Fraud 101

Techniques and Strategies for Understanding Fraud

Stephen Pedneault

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470647844
• Edition: 3
• Topic: Negocios y empresa
• Subtopic: Auditoría

A straightforward guide explaining the nature of financial fraud

Fraud continues to be one of the fastest growing and most costly crimes in the United States and around the world. The more an organization can learn about fraud in general and the potential fraud risks that threaten the financial stability of the organization's cash flow, the better that organization will be equipped to design and implement measures to prevent schemes from occurring in the first place.

Fraud 101, Third Edition serves as an enlightening tool for you, whether you are a business owner or manager, an accountant, auditor or college student who needs to learn about the nature of fraud. In this invaluable guide, you will discover and better understand the inner workings of numerous financial schemes and internal controls to increase your awareness and possibly prevent fraud from destroying your organization's financial stability.

It offers guidance, understanding, and new, real-world case studies on the major types of fraud, including

• An understanding of why fraud is committed
• An overview of financial fraud schemes
• White-collar crime
• Uncovering employee embezzlements
• Establishing internal fraud controls
• The nature of collecting evidence

With case studies included throughout the book to gain insight to the real world of fraud, Fraud 101, Third Edition describes the features of fraud and then provides proven methods of prevention, as well as solutions to expose different types of fraud.

CHAPTER 1

The World of Fraud

I am often asked for my thoughts on fraud. A common question posed is whether I believe fraud is on the rise. My response usually goes like this: “When you say fraud, what do you mean by fraud, and what kind of fraud are you talking about? If you are asking me about fraud in general, my answer is yes, I believe fraud in general has significantly increased during my professional lifetime. If you are asking me if society has become less honest and more accepting of individuals who are trying to beat the system, my answer again would be yes. However, are you referring to a particular area of fraud?”

Definition of Fraud

What is fraud? Although there are common definitions of fraud, no two definitions are the same. If an employee brings home some office supplies for their kids to use with their school projects, is that fraud? Or is it simply an employee stealing office supplies? Or is it just an accepted practice in business that some office supplies may end up being used for personal purposes—a cost of doing business, if you will? Or are we saying the same thing, but three different ways? How about a business that overstates reserve balances on their financial statements, only to use those overstated balances in future periods to “smooth” earnings trends? Is that considered fraud, or is it simply a widely accepted business practice—technically incorrect, but otherwise allowed and accepted? Lastly, how about a family who wants to have their children attend a particular college that they can’t afford? In preparing the financial aid forms, they don’t report certain bank and investment accounts, and underreport their true earnings so that their child will be eligible for financial aid. Are they committing fraud, or are they simply working the system to gain access to funds available for that specific reason—to assist families with high tuition costs?

Depending on who is asked each of these questions, we may get consistent answers or (more likely) we will get disparity based on each individual’s background, values, and beliefs.

Therefore, before we can get into discussions and cases relating to fraud, it would be a good idea to make sure we are all talking about the same thing—fraud. One of the best resources for an objective, defendable definition of fraud is Black’s Law Dictionary. According to Black’s Law Dictionary, fraud is defined as “a knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.”¹

As mentioned earlier, to further define and understand fraud, it has to be discussed within a specific context. Fraud can be further broken down into subcategories of fraud, along with various methods used to commit each type of fraud. Unfortunately, fraud has become prevalent within virtually every aspect of our lives, is accepted by many as the status quo, and acts as a constant reminder of the sad state of society in which we live. Personal characteristics that were likely found within individuals living a socially responsible life, things like ethics, morals, and pride, have been replaced by greed, self-promotion, and the “what’s in it for me” mentality.

The Man Types of Fraud

Names like WorldCom, Enron, and Arthur Andersen have become more than commonplace in discussions regarding fraud. Their names and others—such as Martha Stewart, who was found guilty of lying to authorities about possible insider trading, and Richard Hatch, a Survivor winner who failed to pay the taxes due on his winnings, can and often are used in analogies of what can go wrong. Instances of fraud occur every day and either go undetected or are deemed not worthy of attention. Only cases involving overwhelming amounts of money or some other news-grabbing aspect make the headlines. Traditionally, only one in nine fraud cases ever appears in the media, which means that for every fraud you read or hear about, eight more will never appear in the public eye.

