures.
Likewise, unexplainable variations in percentages can serve as a red flag requiring further
analysis.
42.3. Comparative ratio analysis also allows analysts and auditors to spot discrepancies within
the firm's financial statements. By analysing ratios, information regarding day's sales in
receivables, leverage multiples and other vital metrics could be determined and analysed for
any inconsistencies.
42.4. A mathematical approach, evaluates certain ratios to determine the likelihood of
earnings manipulation. Asset quality, depreciation, gross margin, leverage and other variables
are factored into the analysis.
42.5. Similar to most other ratio-related strategies, the full picture can only be accurately
portrayed once the multiples are compared to with the industry standards and also with
specific firm's historical average.
Having proper knowledge of the red flags so as to avoid companies indulging into
unscrupulous accounting practices is a useful tool to ensure safety of your investments.
42.6. Other measures or steps to be taken are 10 considerations for detecting or preventing
fraudulent financial reporting:
1. Developing a right culture at the top or senior management level: (i.e., tone up at the
top). Probably the most important deterrent to financial fraud is that senior management
creates a culture in the business that send a message amongst all employees that any
kind of dishonesty will not be tolerated. Top Management need to go on record that they
expect to work be carried out in an ethical environment and expect employees to
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conduct themselves in an ethical manner.

2. Establish and promote an effective whistle-blower program. Providing the ability for
employees to anonymously report questionable practices, which could lead to
uncovering frauds before it affects financial reporting systems. Having an effective
whistle-blower program in place can deter fraud before it starts.
3. Questioning financial results that are always on target. No business is immune to
market forces and fluctuations, and those fluctuations should be reflected in financial
results. If the numbers are always on target, it may mean the financial information is
being manipulated.
4. Questioning when there are changes in auditor. All of the changes happened in either
the year of the fraudulent reporting or in the year just prior.
5. Have skeptics on the Board of Directors. Having a Board of Directors and specifically
members of the Audit Committee, who have knowledge about the business and the
sector and willing to question when things seem outside the norms, could be a
significant deterrent to fraudulent financial reporting.
6. Raising question when there are extraordinary or complex transactions, especially
question extraordinary transactions, either positive or negative, that offset results from
operations. One significant gain that would offset a bad year of results may be used to
improve the bottom line.
7. Analysing Accounts Receivables, more particularly, to unearth any instance of revenue
manipulation, a common form of financial fraud, will often affect receivable balances.
Investigation of outlier activity in receivables, basis for uncollectible accounts, and
receivable statistics in comparison to industry standards could help in identification of
potential financial reporting problems.
8. Again raising questions when cash flows do not match the growth in the revenue. Again
because revenue manipulation is among the most common forms of financial fraud,
management should be able to justify if a revenue increase is not accompanied by a
corresponding increase in cash flow.
9. Analysing major swings in the assets or liabilities. Manipulation of revenues or
expenses normally involve unexplained swings in the assets and liability balances.
There should always be a logical explanation for significant changes in balance sheet
accounts.
10. Continue to educate yourself and urge others to do the same. Accountants,
management, employees, investors, and directors need knowledge to combat
fraudulent financial reporting. By knowing the “red flags” of fraud and understanding the
difference between aggressive but acceptable accounting and abusive and prohibited
accounting, individuals can stop fraud before a company and its stakeholders are
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harmed by fraudulent financial information.

