Tag Archives: fraud prevention

Regulators & Silos

I was reading last week on LinkedIn about a large, highly regulated, financial institution that was defrauded over a long period of time by two different companies, both of which where its suppliers. To add insult to injury, subsequent investigation by a CFE revealed that the two vendors were subsidiaries of a third, which proved also to be a supplier of the victim concern; all three cooperated in the fraud and our victim was completely unaware prior to the investigation of any relationship between them; the kind of ignorance that can draw intense regulatory attention.

This is not as uncommon an occurrence as many might think but it is illustrative of the fact that today’s companies are increasingly forced to expend resources simply trying to understand and manage the complex web of relationships that exist between them and the organizations and people with which they deal; that is, if they want to avoid falling victim to frauds running the whole gamut from the simple to the complex. Such efforts involve gaining perspective on individual vendors and customers but extend far beyond that to include sorting through and classifying corporate hierarchies and complex business-to-business relationships involving partners, suppliers, distributors, resellers, contacts, regulators and employees.

These complex, sometimes overlapping, relationships are only exacerbated by dynamic geographic and cross-channel coordination requirements, and multiple products and customer accounts (our victim financial organization operates in three countries and has over 4,000 employees and hundreds of vendors). No fraud prevention program can be immune in the face of these challenges.

Financial companies that want to securely deliver the best experience to their stakeholders within intensified regulatory constraints need to provide themselves with a complete picture of all the critical parties in their relationships at the various points of service in the on-going process of company operations. The ability to do this requires that organizations have a better understanding of the complicated hierarchies and relationships that exist between them and their stakeholders. You cannot manage what you cannot see and you certainly cannot adequately protect it against fraud, waste and abuse.

The active study of organizational hierarchies and relationships (and their related fraud vulnerabilities) is a way of developing an integrated view of the relationship of risk among cooperating entities such as our CFE client companies between their affiliates, customers and partners, across multiple channels, geographies or applications. The identification of organizational relationships can help our client companies clearly and consistently understand how each of their affiliates, business divisions and contacts within a single multi-national enterprise fit within a broader, multidimensional context. Advanced organizational management approaches can help organizations track when key people change jobs within and between their related affiliates, vendors and companies. Advanced systems can also identify these individuals’ replacements feeding a database of who is where, vital to shifting patterns of enterprise risk.

Our client financial companies that take the time to identify and document their organizational relationships and place stakeholders into a wider hierarchical context realize a broad range of fraud, waste and abuse prevention related benefits, including:

• Enhanced ability to document regulatory compliance;
• More secure financial customer experiences, leading to enhanced reputation, increased loyalty and top-line growth;
• More confident financial reporting and more accurate revenue tracking;
• Reduction of over-all enterprise fraud risk;
• More accurate vetting of potential vendors and suppliers;
• More secure sales territory and partner program management;
• Improved security program compliance management;
• More accurate and effective fraud risk evaluation and mitigation.

The ability to place stakeholders within hierarchical context is invaluable to helping companies optimize business processes, enhance customer relationships and achieve enterprise-wide objectives like fraud prevention and mitigation. Organizations armed with the understanding provided by documented relationship contexts can improve revenues, decrease costs, meet compliance requirements, mitigate risk while realizing many other benefits.

As with our victimized financial enterprise, a company without relational data regarding vendors and other stakeholders can be unknowingly dealing with multiple suppliers who are, in fact, subsidiaries of the same enterprise, causing the company to not only inadvertently misrepresent its vendor base but, even more importantly, increase its vulnerability to fraud. Understanding the true relational context of an individual supplier may allow a company to identify areas of that vendor’s organization that represents enhanced internal control weakness or fraud risk. Conversely, an organization may fail to treat certain weakly controlled stakeholders strategically because the organization is unaware of just how much business it is doing with that stakeholder and its related subsidiaries and divisions.

Risk management has always been a core competency for organizations in general and for financial institutions in particular. However, integrated enterprise risk management (ERM) practices and corporate governance disciplines are now a regulatory imperative. Any institution that views corporate governance as merely a compliance exercise is missing the mark. Regulatory compliance is synonymous with the quality of the integrated ERM framework. Risk and control are virtually inseparable, like two sides of a coin, meaning that risks first must be identified and assessed, and then managed and mitigated by the implementation of a strong system of internal control. Accurate stake holder relational data is, therefore, critical to the effectiveness of the overall ERM process.

In today’s environment, the compliance onus rests with the regulated. In a regulatory environment where client enterprise ignorance of the situation in the client’s own overall enterprise is no longer a defense, responsibility for compliance now rests with the board and senior management to satisfy regulators that they have implemented a mature fraud prevention framework throughout the organization, effectively managing risk from the mailroom to the boardroom.

An integrated control framework with more integrated risk measures, both across risk types and economic and regulatory capital calculations, is warranted. Increased demands for self-attestation require elimination of fragmentation and silos in business and corporate governance, risk management, and compliance.

Compliance needs to be integrated into the organization’s ERM base fraud prevention framework, thereby making the management of regulatory risk a key part of effective overall compliance. Compliance needs to be seen as less of a function and more as an institutional state of mind, helping organizations to anticipate risk as well as to avoid it. Embedding compliance as a corporate discipline ensures that fraud prevention controls are entrenched in people’s roles and responsibilities more effectively than external regulations. The risk management function must not only address the compliance requirements of the organization but must also serve as an agent for improved decision making, loss reduction and competitive advantage within the marketplace.

Organizations can approach investments in corporate governance, relationship identification, risk management practices and regulatory compliance initiatives as one-off, isolated activities, or they can use these investments as an opportunity to strengthen and unify their risk culture, aligning best practices to protect and enhance stakeholder value. A silo-based approach to fraud prevention will not only be insufficient but will also result in compliance processes layered one upon the other, adding cost and duplication, and reducing the overall agility of our client’s business; in effect, increasing risk. This piecemeal reactive approach also leaves a gap between the processes designed to keep the organization in line with its regulatory obligations and the policies needed to protect and improve the franchise. Organizations are only as strong as their weakest components, like the links in a chain.

The ACFE tells us that people tend to identify with their positions, focusing more on what they do rather than on the purpose of it. This leads to narrowed vision on the job, resulting in a myopic sense of responsibility for the results produced when all positions interact. ln the event of risk management breakdowns or when results are below expectations, it is difficult for people to look beyond their silo. The enemy is out there syndrome, a byproduct of seeing only one’s own position, results in people quickly blaming someone or something outside themselves, including regulators, when negative events like long running frauds are revealed and retreating within the perceived safety of their fortress silo. This learning disability makes it almost impossible to detect the leverage that can be used on issues like fraud prevention and response that straddle the boundary between ‘us’ and ‘them’.

However, it is particularly disconcerting that the weakest numbers by industry sector, including financial services, occur in the ACFE studies measuring organization wide accountability and people’s understanding of their accountability. My personal feeling is that much of the reason for this low score is the perpetuation of organizational silos resulting from management’s failure to adequately identify and document all of its stakeholders’ cross-organizational relationships.

Trust but Check

The community support for a business, and business in general, depends on the credibility that stakeholders place in corporate commitments, the company’s reputation, and the strength of its competitive advantage. All of these depend on the trust that stakeholders place in a company’s activities. Trust, in turn, depends on the values underlying corporate activities. Off-shore accounts, manipulation of shell corporations to evade taxes, loan fraud and management self-dealing are just a few instances of the moral cancer that, drop by drop, erodes trust until the point where the free enterprise systems of democratic nations are replaced by naked oligarchy, kleptocracy and cultures of corruption.

If the interests of all stakeholders are systematically not respected, then action that continues to be often painful to shareholders, officers, and directors usually occurs. In fact, it is unlikely that businesses or professions can achieve their long-run strategic objectives without the support of key stakeholders, such as shareholders, employees, customers, creditors, suppliers, governments, and host communities.

