The Conflicted Board

Our last post about cyberfraud and business continuity elicited a comment about the vital role of corporate governance from an old colleague of mine now retired and living in Seattle.  But the wider question our commenter had was, ‘What are we as CFEs to make of a company whose Board willfully withholds for months information about a cyberfraud which negatively impacts it customers and the public? From the ethical point of view, does this render the Board somehow complicit in the public harm done?’

Governance of shareholder-controlled corporations refers to the oversight, monitoring, and controlling of a company’s activities and personnel to ensure support of the shareholders’ interests, in accordance with laws and the expectations of stakeholders. Governance has been more formally defined by the Organization for Economic Cooperation and Development (OECD) as a set of relationships between a company’s management, its Board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set (including about ethical continuity), and the means of attaining those objectives and monitoring performance. Good corporate governance should provide proper incentives for the Board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring.

The role and mandate of the Board of Directors is of paramount importance in the governance framework. Typically, the directors are elected by the shareholders at their annual meeting, which is held to receive the company’s audited annual financial statements and the audit report thereon, as well as the comments of the chairman of the Board, the senior company officers, and the company auditor.

A Board of Directors often divides itself into subcommittees that concentrate more deeply in specific areas than time would allow the whole Board to pursue. These subcommittees are charged with certain actions and/or reviews on behalf of the whole Board, with the proviso that the whole Board must be briefed on major matters and must vote on major decisions. Usually, at least three subcommittees are created to review matters related to (1) governance, (2) compensation, and (3) audit, and to present their recommendations to the full Board. The Governance Committee deals with codes of conduct and company policy, as well as the allocation of duties among the subcommittees of the Board. The Compensation Committee reviews the performance of senior officers, and makes recommendations on the nature and size of salaries, bonuses, and related remuneration plans. Most important to fraud examiners and assurance professionals, the Audit Committee reviews internal controls and systems that generate financial reports prepared by management; the appropriateness of those financial reports; the effectiveness of the company’s internal and external auditors; its whistle-blowing systems, and their findings; and recommends the re-election or not of the company’s external auditors.

The Board must approve the selection of a Chief Executive Officer (CEO), and many Boards are now approving the appointment of the Chief Financial Officer (CFO) as well because of the important of that position. Generally, the CEO appoints other senior executives, and they, in turn, appoint the executives who report to them. Members of these committees are selected for their expertise, interest, and character, with the expectation that the independent judgment of each director will be exercised in the best interest of the company. For example, the ACFE tells us, members of the Audit Committee must be financially literate, and have sufficient expertise to understand audit and financial matters. They must be of independent mind (i.e., not be part of management or be relying upon management for a significant portion of their annual income), and must be prepared to exercise that independence by voting for the interest of all shareholders, not just those of management or of specific limited shareholder groups.

Several behavioral expectations extend to all directors, i.e., to act in the best interest of the company (shareholders & stakeholders), to demonstrate loyalty by exercising independent judgment, acting in good faith, obedient to the interests of all and to demonstrate due care, diligence, and skill.

All directors are expected to demonstrate certain fiduciary duties. Shareholders are relying on directors to serve shareholders’ interests, not the directors’ own interests, nor those of management or a third party. This means that directors must exercise their own independent judgment in the best interests of the shareholders. The directors must do so in good faith (with true purpose, not deceit) on all occasions. They must exercise appropriate skill, diligence, and an expected level of care in all their actions.

Obviously, there will be times when directors will be able to make significant sums of money by misusing the trust with which they have been bestowed and at the expense of the other stakeholders of the company. At these times a director’s interests may conflict with those of the others. Therefore, care must be taken to ensure that such conflicts are disclosed, and that they are managed so that no harm comes to the other shareholders. For example, if a director has an interest in some property or in a company that is being purchased, s/he should disclose this to the other directors and refrain from voting on the acquisition. These actions should alert other directors to the potential self-dealing of the conflicted director, and thereby avoid the non-conflicted directors from being misled into thinking that the conflicted director was acting only with the corporation’s interests in mind.

From time to time, directors may be sued’ by shareholders or third parties who believe that the directors have failed to live up to appropriate expectations. However, courts will not second-guess reasonable decisions by non-conflicted directors that have been taken prudently and on a reasonably informed basis. This is known as the business judgment ru1e and it protects directors charged with breach of their duty of care if they have acted honestly and reasonably. Even if no breach of legal rights has occurred, shareholders may charge that their interests have been ‘oppressed’ (i.e., prejudiced unfairly, or unfairly disregarded) by a corporation or a director’s actions, and courts may grant what is referred to as an oppression remedy of financial compensation or other sanctions against the corporation or the director personally. If, however, the director has not been self-dealing or misappropriating the company’s opportunities, s/he will likely be protected from personal liability by the business judgment rule.

Some shareholders or third parties have chosen to sue directors ‘personally in tort’ for their conduct as directors, even when they have acted in good faith and within the scope of their duties, and when they believed they were acting in the best interests of the corporations they serve.  Recently, courts have held that directors cannot escape such personal liability by simply claiming that they did the action when performing their corporate responsibilities. Consequently, directors or officers must take care when making all decisions that they meet normal standards of behavior.

Consequently, when management and the Board of a company who has been the victim of a cyber-attack decides to withhold information about the attack (sometimes for weeks or months), fundamental questions about compliance with fiduciary standards and ethical duty toward other stakeholders and the public can quickly emerge.   The impact of recent corporate cyber-attack scandals on the public has the potential to change future governance expectations dramatically. Recognition that some of these situations appear to have resulted from management inattention or neglect (the failure to timely patch known software vulnerabilities, for example) has focused attention on just how well a corporation can expect to remediate its public face and ensure ongoing business continuity following such revelations to the public.

My colleague points out that so damaging were the apparently self-protective actions taken by the Boards of some of these victim companies in the wake of several recent attacks to protect their share price, (thereby shielding the interests of existing executives, directors, and investors in the short term) that the credibility of their entire corporate governance and accountability processes has been jeopardized, thus endangering, in some cases, even their ability to continue as viable going concerns.

In summary, in the United States, the Board of Directors sits at the apex of a company’s governing structure. A typical Board’s duties include reviewing the company’s overall business strategy, selecting and compensating the company’s senior executives; evaluating the company’s outside auditor, overseeing the company’s financial statements; and monitoring overall company performance. According to the Business Roundtable, the Board’s ‘paramount duty’ is to safeguard the interests of the company’s shareholders.  It’s fair to ask if a Board that chooses not to reveal to its stakeholders or to the general investor public a potentially devastating cyber-fraud for many months can be said to have meet either the letter or the spirit of its paramount duty.

Cyberfraud & Business Continuity

We received an e-mail inquiry from a follower of our Chapter’s LinkedIn page last week asking specifically about recovery following a cyberfraud penetration and, in general, about disaster planning for smaller financial institutions. It’s a truism that with virtually every type of business process and customer moving away from brick-and-mortar places of business to cloud supported business transactions and communication, every such organization faces an exponential increase in the threat of viruses, bots, phishing attacks, identity theft, and a whole host of other cyberfraud intrusion risks.  All these threats illustrate why a post-intrusion continuity plan should be at or near the top of any organization’s risk assessment, yet many of our smaller clients especially remain stymied by what they feel are the costs and implementational complexity of developing such a plan. Although management understands that it should have a plan, many say, “we’ll have to get to that next year”, yet it never seems to happen.

Downtime due to unexpected penetrations, breeches and disasters of all kinds not only affect our client businesses individually, but can also affect the local, regional, or worldwide economy if the business is sufficiently large or critical. Organizations like Equifax do not operate in a vacuum; they are held accountable by customers, vendors, and owners to operate as expected. Moreover, the extent of the impact on a business depends on the products or services it offers. Having an updated, comprehensive, and tested general continuity plan can help organizations mitigate operational losses in the event of any disaster or major disruption. Whether it’s advising the organization about cyberfraud in general or reviewing the different elements of a continuity plan for fraud impact, the CFE can proactively assist the client organization on the front end in getting a cyberfraud-recovery continuity plan in place and then in ensuring its efficient operation on the back end.

Specifically, regarding the impact of cyberfraud, the ACFE tells us that, until relatively recently, many organizations reported not having directly addressed it in their formal business continuity plans. Some may have had limited plans that addressed only a few financial fraud-related scenarios, such as employee embezzlement or supplier billing fraud, but hadn’t equipped general employees to deal with even the most elemental impacts of cyberfraud.   However, as these threats increasingly loomed, and as their on-line business expanded, more organizations have committed themselves to the process of formally addressing them.

