Common Fraud

Scenarios Guide
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 Table of Contents
COMMON FRAUD SCENARIOS GUIDE: SAMPLE 1 ...............................................................................................3
COMMON FRAUD SCENARIOS GUIDE: SAMPLE 2 ...............................................................................................5

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 COMMON FRAUD SCENARIOS GUIDE: SAMPLE 1

COMMON INSIDER FRAUD AGAINST THE COMPANY

• Cash diversions, conversions and thefts (front-end frauds)

• Check raising and signature or endorsement forgeries
• Receivables manipulations such as lapping and false credit memos
• Payables manipulations such as raising or fabricating vendor invoices, benefit claims, and expense vouchers,
and allowing vendors, suppliers and contractors to overcharge
• Payroll manipulations such as adding nonexistent employees or altering timecards
• Inventory manipulations and diversions such as erroneous reclassifications of inventories to obsolete,
damaged or sample status to create a cache from which thefts can be made more easily
• Favors and payments to employees by vendors, suppliers and contractors

COMMON OUTSIDER FRAUD AGAINST THE COMPANY

• Vendor, suppliers and contractor frauds, such as short shipping goods

• Substituting goods of inferior quality
• Overbilling
• Double billing
• Billing, but not delivering or delivering elsewhere
• Vendor, supplier and contractor corruption of employees
• Customer corruption of employees

COMMON FRAUDS FOR THE COMPANY

• Smoothing profits (cooking the books) through practices such as inflating sales, profits and assets
• Understating expenses, losses and liabilities
• Not recording or delaying the recording of sales return
• Early booking of sales and inflating ending inventory
• Check kiting
• Price fixing
• Cheating customers by using devices such as short weights, counts and measures; substituting cheaper
materials; and false advertising
• Violating governmental regulations, including EEOC, OSHA, environmental, securities or tax violation
standards
• Corrupting customer personnel
• Political corruption

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• Padding costs on government contracts

PROCEDURES USED BY TOP MANAGEMENT TO ACCOMPLISH FRAUD

From “Fraud, Window Dressing and Negligence in Financial Statements” by Loren B. Kellogg and Denise
Kellogg:

Procedures used (by top management) to accomplish fraud:

Cash: Inflate the bank balance by ordering false entries, keeping cash received records open beyond the balance
sheet date or closing the disbursement records before the balance sheet date.

Ratios: Ratios includes quick ratio, accounts receivable turnover and accounts payable turnover.

Accounts Receivable: Inflate accounts receivable by creating false charges to customers, shipping merchandise
not ordered, designating consignments as sales and shipping merchandise to customers with right of return.

Ratios: Ratios include accounts receivable turnover and revenue trends.

Inventories: Overvalue inventories, ignore obsolescence, alter inventory sheets, count empty boxes and alter
computer documents.

Ratios: Ratios include inventory turnover.

Prepaid Expenses: Instruct bookkeepers to reduce or eliminate amortization of expenses paid in advance:
insurance, taxes, advertising and supplies.

Ratios: Ratios include quick ratio.

Property, Plant and Equipment: Instruct bookkeepers to enter amounts to these asset accounts even though
the amounts properly belong in expenses like labor, supplies, repairs or tools:
• Instruct bookkeepers to reduce the depreciation rates on plant and equipment so that the write-off to expense
is understated.

Ratios: Ratios include depreciation and amortization as percentages of sales, fixed asset depreciated percent,
capital outlay as a percent of sales, capital outlay funded by operations and asset turnover.

Goodwill: Add amounts unreasonably to this account, and amortize it over an unreasonably long life; the result is
an understated expense and overstated net income.

Ratios: Ratios include depreciation and amortization as percentages of sales.

Other Intangibles: Add amounts unreasonably to this account, and amortize it over an unreasonably long life;
the result is an understated expense and overstated net income.

Ratios: Ratios include depreciation and amortization as percentages of sales.

Other Assets: Use the procedures listed above to create fictitious assets or to keep on the accounting records
assets that should be written off.

Ratios: Ratios include asset turnover, depreciation and amortization as percentages of sales, quick ratio and
inventory turnover.