A constant theme and trend (as echoed in the trade press) has become increasingly more evident since the turn of the century. The judgment and moral character of executives, owners, boards of directors, and auditors has been often insufficient, on their own, to prevent increasingly severe corporate, ethical, and governance scandals. Governments and regulators world-wide have been required to constantly tighten guidelines and governance regulations to assure the protection of the public. The self-interested lure of greed has proven to be too strong for many to resist, and they have succumbed to conflicts of interest when left too much on their own. Corporations that were once able to shift jurisdictions to avoid new regulations regarding tax and other matters now are facing global measures designed to expose and control questionable ethics and governance practices. Assurance professionals themselves, of all types, are also facing international standards of behavior.

These changes have come about because of the pressures brought to bear on corporations and management by the reporting of scandals and abuses by a still potent free press and by suits by activist investors and other involved stakeholders. But changes in laws, regulations, and standards are only part of what stakeholders have contributed. The expectations for good ethical behavior and good governance practices have changed. Failure to comply with these expectations now impacts reputations, profits, and careers even if the behavior is strictly within legal boundaries.

As ACFE training tells us, it’s become increasingly evident to most executives, owners, and auditors that their individual success is directly related to their ability to develop and maintain a corporate culture of integrity. They cannot afford the loss of reputation, revenue, reliability, and credibility as a result of a loss of integrity. It is no longer an effective, sustainable, or medium or long-term strategy to project or practice questionable ethics. ACFE training goes on to indicate a number of causes, or signs, of ethical problems within any given corporation:

— Pressure to meet goals, especially financial ones, at any cost;
–A culture that does not foster open and candid conversation and discussion;
–A CEO who is surrounded by people who will agree and flatter the CEO, as well as a CEO whose reputation is ‘beyond criticism’;
–Weak boards that do not exercise their fiduciary responsibilities with diligence;
–An organization that promotes people on the basis of nepotism and favoritism;
–Hubris. The arrogant belief that rules are for other people, but not for us;
–A flawed cost/benefit attitude that suggests that poor ethical behavior in one area can be offset by good ethical behavior in another area.

The LIBOR rate scandal of 2012 is an almost perfect example of ethical collapse and manifests a majority of the red flags enumerated above. The scandal featured the systematic manipulation of a benchmark interest rate, supported by a culture of fraud in the world’s biggest banks, in an environment where little or no regulation prevailed. After decades of abuse that enriched the big banks, their shareholders, executives and traders, at the expense of others, investigations and lawsuits were finally undertaken resulting in prosecutions and huge penalties for the banks and the individual traders involved.

The London Interbank Offered Rate (LIBOR) rate is a rate of interest, first computed in 1985 by the British Banking Association (BBA), the Bank of England and others, to serve as a readily available reference or benchmark rate for many financial contracts and arrangements. Prior to its creation, contracts utilized many privately negotiated rates, which were difficult to verify, and not necessarily related to the market rate for the security in question. The LIBOR rate, which is the average interest rate estimated by leading banks that they would be charged if they were to borrow from other banks, provided a simple alternative that came to be widely used.

At the time of the LIBOR scandal, 18 of the largest banks in the world provided their estimates of the costs they would have had to pay for a variety of interbank loans (loans from other banks) just prior to 11:00 a.m. on the submission day. These estimates were submitted to Reuters news agency (who acted for the BBA) for calculation of the average, and its publication, and dissemination. Reuters set aside the four highest and four lowest estimates and averaged the remaining ten.

So huge were the investments affected that a small manipulation in the LIBOR rate could have a very significant impact on the profit of the banks and of the traders involved in the manipulation.

Insiders to the banking system knew about the manipulation of LIBOR rate submissions for decades, but changes were not made until the public became aware of the problem, and until the U.S. Department of Justice (DOJ) forced the U.K. government to act. The president of the New York Federal Reserve Bank (Fed), at that time emailed the governor of the Bank of England in June 2008, suggesting ways to “enhance” LIBOR. Although ensuing emails report agreement on the suggestions, and articles appeared in the trade press from 2008 to 2011, serious changes were not applied until October 2012 when the U.K. government accepted the recommendations of the Wheatley Review of Libor. This Review by Martin Wheatley, managing director of British Financial Services Authority, was commissioned in June 2012 in view of investigations, charges and settlements that were raising public awareness of LIBOR deficiencies.

One of the motivations for creating the Wheatley Review involved the prosecution of a former UBS and later Citigroup Inc. trader, on criminal fraud charges for manipulating the LIBOR rates. The trader, known to insiders as the “Rain Man” for his abilities and demeanor, allegedly sought his superiors approval before attempting to influence the LIBOR rates, an act that some observers thought at the time would provide a strong defense against conviction.

Insiders who knew of LIBOR manipulations were generally reluctant to take a public stand for earlier change. However, on July 27, 2012, a former trader for Morgan Stanley in London, published an article that told of his earlier attempts to bring LIBOR rate manipulations to the attention of authorities, but without success. In his article, he indicated how he learned as a new trader in 1991 that the banks manipulated their rate submissions to make profit on specific contracts, and to mask liquidity problems such as during the subprime lending crisis of 2008. For example, if the LIBOR rate submissions were misstated to be low, the discounted valuation of related assets would be raised, thus providing misleadingly higher levels of short-term, near-cash assets than should have been reported.

Numerous studies since the scandal have detailed the effects of unethical LIBOR manipulation. Just two examples of such manipulation. At the time of the scandal many home owners borrowed their mortgage loans on a variable- or adjustable-rate basis, rather than a fixed-rate basis. Consequently, many of these borrowers received a new rate at the first of every month based on the LIBOR rate. A study prepared for a class action lawsuit has shown that on the first of each month for the period 2007-2009, the LIBOR rate rose more than 7.5 basis points on average. As a consequence, one observer estimated that each LIBOR submitting bank may be liable for as much as $2.3 billion.

Municipalities raise funds through the issue of bonds, and many were encouraged to issue variable-rate, rather than fixed-rate, bonds to take advantage of lower interest payments. For example, the saving could be as much as $1 million on a $100 million bond. After issue, the municipalities were encouraged to buy interest rate swaps from their investment banks to hedge their risk of volatility in the variable rates by converting or swapping into a fixed rate arrangement. The seller of the swap agrees to pay the municipality for any requirement to pay interest at more than the fixed rate agreed if interest rates rise, but if interest rates fall the swap seller buys the bonds at the lower variable interest rate. However, the variable rate was linked to the LIBOR rate, which was artificially depressed, thus costing U.S. municipalities as much as $10 billion. Class action suits were eventually launched to recover these losses, which cost municipalities, hospitals, and other non-profits as much as $600 million a year.

At the end of the day, trust in each other and in our counter-parties is all we really have as economic actors; CFEs and forensic accountants thus have a vital role to play in investigating, documenting and assisting in the identification and possible prosecution of those, like the LIBOR manipulators, who knowingly collude in making the choice to violate that trust.

Loose Ends

A forensic accountant colleague of mine often refers to “loose-ends”. In his telling, loose-ends are elements of an investigation that get over-looked or insufficiently investigated which have the power to come back and bite an examiner with ill effect. That a small anomaly may be a sign of fraud is a fact that is no surprise to any seasoned investigator. Since fraud is typically hidden, the discovery of fraud usually is unlikely, at least at the beginning, to involve a huge revelation.

The typical audit does not presume that those the auditor examiners and the documents s/he reviews have something sinister about them. The overwhelming majority of audits are conducted in companies in which material fraud does not exist. However, the auditor maintains constant awareness that material fraud could be present.

Imagine a policewoman walking down a dark alley into which she knows a suspect has entered just before her. She doesn’t know where the suspect is, but as she walks down that alley, she is acutely aware of and attuned to her surroundings. Her senses are at their highest level. She knows beyond the shadow of a doubt that danger lurks nearby.

