Tag Archives: anti-fraud policy

A Blueprint for Fraud Risk Assessment

It appears that several of our Chapter members have been requested these last few months to assist their employers in conducting several types of fraud risk assessments. They usually do so as the Certified Fraud Examiner (CFE) member of their employing company’s internal audit-lead assessment team.   There is a consensus emerging among anti-fraud experts that conducting a fraud risk assessment (FRA) is critical to the process of detecting, and ultimately designing controls to prevent the ever-evolving types of fraud threatening organizations.

The ACFE tells us that FRAs do not necessarily specify what types of fraud are occurring in an organization. Instead, they are designed to focus detection efforts on specific fraud schemes and scenarios that could occur as well as on incidents that are known to have occurred in the past. Once these are identified, the audit team can proceed with the series of basic and specific fraud detection exercises that broad experience has shown to be effective. The objective of these exercises is to hopefully reveal the specific fraud schemes to which the organization is most exposed. This information will enable the organization’s audit team to recommend to management and to support the implementation of antifraud controls designed to address exactly those risks that have been identified.  It’s important to emphasize that fraud risk assessments are not meant to prevent fraud directly in and of themselves. They are exercises for identifying those specific fraud schemes and scenarios to which an organization is most vulnerable. That information is in turn used to conduct fraud audit exercises to highlight the circumstances that have allowed actual, known past frauds to occur or to blueprint future frauds that could occur so that the necessary controls can be put in place to prevent similar future illegal activity.

In the past, those FRAs that were conducted were usually performed by the firm’s external auditors. Increasingly, however, internal audit departments are being pressured by senior management to conduct FRAs of their own. Since internal audit departments are increasingly employing CFEs or have their expertise available to them through other company departments (like loss prevention or security), this effort can be effective since internal auditors have the tenure and experience with their organizations to know better than anyone how its financial and business operations function and can understand more readily how fraud could occur in particular processes, transactions, and business cycles.

Internal audit employed CFE’s and CIA’s aren’t involved by requirement of their professional standards in daily operations and can, therefore, provide an independent check on their organization’s overall risk management process. Audits can be considered a second channel of information on how well the enterprise’s anti-fraud controls are functioning and whether there are any deficiencies that need to be corrected.  To ensure this channel remains independent, it is important that the audit function report directly to the Audit Committee or to the board of directors and not to the chief executive officer or company president who may have responsibility for her company’s internal controls.

The Institute of Internal Auditors has endorsed audit standards that outline the techniques and procedures for conducting an FRA, specifically those contained in Statement of Auditing Standards 99 (SAS 99). By this (and other) key guidelines, an FRA is meant to assist auditors and/or fraud examiners in adjusting their audit and investigation plans to focus on gathering evidence of potential fraud schemes and scenarios identified by the FRA.

Responding to FRA findings requires the auditor to adjust the timing, nature, and extent of testing in such ways as:

• Performing procedures at physical locations on a surprise or unannounced basis by, for example, counting cash at different subsidiary locations on a surprise basis or reviewing loan portfolios of random loan officers or divisions of a savings and loan on a surprise basis;
• Requesting that financial performance data be evaluated at the end of the reporting period or on a date closer to period-end, in order, for example, to minimize the risk of manipulation of records in the period between the dates of account closings and the end of the reporting period;
• Making oral inquiries of major customers and vendors in addition to sending written confirmations, or sending confirmation requests to a specific party within vendor or customer organization;
• Performing substantive analytical procedures using disaggregated data by, for example, comparing gross profit or operating margins by branch office, type of service, line of business, or month to auditor-developed expectations;
• Interviewing personnel involved in activities in areas where a risk of material misstatement due to fraud has been identified in the past (such as at the country or regional level) to obtain their insights about the risk and how controls could address the risk.

CFE team members can make a substantial contribution to the internal audit lead team effort since it’s essential that financial operations managers and internal audit professionals understand how to conduct an FRA and to thoroughly assess the organization’s exposure to specific frauds. That contribution can add value to management’s eventual formulation and implementation of specific, customized controls designed to mitigate each type of fraud risk identified in the FRA. These are the measures that go beyond the basic, essential control checklists followed by many external auditors; they optimize the organization’s defenses against these risks. As such, they must vary from organization to organization, in accordance with the particular processes and procedures that are identified as vulnerable to fraud.

As an example, company A may process invoices in such a tightly controlled way, with double or triple approvals of new vendors, manual review of all invoices, and so on, that an FRA reveals few if any areas where red flags of vendor fraud can be identified. Company B, on the other hand, may process invoices simply by having the appropriate department head review and approve them. In the latter case, an FRA would raise red flags of potential fraud that could occur through double billing, sham company schemes, or collusion between a dishonest vendor and a company insider. For that reason, SAS 99 indicates that some risks are inherent in the environment of the entity, but most can be addressed with an appropriate system of internal control. Once fraud risk assessment has taken place, the entity can identify the processes, controls, and other procedures that are needed to mitigate the identified risks. Effective internal controls will include a well-developed control environment, an effective and secure information system, and appropriate control and monitoring activities. Because of the importance of information technology in supporting operations and the processing of transactions, management also needs to implement and maintain appropriate controls, whether automated or manual, over computer generated information.

