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Fraud Examination, Fourth Edition 2012, 2009 South-Western, Cengage Learning
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The Nature of Fraud
LEARNING OBJECTIVES TO THE STUDENT
After studying this chapter, you should be able to: With this chapter, you are
embarking on an exciting
Understand the seriousness of fraud and how fraud affects individuals, consumers,
journey of the study of
organizations, and society.
fraud. Many of you will
Define fraud. find this course more in-
Understand the different types of fraud. teresting than any other
course you have taken be-
Understand the difference between fraud committed against an organization and fore. Chapter 1 will provide
fraud committed on behalf of an organization. an overview of fraud
Understand the difference between criminal and civil fraud laws. what is fraud, how serious
is the problem, fraud-
Understand the types of fraud-fighting careers available today.
fighting careers, criminal
and civil laws, and other
overview topics.
4 Part 1: Introduction to Fraud
n December 11, 2008 the Federal Bureau then pays those victims a premium or inter-
O of Investigation (FBI) arrested Bernard est from money that is paid by subsequent
Bernie Madoff for perpetrating the single investors.3 Without intervention, Ponzi
largest investment fraud in the history of schemes will continue to grow until new
the world. A day earlier, Madoffs own sons recruits become unavailable, at which time,
had turned him in, reporting to authorities the scam is broken down and discovered.
that Madoffs wealth management business Individuals throughout the world lost
was not a legitimate business but was a money in Madoffs pyramid scheme.4 While
shell company for a large scam. While the many of the victims were blue-collared work-
actual amounts of the fraud are still not ers that came from humble backgrounds,
known, estimates suggest that the amount others were extremely wealthy. For exam-
missing from client accounts, including fab- ple, Prince Michel of Yugoslavia traveled
ricated gains, may be as much as $65 billion.1 across Europe to raise money for Madoff.
Madoff was born in Queens, New York, Other victims included various royal families
and later graduated from Hofstra College in and even Londons House of Lords. Actor
1960. After college he dedicated himself to Kevin Bacon and producer Steven Spielberg,
building his firm, Bernard L. Madoff Invest- as well as various other Hollywood movie
ment Securities, where he remained until stars had invested with Madoff. Because
his arrest in 2008. Throughout his career, Madoff had connections to the Jewish
Madoff became one of the most respected community, many Jewish charities and
and trusted individuals on Wall Street, ser- institutions lost a significant amount of
ving both as Chairman of the Board of Direc- money in the scam.5
tors and on the Board of Governors of the
NASD (National Association of Securities Seriousness of the Fraud
Dealers). Madoff was also actively engaged
in creating the technology that eventually Problem
became the NASDAQ stock exchange. Bernard Madoff is an example of an individual who
Madoff perpetrated his scheme by con- misrepresented himself and his company to commit
fraud. Investment fraud, like the fraud committed by
sistently providing high returns for his inves- Bernard Madoff, is just one of the many types of frauds
tors. Madoff claimed that he was able to that present major problems for businesses and consu-
provide such returns by investing in what mers throughout the world.
is known as a split-strike conversion strategy. Although most people and even most researchers be-
A split-strike conversion strategy is a com- lieve that fraud is increasing both in size and frequency,
plicated investment where investors take it is difficult to know for sure.6 First, it is impossible
to know what percentage of fraud perpetrators are
a long position in equities together with a caught. Are there perfect frauds that are never detected,
short call and a long put on an equity index or are all frauds eventually discovered? In addition, many
to lower the volatility of the position.2 While frauds that are detected are quietly handled by the vic-
the entire split-strike conversion strategy tims and never made public. In many cases of employee
may seem very elaborate, the strategy was fraud, for example, companies merely hide the frauds
nothing more than a tool employed by Mad- and quietly terminate or transfer perpetrators rather
than make the frauds public. Companies and individuals
off to attract additional investors to his large
who have been defrauded are often more concerned
Ponzi scheme. about the embarrassment of making frauds public, and
A Ponzi scheme is a type of fraud that the costs of investigating fraud, than they are about seek-
lures investment funds from victims and ing justice and punishing fraud perpetrators.
Chapter 1: The Nature of Fraud 5
Statistics on how much fraud is occurring, whether amounts lost to fraud seem to be increasing.7 In
it is increasing or decreasing, and how much the aver- the past few years alone, we have seen huge frauds
age fraud costs come from four basic sources. both in the form of the largest-ever investment scam
committed by Bernard Madoff as well as the massive
1. Government agenciesAgencies such as the FBI,
frauds in the mortgage and insurance industries that
FDIC, IRS, and various health agencies publish
contributed to the worlds economic decline.8
fraud statistics from time to time, but these orga-
Because fraud affects how much we pay for goods
nizations only publish those statistics that are di-
and services, each of us pays not only a portion of the
rectly related to their jurisdiction. As a result,
fraud bill but also for the detection and investigation of
their statistics are not complete, and do not pro-
fraud. It is almost impossible to read a newspaper or
vide a total picture of fraudeven in the areas for
business magazine without coming across multiple
which they have responsibility.
incidents of fraud.
2. ResearchersResearchers often conduct studies
Even more alarming than the increased number of
about particular types of fraud within certain indus-
fraud cases is the size of discovered frauds. In earlier
tries. Unfortunately, data on actual frauds are hard to
times, if a perpetrator wanted to steal from his or her
obtain and, as a result, most research only provides
employer, he or she had to physically remove the assets
small insights into the magnitude of the problem,
from the business premise. Because of fear of being
even in the specific areas being studied. Comprehen-
caught with the goods, frauds tended to be small.
sive research on the occurrence of fraud is rare and is
With the advent of computers, the Internet, and com-
not always based on sound scientific approaches.
plex accounting systems, perpetrators now need only to
3. Insurance companiesInsurance companies often
make a telephone call, misdirect purchase invoices,
provide fidelity bonding or other types of coverage
bribe a supplier, manipulate a computer program, or
against employee and other fraud. When fraud oc-
simply push a key on the keyboard to misplace com-
curs, they undertake investigations and, as a result,
pany assets.9 Because physical possession of stolen
collect some fraud statistics. Generally, however,
property is no longer required and because it is just
their statistics relate only to actual cases where
as easy to program a computer to embezzle $1 million
they provided employee bonding or other insur-
as it is $1,000, the size and number of frauds have
ance. At best, their analysis of the problem is
increased tremendously.
In addition, as companies have given in to the pres-
4. Victims of fraudSometimes we learn about fraud
sures to meet Wall Streets earnings expectations and as
from those who have been victims. In almost all
these pressures to meet the numbers have intensified,
industries, there is no organized way for victims
some very large financial statement frauds have been
to report fraud and, even if there were, many com-
committed. Hundred million- or even billion-dollar
panies would choose not to make their fraud losses
frauds are not unusual and, in some cases, the decline
in market value of the companys stock has been in the
The Association of Certified Fraud Examiners billions of dollars.
(ACFE) regularly conducts one of the most compre- To understand how costly fraud is to organizations,
hensive fraud studies in the United States. First con- consider what happens when fraud is committed
ducted in 1996 and then conducted again in 2002, against a company. Losses incurred from fraud reduce
2004, 2006, and 2008, the ACFE study, also known as a firms income on a dollar-for-dollar basis. This means
the Report to the Nation on Occupational Fraud & that for every $1 of fraud, net income is reduced by $1.
Abuse, is based on actual fraud cases reported by certi- Since fraud reduces net income, it takes significantly
fied fraud examiners (CFEs) who investigate the frauds. more revenue to recover the effect of the fraud on
The 2008 study estimates that U.S. organizations lose net income. To illustrate, consider the $436 million
roughly 7 percent of their annual revenues to fraud. Ap- fraud loss that a large U.S. automobile manufacturer
plied to the 2008 U.S. gross domestic product (GDP), experienced a few years ago.10 If the automobile man-
this 7 percent figure would translate to approximately ufacturers profit margin (net income divided by
$994 billion in fraud lossesin the United States alone. revenues) at the time was 10 percent, the company
Even with the difficulties in measuring fraud, most would have to generate up to $4.36 billion in additional
people believe that fraud is a growing problem. Both revenue (or 10 times the amount of the fraud) to re-
the numbers of frauds committed and the total dollar store the effect on net income. If we assume an average
6 Part 1: Introduction to Fraud
selling price of $20,000 per car, the company must $49.5 billion, the lowest level since 1996. Whether
make and sell an additional 218,000 cars. Considered these foreign investors funds moved to stocks in other
this way, fighting fraud is serious business. The auto- economies that were deemed safer or whether investors
mobile company can spend its efforts manufacturing decided to stand on the sidelines and wait out the cor-
and marketing additional new cars, or reducing fraud, porate scandals is not clear. What is clear is that the
or a combination of both. U.S. economy was significantly hurt by the fraudulent
As another example, consider the case of a large acts at Enron, WorldCom, and others.
bank that was the victim of several frauds that totaled Because of different cost/revenue structures, the
approximately $100 million in one year alone. With amount of additional revenues a firm must generate
a profit margin of 5 percent, and assuming that to recover fraud losses varies from firm to firm and
the bank made $100 per checking account per year, from industry to industry. However, it is easy to see
how many new checking accounts must the bank that in order to maximize profits, eliminating fraud
generate to compensate for the fraud losses? The should be a key goal of every organization. The best
answer, of course, is up to 20 million new checking way to minimize fraud is to prevent it from occurring.
accounts ($100 million fraud loss/0.05 $2 billion In this book, we will cover fraud prevention, as well as
in additional revenues; $2 billion/$100 per account fraud detection and investigation.
20 million new accounts).
Firms are not the only victims of fraud. In the
aggregate, national economies also suffer from large- Remember this
scale fraud and corruption. If we use the logic described Statistics about how much fraud is occurring are
in the case of the automobile manufacturer described difficult to get. However, all signs indicate that
earlier, we can better understand how, from a macro- fraud is increasing both in frequency and amount.
level, countries suffer from fraud. Take, for example, Fraud is very costly to organizations and to eco-
three different economies. If Economy A, whose profit nomies. Because fraud reduces net income on a
margin is 10 percent, loses $500 million to fraud, dollar-for-dollar basis, the amount of additional
it must generate $5 billion of additional revenue to revenue needed to restore the stolen funds is
offset the loss to net income. If Economy B, whose many multiples of the amount of the fraud.
profit margin is also 10 percent, loses $200 million to
fraud, it must generate $2 billion. Finally, if Economy
C, whose profit margin is 5 percent, loses $100 million
to fraud, it must also generate $2 billion. The strain What Is Fraud?
fraud imposes on economies throughout the world
There are two principal methods of getting something
is tremendous. If just one fraud is prevented, billions
from others illegally. Either you physically force some-
of dollars can be savedresources that can be rein-
one to give you what you want (using a gun, knife, or
vested in building the economy. Given this analysis, it
other weapon), or you trick them out of their assets.
is easy to see how difficult it is for countries with high
The first type of theft we call robbery, and the second
amounts of corruption to ever compete with countries
type we call fraud. Robbery is generally more violent
with low rates of corruption. High-corruption coun-
and more traumatic than fraud and attracts much more
tries are constantly trying to overcome fraud losses,
media attention, but losses from fraud far exceed losses
while low-corruption countries are growing and mov-
from robbery.
ing ahead. As a result, many honest economists, politi-
Although there are many formal definitions of
cians, and regulators spend a considerable amount of
fraud, probably the most common is the following:
time and resources trying to reduce fraud.