An overall business continuity plan, including targeted elements to address cyberfraud, isn’t a short-term project, but rather an ongoing set of procedures and control definitions that must evolve along with the organization and its environment. It’s an action plan, complete with the tools and resources needed to continue those critical business processes necessary to keep the entity operating after a cyber disruption. Before advising our clients to embark on such a business continuity plan project, we need to make them aware that there is a wealth of documentation available that they can review to help in their planning and execution effort. An example of such documentation is one written for the industry of our Chapter’s inquirer, banking; the U.S. Federal Financial Institutions Examination Council’s (FFIEC’s) Business Continuity Planning Handbook. And there are other such guides available on-line to orient the continuity process for entities in virtually every other major business sector.  While banks are held to a high standard of preparedness, and are subject to regular bank examination, all types of organizations can profit from use of the detailed outline the FFIEC handbook provides as input to develop their own plans. The publication encourages organizations of all sizes to adopt a process-oriented approach to continuity planning that involves business impact analysis as well as fraud risk assessment, management, and monitoring.

An effective plan begins with client commitment from the top. Senior management and the board of directors are responsible for managing and controlling risk; plan effectiveness depends on management’s willingness to commit to the process from start to finish. Working as part of the implementation team, CFEs can make sure both the audit committee and senior management understand this commitment and realize that business disruption from cyber-attack represents an elevated risk to the organization that merits senior-level attention. The goal of this analysis is to identify the impact of cyber threats and related events on all the client organizations’ business processes. Critical needs are assessed for all functions, processes, and personnel, including specialized equipment requirements, outsourced relationships and dependencies, alternate site needs, staff cross-training, and staff support such as specialized training and guidance from human resources regarding related personnel issues. As participants in this process, CFEs acting proactively are uniquely qualified to assist management in the identification of different cyberfraud threats and their potential impacts on the organization.

Risk assessment helps gauge whether planned cyberfraud-related continuity efforts will be successful. Business processes and impact assumptions should be stress tested during this phase. Risks related to protecting customer and financial information, complying with regulatory guidelines, selecting new systems to support the business, managing vendors, and maintaining secure IT should all be considered. By focusing on a single type of potential cyber threat’s impact on the business, our client organizations can develop realistic scenarios of related threats that may disrupt the cyber-targeted processes.  At the risk assessment stage, organization should perform a gap analysis to compare what actions are needed to recover normal operations versus those required for a major business interruption. This analysis highlights cyber exposures that the organization will need to address in developing its recovery plan. Clients should also consider conducting another gap analysis to compare what is present in their proposed or existing continuity plan with what is outlined (in the case of a bank) in the recommendations presented in the FFIEC handbook. This is an excellent way to assess needs and compliance with these and/or the guidelines available for other industries. Here too, CFEs can provide value by employing their skills in fraud risk assessment to assist the organization in its identification of the most relevant cyber risks.

After analyzing the business impact analysis and risk assessment, the organization should devise a strategy to mitigate the risks of business interruption from cyberfraud. This becomes the plan itself, a catalog of steps and checklists, which includes team members and their roles for recovery, to initiate action following a cyber penetration event. The plan should go beyond technical issues to also include processes such as identifying a lead team, creating lists of emergency contacts, developing calling trees, listing manual procedures, considering alternate locations, and outlining procedures for dealing with public relations.  As members of the team CFEs, can work with management throughout response plan creation and installation, consulting on plan creation, while advising management on areas to consider and ensuring that fraud related risks are transparently defined and addressed.

Testing is critical to confirm cyber fraud contingency plans. Testing objectives should start small, with methods such as walkthroughs, and increase to eventually encompass tabletop exercises and full enterprise wide testing. The plan should be reviewed and updated for any changes in personnel, policies, operations, and technology. CFEs can provide management with a fraud-aware review of the plan and how it operates, but their involvement should not replace management’s participation in testing the actual plan. If the staff who may have to execute the plan have never touched it, they are setting themselves up for failure.

Once the plan is created and tested, maintaining it becomes the most challenging activity and is vital to success in today’s ever-evolving universe of cyber threats. Therefore, concurrent updating of the plan in the face of new and emerging threats is critical.

In summary, cyberfraud-threat continuity planning is an ongoing process for all types of internet dependent organizations that must remain flexible as daily threats change and migrate. The plan is a “living” document. The IT departments of organizations are challenged with identifying and including the necessary elements unique to their processes and environment on a continuous basis. Equally important, client management must oversee update of the plan on a concurrent basis as the business grows and introduces new on-line dependent products and services. CFEs can assist by ensuring that their client organizations keep cyberfraud related continuity planning at the top of mind by conducting periodic reviews of the basic plan and by reporting on the effectiveness of its testing.

The Right Question, the Right Way

As every CFE knows, an integral part of the fraud examination process involves obtaining information from people. Regardless of the interview’s objective, all CFEs should embrace the role of interviewer and use the time-tested techniques recommended to us by the ACFE. But asking the right questions does not necessarily ensure key information will be uncovered; an effective interviewer also recognizes the need to separate truth from deception. Consequently, crafting effective questions, understanding the communication dynamics at play, actively participating in the interview process, and remaining alert to signs of deception will help examiners increase the effectiveness and efficiency of our interviews and of our overall engagements.

Some interviewers try to gather as much information using as few questions as possible and end up receiving convoluted or vague responses. Others seek confirmation of every detail, which can quickly turn an interview into an unproductive probing of minutia. Balancing thoroughness and efficiency is imperative to obtaining the necessary and relevant facts without overburdening the interviewee. Because the location of this line varies by interviewee, CFEs can find this balance most effectively by ensuring they ask only clear questions throughout the interview.

Some individuals might respond to a question in a way that doesn’t provide a direct answer or that veers off topic. Sometimes these responses are innocent; sometimes they are not. To make the most of an interview, examiners must remain in control of the situation, regardless of how the interviewee responds.  Being assertive does not require being impolite, however. In some instances, wording questions as a subtle command (e.g., “Tell me about…. or “Please describe….) can help establish the interview relationship. Additionally, remaining in control does not mean dissuading the interviewee from exploring pertinent topics that are outside the planned discussion points.  Interview questions can be structured in several ways, each with its own strengths, weaknesses, and ideal usage. Open questions ask the interviewee to describe or explain something. Most examination interviews should rely heavily on open questions, as these provide the best view of how things operate and the perspective of the staff member involved in a particular area. They also enable the reviewer to observe the interviewee’s demeanor and attitude, which can provide additional information about specific issues. However, if the CFE believes an individual might not stay on topic or may avoid providing certain information, open questions should be used cautiously.  In contrast, closed questions can be answered with a specific, definitive response, most often “yes” or “no.” They are not meant to provide the big picture but can be useful in gathering details such as amounts and dates. Examiners should use closed questions sparingly in an informational interview, as they do not encourage the flow of information as effectively as open questions.

Occasionally, the questioner might want to direct the interviewee toward a specific point or evoke a certain reply. Leading questions can be useful in such circumstances by exploring an assumption, a fact or piece of information, that the interviewee did not provide previously. When used appropriately, such questions can help the interviewer confirm facts that the interviewee might be hesitant to discuss. Examples of leading questions include: “So there have been no changes in the process since last year?” and “You sign off on these exception reports, correct?” If the interviewee does not deny the assumption, then the fact is confirmed. However,  before using leading questions, the interviewer should raise the topic with open questions and allow the interviewee the chance to volunteer information.

The examiner should establish and maintain an appropriate level of eye contact with the interviewee throughout the interview to personalize the interaction and build rapport. However, the appropriate level of eye contact varies by culture and even by person; consequently, the examiner should pay attention to the interviewee to determine the level of eye contact that makes him or her comfortable.

People tend to mirror each other’s body language subconsciously as a way of bonding and creating rapport. CFEs can help put interviewees at ease by subtly reflecting their body language. Further, the skilled interviewer can assess the level of rapport established by changing posture and by watching the interviewee’s response. This information can help CFEs determine whether to move into sensitive areas of questioning or to continue establishing a connection with the individual.

Confirming periodically that the examiner is listening can encourage interviewees to continue talking. For example, the interviewer can provide auditory confirmation with a simple “mmm hmmm” and nonverbal confirmation by nodding or leaning toward the interviewee during his or her response.

When the interviewee finishes a narrative response, the examiner can encourage additional information by echoing back the last point the person made. This confirms that the interviewer is actively listening and absorbing the information, and it provides a starting point for the person to continue the response.

Occasionally, the examiner might summarize the information provided to that point so that the interviewee can affirm, clarify, or correct the interviewer’s understanding.

Most often, the greatest impediment to an effective interview is the interviewer him or herself.  While it is clearly important for the interviewer to observe, to listen, and to assess the subject in a variety of ways, the role of the interviewer, and the effect he or she has on the interview process, cannot be minimized.

