Emerging Issues in

Accounting UNIT 16 FORENSIC ACCOUNTING

Objectives
After going through this unit, you would be able to

 Understand the dynamics of fraud

 Understand the concept of fraud triangle
 Identify the potential frauds which can occur in various accounting
cycles
 Classify the various frauds
 Understand various forensic audit techniques

Structure
16.1 Introduction
16.2 An Overview of Fraud
16.3 Fraud Triangle
16.4 Major Corporate Frauds
16.5 Application of Forensic Accounting
16.6 Type of Frauds
16.7 Fraud origin and Accounting Cycles
16.8 Fraudulent Financial Reporting Schemes
16.9 Improper Revenue recognitions
16.10 Other Financial Reporting Schemes
16.11 IT Tools for Fraud Detection
16.12 Methods of Fraud Detection
16.13 Forensic Audit Techniques
16.14 Summary
16.15 Self-Assessment Questions

16.1 INTRODUCTION
The growth and development of accounting are linked to the growth and
development of trade and commerce. A few centuries back, most of the trade
and commerce were carried out by individuals with their own money and
resources. As the volume of trade and commerce grew, there was a
requirement for increased resources, both human resources and finance
(capital). The proprietorship form of business gave way to partnership firms,
which further transformed themselves into joint stock companies. In contrast
to proprietorship/partnership firms, companies delegate the responsibility of
running the business to managers with considerable autonomy to take
transactional and strategic decisions. The overall supervision is done by the
Board of Directors.
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This delegation of authority creates an agency cost problem. Agency cost is Human Resource
Accounting
the internal cost arising from conflict of interest between the principal
(shareholders) and the agents (managers).It is hidden in the actions of
managers/executives, which are not aimed at maximising the company‟s
profit but rather enriching themselves at the cost of the company‟s assets.
Agency cost can be reduced by the application of forensic accounting, as
forensic accounting findings can be used to design the management and
supervisory systems of the company leading to effective monitoring.

One distinctive feature of companies is that the funds invested in companies

belong to a large number of people and financial institutions. Since the
interest of a large number of people (stakeholders) is tied to the company, it
is but natural that the information provided by the companies is true and fair
and reflective of the actual state of affairs. This information is provided in the
form of the annual report and quarterly results. This information is compiled
by the company by collating the information provided by the managers of
various constituent divisions of the company. The verification of this
information is carried out by both the internal and external auditors based on
the documentary evidence and explanations provided by the concerned
divisions. At this stage, certain irregularities can be detected. However, when
irregularities are well planned, accounts are window dressed, and
irregularities are carried out in collusion with executives and supervisory
managers to cover the tracks, it becomes difficult to track them down.
Sometimes these irregularities may be perpetuated by the promoters in
collusion with senior managers or, even worse, collusion between senior
managers, promoters and auditors. Normal fraudulent activities can be
uncovered through regular audits, but when fraudulent activities are complex
involving multiple accounts and divisions, the role of forensic accounting
arises.

Now let us briefly explain the concept of forensic accounting. Forensic

accounting is a multidisciplinary activity involving accounting, auditing,
computer forensics, investigation and law. It involves gathering information
and evidence which can withstand the scrutiny of a court of law.

The scope of this unit is limited to the frauds committed in a corporate

setting.Let us understand the meaning of occupational fraud. Occupational
frauds are those in which an employee, manager, promoter or owner of an
organisation commits fraud determinant to the organisation.

16.2 AN OVERVIEW OF FRAUDS

In order to get a general understanding of fraud, let us have a look at the
finding of the “Report to the Nations, 2020” published by the association of
certified fraud examiners. In this study, they examined 2504 fraud cases from
125 countries. These fraud cases had caused a total loss of more than $3.6
billion. A typical fraud case lasts for 14 months before being detected and
caused a loss of $8300 per month. It is estimated that organisations lose 5%
of revenues to fraud each year, with a median loss of $1,25,000 per case and
an average loss of $15,09,000 per case. Asset misappropriation was the most
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Emerging Issues in common and least costly scheme accounting for 86% of the cases and
Accounting
causing a median loss of $1,00,000. In contrast, Financial Statement Fraud
schemes are the least common and most expensive, accounting for 10% of
the cases and causing a median loss of $9,54,000.