In addition to the actual reduction of a countrys Fraud is a generic term, and embraces all the multi-
total GDP, the amount of fraud an economy suffers farious means which human ingenuity can devise,
has a big impact on how willing investors are to invest which are resorted to by one individual, to get an
in a given economy. When organizations commit advantage over another by false representations. No
fraud, for example, investors lose confidence in the in- definite and invariable rule can be laid down as a
tegrity of the country and become more hesitant to general proposition in defining fraud, as it includes
invest. After the revelations of corporate wrongdoing surprise, trickery, cunning and unfair ways by which
in the early 2000s in the United States, for example, another is cheated. The only boundaries defining it
foreign investors purchases of U.S. stocks dropped to are those which limit human knavery.11
Chapter 1: The Nature of Fraud 7
Fraud is deception that includes the following exchange it for American postage stamps. He would then
elements: use those American stamps to send magazines to Spain.
Ponzi noticed that the postal coupon had been pur-
1. A representation chased in Spain for about one cent in American funds. Yet,
2. About a material point, when he cashed it in, he was able to get six American one-
3. Which is false, cent stamps. Immediately, Ponzi started to consider the
4. And intentionally or recklessly so, many possibilities to invest. Assuming this was possible,
5. Which is believed he could buy $100 worth of stamps in Spain and then
6. And acted upon by the victim cash them in for $600 worth of stamps in the United States.
Then cash in or sell the stamps to a third party and Ponzi
7. To the victims damage
would have, well, good old cash. In the early 1900s, just
like today, it was impossible to get this kind of interest in
C A U T I O N Who is in the best position to con you the bank.13
right now? Who is in the best position to con your Ponzis mind quickly went into overdrive and devised a
parents? Remember, it is always those you trust most clever scheme to capitalize on his idea. He was determined
who are in the best position to con you or commit fraud. to be a rich man. His first step was to convert his American
money into Italian lire (or any other currency where the
exchange rate was favorable). Ponzis foreign agents would
Fraud is different from unintentional errors. If, for
then use these funds to purchase international postal cou-
example, someone mistakenly enters incorrect numbers
pons in countries with weak economies. The stamp cou-
on a financial statement, is this fraud? No, it is not pons were then exchanged back into a favorable foreign
fraud because it was not done with intent or for the currency and finally back into American funds. He claimed
purpose of gaining advantage over another through that his net profit on all these transactions was in excess
false pretense. But, if in the same situation, someone of 400 percent.
purposely enters incorrect numbers on a financial Was he really able to do this? The answer is a definite
statement to trick investors, then it is fraud! no. The red tape of dealing with the various postal organi-
As was discussed in the beginning of this chapter, zations, coupled with the long delays in transferring cur-
one of the most common types of fraud today is a scam rency, ate away at all of Ponzis imagined profits.
that lures investment funds from victims and then pays However, a failed scheme couldnt keep Ponzi from
bragging about his great idea. As a result, friends and fam-
those victims a premium or interest from money that is
ily members easily understood what he was saying, and
paid by subsequent investors. This popular fraud
they wanted in on the investment.
scheme, also known as a Ponzi scheme, was named On December 26, 1919, Ponzi filed an application with
after Charles Ponzi who perpetrated a large scam in the city clerk establishing his business as The Security
the early 1900s. To better understand fraud in general, Exchange Company. He promised 50 percent interest in
lets take a closer look at Charles Ponzi. 90 days, and the world wanted in on it. However, person-
ally he claimed to be able to deliver on his promise in just
45 days. This, of course, translates into doubling investors
Charles Ponzi and the money in just 90 days.
Famous Ponzi Scheme Word spread very quickly about Ponzis great idea, and
within a few short months, the lines outside the door of his
Carlo Charles Ponzi was born in Parma, Italy, in 1882 and School Street office began to grow. Thousands of people
then emigrated to the United States in November 1903. purchased Ponzi promissory notes at values ranging from
Over the next 14 years, Ponzi wandered from city to city $10 to $50,000. The average investment was estimated to
and from job to job. He worked as a dishwasher, waiter, be about $300, a large sum of money in the 1920s.
store clerk, and even an Italian interpreter. In 1917, he set- Why would so many people invest in a scheme that
tled in Boston where he took a job typing and answering didnt work? The real reason was that the early investors
foreign mail. It was in Boston in 1919 that Ponzi discovered did see the great returns on their money. Ponzi used the
the mechanism that he thought would make both him and money from later investors to pay off his earlier obliga-
his investors very wealthy.12 tions. It was a new twist on the age-old pyramid scheme.
At the time, Ponzi was considering issuing an export With an estimated income of $1,000,000 per week at the
magazine. He had written a letter about the proposed publi- height of his scheme, his newly hired staff couldnt take in
cation to a gentleman in Spain, and when Ponzi received his the money fast enough. They were literally filling all of the
reply, the man had included an international postal reply desk drawers, wastepaper baskets, and closets in the office
coupon. The idea behind this enclosure was quite simple. with investors cash. Branch offices opened, and copycat
Ponzi was to take the coupon to his local post office and schemes popped up across New England.
8 Part 1: Introduction to Fraud
By the summer of 1920, Ponzi had taken in millions and approximately 180 million postal coupons, of which au-
started living the life of a very rich man. Ponzi dressed in thorities could only actually confirm the purchase of two.
the finest suits, had dozens of gold-handled canes, show- Ponzis only legitimate source of income was $45 that
ered his wife in fine jewels, and purchased a 20-room he received as a dividend of five shares of telephone stock.
Lexington mansion. His total assets came to $1,593,834.12, which didnt come
Any get-rich scheme is certain to attract the attention of close to paying off the outstanding debt. It took about eight
the law, and Ponzis was no exception. From the start, fed- years, but noteholders were able to receive an estimated
eral, state, and local authorities investigated him. Yet, no 37 percent of their investment returned in installments.
one could pin Ponzi with a single charge of wrongdoing. Ultimately, Ponzi was sentenced to five years in federal
Ponzi had managed to pay off all of his notes in the prom- prison. After three years in prison, Ponzi was sentenced to
ised 45 days and, since everyone was happy to get their an additional seven to nine years by Massachusetts
earnings, not a single complaint had ever been filed. authorities. However, Ponzi was released on $14,000 bond
On July 26, 1920, Ponzis house of cards began to pending an appeal and disappeared the following month.
collapse. The Boston Post headlined a story on the front Ponzi turned up a short time later in Florida under the
page questioning the legitimacy of Ponzis scheme. Later assumed name of Charles Borelli. Ponzi was involved in a
that day, the district somehow convinced Ponzi to suspend pyramid land scheme and was purchasing land at $16 an
taking in new investments until an auditor examined his acre, subdividing it into 23 lots, and selling each lot off at
books. Within hours, crowds of people lined up outside $10 a piece. He promised all investors that their initial $10
Ponzis door demanding that they get their investment investment would translate into $5.3 million in just two
back. Ponzi obliged and assured the public that his organi- years. Unfortunately, much of the land was under water
zation was financially stable and that he could meet all and worthless.
obligations. He returned the money to those who re- Ponzi was indicted for fraud and sentenced to one year
quested it. By the end of the first day, he had settled nearly in a Florida prison. Once again, Ponzi jumped bail and was
1,000 claims with the panicked crowd. later found in Texas. Ponzi hopped a freighter headed for
By continuing to meet all of his obligations, the angry Italy but was captured on June 28 in a New Orleans port.
masses began to dwindle and public support swelled. On June 30, he sent a telegram to President Calvin Coolidge
Crowds followed Ponzis every move. He was urged by asking to be deported. Ponzis request was denied, and he
many to enter politics and was hailed as a hero. Loud was sent back to Boston to complete his jail term. After
cheers and applause were coupled with people eager to seven years, Ponzi was released on good behavior and
touch his hand and assure him of their confidence. deported to Italy on October 7, 1934. Back in Rome, Ponzi
Because of the additional attention, Ponzi dreamed of became an English translator. Mussolini then offered Ponzi
opening more investments. For example, Ponzi began to a position with Italys new airline, and he served as the
make plans to establish a new type of bank where the prof- Rio de Janeiro branch manager from 19391942. Ponzi dis-
its would be split equally between shareholders and de- covered that several airline officials were using the carrier
positors. Ponzi also planned to reopen his company under to smuggle currency, and Ponzi wanted a cut. When they
a new name, the Charles Ponzi Company, whose main pur- refused to include him, he tipped off the Brazilian govern-
pose was to invest in industries throughout the world. ment. World War II brought about the airlines failure, and
The public continued to support Ponzi until August 10, Ponzi found himself unemployed.
1920. On this date, the auditors, banks, and newspapers Ponzi died in January 1949 in the charity ward of a Rio
declared that Ponzi was indeed bankrupt. Two days later, de Janeiro hospital. He left behind an unfinished manu-
Ponzi confessed to serving 20 months in a Canadian prison script appropriately titled The Fall of Mister Ponzi.
in 1908 on forgery charges related to a similar high-interest
scheme followed by an additional two-year sentence in
Atlanta, Georgia, for smuggling five Italians over the
Canadian border into the United States.
On August 13, Ponzi was finally arrested by federal au- Fraud, Greed, Deception,
thorities and released on $25,000 bond. Just moments and Confidence
later, he was rearrested by Massachusetts authorities and Ponzis scam is extremely helpful in understanding
re-released on an additional $25,000 bond.
fraud. Certainly, the scheme involved deception. It
Following his arrest, there were federal and state civil
also involved greed by the perpetrator andthis is
and criminal trials, bankruptcy hearings, suits against
Ponzi, suits filed by Ponzi, and the ultimate closing of five
importantgreed by the investors, who wanted higher-
different banks. An estimated 40,000 people had entrusted than-sensible returns. Finally, Ponzis scheme involved
an estimated $15 million (about $140 million in U.S. funds the element of confidence. If he had not paid returns
today) in Ponzis scheme. A final audit of his books con- to original investors, no one would have invested addi-
cluded that he had taken in enough funds to buy tional money. By paying early returns, Ponzi gained
Chapter 1: The Nature of Fraud 9
investors confidence and convinced them that he had age group includes managers who have worked them-
a legitimate business. In fact, confidence is the single selves into positions of trust. In addition, they are prob-
most critical element for fraud to be successful. (The ably the group with the highest financial pressures.
word con, which means to deceive, comes from con- When young people graduate from college, they look
fidence.) It is difficult to con anyone out of anything ahead and think, By the time Im 40, Ill have my
unless the deceived has confidence in the deceiver. We house and cars paid off and have savings to pay for
cannot be conned unless we trust the person trying to my childrens college. But, when many people reach
deceive us. Similarly, employers cannot con employees 40, their houses and cars are mortgaged to the hilt and
if they do not have their employees trust and confi- they have no savings to pay for their childrens college.
dence. And, without investor confidence, fraudulent During this same time frame (3645), people are also
companies cannot con unsuspecting investors. better positioned in their careers to commit fraud.
The following example illustrates the role that con- As we will discuss in future chapters, anytime opportu-
fidence plays in committing fraud: nity and life pressures are present, the number of fraud
cases increase.