The interviewer typically focuses on the subject as the person who will provide the information he or she seeks. The interviewer concentrates on establishing rapport, listening effectively, analyzing the subject’s verbal and nonverbal communication, and gauging how much or how little the subject is telling her. These are valid areas of concentration for the interviewer. One significant risk is that the interviewer may pay too little attention to the negative influences s/he can bring to the interview, process. The terms interview and communication are interchangeable, and effective communication is a two-way street. What makes the interviewer an effective communicator and effective interviewer is not just the signals he or she picks up from the subject but also the signals, the information, the tone, and the body language he or she sends to the subject. It is highly presumptuous of the interviewer to think he or she has little or no effect on the subject and that the subject is not evaluating, assessing, and analyzing the interviewer.

The interviewer’s style of dress, jewelry, and grooming may tell the subject as much about the interviewer as does the interviewer’s demeanor. If the interviewer is overdressed for the occasion, does it make the subject feel inferior or intimidated? If too casual, does the interviewer send a signal of the lack of importance of the interview and, as a result, does the subject become too relaxed or not as attentive? Attire should have a desired effect. For example, when interviewing an enforcement officer or other professional who is familiar with uniforms and clothing as indicators of status, it may be appropriate to wear a coat and tie. In general, it is best to always to err on the side of conservative dress for the circumstances.

The examiner should not attempt to interview two or more persons at one time unless there is no other option. It is more difficult to control an interview with two or more subjects. One subject may be more dominant than the other. The subjects will influence each other’s memories. Some subjects will not want to embarrass themselves in front of a peer or supervisor. The environment for confidential communications will be adversely affected.

When the interviewer responds to the subject’s responses, he sends signals. At times, it might be advisable to not write notes down at the time the individual tells the interviewer something sensitive. Rather, the interviewer might consider devoting his attention to the subject and writing down the sensitive information after the conversation has moved away from the sensitive area.  The interviewer should never become argumentative, antagonistic, or belligerent. The use of the  “Good Cop, Bad Cop” routine can have unwanted results, especially long term. The CFE interviewer should use tact, speak clearly and with authority but without use of threatening language. The interviewer should consistently set a professional tone.

Finally, all individuals want to be shown respect. Maintaining the personal dignity of the subject is critical for the success of the interview and follow-up efforts. Everyone wants respect, from homeless persons to top executives. To be shown respect, especially if the subject is not accustomed to it, is disarming and contributes to that essential, professional tone.

From Inside the Building

By Rumbi Petrozzello, CFE, CPA/CFF
2017 Vice-President – Central Virginia Chapter ACFE

Several months ago, I attended an ACFE session where one of the speakers had worked on the investigation of Edward Snowden. He shared that one of the ways Snowden had gained access to some of the National Security Agency (NSA) data that he downloaded was through the inadvertent assistance of his supervisor. According to this investigator, Snowden’s supervisor shared his password with Snowden, giving Snowden access to information that was beyond his subordinate’s level of authorization. In addition to this, when those security personnel reviewing downloads made by employees noticed that Snowden was downloading copious amounts of data, they approached Snowden’s supervisor to question why this might be the case. The supervisor, while acknowledging this to be true, stated that Snowden wasn’t really doing anything untoward.

At another ACFE session, a speaker shared information with us about how Chelsea Manning was able to download and remove data from a secure government facility. Manning would come to work, wearing headphones, listening to music on a Discman. Security would hear the music blasting and scan the CDs. Day after day, it was the same scenario. Manning showed up to work, music blaring.  Security staff grew so accustomed to Manning, the Discman and her CDs that when she came to work though security with a blank CD boldly labelled “LADY GAGA”, security didn’t blink. They should have because it was that CD and ones like it that she later carried home from work that contained the data she eventually shared with WikiLeaks.

Both these high-profile disasters are notable examples of the bad outcome arising from a realized internal threat. Both Snowden and Manning worked for organizations that had, and have, more rigorous security procedures and policies in place than most entities. Yet, both Snowden and Manning did not need to perform any magic tricks to sneak data out of the secure sites where the target data was held; it seems that it all it took was audacity on the one side and trust and complacency on the other.

When organizations deal with outside parties, such as vendors and customers, they tend to spend a lot of time setting up the structures and systems that will guide how the organization will interact with those vendors and customers. Generally, companies will take these systems of control seriously, if only because of the problems they will have to deal with during annual external audits if they don’t. The typical new employee will spend a lot of time learning what the steps are from the point when a customer places an order through to the point the customer’s payment is received. There will be countless training manuals to which to refer and many a reminder from co-workers who may be negatively impacted if the rooky screws up.

However, this scenario tends not to hold up when it comes to how employees typically share information and interact with each other. This is true despite the elevated risk that a rogue insider represents. Often, when we think about an insider causing harm to a company through fraudulent acts, we tend to imagine a villain, someone we could identify easily because s/he is obviously a terrible person. After all, only a terrible person could defraud their employer. In fact, as the ACFE tells us, the most successful fraudsters are the ones who gain our trust and who, therefore, don’t really have to do too much for us to hand over the keys to the kingdom. As CFEs and Forensic Accountants, we need to help those we work with understand the risks that an insider threat can represent and how to mitigate that risk. It’s important, in advising our clients, to guide them toward the creation of preventative systems of policy and procedure that they sometimes tend to view as too onerous for their employees. Excuses I often hear run along the lines of:

• “Our employees are like family here, we don’t need to have all these rules and regulations”

• “I keep a close eye on things, so I don’t have to worry about all that”

• “My staff knows what they are supposed to do; don’t worry about it.”

Now, if people can easily walk sensitive information out of locations that have documented systems and are known to be high security operations, can you imagine what they can do at your client organizations? Especially if the employer is assuming that their employees magically know what they are supposed to do? This is the point that we should be driving home with our clients. We should look to address the fact that both trust and complacency in organizations can be problems as well as assets. It’s great to be able to trust employees, but we should also talk to our clients about the fraud triangle and how one aspect of it, pressure, can happen to any staff member, even the most trusted. With that in mind, it’s important to institute controls so that, should pressure arise with an employee, there will be little opportunity open to that employee to act. Both Manning and Snowden have publicly spoken about the pressures they felt that led them to act in the way they did. The reason we even know about them today is that they had the opportunity to act on those pressures. I’ve spent time consulting with large organizations, often for months at a time. During those times, I got to chat with many members of staff, including security. On a couple of occasions, I forgot and left my building pass at home. Even though I was on a first name basis with the security staff and had spent time chatting with them about our personal lives, they still asked me for identification and looked me up in the system. I’m sure they thought I was a nice and trustworthy enough person, but they knew to follow procedures and always checked on whether I was still authorized to access the building. The important point is that they, despite knowing me, knew to check and followed through.

Examples of controls employees should be reminded to follow are:

• Don’t share your password with a fellow employee. If that employee cannot access certain information with their own password, either they are not authorized to access that information or they should speak with an administrator to gain the desired access. Sharing a password seems like a quick and easy solution when under time pressures at work, but remind employees that when they share their login information, anything that goes awry will be attributed to them.

• Always follow procedures. Someone looking for an opportunity only needs one.

• When something looks amiss, thoroughly investigate it. Even if someone tells you that all is well, verify that this is indeed the case.

• Explain to staff and management why a specific control is in place and why it’s important. If they understand why they are doing something, they are more likely to see the control as useful and to apply it.

• Schedule training on a regular basis to remind staff of the controls in place and the systems they are to follow. You may believe that staff knows what they are supposed to do, but reminding them reduces the risk of them relying on hearsay and secondhand information. Management is often surprised by what they think staff knows and what they find out the staff really knows.

It should be clear to your clients that they have control over who has access to sensitive information and when and how it leaves their control. It doesn’t take much for an insider to gain access to this information. A face you see smiling at you daily is the face of a person you can grow comfortable with and with whom you can drop your guard. However, if you already have an adequate system and effective controls in place, you take the personal out of the equation and everyone understands that we are all just doing our job.

Governance and Fraud Detection

Originally, the business owner had the most say in decisions regarding the enterprise. Then, corporate structures were put in place to facilitate decision making, as ownership was spread over millions of shareholders. Boards of directors took over many responsibilities. But with time, the chief executive officer (CEO) ended up having a large say in the composition of the board and, in many instances, ruled and controlled the company and its strategy. The only option for shareholders appeared to be to sell their shares if they were not happy with the performance of a specific organization. Many anti-fraud professionals think that this situation contributed significantly to business demises such as that of Enron and to the horrors consequent to the mortgage meltdown and accompanying fiscal crisis.

