Definition of Fraud
Definition
Fraud – An act of deception intended to secure personal gain for the person committing the fraudulent act or to cause loss to someone else.
Fraud is a criminal activity.
Employees may commit fraud to make a dishonest gain from their employer. They may steal items from stocks or make false expense claims.
A person may commit fraud alone, but it can be more challenging to detect when two or more people commit fraud together (collusion).
This is known as collusion.
Types of Fraud
We can divide fraud by employees or managers into two main types.
Taking money or other assets from the business dishonestly, such as making false expense claims.
Making false statements to deceive and disguise the truth.
In particular, it may involve preparing misleading financial statements to deceive shareholders, lenders or regulators. This has happened in the case of several high-profile corporate failures.
Key Point
The difference between fraud and error is:
An error is an unintentional mistake, usually through negligence or ignorance; whereas
Fraud is an intentional deception.
Activity 1 Fraud or Error
Classify the actions as fraud or error.
Action
Fraud or error
Alteration, falsification or manipulation of accounting records or documents.
Ignorant application of inappropriate accounting policies.
Collusion.
Mathematical or clerical mistakes in collecting or processing accounting data.
Unintentional misapplication of accounting policies.
Misappropriation of assets (i.e. theft).
Oversight or misinterpretation of facts resulting in an incorrect accounting estimate.
Purposeful recording of transactions without economic substance.
Suppression of effects of transactions from records or documents.
Asset Misappropriation
There are various ways in which individuals, acting alone or in collusion with someone else, can commit fraud by taking money or other assets dishonestly from their employer or other people or businesses.
Fraudulent activity
Description
Example
Theft
Taking assets from the company for personal gain
Employees may steal cash from the business or other assets such as materials, inventory or a laptop computer.
Overstating expense claims
Overstating claims to receive more reimbursement than entitled.
Examples include an employee who claims first-class business travel but travels second class or for staying in an expensive four-star hotel but stays in a cheap budget hotel.
Fictitious customer
Creating fake customers to receive goods for personal gain
An employee makes a record for a new customer who does not exist and ‘sells’ goods to the ‘customer’.
The employee receives the goods, and the debt is written off when the fictitious customer doesn’t pay.
Collusion with a customer
Working together to receive higher value goods than invoiced.
An employee may collude with a customer – for example, by sending an invoice for much less than the value of goods sold.
The difference between the invoice and fair prices is then shared between the employee and the customer.
Collusion with a supplier
Working together with a supplier to receive payment for non-existent supplies.
For example, paying the supplier for goods that have not been delivered and receiving part of the payment from the supplier.
Disposal of business assets for less than their value
Buying company assets for less than their fair value
An employee buys an asset from the employer – such as a company car or a smartphone – for much less than its actual value.
Teeming and Lading
Cash for invoice payment is taken, and payment to invoices is delayed concealing missing funds.
Cash marked for payment of invoice 0001 is stolen by an employee. To hide the fraud, the employee uses money earmarked for payment of invoice 0002 to pay for invoice 0001.
The employee informs the customer of invoice 0002 that payment clearance is delayed.
Example Teeming and Lading
Misrepresentation of Information
Other reasons to misrepresent financial information include:
Features of Misrepresentation
Misrepresentation
Overvalue inventory
It makes the cost of sales lower and profits higher.
Alternatively, a company may not write off obsolete inventory.
Fictitious sales
A company may create fictitious sales to increase reported profits.
One way of doing this is to collude with a customer.
Near the end of the financial year, goods are sold to the customer, increasing sales and profit for the year. But there is an agreement that the customer will return the goods after the year-end and will not pay for them.
Understating or overstating expenses
Profit may be manipulated by understating or overstating some items of expense.
Implications of Fraud
Conditions for Fraud
Condition
Dishonesty
Fraud can only occur if one or more individuals are dishonest and are prepared to commit a crime, usually for personal gain.
Motivation
Reason for an individual to commit fraud.
For example, the motivation may be that the individual wants more money.
Another important motivating factor, however, is that if the individual commits fraud, the risk of being discovered is small – or if found, the threat of severe punishment is minor.
Opportunity
The individual must be able to see an opportunity for committing fraud without being discovered. Even if an individual would like to commit fraud, they can do it only if an opportunity exists.
Signs of Potential Fraud
Management and supervisors should be alert to signs and risks of possible fraudulent activity.
When an employee behaves secretively and does not want colleagues to see what they are doing.
Employees may work long hours and refuse to take holidays so no one else can take over their work and see what they have been doing.