Two men enter a bank. One is dressed in a business
suit and is well groomed. The second has scraggly
S T O P & T H I N K Why is it more difficult to tell if
hair, has tattoos up and down both arms, is wearing
someone can be trusted on the Internet than in person?
tattered jeans, and is carrying a motorcycle helmet
under his arm. Based on the probably unfounded
categorization of these two individuals by most peo-
ple in society, which one do you think is in the best Types of Fraud
position to successfully con a teller?
While there are many ways to classify the various types
Most of us would agree that the man in the business of fraud, the most common way is to simply divide
suit is in a better position to defraud the bank. He is, frauds into those that are committed against organiza-
simply put, much more likely to be trusted, stereotypes tions and those that are committed on behalf of
being what they are. Most people would argue that the organizations.
scraggly fellow is unlikely to pull off a successful fraud In employee fraud, for examplefraud committed
because the bank employees are less likely to trust him against an organizationthe victim of the fraud is the
initially. employees organization.15 On the other hand, with
One common response of fraud victims is disbelief: financial statement fraud, for example, executives usu-
I cant believe she would do this. She was my most ally commit fraud on behalf of an organization,16
trusted employee Or my best customer Or my usually to make its reported financial results look better
best friend. Someone who understands fraud will sadly than they actually are. In this case, the executives of
tell you, What else could they be? They wouldnt have the company benefit because a companys stock price
succeeded without your trust! Indeed, fraud perpetra- increases or remains artificially high and the victims
tors are often the least suspected and the most trusted are investors in the companys stock. Sometimes,
of all the people with whom victims associate. executives misstate earnings in order to ensure a larger
One companys research revealed that its largest year-end bonus. Financial statement fraud often occurs
group of fraud perpetrators is comprised of people be- in companies that are experiencing net losses or have
tween the ages of 36 and 45.14 The statistics dont tell profits much less than expectations.
us why this is the case, but one reason may be that this Another way to classify frauds is to use the ACFEs
definition of occupational fraud. The ACFE defines
this type of fraud as, The use of ones occupation for
Remember this personnel enrichment through the deliberate misuse
or misapplication of the employing organizations
Fraud involves all deceptive ways in which one resources or assets.17 Occupational fraud results from
individual obtains an advantage over another by the misconduct of employees, managers, or executives.
false representations. Fraud always involves con- Occupational fraud can be anything from lunch break
fidence and trickery. Fraud is different than rob- abuses to high-tech schemes. The Report to the Nation
bery where force is used. on Occupational Fraud & Abuse by the ACFE states
that, The key to occupational fraud is that the activity
10 Part 1: Introduction to Fraud
(1) is clandestine, (2) violates the employees fiduciary 2. Management fraudvictims are shareholders or
duties to the organization, (3) is committed for the debt-holders of the organization.
purpose of direct or indirect financial benefit to the 3. Investment scams and other consumer frauds
employee, and (4) costs the employing organization as- victims are unwary individuals.
sets, revenues, or reserves.18 4. Miscellaneous fraudsany other type of fraud.
The ACFE includes three major categories of occupa-
Fraud that doesnt fall into one of the first three
tional fraud: (1) asset misappropriations, which involve
types of fraud and may have been committed for
the theft or misuse of an organizations assets; (2) cor-
reasons other than financial gain is simply labeled
ruption, in which fraudsters wrongfully use their influ-
miscellaneous fraud. The various types of fraud are
ence in a business transaction in order to procure some
summarized in Table 1.1 and are discussed in the
benefit for themselves or another person, contrary to
paragraphs that follow.
their duty to their employer or the rights of another;
and (3) fraudulent statements, which generally involve
falsification of an organizations financial statements. Employee Embezzlement
A third classification scheme divides fraud accord-
Employee embezzlement is the most common type of
ing to victims:
occupational fraud. As stated previously, in this type
1. Frauds where a company or organization is the of fraud, employees deceive their employers by taking
victim. company assets.19 Embezzlement can be either direct
a. Employee embezzlementperpetrator is an or indirect. Direct fraud occurs when an employee
employee of the organization. steals company cash, inventory, tools, supplies, or other
b. Vendor fraudperpetrator is a vendor of the assets. It also occurs when employees establish dummy
organization. companies and have their employers pay for goods that
c. Customer fraudperpetrator is a customer of are not actually delivered. With direct fraud, company
the organization. assets go directly into the perpetrators pockets without
TA BLE 1. 1 TY PE S OF F RAU D
T Y P E O F FRA UD PERPETRATOR VIC T I M EXPLANATION
Employee embezzlement Employees of an The employer Employees use their positions to take or
organization divert assets belonging to their em-
ployer. This is the most common type
Vendor fraud Vendors of an The organization to which the Vendors either overbill or provide
organization vendors sell goods or services lower quality or fewer goods than
Customer fraud Customers of an The organization which sells to Customers dont pay, pay too little, or
organization the customers get too much from the organization
Management fraud Management of a Shareholders and/or debt- Management manipulates the financial
(Financial statement company holders and regulators (taxing statements to make the company look
fraud) authorities, etc.) better than it is. This is the most ex-
pensive type of fraud.
Investment scams and Fraud perpetratorsall Unwary investors These types of frauds are committed on
other consumer frauds kinds the Internet and in person and obtain
the confidence of individuals to get
them to invest money in worthless
Other (Miscellaneous) All kindsdepends on All kindsdepends on the Anytime anyone takes advantage of the
types of fraud the situation situation confidence of another person to deceive
Chapter 1: The Nature of Fraud 11
the involvement of third parties. Indirect employee conspiracy charges pertaining to cost overruns and ex-
fraud, on the other hand, occurs when employees ecutive personnel expenses charged to the Department
take bribes or kickbacks from vendors, customers, or of Defense. The corporation agreed to make restitution
others outside the company to allow for lower sales of $115 million to the government. The corporation
prices, higher purchase prices, nondelivery of goods, later agreed to an additional payment of $71.3 million
or the delivery of inferior goods. In these cases, to resolve pending administrative and noncriminal is-
payment to employees is usually made by organizations sues and to dismiss certain officers proven criminally
that deal with the perpetrators employer, not the culpable through investigation.21
employer itself. Over the last several years, Halliburtona large
The case of CVC Construction provides an example defense contractorhas been accused of bribery, bid
of direct employee fraud: rigging, defrauding the military, and various other
fraud claims as it has secured contracts to help rebuild
CVC Construction specializes in building new homes
Iraq. In one case alone, it was alleged that the Pentagon
as well as remodeling older homes. While CVC
secretly awarded billions of dollars of Iraqi oil field
Construction has a large market share they, unfortu-
work to Halliburton without giving any other contrac-
nately, have a hard time making a profit. An investi-
tors a chance to bid on the work. The claims against
gation into the matter revealed that several of CVCs
Halliburton are considered a type of vendor fraud, as
employees were using company supplies and equip-
the claims have included multiple vendors and parties.
ment to do their own remodeling jobs on the
side and pocketing the profits. One employee alone
had stolen more than $25,000 worth of company Customer Fraud
assets. When customer fraud takes place, customers either do
not pay for goods purchased or they get something for
To highlight indirect fraud, consider the case of nothing.22 For example, consider the bank customer
Mark who committed fraud against his employer Big who walked into a branch of a large bank one Saturday
D Advertising: morning and convinced the branch manager to give
In his role as purchase agent, Mark paid a company her a $525,000 cashiers check, even though she had
in New York City nearly $100,000 for contracted only $13,000 in her bank account. The manager
work that should have cost about $50,000. The con- believed she was a very wealthy customer and didnt
tractor then paid Mark a kickback of nearly $30,000. want to lose her business. Unfortunately for the bank,
Only after someone noticed that the quality of work she was a white-collar thief, and she proceeded to
performed by the New York contractor decreased defraud the bank of over $500,000. In another cus-
substantially was the fraud suspected and eventually tomer fraud, six individuals sitting in a downtown
detected. Chicago hotel room pretended to be representatives
of large corporate customers, made three calls to a
Chicago bank, and had the bank transfer nearly
Vendor Fraud $70 million to their accounts in another financial insti-
Vendor fraud has been in the news time and again tution in New Jersey. Once the money was transferred
over the years because of significant overcharges by to New Jersey, it was quickly transferred to Switzerland,
major vendors on defense and other government withdrawn, and used to purchase Russian diamonds.
contracts. Vendor fraud, which is extremely common
in the United States, comes in two common forms:
(1) fraud perpetrated by vendors acting alone, and Management Fraud
(2) fraud perpetrated through collusion between buyers As stated previously, management fraud, often called
and vendors. Vendor fraud usually results in either an financial statement fraud, is distinguished from other
overcharge for purchased goods, the shipment of infe- types of fraud both by the nature of the perpetrators
rior goods, or the nonshipment of goods even though and by the method of deception. In its most common
payment was made.20 form, management fraud involves top managements
A recent Department of Defense case highlights deceptive manipulation of financial statements.23
the typical vendor fraud. As a result of a joint FBI/ Well-known examples of alleged management fraud
Department of Defense investigation, an Illinois- in recent years include WorldCom, Enron, Waste Man-
based corporation pleaded guilty to false claims and agement, Sunbeam, Rite-Aid, Phar-Mor, Parmalat,
12 Part 1: Introduction to Fraud
ZZZZ Best, ESM Government Securities, Regina because the offer wont last or somehow convince
Vacuum Company, and MiniScribe Corporation, the victim that he or she has won a free gift such as
among others. a cruise, trip, or vacation. In order to redeem the
To illustrate management fraud, consider John Blue, prize, the victim must pay for postage and/or han-
the CEO for a fast-growing music store chain. The dling by providing their credit card number and
company was opening new stores almost monthly. personal information to the perpetrator.
The company had loyal customers and was famous 3. Nigerian letter or money scams. This type of
for its low prices. When the company went public, fraud typically occurs when a potential victim re-
shares of the stock soared. Unfortunately, the new ceives an e-mail or other form of communication
shareholders didnt know that the chain was selling promising the victim a large financial payout in
the music below cost and was actually losing money exchange for help in transporting large sums of
on each item it sold. John and the other executives money from one country to another. The author
hid the losses by inflating inventories and recording of the letter usually states that an up-front cost is
fictitious revenues. The scam eventually unraveled needed in order to pay taxes, bribe government of-
when a top accountant reported the fraud. When ficials, or pay other legal fees.
word leaked out, shares of the companys stock became 4. Identity theft. Identity theft occurs when someone
worthless overnight. assumes the identity of another person to purchase
goods, engage in criminal activity, or perpetrate
S T O P & T H I N K Why do you think it is easier for top fraud. Perpetrators steal a persons identity by
management to manipulate financial statements than for accessing personal financial information such as
other individuals in the organization? information that is found on credit statements,
credit cards, bank statements, social security, and
other personal documents such as a drivers li-
Investment Scams and Other cense. Perpetrators will also gain this information
Consumer Frauds by going through a victims mailbox or trashcan.