Two main areas of fraud exist in the world of accounting: management fraud, commonly known as financial statement fraud, and employee fraud, or embezzlement. Many of the notorious frauds of this and past decades fall into one of these two categories. However, many other categories of fraud or fraudulent activity exist. If you watch the news, read the newspaper, or scan news posts on the Internet, you should be able to name a few more categories. How about political malfeasance? These frauds are committed by elected officials who abuse their office or position, usually for some form of personal enrichment. Bribes, gifts, preferential treatment, bid rigging, and kickbacks involving politicians and elected officials have been the target of many investigations and convictions as seen in so many news stories.

Then, of course, there is tax fraud. Tax fraud can be carried out by any business, organization, or individual, at the federal or state level. And for all the types of taxes that are imposed at the local, city, county, state, and federal level, there exists an equal number of tax fraud schemes committed to minimize each type of tax. Based on personal experience, the rate of occurrence of some form of tax fraud, whether a large scheme or simply minor cheating, is present on virtually every tax return filed.

Rounding out the top most widely known fraud categories are crimes committed at the federal level: wire fraud, mail fraud, and bank fraud, to name a few of the most common. Convictions on these types of fraud are generally easy to obtain. A scheme to defraud involving an electronic banking transaction or simply mailing a check or payment is all it would take for a violation. The use of either means, common in so many schemes, can lead to a conviction of a federal law. The only conviction easier to obtain is obstruction of justice. Simply provide any false statement or fact to a federal investigator and you have committed obstruction of justice.

There is a risk for fraud in every type of social program that exists. Unfortunately, the reality of the situation is that every program in existence has a certain level of fraud; due to limited resources available to combat the issue, many individuals successfully defraud the programs. At the local level, for example, many towns offer residents below a set income level assistance with their town tax bills. Typically, a form needs to be completed by each applicant, along with a copy of the most recent tax return. Change the amounts to lower figures, copy the return, and submit it with the form and you will receive assistance. At the state level, complete the forms required for state aid, remain silent about the children’s father working, earning a decent amount, and living in the same home, and the household income then falls below the set levels so that rent assistance will be provided by the state.

Case Study 1.1 - Public Aid Goes “Fraud Proof”

In my state, we have a publicly funded social program available to low-income individuals whereby qualifying recipients receive state aid to purchase food and other qualifying provisions. Our food stamp program used to require individuals to apply for assistance, and once qualified, the individuals received food stamps in the mail each month to be used similar to cash for purchasing food.

There were many fraud schemes perpetrated involving the food stamp program. Food stamps were often mailed to recipients on the same day each month, and the theft of recipients’ mail became commonplace, as did simply robbing the recipient of his or her food stamps as they redeemed them. Food stamps became a form of currency on the black market, used in exchange for virtually any item and service. Recipients would pay for things never intended to be covered by food stamps, and in turn the individuals who were redeeming food stamps for food purchases were often living well beyond the intended income levels of the program.

There were also individuals who received multiple food stamp allocations each month by applying and qualifying using different names and multiple addresses. Children of qualified individuals were often claimed by several different individuals in their own qualification process, enabling each applicant to receive more food stamps per month than they were entitled to by listing children who were actually someone else’s children who were already receiving food stamp benefits.

I remember waiting in the supermarket checkout lines behind individuals purchasing groceries with food stamps. Although the program required recipients to purchase generic labeled items, they were purchasing brand-name labels intermixed with generic items. I also saw alcohol, cigarettes, magazines and many other non-covered items being purchased. In the stores with more sophisticated registers, the non-covered items would be segregated and could not be paid for using food stamps. The clerk would collect food stamps for the covered items and then I would watch as the customer pulled out a large roll of cash to pay for the remaining items. I often wondered how the person could have qualified for food stamps with such a large amount of cash. In less sophisticated stores, though, all the items (even those specifically deemed as non-qualifying items) went through and were purchased with food stamps.

Once I asked a cashier after the customer had left why the non-covered items were allowed to be paid for by food stamps. The clerk told me that the store is reimbursed by the state for the same amount either way, so why should they tell customers what they can and can’t buy with the food stamps? That mentality made the store an accessory to defrauding the food stamp program.

A few years ago, the state recognized the extent of the fraud issues, or more likely decided to finally address the issue and developed a new system. I attended a session sponsored by the food stamp program in which the two individuals who designed the new automated system presented the way the new food stamp system would work. The individuals explained that they had developed a debit card system to eliminate fraud within the program.

Each recipient would be issued a card similar to an ATM card that could be used to purchase qualifying food items. Each card would have an account associated with it, and each month the card would be replenished with the individual’s qualifying amount. There would be no mailing of coupons, theft of mail, or robbing recipients. One card would be issued to each recipient, eliminating the risk that recipients would trade cards or use the monthly proceeds as trade in other transactions.