With regards to organisational preparedness, organisations with formal fraud

awareness training for employees are most likely to gather tips through a
formal reporting mechanism.56% of organisations with formal training
programmes were able to gather fraud information through tips, in contrast to
37% of organisations without fraud awareness training.

The use of anti-fraud controls has increased over the last decade, and lack of
internal controls for nearly 1/3 of frauds. The presence of anti-fraud controls
contributed to lower fraud losses and quicker detection of frauds.

43% of fraud schemes were detected by tips, and half of these tips came from
employees. The preferred communication mode was telephone, hotline and
email, which were used by whistleblowers in 33% of cases.

Small businesses are more prone to fraud risk than large organisations as
large organisations have well-defined structures coupled with structural
rigidities and effective internal controls, which are largely absent in small
organisations. The probability of certain frauds occurring in small business is
high, i.e. the probability of billing and payroll fraud is 2times higher in
smaller organisations, whereas the probability of cheque and payment
tampering is 4 times higher.

Concerning profile of fraudsters, men accounted for 72% of all occupational

frauds causing a median loss of $1,50,000, whereas women employees
accounted for 28% of frauds, causing a median loss of $85000.

Owners/promoters committed only 20% of occupational frauds but caused a

median loss of $6,00,000, whereas managers and employees caused a median
loss of $150,000 and $60,000, respectively. 80% of fraudsters faced some
disciplinary action in the past from victim organisations, and 46% of victim
organisations did not pursue any legal remedies as they felt internal
disciplinary action was sufficient to rectify the deviant behaviour.42% of
fraudsters were living beyond their means, and 26% of them were facing
some financial difficulties.

Divisions more prone to fraud includeoperations, whichaccount for 15%of

frauds, while 14% of frauds originate in the accounting department;
executives and upper management accounts for 12% of frauds and sales for
11% of frauds.

16.3 FRAUD TRIANGLE

In the context of Forensic Auditing, it would be worthwhile to discuss the
concept of the Fraud Triangle. This concept identifies three categories factors
of risk that are present in the organisation.These factors can potentially lead
to fraud, or when a fraud occurs, these factors are present in the organisation.
These three factors are:
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 Incentive and pressure – that is need Human Resource
Accounting
 Opportunity
 Rationalisation and attitude

Incentive Rationalization
or Attitude
or Pressure FRAUD

Opportunity

Figure 16.1 Fraud Triangle

These three factors are graphically represented in Figure 16.1 and are called
Fraud Triangle. Now let us briefly discuss each of these factors.

1. Incentive and Pressure

Management and employees are often put under pressure or offered

incentives to achieve certain milestones, which can be financial,
operational, related to sales, cast etc. These targets can be realistic or
unrealistic. The problem arises when unrealistic targets are tied to
remuneration and advancement opportunities. In order to achieve these
unrealistic targets, the individuals, divisions, and company may have
incentives to manipulate results or put pressure on others to do so. The
company‟s pressure can also come from other stakeholder‟s viz.
investors, banks, venture capitalists, government etc.

The risk factors that may lead to fraud by companies are :

 Situations that may threaten the financial stability or profitability of

the company
 Pressure on management to meet the expectation of other
stakeholders especially that of investors and financial institutions.
 Threat to the personal wealth of top management and promoters as a
result of the performance .
 Pressure on divisional managers by senior managers or Board of
directors.
 Effort to maintain existing debt rating or move to higher debt rating
order to raise more finance.
 Inability to meet debt covenants or fulfil conditions in merger or
acquisition agreements.

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Emerging Issues in Incentives and pressure can come in a variety of ways. Seen in the
Accounting
context of variable pay structure where a large portion of remuneration is
based on achievement of performance targets, there will be an incentive
for employees and senior managers to mistake achievements if the target
performance is not achieved. Another source of pressure is the practice
of awarding stock options. The value of stock options is derived from
stock prices, which are partly derived from company‟s performance. In
order to protect the value of stock options awarded, employees have an
incentive to paint a rosy picture of the company, while the reality lies
somewhere else.

With reference to the risk of material misstatement due to

misappropriation of assets, the risk factors are

 Personal financial problems, greed, dishonesty, no fear of being

caught or punished may lead employees to commit fraud.
 Adverse relationships with senior employees, dissatisfaction with
organisationor organisationalpolicies, or a revengeful attitude might
create a feeling of resentment and disloyalty, which may lead to
fraudulent activities.