43. Magnitude of Fraud Losses:
43.1. Every organisation, whether large or small, is, in general prone to frauds. On a number
of occasions over the past few decades, major public companies have experienced financial
reporting frauds, resulting into turmoil in the capital markets, loss of shareholders value, and,
in some cases, even the bankruptcy of the company itself. Although, it is generally accepted
that the Sarbanes-Oxley Act (SOX) has improved corporate governance and decreased the
incidence of frauds, recent studies and surveys indicate that investors and management
continue to have concerns about financial statement frauds.
44. Consequences of Fraudulent Reporting
44.1. Fraudulent financial reporting could have significant consequences for the organisation,
investors and its other stakeholders, it as well as badly impacts the public confidence in the
capital markets and financial reporting process. They tend to lose their faith in the accounting
and auditing system.
44.2. Periodic high-profile cases of fraudulent financial reporting also raises concerns about
the credibility of the financial reporting process and calls for several questions about the roles
of management, their integrity, auditors, regulators, and analysts, among others. Moreover,
corporate fraud impacts organisations in several areas viz., financial, operational and
psychological. While the monetary loss owing to fraud is significant, the full impact of fraud on
an organisation could be staggering. In fact, the loss of reputation and customer relations
could have devastating effects.
44.3. When there are instances of fraudulent financial reporting, they give rise to serious
consequences. The resultant damage could be severe and widespread, with a sometimes
devastating “ripple” effect. Those affected may range from the “immediate” victims (the
company’s investors and other stake holders) to the more “remote” (those harmed when
investor confidence in the stock market is shaken). Between these two extremes, many others
may be affected: “employees” who suffer job loss or diminished pension fund value;
“depositors” in financial institutions; the company’s “underwriters, auditors, attorneys, and
insurers”; and even honest “competitors”, whose reputations suffer for their association with
the company or enterprise.
44.4. As frauds could be perpetrated by an employee (within the organisation) or by those
from the outside, therefore, it is important to establish and have an effective “fraud
management” programme in place to safeguard the assets and image of the organisation.
Thus, the process of prevention and quicker detection of fraudulent financial reporting, must
start with the entity that prepares financial reports.
44.5. Given the current state of the economy and recent corporate scandals, fraud is still a
topmost concern for corporate executives. In fact, the sweeping regulations of Sarbanes-
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Oxley, designed to help prevent and detect corporate frauds, have exposed fraudulent
practices that have gone undetected in the past. Additionally, more corporate executives are
paying fines and serving prison time than ever before. No industry is immune from frauds and
the negative publicity, which swirls around them. The implications for management are clear:
every organisation is vulnerable to fraud, and managers must know how to detect it, or at
least, when to suspect it.
44.6. Methods for detection of Financial Frauds mainly rely on financial statistics, although
recent research suggest that even linguistic or vocal cues may also be useful indicators of
deception. Tools developed based on financial numbers, linguistic behaviour, and non-verbal
vocal cues have demonstrated the potential for detecting financial frauds. However, the quality
of performance of such tools is considered to be poorer than expected and thereby limiting
their use on a stand-alone basis to help identify companies for further investigation.
Financial Statement frauds have become quite rampant in the current times, when a number
of financial frauds have been unearthed and reported. These financial frauds run into millions
of rupees and have revealed complete absence of surveillance and disregards to the financial
controls and applicable accounting standards. These frauds have been perpetrated mainly by
the key managerial persons for achieving certain financial benefits.
45. Effects of the Financial Statement Frauds
(i) It reduces the reliability, quality, transparency and integrity of the Financial Reporting
Process;
(ii) Jeopardises the integrity and reliability of the auditing profession and erodes public
confidence in the accounting and auditing profession;
(iii) Reduces Investors’ confidence in the Capital Markets and makes Capital Markets less
efficient;
(iv) It adversely effects Nations economic growth and prosperity;
(v) Raises serious doubts about the financial statement audit;
(v) Destroys career of the employees involved in the financial statement frauds;
(vi) Causes bankruptcy or substantial economic losses to the company involved in the
financial statement frauds
46. Auditor Responsibilities
46.1. Normally, the risk of not detecting material misstatements due to fraud is higher than not
detecting misstatements due to error. This may occur because perpetrators of fraud might
have used carefully designed methods of forgery, transactions recording, and misstatements.
In addition, several persons may collude to conceal the fraud. The risk of management fraud
not being detected is usually greater than employee fraud, because management has a
greater opportunity to override internal controls and manipulate accounting information.
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46.2. Developing sense of a Professional Skepticism