Proposals were made to re-equilibrate the power structure by giving more power and responsibilities to the board and to specific committees, such as the audit committee, to better deal with internal control and fair financial reporting or the remuneration committee to better deal with the basis for the type and the level of remuneration of the CEO. New legislation was put into place, such as the US Sarbanes-Oxley Act and Basel II. Compliance with these pieces of legislation consumed a lot of attention, energy and cost.

Enterprises exist to deliver value to their stakeholders. This is accomplished by handling risk advantageously and using resources responsibly. Speedy direction setting and quick reaction to change are essential in such a situation so decision making must be shared among many. Therefore, governance comes into play. Successful enterprises implement an over-arching system of governance that facilitates the achievement of their desired outcomes, both at the enterprise level and at each level within the enterprise; this is especially true with regard to the problem of fraud detection.  In this context, a holistic definition of enterprise governance is in order: Governance is the framework, principles, structure, processes and practices to set direction and monitor compliance and performance aligned with the overall purpose and objectives of an enterprise.

This definition is initially implemented by the answers to and actions on the following governance related questions:

Who is accountable and responsible for enterprise governance? Stakeholders, owners, governing bodies and management are responsible and accountable for governance.

What do they do, and how and where do they do it? They engage in activities (set direction, monitor compliance and performance) in relationship with others and use enablers (frameworks, principles, structures, processes, practices) within the governance view appropriate to them (governance of the enterprise; of an organizational entity within the enterprise such as a business unit, division or function; and of a strategic asset within the enterprise or within an organizational entity).

Why do they do it? They institute governance to create value for their enterprise, determine its risk appetite, optimize its resources and use them responsibly.

In summary, accountability and stewardship are delegated to a governance body by the owner/stakeholder, expecting it to assume accountability for the activities necessary to meet expectations. In alignment with the overall direction of the enterprise, management executes the appropriate activities within the context of a control framework, balancing performance and compliance in achieving the governance objectives of value creation, risk management and resource optimization.

Fraud detection (within the context of a fully defined fraud prevention program) is a vital business process of the over-hanging governance function and can be implemented by numerous generally accepted procedures.  But a few examples …

One way to increase the likelihood of the detection by the governance function of fraud abuses is the conduct of periodic external and internal audits, as well as the implementation of special network security audits. Auditors should regularly test system controls and periodically “browse” data files looking for suspicious activities. However, care must be exercised to make sure employees’ privacy rights are not violated. Informing employees that auditors will conduct a random surveillance not only helps resolve the privacy issue, but also has a significant deterrent effect on computer assisted fraud exploits.

Employees witnessing fraudulent behavior are often torn between two conflicting feelings. They feel an obligation to protect company assets and turn in fraud perpetrators, yet they are uncomfortable in a whistleblower role and find it easier to remain silent. This reluctance is even stronger if they are aware of public cases of whistleblowers who have been ostracized or persecuted by their coworkers or superiors, or have had their careers damaged. An effective way to resolve this conflict is to provide employees with hotlines so they can anonymously report fraud. The downside of hotlines is that many of the calls are not worthy of investigation. Some calls come from those seeking revenge, others are vague reports of wrongdoing, and others simply have no merit. A potential problem with a hotline is that those who operate the hotline may report to people who are involved in a management fraud. This threat can be overcome by using a fraud hotline set up by a trade organization or commercial company. Reports of management fraud can be passed from this company directly to the board of directors.

Many private and public organizations use outside computer consultants or in-house teams to test and evaluate their security procedures and computer systems through the performance of system penetration testing.  The consultants are paid to try everything possible to compromise an enterprise’s system(s). To get into offices so they can look for passwords or get on computers, they masquerade as janitors, temporary workers, or confused delivery personnel. They also employ software based hacker tools (readily available on the Internet) and social engineering techniques.  Using such methods, some outside consultants claim that they can penetrate 90% or more of the companies they “attack” to a greater or lesser degree.

All financial transactions and activities should be recorded in a log. The log should indicate who accessed what data, when, and from which location. These logs should be reviewed frequently to monitor system activity and trace any problems to their source. There are numerous risk analysis and management software packages that can review computer systems and networks and the financial transactions they contain. These packages evaluate security measures already in place and test for weaknesses and vulnerabilities. A series of reports are then generated to explain any weaknesses found and suggest improvements. Cost parameters can be entered so that a company can balance acceptable levels of vulnerability and cost effectiveness. There are also intrusion-detection programs and software utilities that can detect illegal entry into systems along with software that monitors system activity and helps companies recover from fraud and malicious actions.

People who commit fraud tend to follow certain patterns and leave tell-tale clues, often things that do not make sense. Software is readily available to search for these fraud symptoms. For example, a health insurance company could use fraud detection software to look at how often procedures are performed, whether a diagnosis and the procedures performed fit a patient’s profile, how long a procedure takes, and how far patients live from the doctor’s office.

Neural networks (programs that mimic brain activity and can learn new concepts) are quite accurate in identifying suspected fraud. For example, Visa and MasterCard operations employ neural network software to track hundreds of millions of separate account transactions daily. Neural networks spot the illegal use of a credit card and notify the owner within a few hours of its theft. The software can also spot trends before bank investigators do.

Each enterprise needs to determine its appropriate overall governance system and the fraud detection approaches it decides to implement in support of that system. To help in that determination, mapping governance frameworks, principles, structures, processes and practices, currently in use, is beneficial. CFE’s and forensic accountants are uniquely qualified to assist in this process given their in-depth knowledge of all types of fraud scenarios and the tailoring of the anti-fraud controls most appropriate for the control of each within a specific company environment.

Sock Puppets

The issue of falsely claimed identity in all its myriad forms has shadowed the Internet since the beginning of the medium.  Anyone who has used an on-line dating or auction site is all too familiar with the problem; anyone can claim to be anyone.  Likewise, confidence games, on or off-line, involve a range of fraudulent conduct committed by professional con artists against unsuspecting victims. The victims can be organizations, but more commonly are individuals. Con artists have classically acted alone, but now, especially on the Internet, they usually group together in criminal organizations for increasingly complex criminal endeavors. Con artists are skilled marketers who can develop effective marketing strategies, which include a target audience and an appropriate marketing plan: crafting promotions, product, price, and place to lure their victims. Victimization is achieved when this marketing strategy is successful. And falsely claimed identities are always an integral component of such schemes, especially those carried out on-line.

Such marketing strategies generally involve a specific target market, which is usually made up of affinity groups consisting of individuals grouped around an objective, bond, or association like Facebook or LinkedIn Group users. Affinity groups may, therefore, include those associated through age, gender, religion, social status, geographic location, business or industry, hobbies or activities, or professional status. Perpetrators gain their victims’ trust by affiliating themselves with these groups.  Historically, various mediums of communication have been initially used to lure the victim. In most cases, today’s fraudulent schemes begin with an offer or invitation to connect through the Internet or social network, but the invitation can come by mail, telephone, newspapers and magazines, television, radio, or door-to-door channels.

Once the mark receives and accepts the offer to connect, some sort of response or acceptance is requested. The response will typically include (in the case of Facebook or LinkedIn) clicking on a link included in a fraudulent follow-up post to visit a specified web site or to call a toll-free number.

According to one of Facebook’s own annual reports, up to 11.2 percent of its accounts are fake. Considering the world’s largest social media company has 1.3 billion users, that means up to 140 million Facebook accounts are fraudulent; these users simply don’t exist. With 140 million inhabitants, the fake population of Facebook would be the tenth-largest country in the world. Just as Nielsen ratings on television sets determine different advertising rates for one television program versus another, on-line ad sales are determined by how many eyeballs a Web site or social media service can command.

Let’s say a shyster want 3,000 followers on Twitter to boost the credibility of her scheme? They can be hers for $5. Let’s say she wants 10,000 satisfied customers on Facebook for the same reason? No problem, she can buy them on several websites for around $1,500. A million new friends on Instagram can be had for only $3,700. Whether the con man wants favorites, likes, retweets, up votes, or page views, all are for sale on Web sites like Swenzy, Fiverr, and Craigslist. These fraudulent social media accounts can then be freely used to falsely endorse a product, service, or company, all for just a small fee. Most of the work of fake account set up is carried out in the developing world, in places such as India and Bangladesh, where actual humans may control the accounts. In other locales, such as Russia, Ukraine, and Romania, the entire process has been scripted by computer bots, programs that will carry out pre-encoded automated instructions, such as “click the Like button,” repeatedly, each time using a different fake persona.