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 COMMON FRAUD SCENARIOS GUIDE: SAMPLE 2

The purpose of this document is to provide a common understanding of the potential fraud schemes and
scenarios that ABC Company has included in its entity-level fraud risk assessment. Each of these
schemes/scenarios should be examined by the internal audit group and senior management from each of the
functional areas within the company.

FRAUD SCHEMES/SCENARIOS AND DEFINITIONS

Benefits Fraud: This scheme encompasses the receipt of benefits by employees that are not eligible,
dependents of employees that are not eligible or the receipt of benefits beyond their departure date from the
company.

Bid Rigging: This scheme occurs when an employee fraudulently assists a vendor in winning a contract through
the competitive bidding process. This may include related party transactions and vendor kickbacks, among other
frauds.

Check Fraud: This scheme includes the use of technology to design/reproduce bank checks and simple check
forgery.

Check Theft: This scheme involves interception of a valid disbursement prior to delivery to the rightful recipient.

Collateral or Records Management: This scheme involves employees using titles to secure other/personal debt.

Concealment of Investing Activity: This scheme involves the failure of personnel to report investing activity for
inclusion in the financial statement preparation process.

Disguised Purchases: This scheme involves the utilization of company funds to make non-company-related
purchases. The purchase may benefit the employee or another party and is intended to have the appearance of a
purchase made in the normal course of business.

Early Recognition of Revenue: Companies try to enhance revenue by manipulating the recognition of revenue.
Improper revenue recognition entails recognizing revenue before a sale is complete before the product is
delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.
Examples of improper revenue recognition include recording sales to nonexistent customers, recording fictitious
sales to legitimate customers, recording purchase orders as sales, altering contract dates and shipping
documents, entering into “bill-and-hold” transactions, holding the books open until after shipment so that the sale
can be recorded in the desired period, entering into side agreements, and channel stuffing.

Earnings Management/Smoothing: The pressure to meet or beat analyst expectations may lead management
to engage in dubious practices such as “big bath" restructuring charges, creative acquisition accounting, "cookie
jar reserves," "immaterial" misapplications of accounting principles, and the premature recognition of revenue.
Insistence on aggressive application of accounting principles, on always being “on the edge” and on applying
“soft” methods allowing for a lot of “running room” when making significant estimates in the financial reporting
process all contribute to an environment that impair or reduce the quality of earnings and breed earnings
management.

Electronic Transaction Fraud: This scheme is similar to embezzlement, but specifically relates to diversion,
theft, or misappropriation of funds that are received or disbursed electronically. This scheme may be perpetuated
at the initiation point of the transaction, during transmission or at the destination of the transaction.

Embezzlement: The property of another party is wrongfully taken or converted for the wrongdoer’s benefit. This
may include theft of cash or property or the use of company assets for personal gain.

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Employee Fraud: While every industry is at risk for employee fraud, the nature of the financial services industry
makes it an attractive target for employees who can figure out how to work around existing or lax controls and, for
example, create dummy loans, siphon money from customer accounts or arrange to get kickbacks for providing
services. This may also include fraud resulting from a “rogue employee,” (e.g., the trader who manages to trade
off-book and/or hide his trading losses in accounts that only he controls or from insider dealing [i.e., the use of
nonpublic information for personal gain]).

Fictitious Borrowing/Borrowing Fraud: Personnel may enter into borrowing arrangements for personal gain
utilizing company credentials/collateral.

Fictitious Vendors: This scheme involves the intent to divert funds to an employee or another party with no
corresponding receipt of goods or services.

Fictitious/False Employees: This refers to someone on payroll who does not work for the company. Through the
falsification of personnel or payroll records, a fraudster causes paychecks to be generated to a “ghost.” The
fraudster or an accomplice then converts these paychecks. The ghost employee may be a fictitious person or a
real individual who simply does not work for the victim's employer. When the ghost is a real person, it is often a
friend or relative of the perpetrator.