Fraud audits (and audits in general) aren’t like that. Fraud audits are more like walking through a busy mall and watching normal people go about their daily activities. In the back of the examiner’s mind, he knows that among all the shoppers are a few, a very few, shoplifters. They look just like everyone else. The examiner knows they are there because statistical studies and past experience have shown that they are, but he doesn’t know exactly where or who they are or when he will encounter them, if at all. If he were engaged to find them, he would have to design procedures to increase the likelihood of discovery without in any way annoying the substantial majority of honest shoppers in whose midst they swim.

A fraud risk assessment evaluates areas of potential fraud to determine whether the current control structure and environment are addressing fraud risk at a level that aligns with the organization’s risk appetite and risk tolerance. Therefore, it is important during the development and implementation of the risk management program to specifically address various fraud schemes to establish the correct levels of control.

It occurred to me a while back that a fraud risk assessment can of thought of as ignoring a loose-end if it fails to include sufficient consideration of the client organization’s ethical dimension. That the ethical dimension is not typically included as a matter of course in the routine fraud risk assessment constitutes, to my mind, a lost opportunity to conduct a fuller, and potentially, a more useful assessment. As part of their assessments, today’s practitioners can potentially use surveys, Control Self-Assessment sessions, focus groups, and workshops with employees to take the organization’s ethical temperature and determine its ethical baseline. Under this expanded model, the most successful fraud risk assessment would include small brainstorming sessions with the operational management of the business process(s) under review. Facilitated by a Certified Fraud Examiner (CFE), these assessments would look at typical fraud schemes encountered in various areas of the organization and identify the internal controls designed to mitigate each of them. At a high level, this analysis examines internal controls and the internal control environment, as well as resources available to prevent, detect, and deter fraud.

Fraud risk assessments emphasize possible collusion and management overrides to circumvent internal controls. Although an internal control might be in place to prevent fraudulent activity, the analysis must consider how this control could be circumvented, manipulated, or avoided. This evaluation can help the CFE understand the actual robustness and resilience of the control and of the control environment and estimate the potential risk to the organization.

One challenge at this point in the process is ensuring that the analysis assesses not just roles, but also those specific individuals who are responsible for the controls. Sometimes employees will feel uncomfortable contemplating a fellow employee or manager perpetrating fraud. This is where an outside fraud expert like the CFE can help facilitate the discussion and ensure that nothing is left off the table. To ask and get the answers to the right questions, the CFE facilitator should help the respondents keep in mind that:

o Fraud entails intentional misconduct designed to avoid detection.
o Risk assessments identify where fraud might occur and who the potential perpetrator(s) might be.
o Persons inside and outside of the organization could perpetrate such schemes.
o Fraud perpetrators typically exploit weaknesses in the system of controls or may override or circumvent controls.
o Fraud perpetrators typically find ways to hide the fraud from detection.

It’s important to evaluate whether the organization’s culture promotes ethical or unethical decision-making. Unfortunately, many organizations have established policies and procedures to comply with various regulations and guidelines without committing to promoting a culture of ethical behavior. Simply having a code of conduct or an ethics policy is not enough. What matters is how employees act when confronted with an ethical choice; this is referred to by the ACFE as measuring the organization’s ethical baseline.

Organizations can determine their ethical baseline by periodically conducting either CFE moderated Control Self-Assessment sessions including employees from high-risk business processes, through an online survey of employees from various areas and levels within the organization, or through workshop-based surveys using a balloting tool that can keep responses anonymous. The broader the survey population, the more insightful the results will be. For optimal results, surveys should be short and direct, with no more than 15 to 20 questions that should only take a few minutes for most employees to answer. An important aspect of conducting this survey is ensuring the anonymity of participants, so that their answers are not influenced by peer pressure or fear of retaliation. The survey can ask respondents to rate questions or statements on a scale, ranging from 1—Strongly Disagree to 5—Strongly Agree. Sample statements might include:

1. Our organizational culture is trust-based.
2. Missing approvals are not a big deal here.
3. Strong personalities dominate most departments.
4. Pressure to perform outweighs ethical behavior.
5. I share my passwords with my co-workers.
6. Retaliation will not be accepted here.
7. The saying “Don’t rock the boat!” fits this organization.
8. I am encouraged to speak up whenever needed.
9. Ethical behavior is a top priority of management.
10.I know where I can go if I need to report a potential issue of misconduct.

The ethical baseline should not be totally measured on a point system, nor should the organization be graded based on the survey results. The results should simply be an indicator of the organization’s ethical environment and a tool to identify potential areas of concern. If repeated over time, the baseline can help identify both positive and negative trends. The results of the ethical baseline survey should be discussed by the CFE with management as part of a broader fraud risk assessment project. This is especially important if there are areas with a lack of consensus among the survey respondents. For example, if the answer to a question is split down the middle between strongly agree and strongly disagree, this should be discussed to identify the root cause of the variance. Most questions should be worded to either show strong ethical behaviors or to raise red flags of potential unethical issues or inability to report such issues promptly to the correct level in the organization.

In summary, the additional value created by combining of the results of the traditional fraud risk assessment with an ethical baseline assessment can help CFEs better determine areas of risk and control that should be considered in building the fraud prevention and response plans. For example, fraud risk schemes that are heavily dependent on controls that can be easily overridden by management may require more frequent assurance from prevention professionals than those schemes that are mitigated by system-based controls. And an organization with a weak ethical baseline may require more frequent assessment of detective control procedures than one with a strong ethical baseline, which might rely on broader entity-level controls. By adding ethical climate evaluation to their standard fraud risk assessment procedures, CFEs can tie up what otherwise might be a major loose-end in their risk evaluation.

Using Control to Foster a Culture of Honesty

One of the most frequent questions we seem to receive as practicing CFEs from clients and corporate counsel alike regards the proactive steps management can take to create what’s commonly designated a ‘culture of honesty’. What kinds of programs and controls can an entity implement to create such a culture and to prevent fraud?

The potential of being caught most often persuades likely perpetrators not to commit a contemplated fraud. As the ACFE has long told us, because of this principle, the existence of a thorough control system is essential to any effective program of fraud prevention and constitutes one of the most vital underpinnings of an honest culture.

Corporations and other organizations can be held liable for criminal acts committed as a matter of organizational policy. Fortunately, most organizations do not expressly set out to break the law. However, corporations and other organizations may also be held liable for the criminal acts of their employees if those acts are perpetrated in the course and scope of their employment and for the ostensible purpose of benefiting the corporation. An employee’s acts are considered to be in the course and scope of employment if the employee has actual authority or apparent authority to engage in those acts. Apparent authority means that a third party would reasonably believe the employee is authorized to perform the act on behalf of the company. Therefore, an organization could be held liable for something an employee does on behalf of the organization even if the employee is not authorized to perform that act.

An organization will not be vicariously liable for the acts of an employee unless the employee acted for the ostensible purpose of benefiting the corporation. This does not mean the corporation has to receive an actual benefit from the illegal acts of its employee. All that is required is that the employee intended to benefit the corporation. A company cannot seek to avoid vicarious liability for the acts of its employees by simply claiming that it did not know what was going on. Legally speaking, an organization is deemed to have knowledge of all facts known by its officers and employees. That is, if a prosecutor can prove that an officer or employee knew of conduct that raised a question as to the company’s liability, and the prosecutor can show that the company willfully failed to act to correct the situation, then the company may be held liable, even if senior management had no knowledge or suspicion of the wrongdoing.