The ACFE tells us that the heart of an effective internal controls system and the effectiveness of an anti-fraud program are contingent on an effective risk management assessment.  Although conducting an FRA is not terribly difficult, it does require careful planning and methodical execution. The structure and culture of the organization dictate how the FRA is formulated. In general, however, there is a basic, generally accepted form of the FRA that the audit and fraud prevention communities have agreed on and about which every experienced CFE is expected to be knowledgeable. Assessing the likelihood and significance of each potential fraud risk is a subjective process that should consider not only monetary significance, but also significance to an organization’s reputation and its legal and regulatory compliance requirements. An initial assessment of fraud risk should consider the inherent risk of a particular fraud in the absence of any known controls that may address the risk. An organization can cost-effectively manage its fraud risks by assessing the likelihood and significance of fraudulent behavior.

The FRA team should include a senior internal auditor (or the chief internal auditor, if feasible) and/or an experienced inside or outside certified fraud examiner with substantial experience in conducting FRAs for organizations in the company’s industry.  The management of the internal audit department should prepare a plan for all the assignments to be performed. The audit plan includes the timing and frequency of planned internal audit work. This audit plan is based on a methodical control risk assessment A control risk assessment documents the internal auditor’s understanding of the institution’s significant activities and their associated risks. The management of the internal audit department should establish the principles of the risk assessment methodology in writing and regularly update them to reflect changes to the system of internal control or work process, and to incorporate new lines of business. The risk analysis examines all the entity’s activities, and the complete internal control system. Based on the results of the risk analysis, an audit plan for several years is established, considering the degree of risk inherent in the activities. The plan also considers expected developments and innovations, the generally higher degree of risk of new activities, and the intention to audit all significant activities and entities within a reasonable time period (audit cycle principle for example, three
years). All those concerns will determine the extent, nature and frequency of the assignments to be performed.

In summary…

• A fraud risk assessment is an analysis of an organization’s risks of being victimized by specific types of fraud;
• Approaches to FRAs will differ from organization to organization, but most FRAs focus on identifying fraud risks in six key categories:
— Fraudulent financial reporting;
— Misappropriation of assets;
— Expenditures and liabilities for an improper purpose;
— Revenue and assets obtained by fraud;
— Costs and expenses avoided by fraud;
— Financial misconduct by senior management.
• A properly conducted FRA guides auditors in adjusting their audit plans and testing to focus specifically on gathering evidence of possible fraud;
• The capability to conduct an FRA is essential to effective assessment of the viability of existing anti-fraud controls and to strengthen the organization’s inadequate controls, as identified by the results of the FRA;
• In addition to assessing the types of fraud for which the organization is at risk, the FRA assesses the likelihood that each of those frauds might occur;
• After the FRA and subsequent fraud auditing work is completed, the FRA team should have a good idea of the specific controls needed to minimize the organization’s vulnerability to fraud;
• Auditing for fraud is a critical next step after assessing fraud risks, and this requires auditing for evidence of frauds that may exist according to the red flags identified by the FRA.

Help for the Little Guy

It’s clear to the news media and to every aware assurance professional that today’s cybercriminals are more sophisticated than ever in their operations and attacks. They’re always on the lookout for innovative ways to exploit vulnerabilities in every global payment system and in the cloud.

According to the ACFE, more consumer records were compromised in 2015-16 than in the previous four years combined. Data breach statistics from this year (2017) are projected to be even grimmer due to the growth of increasingly sophisticated attack methods such as increasingly complex malware infections and system vulnerability exploits, which grew tenfold in 2016. With attacks coming in many different forms and from many different channels, consumers, businesses and financial institutions (often against their will) are being forced to gain a better understanding of how criminals operate, especially in ubiquitous channels like social networks. They then have a better chance of mitigating the risks and recognizing attacks before they do severe damage.

As your Chapter has pointed out over the years in this blog, understanding the mechanics of data theft and the conversion process of stolen data into cash can help organizations of all types better anticipate in the exact ways criminals may exploit the system, so that organizations can put appropriate preventive measures in place. Classic examples of such criminal activity include masquerading as a trustworthy entity such as a bank or credit card company. These phishers send e-mails and instant messages that prompt users to reply with sensitive information such as usernames, passwords and credit card details, or to enter the information at a rogue web site. Other similar techniques include using text messaging (SMSishing or smishing) or voice mail (vishing) or today’s flood of offshore spam calls to lure victims into giving up sensitive information. Whaling is phishing targeted at high-worth accounts or individuals, often identified through social networking sites such as LinkedIn or Facebook. While it’s impossible to anticipate or prevent every attack, one way to stay a step ahead of these criminals is to have a thorough understanding of how such fraudsters operate their enterprises.