Closely related to management fraud are investment 5. Advance fee scams. An advance fee scam occurs
scams. In these scams, fraudulent and usually worthless when a victim pays an up-front cost for a good or
investments are sold to unsuspecting investors.24 Tele- service that is never delivered. In the scam, the vic-
marketing fraud falls into this category, as does the tim pays up-front cost to secure a payment, loan,
selling of worthless partnership interests and other contract, investment, or gift. In the end, once the
investment opportunities. As discussed earlier, Charles perpetrator receives the money, the victim will be
Ponzi is regarded as the father of investment scams. unable to contact the perpetrator and the victim
Unfortunately, he has not lacked imitators. His form loses the original payment that was made.
of deception is extremely common today. In fact, 6. Redemption/strawman/bond fraud. In this scam,
research suggests that one of every three Americans perpetrators claim that the U.S. government con-
will fall prey to this type of fraud during his or her trols certain bank accounts that can be accessed
lifetime. by submitting paperwork with government offi-
The FBI has suggested that the following are some cials. In order to gain access to this paperwork,
of the most common consumer fraud schemes:25 victims must buy expensive training kits that teach
individuals how to access the funds. When the
1. Ponzi schemes. As discussed earlier in the chapter, victim is unable to access the government funds,
these schemes are named after Charles Ponzi and the perpetrator will indicate that the paperwork
are quite simple: Lure investment funds from vic- was not filled out correctly and will often charge
tims and then pay those victims a premium or in- additional fees for more training.
terest from money that is paid by subsequent 7. Letter of credit fraud. A letter of credit is a legiti-
investors. mate document that is issued by banks to guaran-
2. Telemarketing fraud. When telemarketing fraud tee payment for goods that are shipped in
takes place, victims send money to people they do international trade. In order to scam victims, fraud
not know personally or give personal financial infor- perpetrators will often create bogus letters of credit
mation to unknown callers. Typically, these callers and then sell them to unsuspecting victims. The
put pressure on potential victims to act now victims are told that they can use these letters as
Chapter 1: The Nature of Fraud 13
investments that will pay unrealistic returns. In or- issue more details about this business until your response
der to avoid this type of scam, consumers should is received. As we have not met before, I will give you
be aware that legitimate letters of credit are never every detail you need to know regarding the business and
sold or offered as investments. about me as we progress with the business.
8. Internet fraud. According to the North American At the conclusion of this business, you will be given 35
Securities Administrators Association (NASAA), percent of the total amount, 60 percent will be for me, and
Internet fraud has become a booming business. Re- 5 percent will be for expenses.
cently, federal, state, local, and foreign law enforce- You should send me your bank account information as
ment officials targeted Internet fraudsters during indicated below where you would like the money to be
Operation Cyber Sweep. In the raid, law enforce- transferred so that I can send an application for the release
ment identified more than 125,000 victims with es- of the funds immediately with your account information.
timated losses of more than $100 million and made Beneficiary Name ___________________
125 arrests. Many of the online scams that are per- Bank Name ___________________
petrated today are simply new versions of schemes
Bank Address ___________________
that have been perpetrated offline for years.
Account Number ___________________
As an example of how consumer frauds can occur,
Swift Code ___________________
consider Brian, a hard-working college student, who
was victimized by an investment scam. Routing Number ___________________
State & Country ___________________
During the day, Brian attended school, and at night,
to support himself, he worked as a server at a down- Your Mobile Telephone Number/Fax
town diner. On a good night, Brian brought home Number ___________________
about $100 in tips. During a period of three years, I look forward to hearing from you as soon as possible.
Brian saved almost $1,200. One day at lunch, Brians Obviously, this e-mail, which was actually received by
friend, Lance, told him about a startup company in one of the authors, is an attempt to fraudulently steal your
Canada. If you get in now, Lance said, youll be in money. What in this e-mail suggests that you should never
on the bottom. Youll make at least three times your participate in this scheme?
money in only a couple of weeks. That same night,
Brian accompanied Lance to a meeting describing the
investment opportunity. The following day, they each Remember this
invested $1,000. Lance and Brian had never been so
excited. They thought the opportunity was almost too Frauds can be classified in several ways: by victim,
good to be trueand unfortunately, they were right. by perpetrator, or by scheme. Frauds against orga-
The investment was a scam, and Brian and Lance nizations are most common, but financial state-
never saw their $1,000 again, let alone any of the ment frauds are usually most expensive.
exorbitant earnings they were promised.
C A U T I O N You recently received the following e-mail: Criminal and Civil
Please be so kind as to contact me at your earliest
convenience for a possible business deal involving a Prosecution of Fraud
money transfer of about $22,000,000. When people commit fraud, they can be prosecuted
In conducting an audit of a financial institution, criminally and/or civilly. To succeed in a criminal or
I discovered a dormant account with a balance of civil prosecution, it is usually necessary to show that
$22,000,000 which has not been accessed for the past three the perpetrator acted with intent to defraud the victim.
years. From my investigations and confirmations, the This is best accomplished by gathering evidential
owner of this account is a foreigner by the name of John
matter. Evidential matter consists of the underlying
Doe who died without a will. I am presently in London
data and all corroborating information available. In a
working as an investment consultant with the above bank
later chapter, we will discuss types of evidence and the
at their London office, and I am poised to work this deal out
role evidence plays in successful prosecution and/or lit-
if we can do business. At the moment, I am constrained to
igation of fraud.
14 Part 1: Introduction to Fraud
Criminal Law Every state and the federal government have statutes
Criminal law is that branch of law that deals with prohibiting a wide variety of fraudulent and corrupt
offenses of a public nature. Criminal laws generally practices. Some of the principal federal statutes are
deal with offenses against society as a whole. They listed in Table 1.2.
are prosecuted either federally or by a state for violat- A variety of statutes cover fraudulent activity. Usu-
ing a statute that prohibits some type of activity. ally, when perpetrators are convicted, they serve jail
TA BLE 1. 2 PR INC I PAL F EDE RA L FRAU D ST A TU T ES
STATUTE TITLE AN D CO DE DESCRIPTION
Bribery of Public Officials Title 18, U.S. Code 201 Bribery is punishable by up to 15 years in prison, a fine of up to three
and Witnesses times the thing of value given or received, and disqualification of
Anti-Kickback Act of Title 41, U.S. Code 51 to 58 This act outlaws the giving or receiving of any thing of value by a
1986 subcontractor to a prime contractor in U.S. government contracts.
Willful violations are punished by a fine and up to 10 years in prison.
Mail Fraud Title 18, U.S. Code 1341 Whoever, having devised or intending to devise any scheme or artifice
to defraud, or for obtaining money or property by means of false or
fraudulent pretenses, representations, or promises, for the purpose of
executing such scheme or artifice or attempting so to do, places in any
post office or authorized deposits or causes to be deposited any matter
or thing whatever to be sent or delivered by any private or commercial
interstate carrier, shall be fined under this title or imprisoned.
Bank Fraud Title 18, U.S. Code 1344 Any scheme to defraud federally insured financial institutions by
customers, officers, employees, and owners. Covers banks, savings and
loans, credit unions, and other financial institutions insured by
Racketeer Influenced and Title 18, U.S. Code 1961 This statute makes it an offense for any person associated with an
Corrupt Organizations enterprise engaged in interstate commerce to conduct the affairs of
(RICO) Statute the enterprise through a pattern of racketeering activity. A pattern is
defined as two or more enumerated criminal violations.
Computer Fraud Title 18, U.S. Code 1030 Section 1030 punishes any intentional, unauthorized access to a
protected computer for the purpose of obtaining restricted data
regarding national security, obtaining confidential financial information,
using a computer which is intended for use by the U.S. government,
committing a fraud, or damaging or destroying information contained
Securities Fraud Rule10(b)5 Securities Act of It is unlawful for an insider who has material inside information to
1934, $17(a) purchase or sell the companys securities, irrespective of whether the
insider deals directly or through an exchange. The antifraud provisions
impose civil liability on those who perpetrate or who aid and abet any
fraud in connection with any offer and sale of securities.
Foreign Corrupt Practices Title 15, U.S. Code 78m, This law outlaws bribery of foreign officials by U.S. companies for
Act (FCPA) 78a(b), 78dd-1, 78dd-2, 78ff business purposes. The FCPA also requires that SEC-regulated compa-
nies keep accurate books and records, and have sufficient internal
controls to assure that access to assets is permitted only in accordance
with managements authorization, to prevent slush funds and bribe
Tax Evasion Title 26, U.S. Code 7201 Failure to report income from fraud or bribes may be prosecuted as tax
evasion, or for filing a false return. Also, bribes may not lawfully be
deducted as business expenses.
Chapter 1: The Nature of Fraud 15
sentences and/or pay fines. Before perpetrators are con- gaining financial restitution. The purpose of a civil law-
victed, they must be proven guilty beyond a reason- suit is to compensate for harm done to another indi-
able doubt. Juries must rule unanimously on guilt for vidual. Unlike criminal cases, juries in civil cases need
the perpetrator to be convicted. Recent cases of people not consist of 12 jurors but may have as few as six
who were prosecuted criminally include Bernard jurors. The verdict of the jury need not be unanimous.
Madoff; Ken Lay; Jeff Skilling of Enron; the CEO of Civil cases are often heard by judges instead of juries.
Financial News Network (FNN), who was sentenced To be successful, plaintiffs in civil cases must only
to five years in prison for spinning companies he con- prove their case by the preponderance of the
trolled into a plot that inflated FNNs sales; the CEO of evidence. In other words, there need only be slightly
Towers Financial,26 who was sentenced to 20 years for more evidence supporting the plaintiff than supporting
a Ponzi-like scheme that defrauded investors of $450 the defendant. In both civil and criminal proceedings,
million; and Donald Ferrarini, who was sentenced to the parties often call expert witnesses to give their opin-
12 years in prison for reporting nonexistent revenues ion on matters thought to be too technical for the jur-
that made his income-losing company look like a profit ors or judge to understand. Fraud examiners and
maker.27 accountants are often used as experts in fraud cases
Sometimes fraud perpetrators and other criminals to compute and testify to the amount of damages.
plead guilty without being tried in order to seek more When fraud is committed, criminal prosecution usually
lenient sentences. These guilty pleas are usually accom- proceeds first.
panied by a willingness to help prosecutors in their
investigations of other perpetrators. For example, in S T O P & T H I N K O. J. Simpson was tried for murder
the Enron case, former Enron executive Michael both criminally and civilly. He was found innocent in the
Kopper pleaded guilty to charges of money laundering criminal trial but guilty in the civil trial. Why do you think
and wire fraud. The guilty pleas were the first criminal that was the case?
charges brought against a former Enron employee and
represented significant progress in the U.S. government Table 1.3 identifies the major differences between a
investigation into the scandal. As part of the plea deal, civil and criminal case.
Mr. Kopper agreed to cooperate with prosecutors and As an example of civil litigation, consider the case of
paid back $12 million of assets. WorldCom. After the WorldCom fraud was discov-
ered, investors sued various organizations that the
Civil Law investors claimed help perpetrate the fraud. In 2004,
Civil law is the body of law that provides remedies for one of those organizations, Citigroup, agreed to settle
violations of private rights. Civil law deals with rights investors civil claims by agreeing to pay $2.65 billion
of individuals. Civil claims begin when one party files a to investors. These kinds of out-of-court settlements
complaint against another, usually for the purpose of often occur before civil cases actually go to trial.