In addition, the evolving legal principle of ‘conscious avoidance’ allows the government to prove the employer had knowledge of a particular fact which establishes liability by showing that the employer knew there was a high probability the fact existed and consciously avoided confirming the fact. Employers cannot simply turn a blind eye when there is reason to believe that there may be criminal conduct within the organization. If steps are not taken to deter the activity, the company itself may be found liable. The corporation can be held criminally responsible even if those in management had no knowledge of participation in the underlying criminal events and even if there were specific policies or instructions prohibiting the activity undertaken by the employee(s). The acts of any employee, from the lowest clerk on up to the CEO, can impute liability upon a corporation. In fact, a corporation can be criminally responsible for the collective knowledge of several of its employees even if no single employee intended to commit an offense. Thus, the combination of vicarious or imputed corporate criminal liability and the current U.S. Sentencing Guidelines for Organizations can create a risk for corporations today.

Although many of our client companies do not realize it, the current legal environment imposes a responsibility on companies to ferret out employee misconduct and to deal with any known or suspected instances of misconduct by taking timely and decisive measures.

First, the doctrine of accountability suggests that officers and directors aware of potentially illegal conduct by senior employees may be liable for any recurrence of similar misconduct and may have an obligation to halt and cure any continuing effects of the initial misconduct.

Second, the Corporate Sentencing Guidelines, provide stiff penalties for corporations that fail to take voluntary action to redress apparent misconduct by senior employees.

Third, the Private Litigation Securities Reform Act requires, as a matter of statute, that independent auditors look for, and assess, management’s response to indications of fraud or other potential illegality. Where the corporation does not have a history of responding to indications of wrongdoing, the auditors may not be able to reach a conclusion that the company took appropriate and prompt action in response to indications of fraud.

Fourth, courts have held that a director’s duty of care includes a duty to attempt in good faith to assure corporate information and reporting systems exist. These systems must be reasonably designed to provide senior management and the board of directors timely, accurate information which would permit them to reach informed judgments concerning the corporation’s compliance with law and its business performance. In addition, courts have also stated that the failure to create an adequate compliance system, under some circumstances, could render a director liable for losses caused by non-compliance with applicable legal standards. Therefore, directors should make sure that their companies have a corporate compliance plan in place to detect misconduct and deal with it effectively. The directors should then monitor the company’s adherence to the compliance program. Doing so will help the corporation avoid fines under the Sentencing Guidelines and help prevent individual liability on the part of the directors and officers.

The control environment sets the moral tone of an organization, influencing the control consciousness of the organization and providing a foundation for all other control components. This component considers whether managers and employees within the organization exhibit integrity in their activities. COSO envisions that upper management will be responsible for the control environment of organizations. Employees look to management for guidance in most business affairs, and organizational ethics are no different. It is important for upper management to operate in an ethical manner, and it is equally important for employees to view management in a positive light. Managers must set an appropriate moral tone for the operations of an organization.

In addition to merely setting a good example, however, COSO suggests that upper management take direct control of an organization’s efforts at internal controls. This idea should be regularly reinforced within the organization. There are several actions that management can take to establish the proper control environment for an organization and foster a culture of honesty. These include:

–The establishment of a code of ethics for the organization. The code should be disseminated to all employees and every new employee should be required to read and sign it. The code should also be disseminated to contractors who do work on behalf of the organization. Under certain circumstances, companies may face liability due to the actions of independent contractors. It is therefore very important to explain the organization’s standards to any outside party with whom the organization conducts business.

–Careful screening of job applicants. One of the easiest ways to establish a strong moral tone for an organization is to hire morally sound employees. Too often, the hiring process is conducted in a slipshod manner. Organizations should conduct thorough background checks on all new employees, especially managers. In addition, it is important to conduct thorough interviews with applicants to ensure that they have adequate skills to perform the duties that will be required of them.

–Proper assignment of authority and responsibility. In addition to hiring qualified, ethical employees, it is important to put these people in situations where they are able to thrive without resorting to unethical conduct. Organizations should provide employees with well-defined job descriptions and performance goals. Performance goals should be routinely reviewed to ensure that they do not set unrealistic standards. Training should be provided on a consistent basis to ensure that employees maintain the skills to perform effectively. Regular training on ethics will also help employees identify potential trouble spots and avoid getting caught in compromising situations. Finally, management should quickly determine where deficiencies in an employee’s conduct exist and work with the employee to fix the problem.

–Effective disciplinary measures. No control environment will be effective unless there is consistent discipline for ethical violations. Consistent discipline requires a well-defined set of sanctions for violations, and strict adherence to the prescribed disciplinary measures. If one employee is punished for an act and another employee is not punished for a similar act, the moral force of the company’s ethics policy will be diminished. The levels of discipline must be sufficient to deter violations. It may also be advisable to reward ethical conduct. This will reinforce the importance of organizational ethics in the eyes of employees.

Monitoring is the process that assesses the quality of a control environment over time. This component should include regular evaluations of the entire control system. It also requires the ongoing monitoring of day-to-day activities by managers and employees. This may involve reviewing the accuracy of financial information, or verifying inventories, supplies, equipment and other organization assets. Finally, organizations should conduct independent evaluations of their internal control systems. An effective monitoring system should provide for the free flow of upstream communication.

The Complex Non-Profit

Our Chapter was contacted several weeks ago by the management of a not-for-profit organization seeking a referral to a CFE for conduct of an examination of suspected fraud.  Following a lively discussion with the requester’s corporate counsel, we made the referral which, we’ve subsequently learned, is working out well.  Our discussion of the case with counsel brought the following thoughts to mind. When talking not-for-profits, we’re talking programs; projects that are not funded through the sale of a product or service, but projects that obtain outside funding via the government, charitable grants, or donations to achieve a specific outcome. These outcomes can be any of a variety of things, from a scientific research study to find a cure for a catastrophic illness or federally legislated programs to provide health care to the indigent and elderly, as with the Medicaid and Medicare programs, respectively; or a not-for-profit charity that provides several programs, each funded from different sources, but all providing services to the elderly such as delivered meals, community center operations, adult daycare, and wellness programs. Typically, these outcomes are a social benefit. Some of these programs are of a specific duration, while others are renewed on a periodic basis depending on continued funding and the successful management of the program to achieve the desired outcomes.

In an examination for fraud in such entities, it’s typically not the core projects or programs themselves that are the object of the review; it’s the management of the program. Managers are engaged to operate such programs consistent with the program’s scope and budget. The opportunity for fraud in these programs will vary in several specific aspects: by the independence provided to the program manager, by the organizational structure of the program, and by the level of oversight by the funding source. These three elements make the conduct of a fraud examination of program management different from that of investigations for fraud in the typical core business functions of enterprises like those involved in manufacturing or retail trade. The fraud schemes will be similar because of the ACFE defined primary fraud classifications that apply to almost all organizations, but the key is how they’ve been adapted by program management.

The three primary classifications of fraud that are most common in program management fraud are schemes related to asset misappropriation, corruption, and financial statement reporting.

With asset misappropriation, the fraudulent action most commonly involved is embezzlement, not just simple theft of funds.  While they are both criminal actions, embezzlement has a specific meaning. Black’s Law Dictionary states it best: “the fraudulent taking of private property with which one has been entrusted, especially as a fiduciary.” It really is a matter of intent.
Examples of some inherent fraud schemes and of how these schemes are carried out within a program are:

False expenditures:

— The program is not being conducted, but funds are being expended. This sounds like the classic shell company scam, except a program rather than a for profit business is being exploited. The program by itself is legitimate, but it’s the intent of management that makes it a fraud;

–The program is not performed to its completion; however, the funds are fully expended. The decision to be made is whether the intent was to embezzle funds throughout the program or if there are other underlying reasons as to why the program wasn’t completed that resulted in the embezzlement of the funds;

–The program budget does not allow for program completion. Is this a case of bad budgeting or the use of budgeting with the intent to embezzle;

–The work plan is partially or wholly fictitious. It’s important for the examiner to keep in mind that some programs involve work that is so technologically or scientifically complex that it can be difficult for the examiner to understand just what the objective is.