Although most cyber breaches reported recently in the news have struck large companies such as Equifax and Yahoo, the ACFE tells us that small and mid-sized businesses suffer a far greater number of devastating cyber incidents. These breaches involve organizations of every industry type; all that’s required for vulnerability is that they operate network servers attached to the internet. Although the number of breached records a small to medium sized business controls is in the hundreds or thousands, rather than in the millions, the cost of these breaches can be higher for the small business because it may not be able to effectively address such incidents on its own.  Many small businesses have limited or no resources committed to cybersecurity, and many don’t employ any assurance professionals apart from the small accounting firms performing their annual financial audit. For these organizations, the key questions are “Where should we focus when it comes to cybersecurity?” and “What are the minimum controls we must have to protect the sensitive information in our custody?” Fraud Examiners and forensic accountants with client attorneys assisting small businesses can assist in answering these questions by checking that their client attorney’s organizations implement a few vital cybersecurity controls.

First, regardless of their industry, small businesses must ensure their network perimeter is protected. The first step is identifying the vulnerabilities by performing an external network scan at least quarterly. A small business can either hire an outside company to perform these scans, or, if they have small in-house or contracted IT, they can license off-the-shelf software to run the scans, themselves. Moreover, small businesses need a process in place to remedy the identified critical, high, and medium vulnerabilities within three months of the scan run date, while low vulnerabilities are less of a priority. The fewer vulnerabilities the perimeter network has,
the less chance that an external hacker will breach the organization’s network.

Educating employees about their cybersecurity responsibilities is not a simple check-sheet matter. Smaller businesses not only need help in implementing an effective information security policy, they also need to ensure employees are aware of the policy and of their responsibilities. The policy and training should cover:

–Awareness of phishing attacks;
–Training on ransomware management;
–Travel tips;
–Potential threats of social engineering;
–Password protection;
–Risks of storing sensitive data in the cloud;
–Accessing corporate information from home computers and other personal devices;
–Awareness of tools the organization provides for securely sending emails or sharing large files;
–Protection of mobile devices;
–Awareness of CEO spoofing attacks.

In addition, small businesses should verify employees’ level of awareness by conducting simulation exercises. These can be in the form of a phishing exercise in which organizations themselves send fake emails to their employees to see if they will click on a web link, or a social engineering exercise in which a hired individual tries to enter the organization’s physical location and steal sensitive information such as information on computer screens left in plain sight.

In small organizations, sensitive information tends to proliferate across various platforms and folders. For example, employees’ personal information typically resides in human resources software or with a cloud service provider, but through various downloads and reports, the information can proliferate to shared drives and folders, laptops, emails, and even cloud folders like Dropbox or Google Drive. Assigned management at the organization should check that the organization has identified the sites of such proliferation to make sure it has a good handle on the state of all the organization’s sensitive information:

–Inventory all sensitive business processes and the related IT systems. Depending on the organization’s industry, this information could include customer information, pricing data, customers’ credit card information, patients’ health information, engineering data, or financial data;
–For each business process, identify an information owner who has complete authority to approve user access to that information;
–Ensure that the information owner periodically reviews access to all the information he or she owns and updates the access list.

Organizations should make it hard to get to their sensitive data by building layers or network segments. Although the network perimeter is an organization’s first line of defense, the probability of the network being penetrated is today at an all-time high. Management should check whether the organization has built a layered defense to protect its sensitive information. Once the organization has identified its sensitive information, management should work with the IT function to segment those servers that run its sensitive applications.  This segmentation will result in an additional layer of protection for these servers, typically by adding another firewall for the segment. Faced with having to penetrate another layer of defense, an intruder may decide to go elsewhere where less sensitive information is stored.

An organization’s electronic business front door also can be the entrance for fraudsters and criminals. Most of today’s malware enters through the network but proliferates through the endpoints such as laptops and desktops. At a minimum, internal small business management must ensure that all the endpoints are running anti-malware/anti-virus software. Also, they should check that this software’s firewall features are enabled. Moreover, all laptop hard drives should be encrypted.

In addition to making sure their client organizations have implemented these core controls, assurance professionals should advise small business client executives to consider other protective controls:

–Monitor the network. Network monitoring products and services can provide real-time alerts in case there is an intrusion;
–Manage service providers. Organizations should inventory all key service providers and review all contracts for appropriate security, privacy, and data breach notification language;
–Protect smart devices. Increasingly, company information is stored on mobile devices. Several off-the-shelf solutions can manage and protect the information on these devices. Small businesses should ensure they are able to wipe the sensitive information from these devices if they are lost or stolen;
–Monitor activity related to sensitive information. Management IT should log activities against their sensitive information and keep an audit log in case an incident occurs and they need to review the logs to evaluate the incident.

Combined with the controls listed above, these additional controls can help any small business reduce the probability of a data breach. But a security program is only as strong as its weakest link Through their assurance and advisory work, CFE’s and forensic accountants can proactively help identify these weaknesses and suggest ways to strengthen their smaller client organization’s anti-fraud defenses.