T A B LE 1 .3 D I S T I N C T I ON S B E T W E E N CI V I L A N D C R I M I N A L CA S E S
CRI MINAL CAS E CIV IL CAS E
Purpose To right a wrong To obtain a remedy
Consequences Jail and/or fines Restitution and damage payments
Burden of Proof Beyond a reasonable doubt Preponderance of evidence
Jury Jury must have 12 people May consist of fewer than 12 persons
Initiation Determination by a grand jury that sufficient evidence Filing of a claim by a plaintiff
exists to indict
Verdict Unanimous verdict Parties may stipulate to a less than
Claims Only one claim at a time Various claims may be joined in one action
16 Part 1: Introduction to Fraud
Computers and other forms of technology provide
Remember this some of the best evidence to determine if someone
The purpose of a criminal case is to right a is guilty of fraud. Real-time and even post-hoc
wrong, whereas the purpose of a civil case is to fraud detection and investigation in the future will
obtain a remedy. Criminal cases result in jail involve the use of technology.
and/or fines, while civil cases result in restitution While the three skills addressed here are critical
and damage payments. Juries must reach unan- and most important, other skills that will be extremely
imous verdicts in criminal cases; only a majority useful for future fraud examiners are as follows:
is necessary to convict someone in a civil case.
Some understanding of accounting and business.
One of the major differences between fraud and
other types of crime is the always present con-
How to Prepare to Be a cealment attempts to hide the fraud. Usually,
Fraud-Fighting Professional concealment attempts involve altering accounting
records and documents. Fraud examiners who
At most universities, there is not a major called Fraud
understand accounting and business will be highly
Prevention, Detection and Investigation. Rather, stu-
valued in the future. For example, the FBI has a
dents who want to prepare for fraud-fighting careers
large number of agents who are CPAs. The ex-
must usually choose majors and courses that will pro-
pertise of these agents is highly valued by the FBI.
vide the skills that will make them a successful fraud
A knowledge of civil and criminal laws, crimi-
fighter. The following are some of the most important
nology, privacy issues, employee rights, fraud
skills for a fraud-fighting professional to have:
statutes, and other legal fraud-related issues.
Analytical skills: Fraud detection and investigation Investigating and resolving frauds always involves
are analytical processes where investigators identify legal questions such as should this case be pur-
the kinds of fraud that could occur, the kinds of sued in the criminal or civil courts, are certain
symptoms and indicators those frauds would gen- evidence-gathering techniques legal, and when
erate, and ways in which to examine and follow up should law enforcement be involved?
on symptoms that are discovered. Being a fraud The ability to speak and write in a foreign lan-
investigator is very much like being a physician: it guage. With developments in travel, communica-
requires significant amounts of diagnostic and ex- tion, and technology, many frauds today involve
ploratory work to discover what is really happening. individuals in multiple countries. Cross-border
It is impossible to be a good fraud examiner with- investigations are not uncommon, and the ability
out having great analytical skills. to speak and write a foreign language, such as
Communication skills: Fraud examiners spend Spanish, or Chinese, will be highly valued.
considerable amounts of time interviewing A knowledge of human behavior, including why
witnesses and suspects and communicating those and how people rationalize dishonesty, how they
findings to witnesses, courts, and others. A good react when caught, and what is the most effective
communicator will know how to push for evidence way(s) to deter individuals from committing
and confessions, how to structure questions and fraud. These kinds of skills are usually learned in
interviews, and how to write reports that are val- behavioral courses such as psychology, social psy-
ued by courts, lawyers, and others. It is impossible chology, or sociology.
to be a good fraud examiner without refined
Many readers are probably wondering which major
on campus will provide them with all of these skills.
Technological skills: In the past, fraud detection
The answer is probably none.28 But, majors such as
and investigation involved more luck than
information systems, accounting, and law can provide
anything else. However, with the technological
a basic understanding that is extremely helpful. Re-
advances of the last two decades, we can now
gardless of the major one chooses, it would be benefi-
proactively search for fraud symptoms and fraud
cial to fulfill elective requirements with courses in the
perpetrators and build both fraud-free and fraud-
above-mentioned topics. For example, if you are an
ulent profiles. Technology allows fraud examiners
accounting major, you should probably take as many
to analyze huge databases very efficiently.
Chapter 1: The Nature of Fraud 17
technology and behavioral type classes as you can. field either directly or indirectly related to the detection
While no candidate will possess all of the skills identi- or deterrence of fraud. The following categories are
fied earlier, the more of these skills an individual pos- deemed acceptable as fraud-related experience:
sesses, the better qualified he or she will be to find
Accounting and Auditing: A candidate may
success as a fraud examiner.
qualify to become a CFE if he or she has experi-
ence as an accountant or auditor (e.g., internal or
Certified Fraud Examiners external auditor) and has had certain responsibil-
The ACFE provides the opportunity for an individual ities for the detection and deterrence of fraud by
to become a CFE. CFEs are considered to be leaders evaluating accounting systems for weaknesses,
in the antifraud community and have recognition as designing internal controls, determining the degree
such throughout the world. They represent the highest of organizational fraud risk, interpreting financial
standards held by the ACFE and possess expertise in all data for unusual trends, and following up on fraud
aspects of the antifraud profession. The CFE designa- indicators.
tion is acknowledged globally and preferred by many Criminology and Sociology: Only those profes-
employers. The ACFE states that becoming a CFE sionals with education or research in the fraud and
immediately sets an individual apart and launches an white-collar crime dimensions of sociology or
individual to the top of their profession. criminology may claim experience under this cat-
When an individual becomes a CFE he or she auto- egory. An experienced background in general so-
matically becomes a member of the ACFE. The ACFE ciological fields is insufficient.
is the worlds largest antifraud organization and the Fraud Investigation: Experience in the investiga-
premier provider of antifraud training and education. tion of civil or criminal fraud, or of white-collar
With more than 50,000 members throughout the crime for law enforcement agencies or in the pri-
world, the ACFE reduces fraud and corruption around vate sector, qualifies an individual to become a
the globe. CFE. Examples include federal, state, or local law
The ACFE has the following requirements for an enforcement (e.g., IRS, inspectors general, and
individual to become a certified fraud examiner: district attorney investigators) as well as
Be an associate member of the ACFE in good insurance fraud investigators and fraud examiners
standing. working for corporations, businesses, or other
Meet minimum academic and professional associations.
requirements. Loss Prevention: Security directors for corpora-
Be of high moral character. tions or other organizations who deal directly with
Agree to abide by the Bylaws and Code of issues of loss prevention may claim this experience
Professional Ethics of the ACFE. as credit to become a CFE. Security consultants
dealing with fraud-related issues are also eligible.
Experience as a security guard or equivalent is not
Academic Requirements acceptable.
Generally, applicants for CFE certification have a min- Law: Candidates with experience in the legal field
imum of a bachelors degree (or equivalent) from an might qualify, provided the experience deals with
institution of higher learning. No specific field of study some consideration of fraud. Examples include
is required. If you do not have a bachelors degree, you prosecuting lawyers, fraud litigators, and others
may substitute two years of fraud-related professional with an antifraud specialization.
experience for each year of academic study. For exam-
If an individuals experience does not fall into one of
ple, if you successfully attended college full time for
these categories, but their responsibilities include the
only two years, you would need an additional four
detection, investigation, or deterrence of fraud, they
years of professional experience to satisfy the education
must make a case why their experience is relevant.
Professional Requirements Fraud-Related Careers
When an individual becomes a CFE, he or she must As the number of frauds and the amounts of fraud
have at least two years of professional experience in a losses increase, so do the opportunities for successful
18 Part 1: Introduction to Fraud
careers in fraud fighting. U.S. News and World Report business surviving or failing. If you become a financial
identified fraud examination as one of the fastest grow- consultant, you will be better equipped to help your
ing and most financially rewarding careers.29 The clients avoid high-risk and fraudulent investments. As
American Institute of Certified Public Accountants an investor, you will learn skills that help you distin-
(AICPA) touted fraud examination/fraud auditing as guish between fraudulent and profitable investments. If
one of the six fastest growing and most profitable op- you become an auditor, you will find the document
portunities for accountants. Although there are numer- examination and evidence-gathering skills you learn
ous opportunities for fraud-fighting professionals, here invaluable. If you work with taxes, you will be
careers in forensic work can be broadly classified ac- alert to when information from clients is questionable.
cording to employer, as shown in Table 1.4. Finally, the interviewing skills you learn will be helpful
Taken together, the cost of fighting fraud is very in nearly every possible profession you may choose.
high. In high-profile civil cases, it is not uncommon You may find, to your surprise, that fraud examina-
for defendants and plaintiffs to spend tens of millions tion and forensic accounting are not only rewarding
of dollars defending and prosecuting alleged frauds. and challenging, but they are also intriguing and end-
Many large fraud cases involve multiple law firms, mul- lessly interesting (what good mystery isnt?). We hope
tiple lawyers from each firm, multiple investigators, ex- you enjoy the adventure.
pert witnesses, and large support staff. Often, after
spending large sums of money defending or prosecut-
ing a fraud case, a pretrial settlement is reached, with
no public announcement of the terms of the settlement. Very few fraud-fighting specialties are offered at
One author of this textbook has, throughout his ca- U.S. universities. Instead, a person should choose
reer, been retained as an expert witness in various fraud a path of study that will result in obtaining those
cases. To illustrate the many kinds of fraud, Table 1.5 skills that are most helpful for fraud fighters. The
lists some of these cases. Association of Certified Fraud Examiners is a pro-
Throughout the next few months, you will find your fessional organization comprised of fraud-fighting
study of fraud examination to be very interesting and professionals that certifies individuals as certified
helpfulwhether or not you become a professional fraud examiners. There are many different fraud-
fraud fighter. As a businessperson, understanding the fighting careers, including auditing, consulting,
tremendous costs of fraud and learning to recognize law, investigation, and law enforcement.
fraud may someday mean the difference between your
TA BLE 1. 4 FR A U D - R E L A T E D C A R E E R S
T YP E S OF
EMPLOYERS TY P E OF C A R E E R
Government and FBI, postal inspectors, Criminal Investigation Division of the IRS, U.S. marshals, inspector generals of various
law enforcement governmental agencies, state investigators, and local law enforcement officials.
CPA firms Conduct investigations, support firms in litigation, do bankruptcy-related accounting work, provide internal
audit and internal control consulting work.
Corporations Prevent, detect, and investigate fraud within a company. Includes internal auditors, corporate security officers,
and in-house legal counsels.
Consulting Serve as an independent consultant in litigation fraud work, serve as expert witness, consult in fraud
prevention and detection, and provide other fee-based work.
Law firms Lawyers provide litigation and defense work for companies and individuals being sued for fraud and provide
special investigation services when fraud is suspected.
Chapter 1: The Nature of Fraud 19
T A B LE 1 .5 A U T H O R S EX P ER T WI TN ES SI N G E X P E R I E N C E S
CASE NA TURE RETAINED BY CI TY
Bank Fraud by a customer Plaintiffs attorneys Philadelphia, PA
Large industrial company Financial statement fraud Defendants attorneys Chicago, IL
Financial services firm Financial statement fraud by Plaintiffs attorneys Miami, FL
Financial services firm Financial statement fraud Plaintiffs attorneys Miami, FL
Large industrial company Financial statement fraud CPA firms attorneys Chicago, IL
EDS Corporation Fraud by vendor Defendant attorneys Dallas, TX
Financial institution Derivatives fraud Defendants attorneys New York, NY
Large insurance company Fraud by executives Defendants attorneys West Palm Beach, FL
Wealthy individual Fraud by major stockholders Plaintiffs attorneys Salt Lake City, UT
Large credit union Fraud by customer Plaintiffs attorneys Salt Lake City, UT
Large industrial company Financial statement fraud CPA firms attorneys Atlanta, GA
Large medical company Financial statement fraud CPA firms attorneys Chicago, IL
Large oil and gas company Financial statement fraud CPA firms attorneys New York, NY
Large retailer Financial statement fraud CPA firms attorneys Thomas et al. Houston, TX
Large financial institution Financial statement fraud CPA firms attorneys Cincinnati, OH
Large bank Fraud by executives CPA firms attorneys Philadelphia, PA
Savings and loan Fraud by executives CPA firms attorneys Chicago, IL
Limited real estate Financial statement fraud by CPA firms attorneys Chicago, IL
Large financial institution Fraud by employee CPA firms attorneys Cleveland, OH
Large industrial company Fraud by vendor Plaintiffs attorneys Los Angeles, CA
Large savings and loan Financial statement fraud U.S. government Los Angeles, CA
Limited partnership Financial statement fraud Plaintiffs attorneys Salt Lake City, UT
Wealthy taxpayer Tax fraud Defendants attorney Boise, ID
Review of the Learning available suggest that fraud is increasing in both
amount and frequency. Fraud is extremely costly
Objectives to organizations and economies, often resulting in
the bankruptcy of companies. When someone em-
Understand the seriousness of the fraud problem bezzles from an organization, that organization
and how it affects individuals, consumers, and must generate many times the amount embezzled
organizations. While it is difficult to get accurate in additional revenues to recover the effect on net
fraud statistics, the statistics and studies that are income.