Overbilling:

Unlike false expenditures, the use of overbilling within programs is more of a means to commit the fraudulent act of embezzlement within the program’s specific functions rather than within the overall program as with false expenditures. Specifically, overbilling schemes are found associated with misuse of time or assets by staff or with expenditures not used in an approved manner. For example:

–Staff members are performing non-program duties. Often, personnel are pulled from one program to work on another. There are many reasons for why this decision is made, but was the funding for that amount of personnel intentionally requested with the purpose of using personnel on another program that is not entitled to receive the funding for additional staff members?

–Staff members are misrepresenting the performance of the program. Often, staff will show the project to be operating on a level that seemingly should require more resources. The project is really operating on a lower level of resources, and whoever has the authority to bill uses that authority to overbill.

–Staff members are hired who are not qualified to perform program duties. Many times, often with large grant monies involved, the program manager hires friends or relatives, or perhaps there is such a strict time frame involved with the funding that management will hire a warm body just to fill the approved slot. In both cases, proper vetting procedures should be in place, even though the granting authority may not require them.

–As with staffing, funds are often redirected to other programs for similar reasons.

–Funds expended are not consistent with the proposed budget. The CFE should ask why the budget is out of line with expenditures? Is the approved budget in use, or was it just prepared as window-dressing for a grant proposal?

–Funds are expended that are not consistent with the governing cost principles. The classic example is the outrageous amounts the military spends on commonly used items, like the $5,000 toilet seat the ACFE originally told us about.

–The program is not completed, but the funding has been expended. Embezzlement can occur within the framework of asset misappropriation or overbilling, but because programs can differ in their objectives to a large degree, the vulnerability is greater to asset misappropriation schemes than to schemes involving overbilling.

Program Reporting:

Financial reporting and program reporting are two different things. Financial reporting can be a component of program reporting, but not the other way around. Many funded projects have strict guidelines on how to report project performance.  Like a disease that goes undetected because everything checked out in a physical exam, ethically challenged program managers find subtle ways to misrepresent performance, either to hide misuse of funds or just to indicate program success when there is none.
For example:

–The status of the project is falsely reported. This type of program reporting misstatement is typically done to give the illusion that the project’s objectives will be met to continue the objective of an uninterrupted steam of funding.

–The program results are falsely reported. The difference between project status and program results may not be apparent at first glance. The motivation is the same in that both are done to hide fraud. The false reporting of program status is typically done to keep funds ongoing throughout the project; the falsification of program results is typically done to ensure renewal of funding for another year or for a period of years. The project type will typically determine the likelihood of which type of false reporting is occurring.

–Improper criteria are used to measure performance. This concerns overall performance as opposed to financial performance. Given that funded projects can be difficult to understand considering the complexity of the activity being performed, performance measurement criteria can be manipulated because of the inherently complicated nature of the basic project. No one understands the project, so how can anyone know whether it’s succeeding? This phenomenon is commonly encountered if the project is divided into so many subparts that no one person, except the project manager, knows with certainty just how it’s proceeding.

–Program accomplishments are falsely reported. How many times have newspapers parroted the declaration from a non-profit that their program provided such and such a level of service to the indigent?  How do readers know if the program’s actual goal (and related funding) wasn’t to provide services to a level of recipients three times the amount reported?

–Operating statistics are manipulated to provide false results. Operating statistics are not financial statistics. An example would be a program that provides meals to the homebound elderly. An amount of payment by those receiving the meals is suggested. However, the government reimbursement for those meals deducts any amount contributed by the elderly being served. The project manager may manipulate the statistics to give more weight to the fixed-income, city-dwelling elderly it services, because such recipients are usually unable to pay anything for their delivered meals.

In summary, in approaching the fraud examination of non-profit entities, it’s not the overall programs themselves that are typically fraudulent, meaning that examinations don’t have to start with a determination of whether the entity is real or a shell. Fraud is committed by people, not programs or business systems; they are the tools of fraud. The ultimate funding source of programs are people as well, whether taxpayers (in the case of Federal or State governments) or private citizens (in the case of private charities).   It is not only the vast amount of funding that can flow to not-for-profit programs that constitutes the justification for combating fraud committed by the management of such programs. Programs that rely on funding as non-profits are typically entities that are established to provide a public benefit; to fill in the gaps for services and products not provided through any other means. So, the occurrence of fraud in these programs, no matter the size of the program or the fraud, is an especially heinous act given the loss of social benefit that results. For that reason alone, the examination of program management by CFEs is vital to the public interest.

Vendor Assessment – Backing Corporate Counsel

Pre-emptive fraud risk assessments targeting client vendor security are increasingly receiving CFE attention. This is because in the past several years, sophisticated cyber-adversaries have launched powerful attacks through vendor networks and connections and have siphoned off money, millions of credit card records and customers’ sensitive personal information.

There has, accordingly, been a noticeable jump in those CFE client organizations whose counsel attribute security incidents to current service providers, contractors and to former partners. The evolution of targets and threats outside the enterprise are powerfully influencing the current and near-future of the risk landscape. CFEs who regard these easily predicted changes in a strategic manner can proactively assist their client’s security and risk leadership to identify new fraud prevention opportunities while managing the emerging risk. To make this happen enterprises require adequate oversight insight into vendor involved fraud security risk as part of a comprehensive cyber-risk management policy.

Few managements anticipated only a few years ago that their connectivity with trusted vendors would ever result in massive on-line exploits on sister organizations like retailers and financial organizations, or, still less, that many such attacks would go undetected for months at a time. Few risk management programs of that time would have addressed such a risk, which represents not only a significant impact but whose occurrence is also difficult to predict. Such events were rare and typically beyond the realm of normal anticipation; Black Swan events, if you will. Then, attackers, organized cyber-criminals and some nation-states began capturing news headlines because of high-profile security breaches. The ACFE has long told us that one-third (32 percent) of fraud survey respondents report that insider crimes are costlier or more damaging than incidents perpetrated by outsiders and that employees are not the only source of insider threat; insider threat can also include former employees, service providers, consultants, contractors, suppliers and business partners.

Almost 500 such retailer breaches have been reported this year alone targeting credit card data, personal information, and sensitive financial information. There has, accordingly, been a massive regulatory response.  Regulators are revisiting their guidelines on vendor security and are directing regulated organizations to increase their focus on vendor risk as organizations continue to expand the number and complexities of their vendor relationships. For example, the US Office of the Comptroller of the Currency (0CC) and the Board of Governors of the US Federal Reserve System have released updated guidance on the risk management of third-party relationships. This guidance signals a fundamental shift in how retail financial institutions especially need to assess third-party relationships. In particular, the guidance calls for robust risk assessment and monitoring processes to be employed relative to third-party relationships and specifically those that involve critical activities with the potential to expose an institution to significant risk. CFEs and other assurance professionals can proactively assist the counsels of their client enterprises to elevate their vendor-related security practices to keep pace with ever-evolving fraud threats and security risk associated with their client’s third-party relationships.

Vendor risk oversight from a security point of view demands a program that covers the entire enterprise, outlining the policy and guidelines to manage and mitigate vendor security risk, combined with clearly articulated vendor contracts negotiated by the corporate counsel’s function. Such oversight will not only help organizations improve cybersecurity programs but also potentially advance their regulatory and legal standing in the future. What insights can CFEs, acting proactively, provide corporate counsel?

First, the need for executive oversight. Executive alignment and business context is critical for appropriate implementation throughout the organization. Proper alignment is like a command center, providing the required policies, processes and guidelines for the program. The decision to outsource is a strategic one and not merely a procurement decision. It is, therefore, of the utmost importance that executive committees provide direction for the vendor risk management program. The program can obtain executive guidance from:

–The compliance function to provide regulatory and other compliance requirements that have specific rules regarding vendor risk management to which the vendor organizations must adhere;

–The IT risk and control function to determine the risk and the risk level, depending on the nature of access/data sensitivity shared with the vendor(s). The vendor risk management program should utilize the key risk indicators provided by this function to address risk during vendor assessments;

–The contract governance function and corporate counsel to ensure that vendor contracts adequately address the need for security assessments and define vendors’ obligations to complete these assessments.