Just as horror movie shape-shifters can physically transform themselves from one being into another, these modern screen shifters have their own magical powers, and organizations of men are eager to employ them, studying their techniques and deploying them against easy marks for massive profit. In fact, many of these clicks are done for the purposes of “click fraud.” Businesses pay companies such as Facebook and Google every time a potential customer clicks on one of the ubiquitous banner ads or links online, but organized crime groups have figured out how to game the system to drive profits their way via so-called ad networks, which capitalize on all those extra clicks.

Painfully aware of this, social media companies have attempted to cut back on the number of fake profiles. As a result, thousands and thousands of identities have disappeared over night among the followers of many well know celebrities and popular websites. If Facebook has 140 million fake profiles, there is no way they could have been created manually one by one. The process of creation is called sock puppetry and is a reference to the children’s toy puppet created when a hand is inserted into a sock to bring the sock to life. In the online world, organized crime groups create sock puppets by combining computer scripting, web automation, and social networks to create legions of online personas. This can be done easily and cheaply enough to allow those with deceptive intentions to create hundreds of thousands of fake online citizens. One only needs to consult a readily available on-line directory of the most common names in any country or region. Have a scripted bot merely pick a first name and a last name, then choose a date of birth and let the bot sign up for a free e-mail account. Next, scrape on-line photo sites such as Picasa, Instagram, Facebook, Google, and Flickr to choose an age-appropriate image to represent your new sock puppet.

Armed with an e-mail address, name, date of birth, and photograph, you sign up your fake persona for an account on Facebook, LinkedIn, Twitter, or Instagram. As a last step, you teach your puppets how to talk by scripting them to reach out and send friend requests, repost other people’s tweets, and randomly like things they see Online. Your bots can even communicate and cross-post with one another. Before the fraudster knows it, s/he has thousands of sock puppets at his disposal for use as he sees fit. It is these armies of sock puppets that criminals use as key constituents in their phishing attacks, to fake on-line reviews, to trick users into downloading spyware, and to commit a wide variety of financial frauds, all based on misplaced and falsely claimed identity.

The fraudster’s environment has changed and is changing over time, from a face-to-face physical encounter to an anonymous on-line encounter in the comfort of the victim’s own home. While some consumers are unaware that a weapon is virtually right in front of them, others are victims who struggle with the balance of the many wonderful benefits offered by advanced technology and the painful effects of its consequences. The goal of law enforcement has not changed over the years; to block the roads and close the loopholes of perpetrators even as perpetrators continue to strive to find yet another avenue to commit fraud in an environment in which they can thrive. Today, the challenge for CFEs, law enforcement and government officials is to stay on the cutting edge of technology, which requires access to constantly updated resources and communication between organizations; the ability to gather information; and the capacity to identify and analyze trends, institute effective policies, and detect and deter fraud through restitution and prevention measures.

Now is the time for CFEs and other assurance professionals to continuously reevaluate all we for take for granted in the modern technical world and to increasingly question our ever growing dependence on the whole range of ubiquitous machines whose potential to facilitate fraud so few of our clients and the general public understand.

Structure & Scope

T.J. Jones presented himself as a turnaround specialist to the Chairman of the Board of Central State Corporation, a medium sized, public company, a mid-western manufacturer of computer equipment, who hired him to take over a large, but under-performing division of the company.  Jones immediately set out lofty goals for sales and profits and very quickly replaced all the existing senior staff of the division with new hires loyal to himself. To meet his inflated goals, two of Jones’s managers, in addition to legitimate equipment sales, shipped bricks to distributors and recorded some as sales of equipment to retail distributors and some as inventory out on consignment. No real products left the plant for these “special sales.” The theory was that actual sales would inevitably grow, and the bricks could be replaced later with real products. In the meantime, the unwitting distributors thought they were holding consignment inventory in the unopened cartons.

The result was that overstated sales and accounts receivable quickly caused overstated net income, retained earnings, current assets, working capital, and total assets. Prior to the manipulation, annual sales of the division were $135 million. During the two falsification years of the fraud, sales were $185 million and $362 million. Net income went up from a loss of $20 million to $23 million (income), then to $31 million (income); and the gross margin percent went from 6 percent to 28 percent. The revenue and profit figures outpaced the performance of Central State’s industry category. The accounts receivable collection period grew to 94 days, while it was 70 days elsewhere in the industry.

All the paperwork was in order because the two hand-picked managers had falsified the sales and consignment invoices, even though they did not have customer purchase orders for all the false sales. Shipping papers were in order, and several co-operating shipping employees knew that not every box shipped contained disk drives. Company accounting and control procedures required customer purchase orders or contracts evidencing real orders. A sales invoice was supposed to indicate the products and their prices, and shipping documents were supposed to indicate actual shipment. Sales were always charged to a customer’s account receivable.  During the actual operation of the fraud there were no glaring control omissions that would have pointed to financial fraud. Alert auditors might have noticed the high tension created by concentration on meeting profit goals. Normal selection of sales transactions with vouching to customer orders and shipping documents might have turned up a missing customer order. Otherwise, the paperwork would have seemed to be in order. The problem lay in Jones’ and his managers’ power to override controls and to instruct some shipping staff to send dummy boxes.  Confirmations of distributors’ accounts receivable may have elicited exception responses. The problem was to have a large enough confirmation sample to pick up some of these distributors or to be skeptical enough to send a special sample of confirmations to distributors who took the “sales” near the end of the accounting period. Observation of inventory could have included some routine inspection of goods not on the company’s premises.

The overstatements were not detected. The auditor’s annual confirmation sample was typically small and did not contain any of the false shipments. Tests of detail transactions did not turn up any missing customer orders. The inventory out on consignment was audited by obtaining a written confirmation from the holders, who apparently over the entire period of the fraud had not opened even one of the affected boxes. The remarkable financial performance was attributed to good management.

The fraud was revealed by one of Jones’ subordinate managers who was arrested on an unrelated drug charge and volunteered as a cooperating witness in exchange for the dropping of the drug charge.

This hypothetical case is a good example of the initial situation confronting management when a fraud affecting the financial statements comes to light, often with little or no warning. Everyone involved with company management will have a strong intuitive sense that an investigation is necessary; but the fact is that the company has now lost faith in the validity of its own public disclosures of financial performance.

That will need to be fixed. And it is not enough to simply alert markets that previously issued financial results are wrong; outsiders will want to know what the correct numbers should have been. The only way to find out is to dig into the numbers and distinguish the falsified results from the real ones. Beyond the need to set the numbers straight, the company will need to identify those complicit in the fraud and deal with them. This is not only a quest for justice but the need to restore credibility, and the company will be unable to do so until outsiders are satisfied that the wrongdoing executives and staff have been identified and removed.  Thus, the company needs an audit report on its financial statements. The need for a new audit report arises from the likelihood that, once a company’s financial statements have been found to be unreliable, the company’s external auditor will want to pull its existing, inaccurate,  report.

As a practical matter, pulling its report involves the external auditor’s recommendation that the company issue a press release that previously issued financial statements are not to be relied upon. Once the company issues such a press release, it will be out of compliance with any number of SEC regulations. It will no longer satisfy the threshold prerequisites for trading on the company’s securities exchange. It will be viewed by many, and certainly the plaintiff class action bar, as coming close to having admitted wrongdoing. And everyone on the outside, not to mention its own board of directors, will want answers fast. A critical step in the restoration of important business relationships and a return to compliance with regulatory requirements is the new auditor’s report. And, where fraudulent financial reporting has been discovered, an in-depth and comprehensive investigation is often the only way to get one.

A critical issue at the outset of a financial fraud investigation is its structure and scope. A key attribute for which the external auditor, as well as the SEC, will be on the lookout is that the investigation is overseen by the audit committee. In public companies, it is the audit committee that has explicit legal responsibility for oversight of financial reporting, and accounting fraud falls squarely within the orbit of financial reporting.  In addition, the audit committee, as a matter of statutory design, is structured to be independent and possessed of a level of financial sophistication that makes it the most viable subset of the board of directors to oversee the investigative efforts in this case. It’s also the audit committee that has the statutory power to engage and pay outside advisers even without the consent of management, a statutory power that can be vital if management, or part of management, as in our hypothetical case above, is a participant in the fraud.

The audit committee’s role is to oversee the investigation, not actually conduct it. For that it needs to look to outside professionals, and there are two types. The one is the outside counsel to the audit committee. If the audit committee has not already engaged outside counsel, it needs to do so. It’s audit committee counsel who will conduct the interviews, comb through the financial records, and present factual findings for audit committee consideration. Individual audit committee members may choose to sit in on interviews, and that is their choice. But it’s audit committee counsel who will conduct the investigation. The other group of professionals is the forensic accountants and/or CFEs.  Audit committee counsel, while knowledgeable of financial reporting obligations and investigative techniques, will probably not possess a sufficiently detailed knowledge of accounting systems, generally accepted accounting principles
(GAAP), or computerized ledgers. For that, audit committee counsel is well advised look for help to the category of accountants and fraud examiners specifically trained in digging into financial records for evidence of fraud.