20 Part 1: Introduction to Fraud
Define fraud. Fraud is theft by deception. There employee investment scams,
are two ways to get something from someone ille- embezzlement, p. 10 p. 12
gallythrough force or by trickery. Fraud involves vendor fraud, p. 11 evidential matter, p. 13
all the different ways of using trickery to get an- customer fraud, p. 11 criminal law, p. 14
other persons or organizations assets. management fraud, statute, p. 14
Understand the different types of fraud. Frauds p. 11 civil law, p. 15
can be classified by type of victim, type of perpetra-
tor, or type of scheme. The most common victims
of frauds are organizations, in the case of employee,
vendor, and customer fraud; stockholders and debt- QUESTIONS
holders, in the case of management fraud; and in-
dividuals, in the case of investment scams and other Discussion Questions
types of consumer frauds.
Understand the difference between fraud com- 1. What is fraud?
mitted against an organization and fraud com- 2. How does fraud affect individuals, consumers, and
mitted on behalf of an organization. The most organizations?
common way to classify fraud is to simply divide 3. List and describe the five different types of frauds.
frauds into those that are committed against an 4. What is the difference between civil and criminal
organization and those that are committed on be- laws?
half of an organization. Fraud that is committed 5. For each of the following, indicate whether it is a
against an organization is typically a form of em- characteristic of a civil or a criminal case:
ployee (occupational), vendor, or customer fraud. a. Jury may consist of fewer than 12 jurors.
Fraud that is committed on behalf of an organiza- b. Verdict must be unanimous.
tion is a form of management fraud or financial c. Multiple claims may be joined in one action.
statement fraud. d. Beyond a reasonable doubt.
Understand the difference between criminal and e. Purpose is to right a public wrong.
civil fraud laws and how these laws relate to f. Purpose is to obtain remedy.
fraud. Criminal laws are used to right a wrong g. Consequences of jail and/or fines.
to send someone to jail or to have the government h. Juries may have a less-than-unanimous
invoke fines and penalties. Civil cases are used to verdict.
seek remediesusually in the form of financial 6. Why was Charles Ponzi so successful with his
restitution. fraud scheme?
Understand the types of fraud-fighting careers 7. What are some of the different types of fraud-
available today. Fraud-fighting professionals today fighting careers?
include lawyers, auditors, accountants, consultants, 8. How do employee fraud and management fraud
and government employees. Fraud-ighting profes- differ?
sionals can best prepare for their careers by study- 9. Do you think the demand for careers in fraud
ing those skills useful in fighting fraud. The ACFE prevention and detection is increasing or decreas-
certifies individuals as certified fraud examiners. ing? Why?
10. Why are accurate fraud statistics hard to find?
11. Describe the relationship between fraud, net
income, profit margin, and the revenue required to
KEY TERMS make up for fraud losses.
perpetrators, p. 4 revenue, p. 5 12. Why does it usually require trust for someone to
jurisdiction, p. 5 profit margin, p. 5 be able to commit a fraud?
victims, p. 5 fraud, p. 6 13. In what ways is the Ponzi scam similar to other
Association of Certified financial statement, frauds?
Fraud Examiners p. 7 14. In your own words describe a CFE.
(ACFE), p. 5 miscellaneous fraud, 15. In your own words describe the purpose of the
net income, p. 5 p. 10 ACFE.
Chapter 1: The Nature of Fraud 21
True/False 24. When fraud is committed, criminal prosecution
usually proceeds first.
1. All frauds that are detected are made public. 25. A fraud may be perpetrated through an uninten-
2. Perpetrators use trickery, confidence, and decep- tional mistake.
tion to commit fraud. 26. It is most often people who are not trusted that
3. One of the most common responses to fraud is commit fraud.
disbelief. 27. Management fraud is when managers intentionally
4. Manufacturing companies with a profit margin of deceive their employees about the potential of
10 percent must usually generate about 10 times as raises, vacations, and other perks.
much revenue as the dollar amount from the fraud 28. Despite intense measures meant to impede it, fraud
in order to restore net income to its pre-fraud level. appears to be one of the fastest growing crimes in
5. Fraud involves using physical force to take some- the United States.
thing from someone. 29. The ACFE is a nonprofit organization dedicated to
6. Telemarketing fraud is an example of employee the prevention and dedication of fraud throughout
embezzlement. the world.
7. When perpetrators are convicted of fraud, they 30. There is no difference between a Certified Fraud
often serve jail sentences and/or pay fines. Examiner (CFE) and a Certified Public Accountant
8. Management fraud is deception perpetrated by an (CPA).
organizations top management.
9. A Ponzi Scheme is considered to be a type of in- Multiple Choice
vestment scam.
10. Most people agree that fraud-related careers will be 1. Why does fraud seem to be increasing at such an
in demand in the future. alarming rate?
11. In civil cases, fraud experts are rarely used as ex- a. Computers, the Internet, and technology make
pert witnesses. fraud easier to commit.
12. Many companies hide their losses from fraud b. Most frauds today are detected, whereas in the
rather than make them public. past many were not.
13. The only group/business that must report em- c. A new law requires that fraud be reported
ployee embezzlement is the federal government. within 24 hours.
14. Advances in technology have had no effect on the d. People understand the consequences of fraud to
size or frequency of fraud. organizations.
15. Fraud losses generally reduce a firms income on a 2. Which of the following is not an important element
dollar-for-dollar basis. of fraud?
16. The single most critical element for a fraud to be a. Confidence.
successful is opportunity. b. Deception.
17. Fraud perpetrators are often those who are least c. Trickery.
suspected and most trusted. d. Intelligence.
18. Unintentional errors in financial statements are a 3. Fraud is considered to be:
form of fraud. a. A serious problem that continues to grow.
19. Occupational fraud is fraud committed on behalf b. A problem that affects very few individuals.
of an organization. c. A mild problem that most businesses need not
20. Companies that commit financial statement fraud worry about.
are often experiencing net losses or have profits d. A problem under control.
less than expectations. 4. People who commit fraud are usually:
21. Indirect fraud occurs when a companys assets go a. New employees.
directly into the perpetrators pockets without the b. Not well groomed and have long hair and
involvement of third parties. tattoos.
22. In vendor fraud, customers dont pay for goods c. People with strong personalities.
purchased. d. Trusted individuals.
23. A negative outcome in a civil lawsuit usually results 5. The use of ones occupation for personal
in jail time for the perpetrator. enrichment through the deliberate misuse or
22 Part 1: Introduction to Fraud
misapplication of the employing organizations c. FBI agencies are currently spending approxi-
resources or assets is the definition of which of mately 35 percent of their time on fraudulent
the following types of fraud? activities.
a. Employee embezzlement or occupational fraud. d. None of the above statements are true.
b. Investment scams. 13. Which of the following is not an element of fraud?
c. Management fraud. a. False representation.
d. Vendor fraud. b. Accidental behavior.
6. Corporate employee fraud fighters: c. Damage to a victim.
a. Work as postal inspectors and law enforce- d. Intentional or reckless behavior.
ment officials. 14. What is the best way to minimize fraud within an
b. Prevent, detect, and investigate fraud within a organization?
company. a. Detection of fraud.
c. Are lawyers that defend and/or prosecute b. Investigation of fraudulent behavior.
fraud cases. c. Prevention activities.
d. None of the above. d. Research company activities.
7. Investment scams most often include: 15. What is the most important element in successful
a. An action by top management against fraud schemes?
employees. a. Promised benefits.
b. Worthless investments or assets sold to un- b. Confidence in the perpetrator.
suspecting investors. c. Profitable activities.
c. An overcharge for purchased goods. d. Complexity.
d. Nonpayment of invoices for goods purchased 16. Which of the following characters is least likely to
by customers. be involved in a fraud?
8. Which of the following is not true of civil fraud? a. A middle-aged person with a middle man-
a. It usually begins when one party files a agement position.
complaint. b. A long-haired teenager wearing leather pants.
b. The purpose is to compensate for harm done c. A recent college graduate.
to another. d. A senior executive who has significant stock
c. It must be heard by 12 jurors. options.
d. Only the preponderance of the evidence is 17. Which of the following is not a fraud type?
needed for the plaintiff to be successful. a. Direct employee embezzlement.
9. Future careers in fraud will most likely be: b. Indirect employee embezzlement.
a. In low demand. c. Supervisor fraud.
b. In moderate demand. d. Investment scams.
c. Low paying. 18. Which of the following is not a form of vendor
d. In high demand and financially rewarding. fraud?
10. Studying fraud will help you: a. Overcharge for purchased goods.
a. Learn evidence-gathering skills. b. Shipment of inferior goods.
b. Avoid high-risk and fraudulent activities. c. Nonshipment of goods even though payment
c. Learn valuable interviewing skills. has been made.
d. All of the above. d. Not paying for goods purchased.
11. Which of the following is not a reliable resource 19. Civil law performs which of the following
for fraud statistics? functions?
a. FBI agencies. a. Remedy for violation of private rights.
b. Health agencies. b. Remedy for violations against society as a
c. Insurance organizations. whole.
d. Fraud perpetrators. c. Punishment for guilt beyond reasonable
12. Which of the following statements is true? doubt.
a. Bank robberies are more costly than frauds. d. Monetary reimbursement for federal
b. Fraud is often labeled the fastest growing crime. damages.
Chapter 1: The Nature of Fraud 23
20. Fraud fighting includes what type of careers?
a. Professors.
b. Lawyers. Case 1
c. CPA firms. Clever, Inc., is a car manufacturer. Its 2011 income
d. All of the above. statement is as follows:
21. Which of the following is not an example of
employee embezzlement? Clever, Inc. Income Statement For the Year Ended
a. Land conservation employees stealing December 31, 2011
equipment. Sales revenue $20,000
b. Cashiers stealing money from the cash Less cost of goods sold 10,000
register. Gross margin $10,000
Expenses 8,000
c. Angry employees vandalizing the building Net income $ 2,000
d. Salespeople overcharging for products and
pocketing the excess cash. Alexander, Inc., is a car rental agency based in Florida.
