JurisdictionUnited States


Jeffrey E. Brandlin

David R. Bell

Garret L. Martucci

All businesses, regardless of size, industry or location, are susceptible to fraud. Fraud is not perpetrated inadvertently, but rather through deliberate deception and malfeasance. Fraud is universal and can be committed during any economic cycle, whether that be in a growth or recessionary period. Senior leadership or collusion among senior leaders in cases of fraud is typical. Further, individuals who commit fraud are often those who previously had a reputation for integrity.

Fraud is the result of a breakdown in internal controls or lack thereof. Frauds may extend over multiple periods and are often undetected in financial audits. The primary purpose of a financial audit opinion is to report whether the information presented is correct and free from material misstatements (caused either intentionally or inadvertently).

In the development of a fraud investigation, it is imperative to understand the warning signs of potential fraud and how such frauds might occur. A warning sign occurs when circumstances arise that alert an organization of potential risk. In 2011, red flags preceded 56 percent of fraud cases.2 Being aware of indicators of fraud and responding appropriately can help mitigate a company's loss and increase the chance of recovery. From a preventative standpoint, establishing adequate controls and an ethical company culture is largely contingent upon understanding common fraudulent schemes and their warning signs. In the case of investigating suspected fraud, knowing the environmental circumstances that are commonly associated with fraud can help in identifying it.

This chapter is intended to provide an overview of the various indicia of corporate fraud, the process by which an investigation is developed, and a basis for understanding the various fraud schemes and how to detect them.

I. Organizing a Fraud Investigation

Developing a fraud investigation often begins when there is a suspicion that wrongdoing has occurred within a company. Recovery can only materialize after many steps in the investigative process.

A. Planning

The initial planning phase of a fraud investigation, as with any major project implementation, will help define some of the parameters and steps involved in subsequent stages of the investigative process. In the planning phase, a preliminary assessment of the potential fraud will likely take place. In the preliminary assessment, cursory discussion and interviews will occur, and important records and documentation that will be needed are identified. If the investigation involves outside auditors, fraud investigators or experts, the means by which data will be shared among those parties should be discussed. It is important to determine what information is needed and will potentially be available. In the planning stage of the investigation, the validity of the fraud suspicion, and how it may have been committed, may become more established. Efforts made in the planning stage of an investigation will provide a clearer understanding of the fraud predication.

Being able to draw accurate conclusions is an integral component of the investigative process. The planning phase should allow an opportunity to evaluate the completeness of the information that is available and which areas need investigation.

B. Execution

In the execution phase, initial work plans should be created. The investigation requires identifying red flags and looking at ways that the fraud might have been carried out and concealed. Have there been intentional, material misstatements? How have assets been misappropriated? Gathering pertinent evidence such as business documents, financial statements, accounting records, accounts receivable, inventory information or transaction documentation will help uncover possible fraud schemes. Additionally, it is important to glean information from interviews with company employees and management. Such interviews may help validate suspicions or provide additional details regarding areas to investigate further.

When examining data, look to substantive analytical procedures to help uncover inconsistencies or unusual warning signs. Examples of potential relevant procedures include:

• investigating cash flows (follow the cash);
• inspecting operations and corroborating balance-sheet and P&L relationships;
• self-underwriting key customers and vendors;
• interviewing the company's accountant/auditor;
• comparing the company to its public competitors and/or relevant benchmarks;
• considering third-party verifications; and
• inspecting original documentation.

In gathering, examining, and analyzing company data, it is important to document and organize procedures. This stage of the investigative process is geared toward uncovering whether fraud has occurred within an organization.

II. Indicia of Fraud: The Warning Signs

Knowing some of the warning signs of fraud is imperative in detecting it. When fraud is perpetrated, environmental commonalities often exist. Understanding the warning signs and how to investigate them further will help in executing a fraud investigation.

A. External Market/Industry Factors

1. Economic Conditions

Individuals commit fraud regardless of economic conditions, but according to the 2009/2010 Global Fraud Report, developed by risk consulting firm Kroll Inc., senior executives reported increased levels of fraud in their organizations as a result of the recession.3 Further, many executives admitted that their companies were more vulnerable to fraud due to cutbacks in internal controls. A weakened economy can result in cost-cutting and downsizing. Such reductions can often impact internal controls. Whether it is downsizing in departments responsible for internal controls or a shift in priorities within an organization, a recessionary period can be an indicator of an environment that is ripe for fraud.

2. Comparison to Competitors in the Marketplace

Being aware of industry dynamics can also serve to uncover potential red flags. An auditor should be suspicious of companies that seem to buck industry trends without having an obvious competitive advantage. In other words, is there a reason that a company is prospering when all others in the industry are struggling?

3. Hiding Problems in Mergers

Additionally, many struggling companies trying to stave off bankruptcy during a weak economy may look to potential buyers or partners to maximize their chances of success. Companies saddled with debt and cash-flow problems may look to camouflage their weak performance from potential partners. Cautionary due diligence is an important component to identifying fraud in these scenarios.

4. Changes in Regulations or Market

Significant regulatory changes or rapid sectoral downturns can lead lenders to be more conservative with their lending. Struggling companies may turn to falsifying financial statements and borrowing base reports to stay afloat. Understanding how external market forces might impact the fraud risk of a company will help in identifying fraud and with ultimate recovery.

B. Borrowing Base Reports

Access to capital can be the lifeline of an organization. An asset-based loan (ABL) is typically collateralized by accounts receivable and inventory. These account balances should be fairly easy to verify and understand. ABL borrowing base calculations should not be overly complicated. Any attempts to misrepresent collateral might indicate widespread fraud within a business.

Many of the borrowing base report frauds involve temporarily misrepresenting financial data around the time the borrowing base report is submitted. Such instances might involve delays in processing customer credits. It is important to be aware of credit-processing times within an organization. For example, a company might intentionally overbill a customer to inflate their accounts receivable and not process the credit for 60 to 90 days after the invoice was sent. This will allow a company to increase its borrowing base in times of financial distress. Such actions will misrepresent the borrowing base and allow the business to receive additional capital from its lenders. Additionally, a company might attempt to cut checks to reduce payables but delay the actual payment to the vendor.

Since an ABL can be collateralized by inventory, a distressed business might re-value or otherwise overstate inventory to increase borrowing capacity. Changes to finished goods inventory...

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