Fraud Risk Assessing the Trusted Insider

A bank employee accesses her neighbor’s accounts on-line and discloses this information to another person living in the neighborhood; soon everyone seems to be talking about the neighbor’s financial situation. An employee of a mutual fund company accesses his father-in-law’s accounts without a legitimate reason or permission from the unsuspecting relative and uses the information to pressure his wife into making a bad investment from which the father-in-law, using money from the fund account, ultimately pays to extricate his daughter. Initially, out of curiosity, an employee at a local hospital accesses admission records of a high-profile athlete whom he recognized in the emergency room but then shares that information (for a price) with a tabloid newspaper reporter who prints a story.

Each of these is an actual case and each is a serious violation of various Federal privacy laws. Each of these three scenarios were not the work of an anonymous intruder lurking in cyberspace or of an identity thief who compromised a data center. Rather, this database browsing was perpetrated by a trusted insider, an employee whose daily duties required them to have access to vast databases housing financial, medical and educational information. From the comfort and anonymity of their workstations, similar employees are increasingly capable of accessing personal information for non-business reasons and, sometimes, to support the accomplishment of actual frauds. The good news is that CFE’s can help with targeted fraud risk assessments specifically tailored to assess the probability of this threat type and then to advise management on an approach to its mitigation.

The Committee of Sponsoring Organizations of the Treadway Commission’s (COSO’s) 2013 update of the Internal Control Integrated Framework directs organizations to conduct a fraud risk assessment as part of their overall risk assessment. The discussion of fraud in COSO 2013 centers on Principle 8: “The organization considers the potential for fraud in assessing risks to the achievement of objectives.” Under the 1992 COSO framework, most organizations viewed fraud risk primarily in terms of satisfying the U.S. Sarbanes-Oxley Act of 2002 requirements to identify fraud controls to prevent or detect fraud risk at the transaction level. In COSO 2013, fraud risk becomes a specific component of the overall risk assessment that focuses on fraud at the entity and transaction levels. COSO now requires a strong internal control foundation that addresses fraud broadly to encompass company objectives as part of its strategy, operations, compliance, and reporting. Principle 8 describes four specific areas: fraudulent financial reporting, fraudulent nonfinancial reporting, misappropriation of assets, and illegal acts. The inclusion of non-financial reporting is a meaningful change that addresses sustainability, health and safety, employment activity and similar reports.

One useful document for performing a fraud risk assessment is Managing the Business Risk of Fraud: A Practical Guide, produced by the American Institute of Certified Public Accountants, and by our organization, the Association of Certified Fraud Examiners, as well as by the Institute of Internal Auditors. This guide to establishing a fraud risk management program includes a sample fraud policy document, fraud prevention scorecard, and lists of fraud exposures and controls. Managing the Business Risk of Fraud advises organizations to view fraud risk assessment as part of their corporate governance effort. This commitment requires a tone at the top that embraces strong governance practices, including written policies that describe the expectations of the board and senior management regarding fraud risk. The Guide points out that as organizations continue to automate key processes and implement technology, thus allowing employees broad access to sensitive data, misuse of that data becomes increasingly difficult to detect and prevent. By combining aggressive data collection strategies with innovative technology, public and private sector organizations have enjoyed dramatic improvements in productivity and service delivery that have contributed to their bottom line. Unfortunately, while these practices have yielded major societal benefits, they have also created a major challenge for those charged with protecting confidential data.

CFE’s proactively assessing client organizations which use substantial amounts of private customer information (PCI) for fraud risk should expect to see the presence of controls related to data access surveillance. Data surveillance is the systematic monitoring of information maintained in an automated, usually in a database, environment. The kinds of controls CFE’s should look for are the presence of a privacy strategy that combines the establishment of a comprehensive policy, an awareness program that reinforces the consequences of non-business accesses, a monitoring tool that provides for ongoing analysis of database activity, an investigative function to resolve suspect accesses and a disciplinary component to hold violators accountable.

The creation of an enterprise confidentiality policy on the front end of the implementation of a data surveillance program is essential to its success. An implementing organization should establish a data access policy that clearly explains the relevant prohibitions, provides examples of prohibited activity and details the consequences of non-business accesses. This policy must apply to all employees, regardless of their title, seniority or function. The AICP/ACFE Guide recommends that all employees, beginning with the CEO, be required to sign an annual acknowledgment affirming that they have received and read the confidentiality policy and understand that violations will result in the imposition of disciplinary action. No employees are granted access to any system housing confidential data until they have first signed the acknowledgment.

In addition to issuing a policy, it is imperative that organizations formally train employees regarding its various provisions and caution them on the consequences of accessing data for non-business purposes. During the orientation process for new hires, all employees should receive specialized training on the confidentiality policy. As an added reminder, prior to logging on to any database that contains personal information, employees should receive an electronic notice stating that their activities are being monitored and that all accesses must be related to an official business purpose. Employees are not granted access into the system until they electronically acknowledge this notice.