22. Which of the following is not an example of Its 2011 income statement is as follows:
vendor fraud?
a. A vendor overcharges a contracting job that it Alexander, Inc. Income Statement For the Year Ended
b. A vendor bills for services not performed. Sales revenue $20,000
c. A vendor bills for goods not provided. Expenses 15,000
d. A vendor has much higher prices than its Net income $ 5,000
23. Deceptive manipulation of financial statements During 2011, both Clever, Inc., and Alexander, Inc.,
describes which kind of fraud? incurred a $1,000 fraud loss.
a. Management fraud.
b. Criminal fraud. 1. How much additional revenue must each company
c. Stock market fraud. generate to recover the losses from the fraud?
d. Bookkeeping fraud. 2. Why are these amounts different?
24. Which of the following is required to become a 3. Which company will probably have to generate less
CFE? revenue to recover the losses?
a. An individual must commit to abide by a
strict code of professional conduct and ethics. Case 2
b. Be an associate member, in good standing, of You are having lunch with another graduate student.
the ACFE. During the course of your conversation, you tell your
c. Be of high moral character. friend about your new fraud examination class. After
d. All of the above. you explain the devastating impact of fraud on busi-
25. Which of the following is not true regarding the nesses today, she asks you the following questions:
a. It is the largest antifraud organization in the 1. What is the difference between fraud and error?
world. 2. With all the advances in technology, why is fraud a
b. It has roughly 12,000 members throughout growing problem?
c. The entire organization is dedicated to the Case 3
prevention of fraud. For each of the following examples, identify whether
d. It is the premier provider of antifraud training. the fraud is employee embezzlement, management
24 Part 1: Introduction to Fraud
fraud, investment scam, vendor fraud, customer fraud, when an internal audit sent routine confirmations to
or miscellaneous fraud. customers on a mailing list and received excessive
return-to-sender replies. The investigation disclosed
1. Marcus bought a $70 basketball for only $30, sim-
a telling pattern. The bookkeeper initially denied accu-
ply by exchanging the price tags before purchasing
sations but admitted the crime upon presentation of
2. Craig lost $500 by investing in a multilevel market-
You are a lawyer for the retail company. Now that
ing scam.
the fraud has been detected, would you prosecute her
3. The Bank of San Felipe lost over $20,000 in 2011.
criminally, civilly, or both? What process would you
One of its employees took money from a wealthy
use to try to recover the $15,000?
customers account and put it into his own ac-
count. By the time the fraud was detected, the em-
ployee had spent the money and the bank was held Case 7
responsible. You are a new summer intern working for a major
4. The CEO of Los Andes Real Estate was fined professional services firm. During your lunch break
and sentenced to six months in prison for deceiv- each day, you and a fellow intern, Bob, eat at a local
ing investors into believing that the company sandwich shop. One day, Bobs girlfriend joins you for
made a profit in 2011, when it actually lost over lunch. When the bill arrives, Bob pays with a company
$150 million. credit card and writes the meal off as a business ex-
5. The government lost over $50 million in 2011 pense. Bob and his girlfriend continue to be treated
because many of its contractors and subcontractors to lunch for a number of days. You know Bob is well
charged for fictitious hours and equipment on a aware of a recent memo that came down from manage-
project in the Middle East. ment stating casual lunches are not valid business ex-
6. A student broke into the schools computer system penses. When you ask Bob about the charges, he
and changed her grade in order to be accepted into replies, Hey, were interns. Those memos dont apply
graduate school. to us. We can expense anything we want.
1. Is fraud being committed against the firm?
Case 4 2. What responsibility, if any, do you have to report
Fellow students in your fraud examination class are the activity?
having a hard time understanding why statistics on
fraud are so difficult to obtain. What would you say
to enlighten them? Case 8
After receiving an anonymous note indicating fraudu-
Case 5 lent activities in the company, XYZ Company officials
Youre telling your boyfriend about your classes for the discover that an employee has embezzled a total of
new semester. He is very interested and intrigued by $50,000 over the past year. Unfortunately, this em-
the idea of becoming a fraud detective, but wants to ployee used an assumed identity and has suddenly dis-
know whether fraud detectives will have job security appeared. The CFO at XYZ wants to know how badly
and the type of work that is available. How would this fraud has hurt the company. If XYZ has a profit
you respond to his questions? margin of 7 percent, how much additional revenue will
XYZ have to generate to cover the loss?
A bookkeeper in a $3 million retail company had
earned the trust of her supervisor, so various functions Case 9
normally reserved for management were assigned to Your friend John works for an insurance company.
her, including the authority to issue and authorize cus- John holds a business degree and has been involved
tomer refunds. She proceeded to issue refunds to non- in the insurance business for many years. In a recent
existent customers and created documents with false conversation, John shares some company information
names and addresses. She adjusted the accounting re- with you. He has heard that the internal auditors esti-
cords and stole about $15,000 cash. She was caught mate that the company has lost about $2.5 million over
Chapter 1: The Nature of Fraud 25
the last year as a result of fraud. Because you are a Case 12
certified fraud examiner, John asks you how this will Bob, who works as a credit manager for a large bank,
affect the companys profitability. John doesnt have has a reputation for being a very hard worker. His con-
access to the companys financial information. venient downtown apartment is located near the bank,
1. Compute the additional revenues needed to make which allows him to work undisturbed late into the
up for the lost money, assuming that the company night. Everyone knows that Bob loves his job because
has profit margins of 5, 10, and 15 percent. he has been with the bank for many years and hardly
2. Give examples of three types of fraud that could ever takes a vacation. He is a very strict credit manager
affect the insurance company. and has the reputation for asking very difficult ques-
3. In the case, who are the victims and who are the tions to loan applicants before approving any credit.
perpetrators? Nancy, Bobs director, noticed that Bob had not
taken a mandatory weeklong vacation for a number
of years. Given Bobs history of being tough on approv-
ing credit for the bank, should Nancy be concerned?
You are an accounting student at the local university
pursuing your masters degree. One of your friends has Case 13
been intrigued by the numerous frauds that have re- Upon hearing that you are enrolled in a fraud class, a
cently been reported in the news. This friend knows manager of a local business asks, I dont understand
you are going to pursue a job as an auditor with a large what is happening with all these major scandals such as
public accounting firm, but your friend does not un- the Bernie Madoff scandal, the Goldman Sachs accusa-
derstand the difference between what you will be doing tions, and the Enron fraud. There are billions of dollars
and what fraud examiners do. Write a paragraph that being stolen and manipulated. How can any good au-
explains the difference between auditing and fraud ditor not notice when billions of dollars are missing?
examination. How would you respond?
Case 11 Case 14
You own a local pizza delivery store. Cesar Rodriquez While discussing your class schedule with a friend who
has been working for you as a manager for two years is an accounting major, your friend describes why she
and has been a close friend of yours. Cesar has the decided not to take the fraud class you are enrolled in:
reputation of being a hard worker and has not taken With advances in audit technology and the increased
vacation for the entire time he has worked for you. Last digitalization of business records, fraud detection is a
week, Cesar left town to attend a family funeral. While dying part of a financial statement audit. How would
he was gone, you received several phone calls that you respond?
seemed suspicious. During these suspicious calls, a po- Case 15
tential customer would call and ask for the manager. After telling one of your parents that you want to be a
When you answered the phone (representing the man- fraud examiner after graduation, your parent expresses
ager), the customer would ask for the managers concerns about your career choice. How would you
special. When informed that there was not a man- explain to your father the kind of career opportunities
agers special offered this weekend, the caller would you will have as a fraud examiner, the types of organi-
quickly hang up. This occurred several times. When zations that will hire you, and the kind of work you will
Cesar returned, you decided to spend an evening ob- be doing?
serving the order-taking process. It became apparent
that Cesar was skimming cash from the business. Cesar
would take the order for the managers special with-
out entering the sale into the computer. Cesar would CASE STUDIES
then deliver the pizza and pocket the money.
1. Write a paragraph explaining why Cesar should be Gus Jackson was hired from a Big Four public account-
terminated from employment. ing firm to start a new internal audit function for ABC
2. Write a paragraph explaining why it is important Company, a newly acquired subsidiary of a large orga-
that Cesar is prosecuted for his crime. nization. His first task involved getting to know ABC
26 Part 1: Introduction to Fraud
management and supporting the public accountants in checks. To determine which of the endorsements
their year-end audit work. were authentic, Jane located other examples of the
Once the year-end work was finished, Gus started payees signatures in the lease, correspondence, and
an audit of the accounts payable function. Jane Ramon, personnel files. The checks with supporting documen-
who had worked on the parent companys internal tation matched other signatures on file for the payees.
audit staff for about four years, supported him in this Gus and Jane decided to assess the extent of the
activity. problem while investigating quietly. They wanted to
The accounts payable audit went smoothly, al- avoid prematurely alerting perpetrators or manage-
though many employees made no effort to conceal ment that an investigation was underway. With the
their hostility and resentment toward anyone associ- help of other internal auditors from the parent com-
ated with the new parent company. One exception pany, they worked after normal business hours and re-
was Hank Duckworth, the accounts payable manager. viewed endorsements on 60,000 paid checks in three
Hank was extremely helpful and complimentary of the nights. Ninety-five checks that had been cashed at the
professional approach used by the auditors. Gus had convenience store were identified.
actually met Hank four years earlier, when Hank had Still, all Gus and Jane had were suspicionsno
been an accounting supervisor for an audit client where proof. They decided to alert executive management at
Gus was the junior accountant. the subsidiary and get their help for their next step.
As the audit neared completion, Gus reviewed an
audit comment Jane had writtena statement con- The Follow-Through Since the subsidiary had lit-
cerning some accounts payable checks that lacked tle experience with dishonest and fraudulent activity, it
complete endorsement by the payees. Both Gus and had no formalized approach or written fraud policy.
Jane recognized that in some situations and in some Gus and Jane, therefore, maintained control of the in-
organizations less-than-perfect endorsements were vestigation all the way to conclusion. With the help of
not a critical concern; but these checks were payable operating management, the auditors contacted care-
to dual payees, and the endorsement of each payee fully selected payees. As is often the case involving fic-
was required. Gus asked Jane to make some photo- titious payments to real payees, the real payees had no
copies of the examples so the evidence would be knowledge of the payments and had no money due to
available for the audit close-out meeting with the them. The auditors obtained affidavits of forgery.
management. In order to identify the perpetrator, the auditors
Jane returned 20 minutes later with a puzzled ex- documented the processing in more detail than had
pression. I pulled the examples, she said, but look been done in the original preliminary survey for the
at these! Jane placed five checks on the desk in front routine audit. There were seven people who had access,
of Gus. What do you make of these? she asked. opportunity, and knowledge to commit the fraud. The
Make of what? asked Gus. auditors then prepared a personnel spreadsheet detail-
Dont you see it? The handwriting on all the en- ing information about every employee in the depart-
dorsements looks the same, even though the names are ment. The spreadsheet revealed that one employee
different! And these are manual checks, which in this had evidence of severe financial problems in his per-
system usually means they were pushed through the sonnel file. It also showed that Hank Duckworths
system as rush payments. former residence was three blocks from the conve-
They do look similar, Gus replied, but a lot of nience store.
people have similar handwriting. Armed with the affidavits of forgery, the auditors
It hit Jane and Gus at the same time. All five checks advised management that the case was no longer
had been cashed at the same convenience store less merely based on suspicions. Along with members of
than five miles from the home office, even though the operating management, the auditors confronted the
mailing address of the payee on one of the checks was convenience store owners to learn why they had cashed
over 200 miles away! the checks, and who had cashed them.