What exactly is the audit committee looking for in such an investigation? There are primarily two things. The first, obviously enough, is what the actual numbers should have been. Often fraudulent entries involve judgment calls where the operative question is not whether the number matches the underlying financial records but whether the judgment behind the number was exercised in good faith.  The operative question for the investigators is whether the executive exercised his judgment in good faith to make the best estimate allowed by reasonably available information. Sometimes it’s not so easy to tell.

Beyond the correct numbers, the second thing for which the investigators are looking is executive complicity. In other words: who did it? Again, the good faith of those potentially involved comes into play. The investigators are not seeking simply whether executives reported financial results that turned out to be wrong. The issue rather is whether the executives tried to get them right. If they did and made an honest mistake or estimated incorrectly, that does not sound like fraud and may not even be a violation of GAAP to begin with. The main point here is that, when it comes to executive complicity, the investigators are ordinarily looking for evidence of wrongful intent (scienter). In other words, they are looking for an intentional misapplication of GAAP or an approach to GAAP that is so reckless as to constitute the equivalent of an intentional misapplication.

The scope of the investigation, then, should not pose too difficult an issue at the outset.  Initially, the scope will be largely defined by the potential improprieties that have been uncovered. The tricky question becomes: how far should the investigators go beyond the suspicious entries? The judgment calls here are formidable. One of the key issues involves the expectations of the external auditor and, beyond that, the SEC. If the scope is not sufficiently broad, the investigation may not be satisfactory to either one. Indeed, an insufficient scope can place the external auditor in a particularly awkward spot insofar as the SEC may subsequently fault not only the audit committee for inadequate scope but the external auditor’s acceptance of the audit committee’s investigative report.

An additional complicating factor involves the way fraud starts and grows. A critical issue to consider is that, overtime, as the Central State example illustrates, the manipulations will often get increasingly aggressive as the perpetrators spread the fraud throughout many line items so that no single account stands out as unusual but a substantial number are affected. For example, to prevent the distortion of accounts receivable from getting too large, Jones and his accomplices spread the fraud into inventory, then asset capitalization, then net income. The spread of the fraud is analogous to pouring a glass of water on a tabletop. It can spread everywhere without getting too deep in any one place.

So, once fraudulent financial reporting has been identified, even in just a few entries, the investigators will want to consider the possibility that it’s a symptom of a broader problem. If the investigators have been lucky enough to nip it in the bud, that may be the end of it.  Unfortunately, if the fraud has gotten big enough to be detected in the first place, such a limited size cannot be assumed. Even where the fraud ostensibly starts out small the need for a broader scope has got to be considered.

The scope of the investigation, therefore, can start out with its parameters guided by the suspicious entries revealed at the outset. In most cases, though, it will need to broaden to ensure that additional areas are not affected as well. Throughout the investigation, moreover, the scope will have to remain flexible. The investigators will have to stay on the lookout for additional clues, and will have to follow where they lead. Faced with an ostensibly ever-widening scope, initial audit committee frustration is both to be expected and understandable. But there is just no practical alternative.

Bye-Bye Money

Miranda had responsibility for preparing personnel files for new hires, approval of wages, verification of time cards, and distribution of payroll checks. She “hired” fictitious employees, faked their records, and ordered checks through the payroll system. She deposited some checks in several personal bank accounts and cashed others, endorsing all of them with the names of the fictitious employees and her own. Her company’s payroll function created a large paper trail of transactions among which were individual earnings records, W-2 tax forms, payroll deductions for taxes and insurance, and Form 941 payroll tax reports. She mailed all the W-2 forms to the same post office box.

Miranda stole $160,000 by creating some “ghosts,” usually 3 to 5 out of 112 people on the payroll and paying them an average of $650 per week for three years. Sometimes the ghosts quit and were later replaced by others. But she stole “only” about 2 percent of the payroll funds during the period.

A tip from a fellow employee received by the company hotline resulted in the engagement of Tom Hudson, CFE.  Tom’s objective was to obtain evidence of the existence and validity of payroll transactions on the control premise that different people should be responsible for hiring (preparing personnel files), approving wages, and distributing payroll checks. “Thinking like a crook” lead Tom to readily see that Miranda could put people on the payroll and obtain their checks just as the hotline caller alleged. In his test of controls Tom audited for transaction authorization and validity. In this case random sampling was less likely to work because of the small number of alleged ghosts. So, Tom looked for the obvious. He selected several weeks’ check blocks, accounted for numerical sequence (to see whether any checks had been removed), and examined canceled checks for two endorsements.

Tom reasoned that there may be no “balance” to audit for existence/occurrence, other than the accumulated total of payroll transactions, and that the total might not appear out of line with history because the tipster had indicated that the fraud was small in relation to total payroll and had been going on for years.  He decided to conduct a surprise payroll distribution, then followed up by examining prior canceled checks for the missing employees and then scan personnel files for common addresses.

Both the surprise distribution and the scan for common addresses quickly provided the names of 2 or 3 exceptions. Both led to prior canceled checks (which Miranda had not removed and the bank reconciler had not noticed), which carried Miranda’s own name as endorser. Confronted, she confessed.

The major risks in any payroll business cycle are:

•Paying fictitious “employees” (invalid transactions, employees do not exist);

• Overpaying for time or production (inaccurate transactions, improper valuation);

•Incorrect accounting for costs and expenses (incorrect classification, improper or inconsistent presentation and disclosure).

The assessment of payroll system control risk normally takes on added importance because most companies have fairly elaborate and well-controlled personnel and payroll functions. The transactions in this cycle are numerous during the year yet result in lesser amounts in balance sheet accounts at year-end. Therefore, in most routine outside auditor engagements, the review of controls, test of controls and audit of transaction details constitute the major portion of the evidence gathered for these accounts. On most annual audits, the substantive audit procedures devoted to auditing the payroll-related account balances are very limited which enhances fraud risk.

Control procedures for proper segregation of responsibilities should be in place and operating. Proper segregation involves authorization (personnel department hiring and firing, pay rate and deduction authorizations) by persons who do not have payroll preparation, paycheck distribution, or reconciliation duties. Payroll distribution (custody) is in the hands of persons who do not authorize employees’ pay rates or time, nor prepare the payroll checks. Recordkeeping is performed by payroll and cost accounting personnel who do not make authorizations or distribute pay. Combinations of two or more of the duties of authorization, payroll preparation and recordkeeping, and payroll distribution in one person, one office, or one computerized system may open the door for errors and frauds. In addition, the control system should provide for detail control checking activities.  For example: (1) periodic comparison of the payroll register to the personnel department files to check hiring authorizations and for terminated employees not deleted, (2) periodic rechecking of wage rate and deduction authorizations, (3) reconciliation of time and production paid to cost accounting calculations, (4) quarterly reconciliation of YTD earnings records with tax returns, and (5) payroll bank account reconciliation.

Payroll can amount to 40 percent or more of an organization’s total annual expenditures. Payroll taxes, Social Security, Medicare, pensions, and health insurance can add several percentage points in variable costs on top of wages. So, for every payroll dollar saved through forensic identification, bonus savings arise automatically from the on-top costs calculated on base wages. Different industries will exhibit different payroll risk profiles. For example, firms whose culture involves salaried employees who work longer hours may have a lower risk of payroll fraud and may not warrant a full forensic approach. Organizations may present greater opportunity for payroll fraud if their workforce patterns entail night shift work, variable shifts or hours, 24/7 on-call coverage, and employees who are mobile, unsupervised, or work across multiple locations. Payroll-related risks include over-claimed allowances, overused extra pay for weekend or public holiday work, fictitious overtime, vacation and sick leave taken but not deducted from leave balances, continued payment of employees who have left the organization, ghost employees arising from poor segregation of duties, and the vulnerability of data output to the bank for electronic payment, and roster dysfunction. Yet the personnel assigned to administer the complexities of payroll are often qualified by experience than by formal finance, legal, or systems training, thereby creating a competency bias over how payroll is managed. On top of that, payroll is normally shrouded in secrecy because of the inherently private nature of employee and executive pay. Underpayment errors are less probable than overpayment errors because they are more likely to be corrected when the affected employees complain; they are less likely to be discovered when employees are overpaid. These systemic biases further increase the risk of unnoticed payroll error and fraud.