The presentation ended with the individuals feeling confident that their new system would eliminate the prior fraud and abuse, allowing the program to become a better steward over the public’s funds.

The program wasn’t even a month old when I found myself behind a customer using one of the new cards. I remembered the session, and my interest was piqued to see how this new system would work. I watched as the groceries were rung, and items not covered were segregated for the customary separate cash payment. The individual opened her wallet and removed her state card, then swiped it on the credit card terminal used for debit and credit card purchases. Three swipes later the clerk told the customer the balance on the card was insufficient to cover the cost of the groceries. Without blinking an eye, the customer opened her wallet again and removed three similar cards. By the third card swipe, there were sufficient funds to complete her purchase.

So much for the state’s new program! And how much did they invest in this new system?

Financial aid programs are generally available at every private school, from pre-school through college, to assist families who qualify based on income limits and other requirements. Once again, the families often complete the forms and provide a “version” of the latest tax return showing lower than actual income. These fraud schemes are perpetrated against every program in existence.

Case Study 1.2 - Creative Approaches to Funding Higher Education

Many programs have an application process that requires supporting information to be provided to corroborate the information provided. Unfortunately, the programs’ screening processes are often inadequate or outdated. Home computers and inexpensive software packages have made it relatively easy to create supporting documentation that, unless scrutinized and challenged, can easily meet the requirements for eligibility for the program. Bank statements can be easily scanned and then altered to reflect any desired balances. Tax returns can be run over and over again using packages like TurboTax to produce different results.

One great example of this type of fraud is the application process for college financial aid. In addition to completing the required forms, the applicant must also provide copies of tax returns and bank statements.

In one of my recent cases involving a business owner, I obtained copies of his personal income tax returns for the past three years. I identified that he was married with two children, and he owned a home estimated at a value of $500,000, located in one of the best sections of our state. The taxes on his home alone were in excess of $10,000, and the total of his itemized deductions in the latest year was nearly $20,000.

The total income he reported on their jointly filed tax return was $3,500. I was beyond words. A family of four, living in a $500,000 house in the most expensive section of our state was living on $3,500 per year? Sure!

On the bottom of each page of their tax returns, there was a reference to the daughter’s name and Social Security number. I found a similar reference on each page of the returns for all three years. That was when I realized that the copies of the returns he had given me were the copies he had used to obtain financial aid for his daughter, the one whose name was written on each page of her parent’s return—a requirement of the financial aid system.

With a little research, I learned that the daughter was attending the most expensive college in our state. By giving her school versions of their tax returns reflecting little to no income, I surmised the daughter was likely attending based on funds received through financial aid.

It turned out the tax returns were prepared by her father on his home computer using TurboTax and this was simply the “version” he generated to support his application for financial aid for his daughter’s college education.

Here’s my question: How could this very sophisticated school’s financial aid process not be able to identify that the returns provided were obviously false and that the reported income was unreasonably low based on the other information in plain view on the same returns?

Let’s look at the world of insurance. How many types of insurance fraud can you name? First, there is the fraud committed in the application process to obtain coverage, regardless of the type of coverage. Fraud can be committed in virtually every type of insurance known to exist. Leave the past health issues off the health insurance application, fail to mention that the vehicle will be used primarily for business on the automobile application, or indicate that you will be living in the property when a tenant has already been lined up. Then there are the insurance claim fraud schemes. Staged accidents, torched cars (especially when the amount owed on the vehicle exceeds the car’s value), faked injuries, previous undisclosed health conditions, burglaries that never occurred, fires that were set, water damage that was intentional, thefts that never occurred, and inflated inventories supporting a loss claim are just a few scheme areas. The goal is to obtain free money from the insurance company, who supposedly can afford the pay out, especially since high premiums have been paid to the insurance company on time all along—a “return on investment” rationalization.

Case Study 1.3 - How Many Did I Say It Was?

While attending college, I worked in construction, often building or renovating shopping plazas. The money was better than what I could earn anywhere else, and I was learning a trade that I still use to this day.

In my last year on the job, we were renovating a small shopping plaza that included a jewelry store. We knew all the shop owners and employees, as we interacted with them daily while rebuilding their shops. One sunny afternoon, a man ran out of the jewelry store, followed seconds later by the owner. The owner yelled to stop the guy, as he had just stolen a Rolex watch. The owner chased the thief a short distance, but he had disappeared. It happened so fast, that our crew never had time to come down from the staging to assist in the appre...