When an employee appears to be living an expensive lifestyle beyond what might be expected of their income.
Opportunities for fraud are much more significant when there is no segregation of duties and the same individual is responsible for different tasks, such as invoicing, receiving, and recording payments.
An unusual transaction may be a cover for fraud.
When employees are unhappy and resent the organisation they work for, they may be more motivated to commit fraud.
Management must also be aware that the risk of fraud by unauthorised hackers into the organisation’s IT systems is high, despite improvements in anti-hacker software such as firewalls.
Minimising Risk of Fraud
The implications of fraud for a business organisation are significant. When fraud occurs, it means that:
The organisation has employed one or more dishonest individuals
Internal controls to prevent fraud are weak because opportunities exist to ignore or avoid those controls
Internal controls to detect fraud, and measures to punish fraud when discovered, are weak or ineffective.
The company must have measures to reduce the conditions for fraud.
Measures to reduce the condition
Background checks on potential employees
Probationary periods for new employees
Monitoring
Ethical leadership
Ethical training
Awareness of the cost and consequences of fraud
Effective internal control system
Segregation of duties
Responsibilities of Management Regarding Fraud
Management is responsible for the design and operation of the internal control system, and those charged with governance (board of directors) are responsible for its effectiveness.
They may be assisted by external auditors, internal auditors, and employees.
There must be a control environment in which employees are aware of the risk of fraud and are alert to the need to prevent fraud from happening or report their suspicions.
Improving Internal control
Management should also look for internal control weaknesses that could increase the risk of fraud and should consider improving internal control quality.
Employees
Employees should be aware of the fraud risks and the consequences of committing fraud on the company, on other employees and themselves.
They should be embedded with a moral and ethical obligation not to carry out fraudulent activities, seek opportunities, or encourage others (internally and externally) to do so.
Whistleblowers
Whistleblower – An individual that reports a suspicion or case of financial crime or other irregularity.
Because the board of directors are responsible for the effectiveness of the internal control system, they may establish an anti-fraud system that employees can use to bypass management when reporting suspicions of fraud. This is known as a whistleblowing system.
Whistleblowing system
An effective whistleblowing system must have specific attributes:
Attribute
Reporting channel
A whistleblowing system enables an employee to report suspicions of fraud or wrongdoing by others in the organisation.
Outside regular lines of reporting
The employee can make the report outside their usual line of reporting and does not have to make the report to their boss (who may be involved in the fraud). Reports may be made, for example, to the company secretary or the audit committee.
Confidentiality
The report will be treated in confidence, and the whistleblower’s identity will not be revealed (this may not always be possible).
Investigation
The allegation will be investigated by an individual or small committee that can bring independent judgement and objectivity to the investigation.
Definition of Money Laundering
Money laundering – Activities intended to conceal the origins of proceeds from criminal activity.
Money laundering is often associated in the public mind with activities that disguise the origins of money earned by the sale of illegal drugs. Still, it applies to all crimes that gain money for the criminal, including financial crimes like asset misappropriation and tax evasion.
Aspects of Money Laundering
Money laundering has three stages:
Stage
Placement
Introduction of money earned through crime into the laundering system.
Deposit criminal proceeds in legitimate bank accounts.
Exchange criminal proceeds for other assets, such as chips at casinos.
Layering
Activities and transactions conceal the money’s source, making it difficult for investigators to trace what has happened to it.
Moving money between multiple bank accounts, including overseas banks.
Integration
Using laundered money for a legitimate purpose.
Buying a car, property, jewellery etc.
Other Money Laundering Offenses
Offences related to money laundering include:
This happens when one person informs another that the other person is being investigated for suspicion of money laundering.
Tipping off allows the other person to hide the money somewhere else before the investigators can trace it or to escape before they can be captured and arrested.
Most countries have laws or regulations for dealing with money laundering.
Banks and other regulated institutions within the financial system are required to report suspicions of money laundering by their customers to the authorities.
Failure to report suspicions of money laundering is an offence for individuals with regulatory responsibility for anti-money laundering procedures.
Anti-Money Laundering Regulations
Money laundering is a crime that crosses national boundaries, and the need for international measures to deal with it has been recognised.
Financial Action Task Force (FATF)
The international anti-money laundering initiative has been led by an inter-governmental body, the Financial Action Task Force or FATF.
The Financial Action Task Force was established in 1989 to set standards and promote the effective implementation of legal, regulatory and operational measures against money laundering, terrorism financing and other related threats to the integrity of the international financial system.