46.2.1.“Skepticism refers to an attitude of raising questions, when there are reasons to doubt
and also being alert to conditions that might indicate possible misstatement due to frauds or
errors, and making critical assessment of audit evidences.”
46.2.2. Risk of material misstatement at the financial statement and assertion levels will affect
the degree of the auditor’s professional skepticism. While an auditor will always maintain
professional skepticism, higher assessed levels of risk of material misstatement should result
into higher levels of professional skepticism. For example, when risk of material misstatement
is high, an auditor should request supporting documentation to corroborate management’s
responses to inquiries.
46.3. Engaging in Team Discussion
In the engagement team’s planning and brainstorming meeting, the engagement leader (e.g.,
partner, sole proprietor or practitioner) should facilitate a discussion about possible
misrepresentation in the financial statements and misappropriation of assets. The engagement
team should hold this discussion by disregarding beliefs and knowledge of the honesty and
integrity of entity management and employees. Particularly for recurring audits, familiarity with
the honesty and integrity of reporting entity personnel may inadvertently lead to a decrease in
an auditor’s professional skepticism. Compliance with the specific requirements of this
statement, paired with audit firm’s quality control system, will provide safeguards to prevent
this possibility.
46.3.1. Some of the matters the engagement team should discuss at meetings include:
All internal and external factors that could be part of the “fraud triangle”:
Incentives and pressures to commit fraud.
Opportunities to perpetrate fraud.
Rationalizations for committing fraud.
Possibilities and risk of management override of controls.
Circumstances that might cause management to manage, manipulate, or misstate financial
information.
How professional skepticism should be maintained during the audit and how team members
should respond to assessed levels of risk of material misstatement.
46.3.2. Auditors should follow up fraud indicators by looking for:
Transactions lacking all required supporting documentation;
Numerous disbursements approved by one particular employee to a particular vendor which
are just below the employee’s spending authority or which are for large even amounts or
which are made on unusual dates such as weekends and holidays;
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Invoices which do not match with the original purchase order and if applicable the original
sales contract;
Multiple payments to the same vendors in the same period by the same employee usually
under the employee’s spending limit;
Excessive “soft expenses” such as consulting fees, sales commissions, and advertising where
there are no tangible products attached to the payable, paid to the same vendor by the same
or few employees;
Checks made to “cash” or “bearer” for alleged services or products received;
Suspect endorsements on checks; and
Checks with more than one endorsement, checks payable to businesses or individuals that
were cashed and not deposited and checks endorsed by individuals.
46.3.3. Computer assisted auditing programs are available for many of these indicators.
The auditor should compare the master vendor database against the prior year’s database.
The auditor should inquire into the selection and approval process of new vendors. Further,
the auditor should match the checks issued against the master vendor database, and
investigate any payments to vendors who are not in the master database.
47. Forensic Auditing Techniques
The auditor should perform the following techniques, when investigating revenue recognition
allegations:
Inquire of management and other relevant personnel about the factors which have led the
auditor to believe the scheme exists;
Perform substantive analytics designed to detect the fraud being investigated; and
Perform substantive testing to determine whether there is some evidence to support the
existence of such a scheme or lack of evidence to support the validity of a transaction. Such
substantive procedures include but are not limited to:
Request and review documents such as contracts and support for invoices and deliveries;
Confirmation with customers to the existence of accounts receivable and the amount of
consigned goods;
Possible public records/background research/site visits conducted on customers/third parties
to verify existence of the entity being billed;
Analyzing journal entry activity and supporting documentation in certain accounts, focusing on
round dollar entries at the end of periods;
If entries are accruals, obtaining support for the reversal and confirming the proper timing of
the entries.
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The following general indicators can often alert the auditor or auditor as to the potential
existence of premature revenue recognition:
Unexplained change in recognition policies;
Unexplained improvements in gross margin;
Increasing sales with no corresponding increase in cash from operations;
Reported sales, revenue or accounts receivable balances which appear to be to high or are
increasing too fast;
Reported sales discount, sales returns or bad debts expenses which appear to be too low;
Large, numerous or unusual sales transactions occurring shortly before the end of the period;
Large amounts of returns or credits after the close of a period; or
Inconsistent business activity –
Increased revenues with no corresponding increase in distribution costs or
Increased revenues with no offsetting increase in accounts receivable.
The use of analytics should also not be overlooked as a means of detecting frauds. Analytical
procedures and relationships the auditor can perform or review to determine whether revenue
is being recognized prematurely include:
Comparing current period financial statement amounts with amounts with those from prior
periods and inquiring as to significant changes, in accounts between periods, if there are
significant changes;
Reviewing balances in revenue related accounts for any unusual changes;
Calculating the percent of sales and receivables to the total balance sheet in the current
period, comparing it with prior periods and inquiring of any unusual changes;
Reviewing the statement of cash flows to determine if cash collected is in proportion to
reported revenues;
Reviewing sales activity for the period and take note of any unusual trends or increases such
as increases towards the end of the period;
Significant or unusual or unexplained changes in the following ratios:
Increases in Net Profit Margin (Net Income/Total Sales);
Increases in Gross Profit Margin (Gross Profit/Net Sales);
Increases in the Current Ratio (Current Assets/Current Liabilities);
Increases in the Quick ratio (Cash and Receivables and Marketable Securities/Current
Liabilities);
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Increases in the Accounts Receivable Turnover (Net Sales/A/R);

Increases to Days Sales Outstanding (A/R Turnover/365);
Increases in Sales Return Percentages (Sales Returns/Total Sales);
Increase in Asset Turnover (Total Sales/Average Total Assets);
Increases in Working Capital Turnover (Sales/Average Working Capital);
Decrease in A/R Allowance as a % of A/R (Allowance/Total A/R); and
Decreases in the bad debt expense or allowance accounts.
47.1. Of course, good interviewing and sound analytics will not substitute for having a good
understanding of the client’s business. Even seasoned auditors have been misled and thought
revenue to be appropriate, because they did not fully understand the business. Thus, after all
the analytics and interviews, the auditor must ask him or herself whether the information and
results obtained make sense in light of the client’s industry and business. The auditor should
also, to the extent applicable, benchmark performance results against other companies in the
same industry.
47.2. The auditor should also make broad inquiries of non-financial personnel such as:
Shipping department personnel:
Were shipments earlier than normal for customers?
Is inventory stored in the warehouse documented as shipped?
Was there inventory shipped to addresses other than customer sites?
Were there any adjustments to shipping dates?
Whether there exists consigned goods and their location.
Sales force personnel:
Are shipments of any products designed to arrive ahead of the customer’s required delivery
date?
Do sales personnel pick up product and deliver to customers?
Are there sales personnel with excessive “samples”?
Do sales personnel have free reign in access to the warehouse?
Warehouse personnel:
Are there any misstatements in the amount of merchandise the company ships or receives?
Has there been destruction, concealment, predating, or postdating of shipping and/or
inventory documents?
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Has there been an acceleration of shipments prior to month or year-end?