Financial Statement Fraud: Misstatement(s) of an entity’s financial statements accomplished by:

• Overstatement of revenue and revenue-related assets
• Understatement of costs or expenses and their related liabilities
• Omission or manipulation of required disclosures that involves violation(s) of generally accepted accounting
principles (GAAP) and that defrauds investors or creditors of the entity by manipulation, deception, or
contrivance using false and misleading financial information

Fraudulent Account Activity: This scheme involves the manipulation of customer accounts to conceal
delinquency or boost portfolio performance metrics. The scheme may involve changing receivables status to
current or manipulating bankruptcy account status to boost the quality of receivables and lessen the need for a
bad debt reserve.

Fraudulent Capitalization of Costs: This scheme involves the capitalization of costs that do not provide a
benefit to future periods. Management may undertake this effort to delay the recognition of period expenses and
lessen the current P&L impact.

Fraudulent Journal Entries: Some characteristics may include the following entries:
• Made to unrelated, unusual or seldom-used accounts
• Made by individuals who typically do not make journal entries
• Made with little or no support
• Made post-closing or at the end of a period such as quarter- or year-end and might be reversed in a
subsequent period
• Include round numbers
• Affect earnings

Financial statement fraud is frequently accomplished through the use of fraudulent journal entries and is a form of
management override of the internal control structure. Of particular interest would be journal entries that mask
fund diversion, the improper reversal of reserve accounts, the use of intercompany accounts to hide expenses
and/or the capitalization of costs that should be expensed.

Fraudulent Disbursements: In fraudulent disbursement schemes, an employee makes a distribution of company

funds for a dishonest purpose. Examples of fraudulent disbursements include forging company checks, the
submission of false invoices, doctoring timecards and so forth.

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Fraudulent Loan Setup/Funding Disbursement: This scheme involves booking loans that do not exist or
disbursing funds to fictitious customers. This scheme can inflate revenues, assets (loan receivables) and may
also include embezzlement of funds.

Identity Theft: This scheme involves a crime in which an imposter obtains key pieces of personal information,
such as social security or driver's license numbers, in order to impersonate someone else.

Inflated Time Reporting: Employees may intentionally report hours that were not spent working. This may
involve reporting hours for days the employee did not work, incrementing hours beyond those spent at work, and
failing to report vacation or sick time.

Insider Trading: Insider trading is an illegal act that involves the use of nonpublic information to purchase/sell
company stock. Insider trading most often involves executive management or financial reporting personnel who
have access to company performance results in advance of public filings.

Intentional Misapplication of Payments: This scheme involves taking a customer payment and applying it to
another customer or another type of payable due from the customer.

Kiting: Check kiting is the act of writing checks against a bank account with insufficient funds to cover the check
in hopes that funds will be available prior to the payee depositing the check.

Lapping: Lapping customer payments is one of the most common methods of concealing skimming. It is a
technique that is particularly useful to employees who skim receivables. Lapping is the crediting of one account
through the abstraction of money from another account. It is the fraudster’s version of “robbing Peter to pay Paul.”

Loss Allowance Manipulation: The scheme involves changing allowance calculation assumptions, changing
input data, or simply changing the result of the allowance calculation to delay the impact of impending losses.
This scheme most often must be continued over time to conceal inevitable write-offs and may lead to other
fraudulent journal entries (defined above).

Manipulation of Bonus/Commission Criteria/Results: This scheme is similar to embezzlement but has distinct
characteristics. Personnel responsible for submitting bonus/commission attainment (HR and department
management) may modify compensation criteria or performance results to increase bonus/commission payouts to
themselves or the employees that work for them. In many cases, this scheme is justified by management to
reward employees that are perceived to be strong performers that are not rewarded by established performance
metrics.

Manipulation of Derivative Position: This scheme involves the intentional misreporting of derivative position to
conceal a poor business decision or simply increase earnings. This scheme can be accomplished in various
manners, including the destruction or concealment of supporting documentation, falsifying documentation related
to hedging activities, or modifying the actual position to one more favorable to the company.

Manipulation of Inventory: This scheme involves the modification of inventory records to overstate assets or
failure to recognize the decline/impairment to its value. This scheme may involve the falsification or destruction of
records in an attempt to substantiate activity in the period that did not occur.

Manipulation or Concealment of Trigger Reporting: This scheme involves the intentional cover-up or
falsification of performance reports that would otherwise result in the violation of debt covenants.

