ACCOUNTING RECORDS: HOW THEY ARE USED TO CONCEAL FRAUD. ROSANNE TERHART, CFE, CA Senior Manager BDO Canada LLP Vancouver, British Columbia Canada

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1 Once an employee commits fraud, he has limited time to conceal the financial transaction in the accounting records. Learn how employees hide these fraudulent transactions and what to look for when reviewing accounting records for evidence of fraud. This session will cover three separate case studies of significant employee frauds concealed in accounting records, how the fraud was discovered, and what evidence was used in court for a successful prosecution. ROSANNE TERHART, CFE, CA Senior Manager BDO Canada LLP Vancouver, British Columbia Canada Rosanne Terhart is a Chartered Accountant and Certified Fraud Examiner. She has over 25 years experience in accounting, auditing, and forensic investigations. Ms. Terhart s practice focuses on forensic investigations addressing allegations of fraud, quantification of economic damages, business valuations, special purpose audits, and financial consulting. Ms. Terhart has provided expert witness testimony for civil and criminal trials in the Supreme Court of British Columbia. She has also acted as a court-appointed special referee. Ms. Terhart is a frequent speaker on topics related to fraud for the Institute of Chartered Accountants of British Columbia, Continuing Legal Education, universities and other organizations. Association of Certified Fraud Examiners, Certified Fraud Examiner, CFE, ACFE, and the ACFE Logo are trademarks owned by the Association of Certified Fraud Examiners, Inc. The contents of this paper may not be transmitted, re-published, modified, reproduced, distributed, copied, or sold without the prior consent of the author. 2012

2 Once an employee commits fraud, he or she has a limited time to conceal the fraudulent financial transaction in the accounting records. Many employees can successfully conceal these transactions for up to 18 months or longer by these methods. The accounting records can be very important in prosecution of fraud cases and lend the elements of motivation and intention to the evidence. Examples of Accounting Records General ledger Sub ledgers Journal entries Supporting documents (e.g., invoices and expense reports) Bank statements, cheques, and electronic transfers Evidence That Is Provided by the Accounting Records Who was involved: Most accounting systems have users logged in and out. The log in and out timings can provide evidence regarding who committed the concealing entry. This information can be used in court as evidence to connect the fraud to an individual. Evidence of motivation/intention to commit fraud: The concealing entry in the accounting system is very revealing evidence for motivation. For instance, if an amount is fraudulently paid to an employee and fraudulently booked as a freight expense for the company, this would indicate that there was an intention to conceal the real transaction. Timing of the fraud: Accounting records provide good evidence of the timing of a fraud. The entry must be made within

3 days of the actual fraud (to ensure not discovered through preparation of the bank reconciliation). The accounting records also help determine the start and end of the fraud, to determine the full extent. Additional fraud schemes: Often, additional fraud schemes are identified though the review of the accounting records. For instance, many fraudsters conduct numerous schemes at the same time. They may have a favorite place to book these fraudulent transactions. Other schemes may be found in the same accounting records. Evidence of repayments: Accounting records will often show evidence of repayment of fraudulent amounts. Employees will often take and then return funds for a while, before taking and keeping funds. Accounting records will show both sides of the transaction. How Fraud Is Concealed in the Accounting Records The initial entry to record the transaction in the accounting records must be made in 30 days of the transaction. Bank reconciliations are most often done at the end of the month. In the process of doing a bank reconciliation, funds disbursed by the organization that were not booked would be revealed. The initial entry in the accounting system is usually put into a temporary spot (e.g., suspense account) and then subsequently moved and placed in a final account that will flow through to the financial statements

4 What to Look for in the Accounting Records Lack of segregation of duties involving cheque signing, cash handling, and transaction recording can cause an opportunity for fraud. Access to systems and override capability. For example, access to payroll should be limited to only one person. Look for who performs the bank reconciliation. This is usually the person who can ensure that fraudulent disbursements are not found. Most often, this kind of fraud is found when the preparer of the bank reconciliation is away on vacation. Manual cheques have different and usually lesser controls than regular cheque runs, and it is much easier to forge a signature on a manual cheque. Cheques that are out of sequence. Fraud is often done with cheques that are out of sequence with the regular cheque sequence. This happens when the fraudster has access to a series of cheques that are out of the normal system. Missing, cancelled, or returned cheques. Often fraudulent disbursements are done by cheques that are simply destroyed after they are returned from the bank. Odd or missing signatures on cheques. Odd signature may reveal a forged signature. Electronic transfers and online bill payments. There are often no controls around this. An employee can make personal payments and book them as business expenses. Entries in suspense accounts or other non-regular accounts. Fraud is often initially entered in suspense accounts and then later transferred out. Also, fraud is recorded in non-regular accounts, which are not often scrutinized. Round number entries. Most fraudsters do not consider the tax implications of fraudulent disbursements. Looking for round number entries may be revealing