Given that data surveillance is a process of ongoing monitoring of database activity, it is necessary for individual accesses to be captured and maintained in a format conducive to analysis. There are many commercially available software tools which can be used to monitor access to relational databases on a real-time basis. Transaction tracking technology, as one example, can dynamically generate Structured Query Language (SQL), based upon various search criteria, and provides the capability for customized analyses within each application housing confidential data. The search results are available in Microsoft Excel, PDF and table formats, and may be printed, e-mailed and archived.

Our CFE client organizations that establish a data access policy and formally notify all employees of the provisions of that policy, institute an ongoing awareness program to reinforce the policy and implement technology to track individual accesses of confidential data have taken the initial steps toward safeguarding data. These are necessary components of a data surveillance program and serve as the foundation upon which the remainder of the process may be based. That said, it is critical that organizations not rely solely on these components, as doing so will result in an unwarranted sense of security. Without an ongoing monitoring process to detect questionable database activity and a comprehensive investigative function to address unauthorized accesses, the impact of the foregoing measures will be marginal.

The final piece of a data surveillance program is the disciplinary process. The ACFE tells us that employees who willfully violate the policy prohibiting nonbusiness access of confidential information must be disciplined; the exact nature of which discipline should be determined by executive management. Without a structured disciplinary process, employees will realize that their database browsing, even if detected, will not result in any consequence and, therefore, they will not be deterred from this type of misconduct. Without an effective disciplinary component, an organization’s privacy protection program will ultimately fail.

The bottom line is that our client organizations that maintain confidential data need to develop measures to protect this asset from internal as well as from external misuse, without imposing barriers that restrict their employees’ ability to perform their duties. In today’s environment, those who are perceived as being unable to protect the sensitive data entrusted to them will inevitably experience an erosion of consumer confidence, and the accompanying consequences. Data surveillance deployed in conjunction with a clear data access policy, an ongoing employee awareness program, an innovative monitoring process, an effective investigative function and a standardized disciplinary procedure are the component controls the CFE should look for when conducting a proactive fraud risk assessment of employee access to PCI.

The Initially Immaterial Financial Fraud

At one point during our recent two-day seminar ‘Conducting Internal Investigations’ an attendee asked Gerry Zack, our speaker, why some types of frauds, but specifically financial frauds can go on so long without detection. A very good question and one that Gerry eloquently answered.

First, consider the audit committee. Under modern systems of internal control and corporate governance, it’s the audit committee that’s supposed to be at the vanguard in the prevention and detection of financial fraud. What kinds of failures do we typically see at the audit committee level when financial fraud is given an opportunity to develop and grow undetected? According to Gerry, there is no single answer, but several audit committee inadequacies are candidates. One inadequacy potentially stems from the fact that the members of the audit committee are not always genuinely independent. To be sure, they’re required by the rules to attain some level of technical independence, but the subtleties of human interaction cannot always be effectively governed by rules. Even where technical independence exists, it may be that one or more members in substance, if not in form, have ties to the CEO or others that make any meaningful degree of independence awkward if not impossible.

Another inadequacy is that audit committee members are not always terribly knowledgeable, particularly in the ways that modern (often on-line, cloud based) financial reporting systems can be corrupted. Sometimes, companies that are most susceptible to the demands of analyst earnings expectations are new, entrepreneurial companies that have recently gone public and that have engaged in an epic struggle to get outside analysts just to notice them in the first place. Such a newly hatched public company may not have exceedingly sophisticated or experienced fiscal management, let alone the luxury of sophisticated and mature outside directors on its audit committee. Rather, the audit committee members may have been added to the board in the first place because of industry expertise, because they were friends or even relatives of management, or simply because they were available.

A third inadequacy is that audit committee members are not always clear on exactly what they’re supposed to do. Although modern audit committees seem to have a general understanding that their focus should be oversight of the financial reporting system, for many committee members that “oversight” can translate into listening to the outside auditor several times a year. A complicating problem is a trend in corporate governance involving the placement of additional responsibilities (enterprise risk management is a timely example) upon the shoulders of the audit committee even though those responsibilities may be only tangentially related, or not at all related, to the process of financial reporting.

Again, according to Gerry, some or all the previously mentioned audit committee inadequacies may be found in companies that have experienced financial fraud. Almost always there will be an additional one. That is that the audit committee, no matter how independent, sophisticated, or active, will have functioned largely in ignorance. It will not have had a clue as to what was happening within the organization. The reason is that a typical audit committee (and the problem here is much broader than newly public startups) will get most of its information from management and from the outside auditor. Rarely is management going to voluntarily reveal financial manipulations. And, relying primarily on the outside auditor for the discovery of fraud is chancy at best. Even the most sophisticated and attentive of audit committee members have had the misfortune of accounting irregularities that have unexpectedly surfaced on their watch. This unfortunate lack of access to candid information on the part of the audit committee directs attention to the second in the triumvirate of fraud preventers, the internal audit department.