Most larger organizations today deal with a considerable amount of third parties and service providers. Missing contact information, responsibility matrices or updated contracts are typical areas of concern about which risk managers might have engaged CFEs initiate fraud risk assessments. This can pose a significant challenge, especially, when there are multiple teams involved to carry out the procurement business process. A vendor and contract database (VCD) ensures that an accurate and complete inventory of vendors is maintained, including other third-party relationships (e.g., joint ventures, utilities, business partners, fourth parties, etc.).

In effectively assessing a vendor risk management program, the CFE can’t conduct the same type of fraud risk assessment for all vendors. Rather, it’s necessary to identify those vendor services deemed to carry the greatest risk and to prioritize them accordingly. The first step is to understand which vendors and services are in the scope from an active fraud risk management perspective. Once this subset of vendors has been identified and prioritized, due diligence assessments are performed for the vendors, depending on the level of client internal versus vendor-owned fraud prevention and detection controls. The results of these assessments help establish the appropriate trust-level rating (TLR) and the future requirements in terms of CFE assisted reassessments and monitoring. This approach focuses resources on the vendor relationships that matter most, limiting unnecessary work for lower-risk relationships. For example, a vendor with a high TLR should be prioritized over a vendor with a low TLR.

Proper control and management of vendor risk requires continuous re-assessment. It’s important to decide the types of on-going assessments to be performed on vendors depending on the level of their TLR and the risk they represent.

Outsourced relationships usually go through iterations and evolve as they mature. As your client organizations strategize to outsource more, they should also validate trust level(s) in anticipation of more information and resources being shared. With technological advancements, a continuously changing business environment and increased regulatory demands, validating the trust level is a continuous exercise. To get the most rational and effective findings, it’s best to use the results of ongoing assessments. In such a reiterative process, it is necessary to continuously monitor and routinely assess vendors based on the trust level they carry. The program should share information about the vendor security posture and risk levels with corporate counsel or other executive sponsor, who can help the organization progress toward the target profile. Clearly communicating the fraud risk from a business perspective can be an additional feature, especially when reports are furnished to inform internal stakeholders, internal audit functions, lines of business and the board of directors, if necessary.

Vendor fraud risk management elevates information security from a technical control business process to an effective management business process. Regular fraud risk security assessments of vendors give organizations the confidence that their business is aware of the security risk involved and is effectively managing it by transferring, mitigating or accepting it. Comprehensive vendor security assessments provide enterprises with insight on whether their systems and data are being deployed consistently with their security policies. Vendor fraud risk management is not a mere project; it is an ongoing program and requires continuous trust to keep the momentum going. Once the foundational framework has been established, our client organizations can look at enhancing maturity through initiatives such as improving guidelines and procedures, rationalizing assessment questionnaires, and more automation. Awareness and communication are key to ensuring that the program is effective and achieves its intended outcome, securing enterprises together with all their business partners and vendors.

Internal Auditors as Fraud Auditors

Although fraud prevention is always more effective and less costly than fraud detection (and subsequent investigation), unfortunately prevention is not always possible. That’s why, as CFE’s and forensic accountants we should all be heavy promoters (and supporters) of client internal audit functions.  That is also why we should make it a goal that all employees of our client companies be trained in how to identify the major red flags of fraud they may encounter in their daily activities. Mastering key detection techniques is doubly essential for the internal audit and financial professionals employed by those same enterprises. Our Chapter has long preached that once internal auditors and financial managers know what to look for, there is an enhanced chance that fraud or suspicious activity will be detected one way or another, but only if the organization has the proper monitoring, reporting, and auditing procedures in place.

With that said, many organizations require internal audits of specific business processes and units only once every two or three years. In an age when so much can change so quickly in an internet dominated world, this approach is not the most effective insofar as fraud detection and prevention are concerned. This is especially so because conventional audits were most often not designed to detect fraud in the first place, usually focusing on specified groups of internal controls or compliance with existing policies, laws and regulations. That’s why the ACFE and Institute of Internal Auditors (IIA) now recommend that a fraud risk assessment (FRA) be conducted annually and that the fraud-auditing procedures designed to detect red flags in the high-risk areas identified by the FRA be incorporated into internal audit plans immediately.

There is often a fine line between detection and prevention. In fact, some detection steps overlap with prevention methods, as in the case of conflict of interest, where enforcing a management financial disclosure policy may both detect conflicting financial interests and prevent frauds resulting from them by virtue of the actual detection of the relationships. In most organizations, however, carefully assessing the description of prevention and detection controls demonstrates that there is usually a clear distinction between the two.

The IIA tell us that the internal audit function is a critical element in assessing the effectiveness of an institution’s internal control system. The internal audit consists of procedures to prevent or identify significant inaccurate, incomplete, or unauthorized transactions; deficiencies in safeguarding assets; unreliable financial reporting; and deviations from laws, regulations, and institutional policies. When properly designed and implemented, internal audits provide directors and senior management with timely information about weaknesses in the internal control system, facilitating prompt remedial action. Each institution should have an internal audit function appropriate to its size and the nature and scope of its activities.

This is a complex way of saying that our client’s internal audit function should focus on monitoring the institution’s internal controls, which, although not mentioned explicitly, include controls specifically designed to prevent fraud.  To effectively assess anti-fraud controls, auditors first must exercise detection techniques and procedures that confirm the existence of red flags or actual evidence of potential fraud in the risk areas identified by the FRA.

The Chief Internal Auditor is typically responsible for the following:

–Performing, or contracting for, a control risk assessment documenting the internal auditor’s understanding of significant business activities and associated risks. These assessments typically analyze the risks inherent in each business line, the mitigating control processes, and the resulting residual risk exposure;

–An internal audit plan responsive to results of the control risk assessment. This plan typically specifies key internal control summaries within each business activity, the timing and frequency of internal audit work, and the resource budget;

–An internal audit program that describes audit objectives and specifies procedures performed during each internal audit review;

–An audit report presenting the purpose, scope, and results of each audit. Work papers should be maintained to document the work performed and support audit findings.

There is a joint ACFE-IIA-AICPA document with which every CFE should be familiar.  ‘The Business Risk of Fraud’ provides clarity about the internal auditor’s role in detecting fraud in our client organization’s operations and financial statements. Specifically, the document states that internal auditors should consider the organization’s assessment of fraud risk when developing their annual audit plan and periodically assess management’s fraud detection capabilities. They should also interview and regularly communicate with those conducting the assessments, as well as with others in key positions throughout the company, to help them assess whether all fraud risks have been considered. Moreover, according to the document, when performing audits, internal auditors should devote sufficient time and attention to evaluating the “design and operation” of internal controls related to preventing and detecting significant fraud risks. They should exercise professional skepticism when reviewing activities to be on guard for the signs of potential fraud. Potential frauds uncovered during an engagement should be treated in accordance with a well-defined response plan consistent with professional and legal standards.

Among the most helpful guides for CFEs to recommend to clients for their internal auditors use in planning a detailed audit to detect fraud is the all-important SAS 99 which contains key fraud detection techniques including guidance on the performance of certain financial ratio analysis. Analytical procedures performed during planning may be helpful in identifying the risks of material misstatement due to fraud. However, because such analytical procedures generally use data aggregated at a high level, the results of those analytical procedures provide only a broad initial indication about whether a material misstatement of the financial statements may exist. Accordingly, the results of analytical procedures performed during planning should be considered along with other information gathered by the auditor in identifying the risks of material misstatement due to fraud.