Have there been shipments to a temporary or holding warehouses prior to final shipment to
the customers’ premises?
Are there any other unusual, questionable, or improper practices?
47.3. Additional audit procedures include:
Comparing the purchase order date with the shipment date;
Determine whether sales personnel are paid commissions based on the sale of product or
upon collection;
Inquiring of outside related business interests of key/sales personnel that may be suspected in
an improper revenue recognition scheme;
Performing public records searches on certain entities and individuals;
Determining whether shipments have been made to these outside business interests;
Reviewing amounts and trends of shipping costs at or near the end of a period even to
legitimate customers;
Reviewing rate of returns;
Inspecting shipping documents for missing, altered or incorrect information; and
Reviewing customer complaint logs or e-mail correspondence for complaints of shipments of
goods prior to the customer’s readiness to accept.
48. Fraud Risk Assessment Procedures
48.1. Discussions with management and others included in the auditor’s risk assessment
procedures may include:
Management’s internal control risk assessment and monitoring processes.
Management’s communication with persons charged with governance regarding risk
assessment, monitoring, and any planned corrective actions.
Management’s communication of business practices and ethical behaviour to employees.
Management’s and persons-charged-with-governance's knowledge of alleged, suspected or
actual fraud.
Persons-charged-with-governance's oversight of management’s processes and internal
controls for identifying and responding the risks of fraud.
Results of the auditor’s analytical procedures and any unusual or unexpected relationships
that may be indicative of fraud.
49. Third Party Fraud?
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49.1. This is a fraud committed by people outside an employee employer relationship. They
can be committed against individuals, businesses, companies, the government or any other
entity. Third party frauds are not as common as occupational frauds, but on average each
fraud is for a larger amount.
49.2. Some third party frauds are not meant to remain hidden forever. Some only remain
hidden long enough for the fraudster to make their get-away. The fraudster may not care if the
fraud is eventually discovered as they do not have a continuing relationship with the victim and
they cannot be found.
50. Lessons to be learnt
50.1. The role of auditing was created so that an independent person could look behind the
reality of the financial statements and discover, whether they were accurate. While this is not
an exact science and the cost of an audit could be huge. As costs constraints make test
sample sizes smaller, the chances that mis-statements would slip through the examination
increases.
50.2. Financial statement frauds are committed within the business, not on the business. The
best way of preventing or detecting these frauds is a strong internal and independent audit
function. Internal and independent can seem contradictory, but it is an idea that must become
a reality. Some of these frauds have originated from the pressure to get short term results. If
the consequences of not getting the results are too great, improper or illegal behaviour will
increase. Corporate ideals have a large role to play in deterring these activities, by making
them unnecessary.
50.3. Of all the fraud schemes perpetrated in today’s time, financial statement fraud seems to
get the least air time. That makes no sense, as financial statement fraud happens to be one of
the most costly types of fraud. The problem is that involved parties, both inside and outside
the company, rely on the information provided in the financial statements. They assess the
financial results and make predictions and decisions about the future of the company based
on those results.
50.4. Financial statements are the measuring stick that numerous parties use to assess the
financial health of a company. Falsified financial statements can mean only one thing – those
assessments are faulty.
50.5. Asset misappropriation schemes are easy to understand and recognize. They include
the direct theft of money, inventory, equipment, or other company assets. Most everyone can
relate to the theft of property and money, and the results of such theft are tangible.
But financial statement fraud is an ugly fraud. Its methods are complex and often not
understood by the average consumer or investor. And its results often aren’t tangible to the
average person, unless we’re talking about a famous fraud like Enron.
51. The Perpetrators
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51.1. Financial statement fraud is almost always perpetrated by upper management or

company owners. Executives are entrusted with entire companies. They have access to nearly
all data and employees, and they can exploit this access to commit and fraud and cause the
fraud to be concealed. The power the executive has by virtue of her or his position in the
company is closely linked with the high cost of financial statement fraud. Power and access
within a company make it possible for larger frauds to be committed and covered up.
51.2. The breach of trust when an executive is involved in fraud is huge. How can lower-level
employees be expected to act ethically when those in charge of the company lack ethics of
their own?
51.3. Different types of Frauds, their perpetrators and victims:
Types of Frauds Perpetrator Victim Explanation
1. Employees Employer Employees directly or indirectly
Embezzlements steals.
2. Management Top Stakeholders, Mis-Statement in the financial
Frauds Management Lenders and statements by the Top
others who rely Management.
on Financial
Statements
3. Investment Individuals Investors Investors are deceived and
Scams advised to invest their funds in
fraudulent schemes.
4. Vendors fraud Vendors Buyers Overcharging for goods or no
delivery of the goods which has
been fully paid.
5. Customers Customers Buyer Customers deceive sellers.
fraud Organisation
52. The Methods