It may be that the internal audit department has historically been one of the least understood, and most ineffectively used, of all vehicles to combat financial fraud. Theoretically, internal audit is perfectly positioned to nip in the bud an accounting irregularity problem. The internal auditors are trained in financial reporting and accounting. The internal auditors should have a vivid understanding as to how financial fraud begins and grows. Unlike the outside auditor, internal auditors work at the company full time. And, theoretically, the internal auditors should be able to plug themselves into the financial reporting environment and report directly to the audit committee the problems they have seen and heard. The reason these theoretical vehicles for the detection and prevention of financial fraud have not been effective is that, where massive financial frauds have surfaced, the internal audit department has often been somewhere between nonfunctional and nonexistent.. Whatever the explanation, (lack of independence, unfortunate reporting arrangements, under-staffing or under-funding) in many cases where massive financial fraud has surfaced, a viable internal audit function is often nowhere to be found.

That, of course, leaves the outside auditor, which, for most public companies, means some of the largest accounting firms in the world. Indeed, it is frequently the inclination of those learning of an accounting irregularity problem to point to a failure by the outside auditor as the principal explanation. Criticisms made against the accounting profession have included compromised independence, a transformation in the audit function away from data assurance, the use of immature and inexperienced audit staff for important audit functions, and the perceived use by the large accounting firms of audit as a loss leader rather than a viable professional engagement in itself. Each of these reasons is certainly worthy of consideration and inquiry, but the fundamental explanation for the failure of the outside auditor to detect financial fraud lies in the way that fraudulent financial reporting typically begins and grows. Most important is the fact that the fraud almost inevitably starts out very small, well beneath the radar screen of the materiality thresholds of a normal audit, and almost inevitably begins with issues of quarterly reporting. Quarterly reporting has historically been a subject of less intense audit scrutiny, for the auditor has been mainly concerned with financial performance for the entire year. The combined effect of the small size of an accounting irregularity at its origin and the fact that it begins with an allocation of financial results over quarters almost guarantees that, at least at the outset, the fraud will have a good chance of escaping outside auditor detection.

These two attributes of financial fraud at the outset are compounded by another problem that enables it to escape auditor detection. That problem is that, at root, massive financial fraud stems from a certain type of corporate environment. Thus, detection poses a challenge to the auditor. The typical audit may involve fieldwork at the company once a year. That once-a-year period may last for only a month or two. During the fieldwork, the individual accountants are typically sequestered in a conference room. In dealing with these accountants, moreover, employees are frequently on their guard. There exists, accordingly, limited opportunity for the outside auditor to get plugged into the all-important corporate environment and culture, which is where financial fraud has its origins.

As the fraud inevitably grows, of course, its materiality increases as does the number of individuals involved. Correspondingly, also increasing is the susceptibility of the fraud to outside auditor detection. However, at the point where the fraud approaches the thresholds at which outside auditor detection becomes a realistic possibility, deception of the auditor becomes one of the preoccupations of the perpetrators. False schedules, forged documents, manipulated accounting entries, fabrications and lies at all levels, each of these becomes a vehicle for perpetrating the fraud during the annual interlude of audit testing. Ultimately, the fraud almost inevitably becomes too large to continue to escape discovery, and auditor detection at some point is by no means unusual. The problem is that, by the time the fraud is sufficiently large, it has probably gone on for years. That is not to exonerate the audit profession, and commendable reforms have been put in place over the last decade. These include a greater emphasis on fraud, involvement of the outside auditor in quarterly data, the reduction of materiality thresholds, and a greater effort on the part of the profession to assess the corporate culture and environment. Nonetheless, compared to, say, the potential for early fraud detection possessed by the internal audit department, the outside auditor is at a noticeable disadvantage.

Having been missed for so long by so many, how does the fraud typically surface? There are several ways. Sometimes there’s a change in personnel, from either a corporate acquisition or a change in management, and the new hires stumble onto the problem. Sometimes the fraud, which quarter to quarter is mathematically incapable of staying the same, grows to the point where it can no longer be hidden from the outside auditor. Sometimes detection results when the conscience of one of the accounting department people gets the better of him or her. All along s/he wanted to tell somebody, and it gets to the point where s/he can’t stand it anymore and s/he does. Then you have a whistleblower. There are exceptions to all of this. But in almost any large financial fraud, as Gerry told us, one will see some or all these elements. We need only change the names of the companies and of the industry.

Global Storm Clouds Rising

TankThe recent turbulence in the global financial markets is raising the by now too familiar questions in the trade press.  Who is managing the risk? Where is the oversight? Could this financial turmoil have been avoided if associated risks had been managed more proactively? Manage has a positive connotation, implying that someone is in control, as in “The governor is managing the coastal flooding event.” Risk has a negative connotation, implying a lack of control, as in “An unattended gun puts lives at risk.” Risk is everywhere and can be an opportunity or a threat. Although an effective risk management system cannot provide absolute assurance that events such as the current unsettled market situation will not occur, it can, as the least, lend confidence that the key risks will be identified and dealt with timely.