SAS 99 was formulated with the aim of detecting fraud that has a direct impact on “material misstatement.” Essentially this means that anything in the organization’s financial activities that could result in fraud-related misstatements in its financial records should be audited for by using SAS 99 as a guide. SAS 99 breaks down the potential fraudulent causes of material misstatement into two categories:

1. Misstatement due to fraudulent financial reporting (i.e., “book cooking”);

2. Misstatement due to misappropriation of assets (i.e., theft).

The fraud auditing procedures of SAS 99, or of any other reputable audit guidance, can greatly assist internal auditors in distinguishing between actual fraud and error. Often the two have similar characteristics, with the key difference being that of the existence or absence of intent. Toward this end, SAS 99 and other key fraud auditing guidelines provide detailed procedures for gathering evidence of potential fraud based on the lists of fraud risks resulting from the client’s FRA. As SAS 99 states:

‘SAS 99. . . strongly recommend[s] direct involvement by internal auditors in the organization’s fraud-auditing efforts: Internal auditors may conduct proactive auditing to search for corruption, misappropriation of assets, and financial statement fraud. This may include the use of computer-assisted audit techniques to detect types of fraud. Internal auditors also can employ analytical and other procedures to isolate anomalies and perform detailed reviews of high-risk accounts and transactions to identify potential financial statement fraud. The internal auditors should have an independent reporting line directly to the audit committee, enabling them to express any concerns about management’s commitment to appropriate internal controls or to report suspicions or allegations of fraud involving senior management.

Specifically, SAS 99 provides a set of audit responses designed to gather hard evidence of potential fraud that could exist based on what the client organization learned from its FRA. These responses are critical to the auditor’s success in identifying clear red flags of potential fraud in our client’s operations. The responses are wide ranging and include anything from the application of appropriate ratio analytics, to thorough and detailed testing of controls governing specific business process procedures, to the analysis of anomalies in vendor or customer account activity. There are three broad categories into which such detailed internal audit fraud auditing responses fall:

1. The nature of auditing procedures performed may need to be changed to obtain evidence that is more reliable or to obtain additional corroborative information;
2. The timing of substantive tests may need to be modified. The auditor might conclude that substantive testing should be performed at or near the end of the reporting period to best address an identified risk of material misstatement due to fraud;
3. The extent of the procedures applied should reflect the assessment of the risks of material misstatement due to fraud. For example, increasing sample sizes or performing analytical procedures at a more detailed level may be appropriate.

The contribution of a fully staffed and management-supported internal audit function to a subsequent CFE conducted fraud examination can be extraordinary and its value never overstated; no client fraud prevention and detection program should ever be considered complete without one.

Navigating the Cloud

I’ve read several articles in the trade press recently that indicate CFEs are finding some aspects of fraud investigations involving cloud based data to be especially challenging. This is a consequent follow-on of the uncontested fact that, for many organizations, cloud based computing does improve performance and dramatically reduces a wide range of IT and administrative costs.

Commissioning a cloud service provider can enable an organization to off-load much of the difficulty that comes with implementing, maintaining, and physically protecting the systems required for company operations. The organization no longer needs to employ such a large team of network engineers, database administrators, developers, and other technical staff. Instead, it can use smaller, in-house teams to maintain the cloud solution and keep everything running as anticipated. Moving to the cloud also can introduce new capabilities, such as the ability to add and remove servers based on seasonal demand, an option that would be impractical for a traditional data center.

Now that cloud computing has become a mainstream service, CFEs and forensic accountants are increasingly called upon to assess the cloud environment with an eye to devising innovative approaches to cope with the unique investigative features and risks these services pose while at the same time grappling with the effects on their examinations of the security, reliability and availability of critical data housed by their client’s outside IT provider. Based on this assessment, CFEs can advise their client organizations in how best to meet the new investigative challenges when the inevitable cloud involved fraud strikes.

The cloud encompasses application service providers, cloud infrastructure, and the virtual placement of a server, set of servers, or other set of computing power in an environment that is shared among many entities and organizations. Cloud platforms and servers extend and supplement an organization’s own servers, resulting in multiple options for computing and application hosting. It is not sufficient to think of cloud platform and infrastructure oversight as mere vendor management.  Fraud examinations involving these environments are more complex, because of several factors about which the investigative team needs to make decisions  when determining the structure of the examination.

The ACFE tells us that a cloud deployment can be just as variable in structure and architecture as a traditional IT implementation. Among the numerous cloud platforms confronting the CFE, the most common are infrastructure as a service, software as a service, and platform as a service. The employment of these three options alone makes a wide variety of models and other options available. Each of these options additionally poses a distinct set of fraud risks and preventative controls, depending on a client organization’s specific deployment of a particular cloud platform and infrastructure.

Many challenges and barriers to an unfettered examination can appear when the CFEs client organization has contracted with a cloud provider who is, in actual form, a third-party vendor. In some cases, reviewing the cloud service provider’s processes and infrastructure might not be allowed by contract. In its place, the vendor may offer attestation reports such as the American Institute of Certified Public Accountants’ (AICPA’s) Statement on Standards for Attestation Engagements No. 16 (SSAE 16) as evidence of organizational controls. In other cases, the provider might restrict the examination to a select portion of the service which can be problematic when the CFE is working to obtain an overview of a complex fraud. Further, providers often require the client to obtain specific approvals before any fraud examination activities can even begin. Ideally, client organizations should take these types of consideration into account before contracting with a cloud vendor, but such consideration is, for the most part, not realistic unless a client organization has historically experienced a large number of frauds.  Fraud is, most often, not usually the first thing on many client’s minds when initially contracting with a cloud service provider.

One of the most difficult aspects of the fraud examination of a cloud infrastructure deployment is determining which fraud prevention controls are currently managed by the client organization and which by the cloud provider. With many cloud deployments, few controls are the actual responsibility of the provider. For example, the CFEs client may be responsible for configuration management, patch management, and access management, while the provider is only responsible for physical and environmental security.

A client organization’s physical assets are tangible. The organization buys a physical piece of equipment and keeps a record of this asset; a CFE can see all the organization’s technology assets just by walking through the data center. Cloud infrastructure deployments, however, are virtual, and it’s easy to add and remove these systems. Many organizations base their models on servers and systems that are there one day and gone the next. IT departments themselves also struggle with managing cloud assets, and tools to help cloud providers and clients are continually evolving. As a result, from the CFEs perspective, the examination scope can be hard to manage and execute.  The CFE is also confronted with the fact that, because cloud computing is a relatively recent and fast-growing technology service, a client organization’s employees themselves may not possess much cloud expertise. This scarcity creates risks to the CFEs examination because IT administrators often aren’t positioned to fully explain the details of the cloud deployment and structure so critical details bearing on the fraud under investigation may not be adequately documented. Also, migrating from facilities that are operating internally to cloud-based services can dramatically alter the fraud risk profile of any organization. For example, when an organization moves to a cloud based service, in most cases, all its data is stored on the same physical equipment where other organizations’ data is housed. If configured inappropriately, data leaks can result.

Interacting with the client organization’s IT and management is the CFEs first step toward understanding how the organization’s cloud strategy is or is not related to the circumstances of the fraud under investigation. How did the organization originally expect to use the cloud and how is it using it in actual practice? What are the benefits and drawbacks of using it the way it uses it? What is the scope, from a fraud prevention and security perspective, of the organization’s cloud deployment? The lack of a cohesive, formal, and well-aligned cloud infrastructure strategy should be a red flag for the CFE as a possible contributing factor in any fraud involving cloud computing services.

The second step is CFE review of the client’s security program (or lack thereof) itself.  IT departments and business units should ideally have a cloud security strategy available for CFE review. Such a strategy includes determining the type of data permissible to store in the cloud and how its security will be enforced. It also includes the integration of the information security program into the cloud. All the usual IT risks of traditional data centers apply to cloud deployment as well, among them, malware propagation, denial of service attacks, data breaches, and identity theft, all of which, depending on the implementation, can fall on either party to the contract.  Professionals who have received training in cloud computing may or may not be able to adapt traditional IT programs for fraud examination of servers in physical form to a cloud environment.