5 Invoices and expense reports that lack detail. GST/HST entries. The tax accounts are favorite places to book fraudulent disbursements because they are often not reconciled on a regular basis. Year-end journal entries will show the writing off of accounts. If a fraudulent disbursement is recorded in an asset account, the entries can eliminate the asset that was initially set up to conceal the fraud. What to Look for in the Financial Statements Expenses that are inflated from one year to another with no apparent change in the organization. This may indicate that fraudulent amounts are booked there. New expense or asset categories not in previous financial statements. Assets that are inflated from one year to the next. This could indicate that a fraudulent transaction was hidden there. Gross margin percentages that change and cannot be explained. This could indicate that fraudulent expenses in cost of sales have been made. Examples of Concealment in the Accounting Records Concealment of fraudulent disbursements: Cheque written to employee in the amount of $20,000 is booked in a suspense account and then moved to a consulting expense account. It appears that the company paid $20,000 for an outside accountant. Unless a detailed review of the consulting expense account is done, no one would be the wiser. Concealment of misappropriated cash: An employee steals $2,000 in cash from a bank deposit. The employee replaced the stolen cash with a cheque from the company

6 The transaction is booked to increase accounts receivable by the amount of the cheque of $2,000. If the accounts receivable is not reconciled to customer payments, the fraudulent amount goes unnoticed. Concealment of a tampered cheque: An employee adds $3,000 to a payroll cheque after it was signed but before being cashed. The extra $3,000 is booked into miscellaneous expense. It appears the company paid for some miscellaneous expense in the amount of $3,000. If a detailed review is not done of this account, it will go unnoticed. Expense account fraud: An employee claims the same expense of $1,000 twice. The expense is claimed in two different expense reports. The expenses are booked in travel expenses. Expense report conceals the fraud because it is likely not detailed enough and has not been reviewed sufficiently. A review of the expense report by a supervisor with the employee s agenda would reveal the duplication. Payroll fraud: An employee enters into the payroll system and changes payroll deductions for federal and provincial payroll taxes to zero. Employee received 100% of pay. At year-end, the deductions due to Canada Revenue Agency are paid by cheque from the company, including fraudulent employee s portion

7 Amount is booked to employee benefits. Unless a reconciliation of employee benefits is done, the fraud is concealed. Case Examples Airplane Company: Accounting staff discovers a $30,000 cheque payable to Bank xx visa while preparing a bank reconciliation. Company does not use Bank xx for visa and connects it to the controller. The controller is fired. CFO puts together evidence, finds additional suspicious cheques paid to Bank xx and quantifies at $600,000. Forensic investigation is required by insurance, civil and criminal proceedings. Forensic accountant traces fraudulent cheques to accounting entry. Operator of entry is controller. Traced entry to temporary inventory account. A review of the temporary account reveals how far back the fraud occurred and reveals the subsequent entries made and accounts affected. Other fraudulent amounts were discovered. Total misappropriation amounted to $1.4 million. Discovered that $300,000 was paid back, net misappropriation was $1.1 million. Fraud lasted 10 years before detection. The accounting records revealed: How fraud was concealed Connected concealment to fraudster Extent and timing of fraud Quantified entire completeness of fraud Determined quantum of financial statement misstatement Confirmed amount, if any, repaid

8 Non-Profit Organization: Director of organization discovers, by accident, frequent unexplained electronic transfers from bank accounts. Finance manager quits. Police put together file of transfers totaling $500,000 Forensic accountant reviewed accounting records. Determined entries made to consulting expenses. Traced to invoices, discovered name of consultant. Discovered correspondence between finance manager and consulting regarding misappropriated funds. Discovered that funds were split between two individuals. Eventually traced both individual accounts. Accounting records show fuller extent of fraud. Discovered total misappropriated was $900,000. Both individuals charged. Both admitted. Fraud lasted two years before detection. The accounting records revealed: How fraud was concealed Connected fraud with fraudster Connected fraud to another individual Increased total fraud quantification Insurance Company: Organizational controller discovers, by accident, a short-fall in a daily cash deposit. Controller discovers that cash count done by one of the cash counters. Discovers several other short deposits. All done when a particular cash counter was working. Controller puts together all short deposits by one cashier. Amounted to $40,000 short deposits. Forensic accountant discovers that one other cash counter was involved, based on the accounting entry operation information

9 Fraud was booked to accounts receivable. Fraud quantum increased to $140,000. Two individuals charged. Fraud lasted eight months before detection. The accounting records revealed: How fraud was concealed Connected fraud with fraudster Connected fraud to another individual Increased total fraud quantification

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