As a first step, understanding the structure and dimensions of ideal risk management can support common understanding and effective implementation by management and an adequate fraud risk assessment effort by CFE’s and other assurance professionals. Management must understand the key vulnerabilities to the business model and establish risk expectations, which can then be incorporated into business practices. Likewise, CFE’s must understand and consider the context of those expectations in their periodic fraud risk assessments. A thorough management understanding of fraud risk also improves the quality of any subsequent investigation of financial irregularities as it creates a standard against which to compare management’s due diligence efforts. Although it may be difficult for your individual clients to identify ideal standards for risk management, addressing some fundamentals can help frame those ideals.

Regulatory, market, and fraud risks are common and familiar to CFE’s, who’re used to identifying these external events and asking “What if” questions: What if this process is not in compliance? What if a fraud were to occur as a result? Inside counsel and auditors often encourage management to address these types of risks immediately, which can result in operational silos dedicated to addressing a single significant fraud risk. However, these single events are only part of the picture. What about process efficiency risk, process design risk, system implementation risk, data integrity risk, skill-set risk, and the myriad other internal risks that, from the CFE’s informed perspective impact operations and fraud prevention?  In the end, a risk is only important if it affects achievement of strategic and business objectives. Both external and internal risks can be placed in the context of their impact on business objectives. The strategic and objective framework must be defined and understood if an organization is to gauge the impact of the risks confronting it. The simplest way to define this framework is to start with the strategy and identify who is accountable for its parts. The framework is further defined as interviews with senior management reveal its objectives and accountability. The process continues until the framework has been constructively defined down to a relevant level for any external or internal risk. The relevance is determined based on the fraud risk’s ability to impact key elements of the framework. The framework provides a formal structure for ensuring strategic achievement.

Fraud risk management requires adequate identification of general risks and an awareness of existing vulnerabilities. Failure to do so can have dire consequences as the ever increasing volume of recent fraud cases attest. A century ago, modern soldiers recognized that good weapons were important to survival. However, realizing the value of tanks and exploding shells was only one element of effective risk management. Another was assessing the quality of the armor tanks carried into battle. No general would order a tank advance, without adequate vehicle armor. An army with limited protection would avoid or delay battles while its vehicles were being adequately fitted. Likewise, as an organization pursues its objectives, it must understand its strengths and vulnerabilities. Organizations cannot charge into daily economic battles without both weapons for success and armor to manage their inherent risks. Historically, assurance professionals have operated in a black-and-white world – a control is either present or absent, effective or ineffective. Although this may work for compliance or financial reporting objectives, it doesn’t help management effectively improve governance, risk management, or overall fraud prevention. Recognizing that business operations mature over time requires critical anti-fraud controls to mature with them. So if operations and controls mature over time, how does an organization organize the current state of affairs to avoid fraud vulnerabilities?

It’s important for fraud prevention to evaluate how effectively current business processes are supporting the achievement of strategic and business objectives. This evaluation will provide insights into the overall maturity of the fraud prevention controls that are in place to manage key risks. If the objective is to attack, yet the process or control maturity shows insufficient strength, it’s likely that the risk appetite of the general exceeds that of his government and country. Risk becomes more manageable with a framework of key risks in the context of key objectives and process/control maturity.

Business process and control vulnerability to fraud can be measured by defining high-level management controls that illustrate what management is doing to achieve its strategic and business objectives. By this point organizations should understand the strategy and objectives and be aware of their people, process, and technology capabilities; but this alone does not provide an overall understanding of fraud control maturity. Because maturity implies sustainability, it’s important to concurrently understand just how capable or strong the systems of control are. One way to begin creating a control maturity perspective is to look at what management is currently doing to ensure it achieves its objectives.

  • Does management have formal fraud prevention objectives that are well-written and communicated?
  • Is accountability clearly established?
  • Have metrics been set to measure the progress of those who are accountable?
  • Is existing reporting capable of illustrating the metric?
  • Are the information and communication channels adequate?
  • Does the tone at the top champion ethical behavior?

Frank answers to these types of simple questions help determine whether the CFE’s client organization is closer to the top, middle, or low levels of management fraud control maturity. This determination can help the organization identify gaps between its current level of maturity and the desired level so that actions can be prioritized to address the largest gaps. The answers to these questions can also help determine how formally objective achievement is being managed. They also provide a window into process capabilities and indicate the degree to which these capabilities are aligned with objective achievement. Informal alignment can create vulnerabilities. Management fraud control maturity is by no means the ultimate tool, but it provides a bridge in assessing risk management vulnerabilities.