There is good news for the examining CFE, however. Cloud infrastructure brings with it myriad security technologies useful to the CFE in conducting his or her examination that are not affordable in most traditional deployments from real-time chronological reports on suspect activities related to identity and access management systems, to network segmentation, and multifactor authentication.

In summary, CFEs and forensic accountants should not approach a cloud involved engagement in the same way they approach other fraud examinations involving third-party vendors. Cloud engagements present their own complexities, which CFEs should attempt to understand and assess adequately. SSAE 16 and other attestation reports based on audit and attestation standards can be valuable as informational background to examination of a fraud involving cloud services.  CFEs can help as a profession by reinforcing client community understanding that a correctly implemented cloud infrastructure can reduce a client organization’s residual risk of fraud by offloading a portion of the responsibility for managing IT risks to a cloud service provider. CFEs have a valuable opportunity to see that their client organizations benefit from the cloud while adequately addressing the new fraud risks that are introduced when their clients contract with a service provider and move IT operations to the cloud. Applying the same level of rigor to examinations involving cloud technology that they apply to technology managed in-house creates an environment in which the CFE and forensic accounting professions can be primary advocates for strong cloud strategy implemented within the structure of the client organization’s fraud prevention program.

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.

Write & Wrong

It’s an adage in the auditing world that examination results that can’t be effectively communicated might as well not exist.  Unlike a financial statement audit report, the CFE’s final report presents a unique challenge because there is no standardized format. Our Chapter receives more general inquiries from new practitioners about the form and content of final examination reports than about almost any other topic.

Each fraud investigation report is different in structure and content, depending on the nature and results of the assignment and the information that needs to be communicated, as well as to whom the results are being directed. To be effective, therefore, the report must communicate the findings in an accurate and concise form. Corporate counsel, law enforcement, juries, an employing attorney and/or the audit committee and management of the victimized organization must all be able to delineate and understand the factual aspects of the fraud as well as the related risks and control deficiencies discovered so that appropriate actions can be taken timely. Thus, the choice of words used and the tone of the CFE’s final report are as important as the information presented within it. To help ensure their reports are persuasive and bring positive results, CFEs should strive to keep them specific, meaningful, actionable, results oriented, and timely.

Because the goal of the final report is to ensure that the user can interpret the results of the investigation or analysis with accuracy and according to the intentions of the fraud examiner or forensic accountant, the report’s tone and structure are paramount. The report should begin by aligning issues and recommendations with applicable ACFE and with any other applicable professional standards and end with results that are clearly written and timely presented. To ensure quality and accuracy, there are some basic guidelines or ground rules that authorities recommend should be considered when putting together a final report that adds value.

The CFE should consider carefully what specifically to communicate in the report, including the conditions, cause, effect, and “why” of each of the significant fraud related facts uncovered.  Fraud investigators should always identify and address issues in a specific context rather than in broad or general terms. For example, stating that the fraud resulted from weaknesses in the collection and processing of vendor payment receipts is too broad. The report should identify the exact circumstances and the related control issues and risk factors identified, the nature of the findings, an analysis of the specific actions constituting the fraud and some discussion (if the CFE has been requested to do so) of possible corrective actions that might be taken.

To force the writing toward more specificity, each paragraph of the report should express only one finding, with major points enumerated, or bulleted, and parallel structure should be used for each itemized statement of a listing of items. Further, the most important findings should be listed in the first sentence of a paragraph. Once findings are delineated, the explanatory narration of facts aligned to each finding should be presented. Being specific means leaving nothing to the
user’s interpretation beyond that which is intended by the writer.  Another way to achieve specificity is to align the writing of the report to an existing control framework like the Committee of Sponsoring Organizations of the Treadway Commission’s (COSO’s) internal control or risk management frameworks. When issues are aligned with existing standards or to a framework, it can be easier for the CFE to explain the weaknesses in the client’s control environment that made the fraud possible.

The question to be answered is: Can the client(s) readily tell what the issues are by reading the investigative report alone? If the answer is “no,” how will they satisfactorily address areas the client will eventually deem important in moving forward toward either remediation or possible prosecution? This aspect of the writing process requires the practitioner to, first, identify to whom the final report is specifically directed and, second, determine what is to be communicated that will add value for the client. For example, the report may a communication to an employing attorney, to corporate counsel, to the client’s management or audit committee or to all three. What are their expectations? Is the report the result of a routine investigation requested by client management of possible accounts payable fraud or a special investigation to address a suspected, specifically identified fraud? The answer to these and related questions will help determine the appropriate technical level and tone for the report.

When there are different readers of the report, the process necessarily becomes more complex under the necessity to meet the expectations, understandings and eventual usages of all the parties. Finding the right words to address the identified fraud related facts in a positive tone, especially when client conditions surrounding the fraud are sometimes sensitive or at least not favorable, is crucial to making the report meaningful as well as persuasive. The investigative findings must be clear and logical. If the reported results are understood and meaningful actions that add value to the position of the various users are taken because of the findings, then the purpose and meaning of the CFE’s report (and work) will be realized.

What about investigative situations in which the CFE or forensic accountant is asked to move beyond a straight-forward presentation of the facts and, as an expert on fraud and on fraud prevention, make recommendations as to corrective actions that the client might take to forestall the future commission of frauds similar to those dealt with in the final report? In such cases (which are quite common, especially with larger clients), the final report should strive to demonstrate to the extent possible the capacity of the entity to implement the recommendations the CFE has included in the report and still maintain an acceptable level of operation.  To this end, the requested recommended actions should be written in a way that conveys to management that implementing the recommendations will strengthen the organization’s overall fraud prevention capability. The writing, as well as the complexity of the corrective action, should position the client organization to implement recommendations to strengthen fraud prevention. The report should begin with the most critical issue and progress to the least important and move from the easiest recommended corrective steps to the most difficult, or to the sequence of steps to implement a recommendation. The cost to correct the fraud vulnerability should be
apparent and easily determined in the written report. Additionally, the report should provide management with a rubric to evaluate the extent to which a deficiency is corrected (e.g., minimally corrected, fully corrected). Such a guide can be used to gauge the fraud prevention related decisions of management and serve as a basis for future fraud risk assessments.

Developing the CFE’s final report is a process that involves four stages: outlining, drafting, revising, and editing. In the outlining stage, the practitioner should gather and organize the information so that, when converted to a report, it is easy for the reader to follow. This entails reviewing the working papers and making a list of the fraud related facts to be addressed and of their related chronologies. These should be discussed with the investigative team (if any) and the
client attorney, if necessary, to ensure that there is a clear understanding of the underlying facts of the case. Any further work or research should be completed at this stage. This process may be simple or complicated, depending on the extent of the investigation, the unit or operation that is under examination, and the number of fraud related facts that must be addressed.

Once all information has been gathered, the next stage is writing the draft of the report. In completing the draft, concise and coherent statements with sufficient detail should enable the reader to understand the chronology and related facts of the fraud, the fraud’s impact on operations, and the proposed corrective actions (if requested by the client). After completing the draft, revisions may be necessary to make sure that the evidence supports the results and is written in a specific context.

The final stage involves proofreading and editing for correct grammar, sentence structure, and word usage to ensure that the facts and issues related to the fraud are effectively and completely presented and that the report is coherent. Reviewers should be used at this stage to give constructive feedback. Several iterations may be necessary before a final report is completed.

In summary, the CFE’s final report should be designed to add value and to guide the client organization’s subsequent steps to a satisfactory overall fraud response and conclusion. If the CFE’s report is deficient in communicating results, critical follow-on steps requiring immediate action may be skipped or ignored. This can be costly for any company in lost opportunities for loss recoveries, botched prosecutions and damaged reputation.