Jane decided to pull the supporting documentation The convenience store manager had a ready answer.
for the payments but found there was none! She then We cash those for Hank Duckworth. He brings in
identified other payments to the same payees and several checks a month to be cashed. He used to live
retrieved the paid checks. The endorsements did not down the street. Never had one of those checks come
look at all like the endorsements on the suspicious back!
Chapter 1: The Nature of Fraud 27
The rest is history. Hank was confronted, and con- settlement are: Arizona, Arkansas, Colorado, Con-
fessed. The fully documented case was turned over to necticut, Delaware, Florida, Indiana, Iowa, Kansas,
law enforcement. Hank pled guilty and received a pro- Kentucky, Maine, Maryland, Massachusetts, Michi-
bated sentence in return for full restitution, which he gan, Minnesota, Missouri, New Jersey, North Caro-
paid. lina, Oregon, Pennsylvania, Rhode Island, Tennessee,
Texas, Vermont, West Virginia, and Wisconsin.
1. What clues caused Jane to suspect that fraud was
1. Based on this information, do you believe Publishers
2. Why is it important for fraud examiners to follow
Clearing House has committed fraud?
up on even the smallest inconsistencies?
3. In an attempt to identify possible suspects, the
auditors researched the personal files of every em-
Case Study 3: Trading After Hours
ployee in the department. What things might they
have been looking for to help them identify possible Several years ago, Prudential Securities was charged
suspects? with fraud for late trading. This was the first major
brokerage house to be charged with the illegal practice
of buying mutual funds after hours.
Case Study 2: Sweepstakes-legitimate or The regulators who accused Prudential Securities
deceptive? charged them with carrying out a large-scale, late-
trading scheme that involved more than 1,212 trades
Sweepstakes Company Agrees to Pay Up31
that were valued at a remarkable $162.4 million. These
A recent newspaper contained the following story:
trades were placed after hours in order to benefit
Publishers Clearing House agreed to pay $34 million favored hedge funds. The complaint did not contain
in a deal with 26 states to settle allegations the information regarding any profits that were protected
sweepstakes company employed deceptive marketing by the scandal.
practices. The $34 million will cover customer re- The regulators who accused Prudential stated that
funds, legal expenses, and administrative cost to the Prudential should have noticed the considerable number
states. Each states share has yet to be determined. In of trades that were being placed after 4 p.m. and should
the lawsuits, state attorney generals accused Publish- have begun an internal inquiry. However, the complaint
ers Clearing House of deceptive marketing for its stated that Prudential possessed no internal supervisory
sweepstakes promotions. The suit alleged that the procedures to detect trades placed after hours.
company was misleading consumers by making Market timing, often done in conjunction with late
them believe they had won prizes or would win if trading, involves rapid in and out trading of a mutual
they bought magazines from Publishers Clearing fund designed to take advantage of delays in marking
House. up prices of securities in the funds. By buying before
As part of the settlement, the company will no the markups and selling quickly after them, Prudential
longer use phrases like guaranteed winner. This traders realized quick profits for the firms clients at the
will in fact revolutionize the sweepstakes industry, expense of others. A group of managers and top-
Michigan Attorney General Jennifer Granholm producing brokers were charged last month by the
stated. We listened to the states concerns and have SEC and/or state in separate civil actions related to
agreed to responsive and significant changes that will market timing. The firm denies all wrongdoing.
make our promotions the clearest, most reliable and Normally, orders to buy funds after 4 p.m. should be
trustworthy in the industry, said Robin Smith, filled at the price set the next day. In late trading, which
chairman and CEO of the Port Washington, is illegal, orders instead get the same days 4 p.m. price,
N.Y.based company. enabling investors to react to news a day ahead of other
Publishers Clearing House reached an $18 million investors.
settlement last August with 24 states and the District In order to accomplish late trading, the complaint
of Columbia. The states involved in the latest stated that Prudential clients would engage in the
28 Part 1: Introduction to Fraud
following activities: Prudential clients would submit a Write two or three brief paragraphs about what you
list of potential trades to brokers before the 4 p.m. found. Remember to include the Web sites where your
deadline by fax, e-mail, or telephone. After 4 p.m., clients information came from so that your friend can do some
notified Prudential which of the long list of trades it investigating of his or her own.
wished to execute. Prudential brokers would take the
original order, cross out the trades the client didnt
want to execute, and then forward the order to the firms
New York trading desk. The time stamp on the fax DEBATES
would often deceptively reflect the time it was received For the past year, you have been working as a secre-
originally, not the time that the client confirmed the tary/processor for a local construction company, XYZ
order. For example, in just one afternoon, at 4:58 p.m., Homes, which specializes in the building of low-cost,
Prudentials New York office executed more than limited-option homes. You left a comfortable, good-
65 mutual fund trades, for a total of $12.98 million. paying job to work for XYZ because it was family-
According to the complaint, Prudential did nothing owned and operated by long-time friends.
to substantiate the orders that were received before Soon after you began working for XYZ, you noticed
4 p.m. In early 2003, the brokerage firm issued a policy questionable behavior on the part of Mr. and Mrs. XYZs
change requiring branch managers to initial a cover two sons, who are company salesmen. In fact, you are
sheet for trades before faxing them to New York. Lists positive that they are falsifying documents to increase
of trades could be received at Prudentials New York their commissions and to trick local banks into approving
trading desk as late as 4:45 p.m. Accusations against mortgages to customers who dont meet credit standards.
the firm state that, The orders were never rejected You are trying to decide how to handle the situation
and were always executed at same-day prices. when one of the sons approaches you and asks you to
The complaint further states that Prudential also al- produce and sign a memo to a bank, falsely stating that
lowed the brokers involved in the market-timing and a certain potential home buyer is creditworthy. You
late-trading scheme to have dedicated wire-room per- refuse to do so and, after much consideration, ap-
sonnel to execute trades. It has been suggested that the proach Mr. XYZ about the situation. To your surprise,
brokers compensated the wire-room employees for he simply brushes off your comments as unimportant
their efforts, by sharing year-end bonuses. The state and laughingly states that boys will be boys.
alleges that Prudential also authorized one broker to What would you do in this situation? Is the fact that
obtain special software that gave the employee elec- you correctly refused to produce and sign a false memo
tronic capacity to enter bulk mutual fund exchanges enough, or are you obligated to report these crimes to
after 4 p.m.32 the banks and proper authorities? Discuss the options,
responsibilities, and implications you are facing.
1. Determine whether this case would be prosecuted as END NOTES
a criminal or civil offense, and state reasons to
1. D. Teather, 2009, Bernard Madoff Receives
support your conclusion.
Maximum 150-Year Sentence, The Guardian,
2. Who are the victims of this late-trading scheme, and
available at: www.guardian.co.uk/business/
what losses do they incur?
bernard-madoff.
2. G. Gregoriou and F. Lhabitant, 2009, Madoff:
A Riot of Red Flags, available at: http://papers.
INTERNET ASSIGNMENTS ssrn.com/sol3/papers.cfm?abstract_id=1335639.
Your best friend wants to know why on earth you are 3. U. Bhattacharya, The Optimal Design of Ponzi
taking a fraud examination class. He is curious about Schemes in Finite Economies, Journal of Financial
what careers this class prepares you for. Go to the Inter- Intermediation, Vol. 12 (2003): 1.
net and find information about two different careers 4. E. Arvedlund, MadoffThe Man Who Stole $65
that you could pursue in the field of fraud examination. Billion (London, England: Penguin Books, 2009).
Chapter 1: The Nature of Fraud 29
5. D. Hart and G. Strober, Catastrophe: The Story of Occupational Fraud and Abuse (Austin,
Bernard L. Madoff, the Man Who Swindled the Texas: ACFE, 2008).
World (Beverly Hills, California: Phoenix Books, 19. J. Bologna, Handbook on Corporate Fraud
Inc., 2009). (Woburn, Massachusetts: Butterworth-
6. R. Bolton and D. Hand, Statistical Fraud Detection: Heinemann, 1993).
A Review, Statistical Science, Vol. 17 (2002): 3. 20. J. Tackett, Bribery and Corruption, Journal
7. S. Zahra, R. Priem, and A. Rasheed, Understanding of Corporate Accounting & Finance, Vol. 21
the Causes and Effects of Top Management Fraud, (2010): 4.
Organizational Dynamics, Vol. 36 (2007): 2. 21. Federal Bureau of Investigation (FBI), White Collar
8. G. Sadka, The Economic Consequences of Crime: A Report to the Nation (Washington, D.C.:
Accounting Fraud in Product Markets: Theory Department of Justice, 1989).
and a Case from the U.S. Telecommunications 22. T. King, C. Dennis, and L. Wright, Myoptia,
Industry (WorldCom), American Law and Customer Returns and the Theory of Planned
Economics Review, Vol. 8 (2006): 3. Behavior, Journal of Marketing Management,
9. H. Tan, E-Fraud: Current Trends and Interna- Vol. 24 (2008): 1, 2.
tional Developments, Journal of Financial Crime, 23. J. Efendi, A. Srivastava, and E. Swanson, Why
Vol. 9 (2002): 4. Do Corporate Managers Misstate Financial State-
10. McNamaras Money Game, Newsday: The Long ments? The Role of Option Compensation and
Island Newspaper (April 16, 1992). Other Factors, Journal of Financial Economics,
11. Websters New World Dictionary, College Edition Vol. 85 (2007): 3.
(Cleveland and New York: World Publishing, 24. E. Rice, and B. Shah, Hes Madoff with My
1964): 380. Money!, Trust & Trustees, Vol. 16 (2010): 4.
12. I. Hamilton and I. Francis, The Enron Collapse, 25. Federal Bureau of Investigation, Common Fraud
IMD Case Study (Wellesley, Massachusetts: Schemes, available at: www.fbi.gov/majcases/
ECCH, 2003). fraud/fraudschemes.htm, accessed April 14,
13. Galbraith, J. K., A Short History of Financial 2010.
Euphoria (London, England: Penguin Books, 1994). 26. Securities and Exchange Commission (SEC), 2000,
14. This statistics is the proprietary information of a Litigation Release No. 16489.
major financial institution for which two of the 27. Securities and Exchange Commission (SEC), 1997,
authors were consultants. Litigation Release No. 38765.
15. W. S. Albrecht and D. Schmoldt, Employee 28. A few business schools have recently started
Fraud, Business Horizons, Vol. 31: 4. offering fraud-related majors with as many as 10
16. C. Hogan, R. Zabihollah, R. Riley, and U. Velury, to 12 different fraud-related courses.
Financial Statement Fraud: Insights from the 29. Careers to Count On, U.S. News and World
Academic Literature, Auditing: A Journal of Report (February 18, 2002), p. 4648.
Practice & Auditing, Vol. 27 (2008): 2. 30. C. Thompson, The First Audit, The Internal
17. The Association of Certified Fraud Examiners Auditor, Vol. 52 (1995): 4.
(ACFE), The Report to the Nation on Occupa- 31. T. Miller, 2001, Iowa Department of Justice PCH
tional Fraud and Abuse (Austin, Texas: ACFE, Settlement Release, News Release: June 26, 2001.
32. Fraud Charges Widen Scope of Scandal Facing
18. The Association of Certified Fraud Examiners Mutual Funds, The Wall Street Journal
(ACFE), The Report to the Nation on (December 12, 2003).
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