Payroll data analysis can reveal individuals or entire teams who are unusually well-remunerated because team supervisors turn a blind eye to payroll malpractice, as well as low-remunerated personnel who represent excellent value to the organization. For example, it can identify the night shift worker who is paid extra for weekend or holiday work plus overtime while actually working only half the contracted hours, or workers who claim higher duty or tool allowances to which they are not entitled. In addition to providing management with new insights into payroll behaviors, which may in turn become part of ongoing management reporting, the total payroll cost distribution analysis can point forensic accountants toward urgent payroll control improvements.

The detail inside payroll and personnel databases can reveal hidden information to the forensic examiner. Who are the highest earners of overtime pay and why? Which employees gained the most from weekend and public holiday pay? Who consistently starts late? Finishes early? Who has the most sick leave? Although most employees may perform a fair day’s work, the forensic analysis may point to those who work less, sometimes considerably less, than the time for which they are paid. Joined-up query combinations to search payroll and human resources data can generate powerful insights into the organization’s worst and best outliers, which may be overlooked by the data custodians. An example of a query combination would be: employees with high sick leave + high overtime + low performance appraisal scores + negative disciplinary records. Or, reviewers could invert those factors to find the unrecognized exemplary performers.

Where predication suggests fraud concerns about identified employees, CFEs can add value by triangulating time sheet claims against external data sources such as site access biometric data, company cell phone logs, phone number caller identification, GPS data, company email, Internet usage, company motor fleet vehicle tolls, and vehicle refueling data, most of which contain useful date and time-of-day parameters.  The data buried within these databases can reveal employee behavior, including what they were doing, where they were, and who they were interacting with throughout the work day.

Common findings include:

–Employees who leave work wrongfully during their shift;
–Employees who work fewer hours and take sick time during the week to shift the workload to weekends and public holidays to maximize pay;
–Employees who use company property excessively for personal purposes during working hours;
–Employees who visit vacation destinations while on sick leave;
–Employees who take leave but whose managers do not log the paperwork, thereby not deducting leave taken and overstating leave balances;
–Employees who moonlight in businesses on the side during normal working hours, sometimes using the organization’s equipment to do so.

Well-researched and documented forensic accounting fieldwork can support management action against those who may have defrauded the organization or work teams that may be taking inappropriate advantage of the payroll system. Simultaneously, CFEs and forensic accountants, working proactively, can partner with management to recover historic costs, quantify future savings, reduce reputational and political risk, improve the organization’s anti-fraud policies, and boost the productivity and morale of employees who knew of wrongdoing but felt powerless to stop it.

An Ethical Toolbox

As CFE’s we know organizations that have clearly articulated values and a strong culture of ethical behavior tend to control fraud more effectively. They usually have well-established frameworks, principles, rules, standards, and policies that encompass the attributes of generally accepted fraud control. These attributes include leadership, an ethical framework, responsibility structures, a fraud control policy; prevention systems, fraud awareness, third-party management systems, notification systems, detection systems, and investigation systems.

CFE’s are increasingly being called upon to assist in the planning for an assessment of a client organization’s integrity and ethics safeguards and then as active members of the team performing the engagement. The increasing demand for such assessments has grown out of the increasing awareness that a strong ethical culture is a vital part of effective fraud prevention.  Conducting such targeted research within the client organization, within its industry; and its region will help determine the emerging risk areas and potential gaps in most organizational anti-fraud safeguards. Four key elements of integrity and ethics safeguards have emerged over the past few years.  These are the fraud control plan, handling conflicts of interest, shaping ethical dealings with third parties, and natural justice principles for employees facing allegations of wrongdoing.

The need for a fraud control plan is borne out by an organization’s potential fraud losses; typically, about five percent of revenues are lost to fraud each year, according to the ACFE’s 2016 Report to the Nations on Occupational Fraud and Abuse. A fraud control plan typically will articulate an organization’s fraud risks, controls, and mitigation strategies, including:

–Significant business activities;
–Potential areas of fraud risk;
–Related fraud controls;
–Gaps in control coverage and assurance activities;
–Defined remedial actions to minimize fraud risks;
–Review mechanisms evaluating the effectiveness of fraud control strategies.

Management should review and update the fraud control plan periodically and report the results to the audit committee and senior management. Thus, the role of the board and of the audit committee of the board are vital for the implementation of any ethically based fraud control plan. The chairman of the board is, or should be, the chief advocate for the shareholders, and completely independent of management. It is the chairman’s primary job to direct the company’s executives and drive oversight of their activities in the name of the shareholders. An independent and highly skilled audit committee chairman is essential to maintain a robust system of checks and balances over all operations. To be truly effective, the chairman must be independent of those he or she is charged with watching.  The chairmen of the board and the audit committee must devote material time to their duties. While the board can use the company’s oversight functions to maintain a checks and balances process, there is no substitute for personal, direct involvement. The board must be willing to direct inquiries into allegations of misconduct, and have unquestioned confidential spending authority to conduct reviews and investigations as it deems necessary.

One of the most effective compliance tools available to the board is the day-to-day vigilance of the company’s employees. When an individual employee detects wrongdoing, he or she must have an effective and safe method to report observations, such as a third-party ethics hotline that reports to the chairman of the board and audit committee. All employees must be protected from retribution to avoid any possibility of corrupting the process.

A zero-based budgeting process, requiring that the individual elements of the company’s budget be built from the bottom up, reviewed in detail, and justified, can identify unusual spending in numerous corporate and operating units. This provides an in-depth view of spending as opposed to basing the current year’s spending, in aggregate, on last year’s spending, where irregularities may be buried and overlooked.

In organizations with an internal audit division the overall review would typically be performed by Director of Internal Audit (CAE) whom the CFE and other specialists would support. This review should be integrated into the organization’s wider business planning to ensure synergies exist with other business processes, and should link to the organization-wide risk assessment and to other anti-fraud processes.

The ACFE tells us that there is a growing consensus that managing conflicts of interest is critical to curbing corruption. Reports indicate that unmanaged conflicts of interest continue to cost organizations millions of dollars. To minimize these risks, organizations need a clear and well-understood conflict of interest policy, coupled with practical arrangements to implement and monitor policy requirements. Stated simply, a conflict of interest occurs when the independent judgment of a person is swayed, or might be swayed, from making decisions in the best interest of others who are relying on that judgment. An executive or employee is expected to make judgments in the best interest of the company. A director is legally expected to make judgments in the best interest of the company and of its shareholders, and to do so strategically so that no harm and perhaps some benefit will come to other stakeholders and to the public interest. A professional accountant is expected to make judgments that are in the public interest. Decision makers usually have a priority of duties that they are expected to fulfill, and a conflict of interests confuses and distracts the decision maker from that duty, resulting in harm to those legitimate expectations that are not fulfilled. Sometimes the term apparent conflict of interest is used, but it is a misnomer because it refers to a situation where no conflict of interest exists, although because of lack of information someone other than the decision maker would be justified in concluding (however tentatively) that the decision maker does have one

A special or conflicting interest could include any interest, loyalty, concern, emotion, or other feature of a situation tending to make the decision maker’s judgment (in that situation) less reliable than it would normally be, without rendering the decision maker incompetent. Commercial interests and family connections are the most common sources of conflict of interest, but love, prior statements, gratitude, and other subjective tugs on judgment can also constitute interest in this sense.

The perception of competing interests, impaired judgment, or undue influence also can be a conflict of interest. Good practices for managing conflicts of interest involve both prevention and detection, such as:

–Promoting ethical standards through a documented, explicit conflict of interest policy as well as well-stated values and clear conflicts provisions in the code of ethics;
–Identifying, understanding, and managing conflicts of interest through open and transparent communication to ensure that decision-making is efficient, transparent, and fair, and that everyone is aware of what to do if they suspect a conflict;
–Informing third parties of their responsibilities and the consequences of noncompliance through a statement of business ethics and formal contractual requirements;
–Ensuring transparency through well-established arrangements for declaring and registering gifts and other benefits;
–Ensuring that decisions are made independently, with evidence that staff and contractors routinely declare all actual, potential, and perceived conflicts of interests, involving at-risk areas such as procurement, management of contracts, human resources, decision-making, and governmental policy advice;
–Establishing management, internal controls, and independent oversight to detect breaches of policy and to respond appropriately to noncompliance.

Contemporary business models increasingly involve third parties, with external supplier costs now representing one of the most significant lines of expenditure for many organizations. Such interactions can provide an opportunity for fraud and corruption. An enterprise’s strong commitment to ethical values needs to be communicated to suppliers through a Statement of Business Ethics. Many forward-thinking organizations already have codes of ethics in place that set out the values and ethical expectations of both their board members and staff. The board code of conduct should define the behavioral standards for members, while the staff code of conduct should detail standards for employee conduct and the sanctions that apply for wrongdoing. Similar statements also are appropriate for third parties such as suppliers, service providers, and business partners.