Misappropriation of Customer Payments/Funds: Often accompanies embezzlement, but is a separate and

distinct offense. Misapplication is the wrongful taking or conversion of another’s property, in this case, customer
payments, for the benefit of someone else – that of the employee or for another customer.

Misappropriation of Funds: Often accompanies embezzlement, but is a separate and distinct offense.
Misapplication is the wrongful taking or conversion of another’s property, in this case, company funds, for the
benefit of someone else.

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Misappropriation of Trustee Payments/Funds: Often accompanies embezzlement, but is a separate and
distinct offense. Misapplication is the wrongful taking or conversion of another’s property, in this case, trustee
payments, for the benefit of someone else.

Misleading Analyst Forecasts: This scheme is perpetrated by management to conceal a pending downturn or
flat revenues or to predict a significant increase in revenue despite the lack of supporting analysis.

Overstatement of Assets: Areas where assets can easily be overstated include inventory valuation, accounts
receivable, business combinations and fixed assets:
• Inventory Valuation: Inventory valuation is the failure to write down obsolete inventory, manipulation of
physical inventory counts, recording “bill-and-hold” items as sales and including these items in inventory.
• Accounts Receivable: This scheme includes fictitious receivables and the failure to write off bad debts.
• Business Combinations: This scheme involves setting up excessive merger reserves and taking the
reserves into income.
• Fixed Assets: This scheme includes capitalizing costs that should be expensed or booking an asset although
the related equipment might be leased.

Proprietary Information Dissemination: This scheme involves the intentional dissemination of private company
information to potential customers, vendors or suppliers that give them an unfair advantage in dealing with the
company, whether applying for a loan or providing goods/services. This scheme may be coupled with other acts
such as embezzlement or bid rigging (defined above).

Speculative Investing: This scheme involves company personnel, either on their own or at the direction of
management, to enter into derivative/hedging transactions with no specific risk that is attempting to be mitigated.
This may be an attempt to circumvent investing policies to boost earnings or to profit individually from the
transaction.

Tax Evasion: The company intentionally evades payment of taxes that are otherwise owed to a taxing authority.
This conduct can include concealing assets or income, keeping two sets of books, manipulating quarterly
payment estimates, and destroying books and records.

Title Fraud: This scheme involves the use of company assets, in this case, vehicle titles, to secure personal/other
debt. This scheme is most likely to occur with collateral or records management employees due to their access to
such documents.

Unrecorded, Deferred or Understated Liabilities: The most common methods used to understate liabilities
include failing to record liabilities and/or expenses, failing to record warranty costs and liabilities, and failing to
disclose contingent liabilities. In one high-profile case, liabilities were hidden in off-balance-sheet affiliates.

OTHER FRAUD SCHEMES/SCENARIOS TO CONSIDER

Collusion With Dealers Manipulation of Bank Account Status

Concealment or Manipulation of Financial Results Manipulation of Estimates to Alter Quarterly Tax

and Disclosures Payments

Dealer Buyback: Theft of Funds Manipulation of Payroll Records

Diversion of Funds/Misappropriation of Assets Manipulation of Performance Forecasting

Diversion/Misappropriation of Funds Manipulation of Performance Results

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 Diversion/Theft of Disbursements Manipulation of Significant Accounting Estimates

Electronic Payments Fraud Manipulation or Theft of Fees

Failure to Record/Remit Payroll Taxes Management Circumvention/Override of Loan

Setup Controls

Failure to Remit Ancillary Product Refund to Principal Credit Adjustments to Increase

Customer Recoveries

False Repo Agent Invoices Principal Credit Adjustments to Reduce/Pay Off

Loans

Falsification of Expense Reports Related Party Purchases

Fraudulent Auction Invoices Related Party Transactions

Fraudulent Repo Agent Invoices/Auction Terminated Employee Payments

Expenses

Fraudulent Settlement Negotiation Theft

Improper Re-Aging Accounts to Current Unauthorized Electronic Payments

Initiation of Fraudulent Check Unsupported Top-Side Entries

Kickbacks Use of Resources for Personal Gain

Manipulation of Assumptions Utilized by Financial Vendor Kickbacks

Reporting