52.1. One of the most innocent-sounding terms used to describe financial statement fraud is
“earnings management.” Such a phrase minimizes the seriousness of the crime.
“Management” almost makes it sound like something good.
But earnings management isn’t a noble effort. It is, in fact, financial statement fraud. The
degree and seriousness can vary, but it is fraud nonetheless. It is the purposeful manipulation
of account balances in order to make the financial statements conform to some predetermined
template.
52.2. Especially with public companies, there are expectations related to the financial results,
and executives may alter numbers to conform. Earnings management (financial statement
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fraud) means that management played games with the numbers, shifting revenue or expenses
from one period to the next, or inflating assets or underreporting liabilities.
52.3. In addition to the opportunity to manipulate revenue, expenses, assets and liabilities,
there are other forms of financial statement fraud that are gaining in popularity. Schemes
include the misuse of reserves, often referred to as using reserves as “cookie jars” to shift
income and expenses between periods depending upon the company’s “need” for the financial
statements to fall within certain parameters.
52.4. The misapplication of accounting rules is another opportunity for financial statement
manipulation. Executives may deliberately incorrectly apply accounting rules in a way that
enhances the company’s financial results.
52.5. One of the simplest ways to manipulate financial statements is through the omission of
information. There are rules regarding explanations and disclosures that must accompany
financial statements. Without that additional information, the financial statements themselves
might easily be misinterpreted. Deliberately omitting necessary information from the notes to
the financial statements is a simple, but effective, way to tender misleading financials.
53. The Results
53.1. Financial statement fraud can have an impact on any person or organization that has a
financial interest in the success or failure of a company. A manipulation of the company’s
reported earnings or assets can affect a bank that extends credit to the company, a
shareholder who invests money in the company, and those organizations that enter into
contracts or agreements with the company.
The manipulation of financial statements also affects employees. It has the power to put
employees out of work once the fraud is exposed or collapses. It also has the power to enrich
employees – mostly those involved in the fraud, but potentially those who are not. Good
financial results (actual or fabricated) can be linked to promotions, raises, enhanced benefit
packages, bonuses, and the value of stock option awards.
53.2. Financial statement fraud will cause shareholders to overpay for their investment in the
company and they will get less value for their money than they are aware. They may lose part
or all of their investment if the company ultimately fails or has to go through some sort of
reorganization in order to remain viable. Shareholders also lose the opportunity to invest their
money in other companies which may have better actual financial results or which may be
more honest in their operations.
53.3. Banks lose money, which affects other bank customers who ultimately make up for those
losses and affects the bank’s investors. Creditors can lose large sums of money, which may
not have been risked if the creditors knew the true financial condition of the company.
53.4. If enough financial statement frauds occur, or if the frauds are large enough, there are
wide-reaching effects for other companies. Consider the case of the Sarbanes-Oxley Act of
208
2002. The legislation followed the collapse of some large public companies with executives
who engaged in significant financial statement fraud.
53.5. This legislation attempted to address financial statement fraud and bring more reliability
and transparency to the financial reporting process. Sarbanes-Oxley required companies to
make changes, and it also changed how independent auditors do their work.
53.6. The legislation (SOX) has caused companies to collectively spend billions of dollars on
assessing their processes, engaging consultants to help with the assessments, and enhanced
independent audits. This is an indirect cost of financial statement fraud, but its impact on
companies is direct. It has been very expensive.
53.7. Financial statement fraud often doesn’t have a readily apparent or direct financial impact
on interested parties. But because it is rampant and its indirect costs are so high, it is
important that the users of financial statements be aware of the risk and the impact.
53.8. Regulations may be effective in curbing some of this fraud, but a skeptical eye on the
part of interested parties might be more effective in protecting investors, creditors, and other
business partners from the negative effects of financial statement fraud.
Short Answer Questions on Financial Statement Frauds
Q 1: What does the term “Consideration of Fraud” in a financial statement audit mean?
A: “Consideration of Fraud” in a financial statement audit refers to the specific requirement of
conducting an audit with the view that a “misrepresentation on a financial statement could be
the result of a fraud”. This is also called “professional scepticism”. Every auditor is required to
assume fraud even when an auditor thinks the management is honest and has never engaged
in fraud before.
Q 2: What are some of the indications of a financial statement fraud?
A: Some of the indications of such a fraud includes symptoms such as (a) accounting
anomalies, (b) unusual profit or loss, and (c) inappropriate financial actions by management.
Q 3: What are financial statement fraud cases?
A: Financial statement fraud cases are cases where financial statements are manipulated by
the corporations, brokerage houses or banks to either encourage investors to invest under
false pretences or cheat an account holder out of his money.
Q4: What is financial statement fraud?
A: Financial statement fraud is defined as “misstatement of numbers in financial statement
documents”. Companies compile financial statements to provide the public and other
stakeholders an overview of the revenues and sales. If the figures in the statements are
misleading, this would be considered as a financial statement fraud.
Q 5: Which methods are employed for conducting a financial accounting fraud?
209