FATF has published recommendations about how countries should take measures to combat money laundering. These are called the FATF Recommendations.
One of these recommendations is that money laundering should be a criminal offence. Other recommendations include guidance on how each country should apply anti-money laundering measures in practice.
National Regulations
Countries adopt the FATF Recommendations by producing their anti–money laundering regulations. National regulations are based on the FATF Recommendations.
The anti-money laundering regulations provide for reporting of money laundering activity (including suspicions of money laundering) to a national financial intelligence unit – a government body – for investigation.
For example, the UK has enacted the Proceeds of Crime Act to handle money laundering offences.
Regulations on Specific Industries
The anti-money laundering regulations apply to certain types of organisations but not to others. The laws are also more extensive for some kinds of organisations than for others.
For example, banks are subject to extensive anti-money laundering regulation because the banking system is where most money laundering activity occurs.
Other organisations are also subject to additional money laundering regulations, such as accountants, auditors and tax advisers, casinos, precious metals and jewels dealers, real estate agents and lawyers.
Detecting and Preventing Money laundering
Anti-money laundering procedures are used by any organisation subject to anti-money laundering regulations and deal with customers who may be involved in money laundering.
Anti-money laundering procedures include:
Procedure
Due diligence: know your customer
An essential anti-money laundering measure is customer due diligence. This means confirming the identity of a new customer before agreeing to make any transactions with or for the customer.
This process is also called ‘know your customer’. When the customer is a company, the process involves investigating the identities of the company’s directors and its origins and business activities.
Dealing with large transactions
Large transactions should be referred to a senior manager for approval. The senior manager should be satisfied that the transaction is ‘legitimate’ and that there is no suspicion of money laundering.
Staff training
Staff should receive regular training to remain alert for money laundering and to report suspicions of money laundering transactions.
Retaining records
The organisation should retain transaction records and the results of customer due diligence procedures for a specified minimum period.
Handling potential tipping-off offences
Company staff should be aware that warning customers that they might be reported on suspicion of money laundering is tipping off. This is a criminal offence.
Reporting Suspicions
Organisations must have arrangements that enable staff to report suspicions of money laundering to someone in authority within the organisation.
This arrangement should include preparing a suspicious transaction report by the employee for the Money Laundering Reporting Officer.
An employee prepares a suspicious transaction report on a due diligence check of a customer or a large-sized transaction that a customer wants to make.
The suspicious transaction report is submitted to a Money Laundering Reporting Officer within the organisation.
The Money Laundering Reporting Officer considers the report and decides whether or not it should be reported to the authorities.
Suspicious transactions considered by the Money Laundering Reporting Officer to be potentially a money laundering activity should be reported to the government’s official investigation unit. This unit then investigates the report.
Implications of Money Laundering on the Accountant
Money laundering is a serious offence; involvement will have severe professional and criminal consequences for an accountant.
Doing due diligence on customers, ensuring staff are well trained, keeping detailed records of transactions and reporting suspicious activity to the Money Laundering Reporting Officer are ways in which an accountant can ensure they do not become involved.
Handling Client Money
Professional firms such as accountants or lawyers sometimes act on behalf of a client, for example, to assist them with investing in the stock market. Law firms help clients with property purchases, and insurance brokers help clients to buy insurance policies.
To carry out these tasks for clients, the firm will need some money from the clients to pay for what they want.
Effective policies and procedures must be implemented for handling client money:
Reduce the risk of involvement in financial crime (fraud and money laundering)
Ensure client funds are not misspent or misappropriated.
Ensure client funds are correctly accounted for.
Client money is money held by a firm that belongs to a client. It is not money paid by the client for the firm’s professional services. It is the client’s money that the firm may be required to spend on the client’s behalf.
A risk with client money is that the firm will mix it up with its cash and cannot separate the two.
As a result, the firm might spend client money for its benefit. Or if the firm gets into financial trouble, it may use client money to rescue itself.
There is also a risk that the firm may be implicated in financial crime, especially if the client’s money is discovered to be proceeds of criminal activity.
Keep client money segregated from the firm’s funds, either physically (cash) or in separate bank accounts.
In some countries, this is a legal requirement.
Account for client money separately from the firm’s funds, with separate accounts for each client.
In the case of client money held by business organisations, the risk of improper use of client money by a firm is reduced by the existence of regulations and the threat of criminal and professional sanctions if client money is improperly used (in other words, used by the firm to pay its expenses rather than those of the client).
Internal controls over authorising access to and using funds also help reduce risk.