All CFE’s have a role in educating senior management and the board (if there is one) about effective fraud risk management and irregularity prevention. Risk management means many things to almost everyone, yet communicating a few basic principles to clients will help CFE’s not only be successful but will provide the foundation for a program of robust fraud risk assessment. These principles help define a framework for valuing risk, assessing vulnerabilities, and determining the necessary steps for improving management fraud control maturity. Taken together, they can help any client organization improve the management of its overall risk and fraud prevention program.

Addressing Information System Fraud Risk through Uniform Control Standards – Part 2

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TarantulaThis post is Part 2 of a general consideration of how our clients can address the more common risks associated with information systems facilitated fraud by developing an internal uniform set of security standards; the objective of this short series of three posts  is to discuss a few of the more common controls COSO based control standards employ to address prominent security risks to information systems.

I’ve recently noticed in my consulting practice here in Virginia that audit programs are being prepared by regulatory authorities to reflect a stronger emphasis on the continuing confidentiality, integrity and availability (CIA) of whatever critical information system they currently have under review; this orientation of the audit program structures reviewer  attention specifically on the risks to those organizational critical business processes that the system directly or indirectly supports as well as on the responsibilities of system owners to maintain the CIA of the system .  This is with good reason, since the risk of unauthorized access to software, programs, data files and systems resources seems to have become the organizing principal, or gateway risk, around which Federal and State regulator COSO based audit programs are increasingly organized.  Fraud risk scenarios and related controls remain important but are evaluated within the organizing context of CIA preservation as defined by the entity’s documented IS control standards.  Information systems auditors are looking for defined access standards focusing on logical access controls like the recognition of users by what they know (passwords, PINs, or answers to personal questions) or what they possess (ID cards, active badges) or by personal characteristics (fingerprints, voice patterns, retina prints, facial patterns, signature dynamics or keyboarding patterns).  Our regulatory auditors will additionally want to know how the controls and specific access tools selected by the system owner(s) and the Chief Information Officer (CIO) specifically crosswalk the access control matrix to the organization specific risks defined in the matrix of objectives specifically related to CIA.

The CIA organizing principle leads on from its initial concern with access control to data storage controls; the risk here being unauthorized disclosure or destruction of stored sensitive data vital to the continued operation of the entity’s critical business processes and their related objectives.  The control standards need to specify what the records constituting confidential data are and then clearly identify the protection requirements that address the risks to those data.  What specific protection efforts will be taken for data at rest and data in use and what audit trails documenting data movement have so far been implemented?

Data storage standards naturally lead on to those data transmission controls employed to address the risk of unauthorized system access or inappropriate access to data being transmitted stemming from systems failures or errors in data transmission.   The types of controls to address these threats include the monitoring of organizational networks and data backup components; as well as design of the network itself to handle peak-processing and multiple communication paths between network components.  Something often overlooked or given cursory treatment in otherwise well defined IS standards is a full description of the details related to the performance of preventative maintenance.  Data encryption is also a vital tool in the protection of our client’s data including the specified use of public and private keys, digital certificates, and certificate authorities.  The standards need to document the goals of the data protection tools selected and how they clearly crosswalk to the matrix of related CIA objectives.

To address the risk of ineffective design, operation, review, audit and modification of critical systems, the COSO based regulatory audit program will certainly specify a look at the general system documentation standards the organization or its system design consultants have implemented.   A proper set of control standards would be expected to refer (hyperlink) to existing organizational standards and procedures for data processing, analysis, design, programming, file handling and storage. Systems documentation should address application inputs, processing steps, output definition and error handling.   Operating documentation should clarify equipment configurations, programs, files, set-up and execution procedures and corrective actions in the face of detected system failures or processing error conditions.

Disaster recovery controls are strongly tested in CIA risk oriented compliance auditing to address the risk of prolonged interruption of data processing business operations due to such threats as fire, natural disasters, sabotage and vandalism.    Reviewing information systems auditors are looking for control standards that feature designation of a coordinator responsible for implementing the information systems disaster recovery plan; this person is usually distinct from the organization’s Information Security Officer who is responsible for the Continuity of Operations Plan (COOP) for the entire organization, and not for just the disaster recovery plan for the information systems alone (typically an Information Management [IM] function).  The information security standard will assign responsibility for recovery priorities (a critical component feature for recovery following identified frauds), for fully documenting and testing the plan and for continuously reviewing and revising the plan.

Disaster recovery controls that are especially important for fraud remediation and which need to be cross-walked to the CIA matrix include those related to remote storage or back- up of files and data (electronic vaulting, grandfather-father-son backups), procedures for recovering lost or destroyed files (checkpoint and rollback), insurance coverage, and backup computers, servers and telecommunications equipment (reciprocal servicing agreements, hot and cold sites, and duplicate software).

Our next, and the final post of this short series, will discuss the information system standards related to physical protection of hardware and facilities, internet related controls and malware protection standards of which practicing CFE’s should be aware.

Please make plans to join us on April 16-17th, 2014 for the Central Virginia Chapter’s seminar on the Topic of Introduction to Fraud Examination for 16 CPE ($200.00 for early Registration)! For details see our Prior Post entitled, “Save the Date”!