A: A financial accounting fraud typically makes use of accounting tricks to depict a financially
stronger position by overstating assets, profits and revenues. At the same time, to increase
the net worth and equity of the company, losses, liabilities and expenses are understated.
Sometimes expenditures are overstated and revenues are understated in order to evade
taxes.
Q 6: Can you name some of the warning signs that might indicate the presence of a
fraud financial statement for the auditors?
A: Many signals indicate the possibility of a financial statement fraud. Prominent among these
are “fragile internal control environment”, “management decisions being dominated by an
individual or small group”, “frequent disputes between senior managers and auditors”, and a
huge emphasis on earnings and revenue projection. However, these signs only point out the
probability that a fraud might be occurring, a significant in-depth analysis in the specific case
is required in order to be certain about it.
Q 7: What are the different types of financial statement analysis methods?
A: There are a number of methods used for analysing financial statements. The method
chosen usually depends upon the purpose behind the analysis. Some of the most common
analysis methods are: external analysis, internal analysis, ratio analysis, horizontal analysis,
vertical analysis, and static analysis. Statements are usually analysed to determine the profit
or loss, risk factors and overall performance of a firm.
Q 8: Do you think companies that have regular financial fraud investigation checks gain
credibility?
A: Financial fraud investigations are important for any organization. Regular checks build the
trust of clients or consumers and also keep the employees vigilant. Companies that efficiently
manage bribery, frauds and corruption cases are better equipped to handle crisis situations
and can analyse the risks and loop holes in the business processes that lead to frauds.
Q 9: Can you tell about the most common types of financial reporting fraud cases?
A: There are seven common occurrences that form the basis of financial reporting fraud
cases. These include the following: “fictitious revenues, overstatement of assets, capitalisation
of expenses, misappropriation of assets, premature booking of revenues and understatement
of expenses and liabilities”.
Q 10: How do investigators make financial fraud detection?
A: Financial fraud detection has emerged as a professional field and these experts have the
required training to investigate cases of corruption. They look for misappropriation of financial
statements, fictitious sales, in-correct asset values, hiding of liabilities, accounting irregularity,
weak system of internal control and untraceable deals or third party transactions.
210
Chapter 19
Opportunities for Chartered Accountants in
Forensic Accounting and Fraud Detection
Today’s forensic accountants are involved in a wide variety of cases, from the more mundane
family law and commercial matters through to a range of criminal investigations, which include
white-collar crimes such as business and insurance fraud through to organized crime, murder
and even terrorism where forensic accountants are used to trace the money trail and uncover
just who is financing the terrorist groups.
Forensic Accounting has taken many great leaps of growth in recent history. The Accounting
industry has gradually called for more and more Forensic Accountants. It is predicted that
growth of the industry, based on the amount of jobs, will reach 6.7% for the years between
2013 and 2018.
Forensic accounting in India has come to limelight only recently due to rapid increase in
Frauds and the white collar crimes and the belief that our law enforcement agencies do not
have sufficient expertise or the time needed to uncover frauds. The demand for forensic
accountants is exceeding the supply which has given a wide scope to the professionals in this
field.
There is no mention of Forensic accountants in the Indian statutes so far but there are various
provisions related to Forensic accountants/auditors in the statutes. The introduction of the
Companies Act, 2013 has a significant impact on fighting and preventing frauds. Under section
245 (1g) of the new Companies Act, depositors and members of a company can claim
damages from auditors, management and other consultants for the wrongdoings by the
company and its management. Many consultants and senior executives are expected to
become part of the certified community. Further, under section 140 the auditors and their firm
would be jointly liable for any frauds in the books of accounts and many auditors are likely to
become forensic accountants in the days to come to avoid being caught on the wrong foot.
Under section 149(12), independent directors would be held liable for the frauds in their
knowledge.
A few of the wide and increasing opportunities of services that Chartered Accountants can
best provide are briefly described below:
1. Conventional Investigation assignments as a continuation of
audits
These are typical SAP 4 situations where the audit findings have revealed certain anomalies
and there is a suspicion of fraud or error. The management may ask the auditors to extend
their audit to apply such extended or modified procedures as may be necessary to assess,
evaluate and determine the nature and extent of fraud. This kind of assignment is a regular
investigation and needs no elaboration. Such investigations could cover cash embezzlements,
asset losses, revenue leakages through inflated or replicated invoices, suppression of income,
inflation of liabilities, deflation of receivables and the list could go on and on.
2. Investigations by Statutory authorities
Investigations in respect of violations under any provision under the Income Tax Act,
Companies Act, could be required by any of the respective authorities. Even Police, CBI, CID
and the Economic Offences wing could need the services of chartered accountants. Such
services could include determination of claims from investors of all kinds, assessment of funds
lost or misappropriated, non-compliance of prescribed procedures, bank frauds and any other
economic offence where knowledge of accounting, record-keeping and relevant applicable
laws could be useful. In the recent well published scams such as Harshad Mehta scam, C R
Bhansali, Neek Leeson, and Ketan Parikh, large number of chartered accountants have been
asked to provide valuable insights as to the nature and methodology of the frauds perpetrated.
3. Bank frauds
This area has the highest potential of fraud. The raw material is money itself. Frauds can be