A statement of business ethics outlines both acceptable and unacceptable practices in third-party dealings with an organization. Common features include:

–The CEO’s statement on the organization’s commitment to operating ethically;
–The organization’s values and business principles;
–What third parties can expect in their dealings with the organization and the behaviors expected of them;
–Guidance related to bribery, gifts, benefits, hospitality, travel, and accommodation; conflicts of interest; confidentiality and privacy of information; ethical communications; secondary employment; and other expectations.
–Contact information for concerns, clarification, reporting of wrongdoing, and disputes.

Once established, the organization needs to implement a well-rounded communication strategy for the statement of business ethics that includes education of staff members, distribution to third parties, publication on the organization’s website, references to it in the annual report, and inclusion in future tender proposals and bid packs.

Engaged and capable employees underpin the success of most organizations, yet management does not always recognize the bottom-line effects and employee turnover costs when innocent employees are the subject of allegations of fraud and other wrongdoing. About 60 percent of allegations against employees turn out to be unsubstantiated, according to the ACFE. A charter of rights compiles in a single document all the information that respondents to allegations of wrongdoing may require. Such a charter should be written in an easy-to-understand style to meet the needs of its target audience. It should:

–Outline the charter’s purpose, how it will operate, how it supports a robust complaints and allegations system, and how it aligns with the organization’s values;
–Describe how management handles workplace allegations and complaints, and ensure principles of natural justice and other legislative obligations, such as privacy, are in place;
–Provide a high-level overview diagram of the allegation assessment and investigation process, including the channels for submitting allegations; the distinct phases for logging, assessing, and investigating the allegations; and the final decision-making phase;
–Include details of available support such as contact information for human resource specialists, details about an external confidential employee help line, and processes for updates throughout the investigation;
–Illustrate the tiered escalation process for handling allegations that reflects (at one end) how issues of a serious, sensitive, or significant nature are addressed, and encourages (at the other end) the handling of low level localized issues as close to the source as possible;
–Provide answers to frequent questions that respondents might have about the process for dealing with allegations, such as “What can I expect?” “Are outcomes always reviewable?” “What does frivolous and vexatious mean?” “What will I be told about the outcome?” and “What happens when a process is concluded?”;
–Outline the options for independent reviews of adverse investigation outcomes.

The Who, the What, the When

CFEs and forensic accountants are seekers. We spend our days searching for the most relevant information about our client requested investigations from an ever-growing and increasingly tangled data sphere and trying to make sense of it. Somewhere hidden in our client’s computers, networks, databases, and spreadsheets are signs of the alleged fraud, accompanying control weaknesses and unforeseen risks, as well as possible opportunities for improvement. And the more data the client organization has, the harder all this is to find.  Although most computer-assisted forensic audit tests focus on the numeric data contained within structured sources, such as financial and transactional databases, unstructured or text based data, such as e-mail, documents, and Web-based content, represents an estimated 8o percent of enterprise data within the typical medium to large-sized organization. When assessing written communications or correspondence about fraud related events, CFEs often find themselves limited to reading large volumes of data, with few automated tools to help synthesize, summarize, and cluster key information points to aid the investigation.

Text analytics is a relatively new investigative tool for CFEs in actual practice although some report having used it extensively for at least the last five or more years. According to the ACFE, the software itself stems from a combination of developments in our sister fields of litigation support and electronic discovery, and from counterterrorism and surveillance technology, as well as from customer relationship management, and research into the life sciences, specifically artificial intelligence. So, the application of text analytics in data review and criminal investigations dates to the mid-1990s.

Generally, CFEs increasingly use text analytics to examine three main elements of investigative data: the who, the what, and the when.

The Who: According to many recent studies, substantially more than a half of business people prefer using e-mail to use of the telephone. Most fraud related business transactions or events, then, will likely have at least some e-mail communication associated with them. Unlike telephone messages, e-mail contains rich metadata, information stored about the data, such as its author, origin, version, and date accessed, and can be documented easily. For example, to monitor who is communicating with whom in a targeted sales department, and conceivably to identify whether any alleged relationships therein might signal anomalous activity, a forensic accountant might wish to analyze metadata in the “to,” “from,” “cc,” or “bcc” fields in departmental e-mails. Many technologies for parsing e-mail with text analytics capabilities are available on the market today, some stemming from civil investigations and related electronic discovery software. These technologies are like the social network diagrams used in law enforcement or in counterterrorism efforts.

The What: The ever-present ambiguity inherent in human language presents significant challenges to the forensic investigator trying to understand the circumstances and actions surrounding the text based aspects of a fraud allegation. This difficulty is compounded by the tendency of people within organizations to invent their own words or to communicate in code. Language ambiguity can be illustrated by examining the word “shred”. A simple keyword search on the word might return not only documents that contain text about shredding a document, but also those where two sports fans are having a conversation about “shredding the defense,” or even e-mails between spouses about eating Chinese “shredded pork” for dinner. Hence, e-mail research analytics seeks to group similar documents according to their semantic context so that documents about shredding as concealment or related to covering up an action would be grouped separately from casual e-mails about sports or dinner, thus markedly reducing the volume of e-mail requiring more thorough ocular review. Concept-based analysis goes beyond traditional search technology by enabling users to group documents according to a statistical inference about the co-occurrence of similar words. In effect, text analytics software allows documents to describe themselves and group themselves by context, as in the shred example. Because text analytics examines document sets and identifies relationships between documents according to their context, it can produce far more relevant results than traditional simple keyword searches.

Using text analytics before filtering with keywords can be a powerful strategy for quickly understanding the content of a large corpus of unstructured, text-based data, and for determining what is relevant to the search. After viewing concepts at an elevated level, subsequent keyword selection becomes more effective by enabling users to better understand the possible code words or company-specific jargon. They can develop the keywords based on actual content, instead of guessing relevant terms, words, or phrases up front.

The When: In striving to understand the time frames in which key events took place, CFEs often need to not only identify the chronological order of documents (e.g., sorted by or limited to dates), but also link related communication threads, such as e-mails, so that similar threads and communications can be identified and plotted over time. A thread comprises a set of messages connected by various relationships; each message consists of either a first message or a reply to or forwarding of some other message in the set. Messages within a thread are connected by relationships that identify notable events, such as a reply vs. a forward, or changes in correspondents. Quite often, e-mails accumulate long threads with similar subject headings, authors, and message content over time. These threads ultimately may lead to a decision, such as approval to proceed with a project or to take some other action. The approval may be critical to understanding business events that led up to a particular journal entry. Seeing those threads mapped over time can be a powerful tool when trying to understand the business logic of a complex financial transaction.

In the context of fraud risk, text analytics can be particularly effective when threads and keyword hits are examined with a view to considering the familiar fraud triangle; the premise that all three components (incentive/pressure, opportunity, and rationalization) are present when fraud exists. This fraud triangle based analysis can be applied in a variety of business contexts where increases in the frequency of certain keywords related to incentive/pressure, opportunity, and rationalization, can indicate an increased level of fraud risk.

Some caveats are in order.  Considering the overwhelming amount of text-based data within any modern enterprise, assurance professionals could never hope to analyze all of it; nor should they. The exercise would prove expensive and provide little value. Just as an external auditor would not reprocess or validate every sales transaction in a sales journal, he or she would not need to look at every related e-mail from every employee. Instead, any professional auditor would take a risk-based approach, identifying areas to test based on a sample of data or on an enterprise risk assessment. For text analytics work, the reviewer may choose data from five or ten individuals to sample from a high-risk department or from a newly acquired business unit. And no matter how sophisticated the search and information retrieval tools used, there is no guarantee that all relevant or high-risk documents will be identified in large data collections. Moreover, different search methods may produce differing results, subject to a measure of statistical variation inherent in probability searches of any type. Just as a statistical sample of accounts receivable or accounts payable in the general ledger may not identify fraud, analytics reviews are similarly limited.

Text analytics can be a powerful fraud examination tool when integrated with traditional forensic data-gathering and analysis techniques such as interviews, independent research, and existing investigative tests involving structured, transactional data. For example, an anomaly identified in the general ledger related to the purchase of certain capital assets may prompt the examiner to review e-mail communication traffic among the key individuals involved, providing context around the circumstances and timing, of events before the entry date. Furthermore, the forensic accountant may conduct interviews or perform additional independent research that may support or conflict with his or her investigative hypothesis. Integrating all three of these components to gain a complete picture of the fraud event can yield valuable information. While text analytics should never replace the traditional rules-based analysis techniques that focus on the client’s financial accounting systems, it’s always equally important to consider the communications surrounding key events typically found in unstructured data, as opposed to that found in the financial systems.