perpetrated within a bank itself or by outsiders. Insiders may manipulate funds, loans, and
apply teeming and lading between favored accounts. Outsiders could defraud a bank by
furnishing fabricated, duplicated or altered demand drafts, cheques, bills of exchange, and
other negotiable instruments. Apart from these borrowers also often cheat banks in
hypothecation agreements by inflating inventories or even providing substandard or spurious
stocks with little or no value. Chartered Accountants may find themselves as auditors,
investigators, or a part of the inspection team. These days even pre facility audits are asked to
be carried out. These are audits in the garb of investigations to ensure that funds are going
into safe and reliable hands
4. Business risk evaluation.
This is another area of professional opportunity for chartered accountants. Every business
venture is always fraught with risks. What varies is the degree and extent of the risk. Take for
example a case where a company has to undertake a new project for which it requires a large
finance say Rs 100 crores. In the current financial markets there are plenty of consultants
offering a plethora of services. Very often such means of financing are obtained through
consultants not very well known to the borrowers and possibly of dubious credentials. They
offer new and untested financing schemes through banks or financing institutions or IDBI, or
RBI, etc. In such situations sometimes upfront or advance payments are to be made which run
in substantial amounts. In such circumstances either the financial officers of the company who
could be chartered accountants or audit firms may be asked to inquire into the feasibility of the
scheme as well as the reliability of the consultant. Since the stakes involved are generally
212
Opportunities for Chartered Accountants in Forensic Accounting and Fraud Detection
high, such assignments offer a challenging opportunity for chartered accountants to earn the
appreciation of the clients. Similar situations could arise when a new vendor, or a new client or
a new venture is to be entered into and the company wants to ensure that there is no risk. In
5. Insurance claim frauds
Claims for loss of stocks and loss of profits of large values, particularly exceeding Rs 5 crores
are usually surveyed in detail by most insurance companies. More often than not these claims
are inflated, with or without intention. In such situations as well chartered accountants could
be called upon to review, inquire and investigate into frauds.
As forensic accountants key assignments like
• Loss Valuers
• Arbitrators
• Empanelment as forensic expert for claims
• And such allied services
6. Compliance verifications
There are so many situations where specific guidelines or directives have been laid down for
use of funds. For example a large trust may be given a donation of Rs 10 crores for a project
say providing for orphans and widows. The donor may want an assurance that the funds
donated have been appropriately used. It is possible that this could turn out to be a thriving
ground for frauds and misappropriation of funds. Similarly a hospital may have been given
funds for a specific ward with conditions. There could be misrepresentations and false reports.
A business may have a remote site where certain activities may be in progress. A possibility of
misuse of resources is also likely.
In all such situations, described above, it is not necessary that chartered accountants could be
auditors. They could be chief financial officers, treasurers, and accountants, part of the
management or even consultants. It is also very essential important to remember that there
are no standardized fraud detection methods. Each assignment has to be carried out in a
manner appropriate to the Specific needs. The moral is that knowledge dwells within
ourselves. Whatever be the impediments in a given situation one can find a solution from an
infinite reservoir of knowledge existing within. This analogy cannot be applicable more than in
the field of forensics and fraud detection.
7. Fraud Prevention
• Fraud prevention,
• Fraud deterrence
• Fraud detective measures
213
We as a forensic auditor can provide services at all above three verticals. Eg. Build more
stringent internal controls to prevent chances of fraud, implementing strict policy for
punishment and zero tolerance attitude [organization would spend even lakhs of rupees to
detect, punish and prevent even for a hundred rupee fraud] in the organization for fraud
deterrence, to keep some indicators so as to raise red flags, whistle blowers policy as early
detective indicators.
In all such situations, described above, it is not necessary that chartered accountants could be
auditors. They could be chief financial officers, treasurers, and accountants, part of the
management or even consultants. It is also very essential important to remember that there
are no standardized fraud detection methods. Each assignment has to be carried out in a
manner appropriate to the Specific needs. The moral is that knowledge dwells within
ourselves. Whatever be the impediments in a given situation one can find a solution from an
infinite reservoir of knowledge existing within. This analogy cannot be applicable more than in
the field of forensics and fraud detection.
8. Training
In training available opportunities include
• Conducting Zero fraud tolerance training programs in organizations
• Helping Frame Ethics and Whistle blowing Policies
• Training for basic data analysis to detect indications of fraud
• Collaborating with agencies like CBI, EOW, CAFRAL, NACEN etc. to provide guidance
and research on financial forensics
• Working with Universities offering degrees in forensics to develop research material and
participating as faculty in areas of financial forensics.
• Developing content and designing courses for regulatory agencies like IRDA, RBI as
well as chambers of commerce to create awareness about the Fraud Menace and the
capabilities available to combat it
• Partnering with NASSCOM to establish testing and compliance standards for IT firms
engaged in software development as well for the outsourcing industry
• Workshops for determining Risk frameworks relevant to particular organizations and
industries and Assessment of the extent of exposure after the implementation of
Internal Controls
• Specifically tailored courses for members of ICAI focused on the role of auditors in
commenting on the adequacy of internal financial controls with reference to their
capability to prevent and detect fraud
214
Chapter 20
Useful Websites
Sr. No. Name Website

1 Serious Fraud Investigation Office, http://sfio.nic.in/websitenew/main2.asp
India
2 Serious Fraud Office – UK http://www.sfo.gov.uk/
3 National Fraud Authority – UK https://www.gov.uk/government/organisatio
ns/national-fraud-authority
4 Action Fraud - UK http://www.actionfraud.police.uk/
5 UK's Fraud Prevention Service http://www.cifas.org.uk/
6 Association of Certified Fraud http://www.acfe.com/
Examiners
7 FBI Home page for Fraud http://www.fbi.gov/scams-
safety/fraud/fraud
8 The United States department of http://www.justice.gov/criminal/fraud/
Justice – Fraud section
9 European Anti-Fraud Office http://ec.europa.eu/anti_fraud/investigation
s/report-fraud/
10 Canadian Anti-Fraud Centre (CAFC) http://www.antifraudcentre-
centreantifraude.ca/index-eng.htm

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STUDY ON FORENSIC ACCOUNTING

AND FRAUD DETECTION

The Institute of Chartered Accountants of India

Revised Edition : September, 2017

Committee/Department : Committee on Information Technology

Published by : The Publication Department on behalf of The Institute of

Printed by : Sahitya Bhawan Publications, Hospital Road, Agra - 282 003.

Place: New Delhi CA. Nilesh Shivji Vikamsey

CA Atul Kumar Gupta

Sr. Particulars Other Audits Forensic Audit

advantage. A Fraud could take form of misstatement of an information (Financial or otherwise)

2.3 Fraud Pentagon

2.4 Fraud Scale

2.5 Fraud Circle

strip is reproduced. This type of crime is known as ‘skimming’.

Classification of Occupational in the Fraud Tree is as follows

3.6 Consumer Frauds

• Evaluating produced documentation and information for completeness

2. Accounting & Business reporting systems

• Frequency of transactions. Transactions that are occurring too frequently or not

• Unsupported or unauthorized balances or transactions

• Undue time pressures imposed by management to resolve complex or contentious

• Questionable Accounting Activities

 Duplicate Payments - Duplicate payments are sometimes converted to the

The objectives of the investigation will include:

Step 4. Perform the analysis

7.3.1. Collection of Data

matter because of inadequate preparation, or because insufficient time is allowed to complete

When an interviewee is offering a narrative or explanation, interviewers should not interrupt

(f) Complex Questions

7.3.9. How to Conclude an Interview

Caution should be exercised to avoid misinterpretations of behavior because of nervousness

Detecting fraud is difficult, especially frauds involving material financial statement

o Continuous process throughout an investigation

8.3 Technology Based/ Digital Forensics Techniques

(ix) Voucher No. (x) Rs.

Vendor Max_Val 2nd Max_ Val RSF > 10

Name Doc Ref Date Rs. Particulars

Vendor Max_Val 2nd Max_Val RSF

• Classification of Bill amount field will be for “Max. Value”

• Ageing Analysis or Advance Analysis

Example of ‘IF’ Function:

The Nested ‘IF’ functions

Using ‘IF’ function in combination with ‘AND’/ ‘OR’

Syntax of ‘IF’ function used in combination with ‘AND’

Syntax of ‘IF’ function used in combination with ‘OR’

Example of the Sum IF function:

The ‘VLOOKUP’ Function

This function quickly summarizes large data by:

• Trace dependent and precedents diagrammatically show various relationship between

• For whom the report is intended

3.3. Conduct Interviews

• News groups/club lists/posting

(a) Collection, analysis and dissemination of information on cyber incidents

13.2 Indian Penal Code 1860

13.7 The Foreign Exchange Management Act, 1999

What Frauds need to be reported?

 Company withholding information

I. Fraud Act, 2006 – United Kingdom