Determining the presence and degree of these pressures or incentives and

evaluating the risk that these variables possess in perpetuating fraud, are
the job of forensic auditors. Forensic accounting is used to quantify the
losses due to fraud and trace the path through which fraud has been
perpetuated.

2. Opportunity

It is generally assumed that people are honest, but circumstances may

exist or be created that may push employees or management to commit
fraud. An opportunity must not exist to commit fraud, and these
opportunities may come in the form of ineffective internal control, lack
of supervision, non-segregation of duties etc. Sometimes the
organisationalstructure itself provides opportunity for fraud due to the
nature, size and structure of the business. By their inherent nature,some
transactions are more prone to falsification or manipulation as compared
to other transactions, as do certain kinds of balances or accounts.
Similarly, certain types of assets are more prone to misappropriation.

Various risk factors that are indicative of opportunities that could lead to
fraud are:
 Nature of industry in which company operates
 Nature of business transactions and the manner in which they are
recorded
 Degree of Dominance Company enjoys over supplier and customers.
A high degree of dominance may create the opportunity for
inappropriate or non-arm‟s length transaction
 Degree of subjectivity involved, the higher the subjectivity involved
greater the opportunity for deliberate manipulation
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  The level of opportunity will also depend on the extent of Human Resource
Accounting
supervision of senior management by the audit committee, non-
executive and independent directors and Board of directors
 The complexity of the organisational structure and the stability of
the company or group to which the company belongs
 The overall control environment, including the effectiveness of
internal controls and information technology infrastructure

3. Rationalisation and Attitude

The propensity to commit fraud by individuals is a function of ethical

values and personal circumstances. The external environment also plays
a role in shaping attitude, especially during hard times. Management‟s
attitude towards fraud tolerance also shapes individual attitudes towards
fraud. Rationalisation and attitude are intangible factors and, by nature,
are difficult to observe and ascertain. Rationalisation and attitude is a
product of the culture of an organisation and the psychology of those
who work in it. Risk factors in this category are:

 Lack of clarity about corporate ethical values

 Fraud risk is taken lightly, and occurrence dealt ineffectively by
management
 Budgeting and forecasting with large variance
 Management justifies inappropriate accounting and disclosure
policies
 Non-cordial relationship with auditors
Most of the frauds begin on a smaller scale and grow in proportion over
time. The typical rationalisationarguments advanced by fraud
perpetrators are:

 It is just temporary, and the manipulated entry would be reversed in

the next quarter there would be no material impact on the yearly
results
 Management is indifferent towards frauds, and it does not seriously
monitor internal controls, nor it is proactive in correcting known
lacunas in internal controls
 Management is hand in glove and expects & rewards this kind of
behaviour
 I deserve a better position and remuneration than offered by the
company
The forensic audit shall try to find out whether such biases exist, and if
such biases exist, then the company is a fit case for the occurrence of
potential frauds

Before we move further, let us briefly discuss the major corporate frauds
of the last two decades, in India and around the world. We first start with

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Emerging Issues in corporate frauds in India and later on, move to international corporate
Accounting
frauds.

16.4 MAJOR CORPORATE FRAUDS

i) Satyam computer was one of the leading Information Technology
companies of India. The promoters of the company devised ingenious
ways to defraud the company and siphon off a large amount of money to
the tune of 1 billion dollars. The modus operandi was to issue dummy
bills for services not actually rendered to foreign clients. The take
proceeds were shown in bank accounts opened in various countries, and
many of these bank accounts were either nonexistent, or the balances
shown in them were highly inflated. In a nutshell, this fraud is comprised
of two parts. One is showing inflated revenue, and the second is showing
inflated cash balances with the banks.
ii) Kingfisher Airlines: Kingfisher airlines, after its establishment,
developed as one of the finest airlines in the private sector in India,
garnering the second highest market share after Jet Airways.
The fall of the airlines started with the company borrowing huge funds
from banks and related parties. The collateral for this borrowing was
kingfisher Brand, an intangible asset. In India‟s financial history, it was
probably the first time when banks had considered an intangible asset as
collateral. When the promoters failed to pay back the principal amount
and interest thereon, the brand value of Kingfisher took a nosedive and
was virtually not of any value. The banks were saddled with NPA‟s of
more than Rs. 9000 crores.
iii) Jet Airways had the largest market share among the Indian airline
operators with best in class services. However, its financial practices
were questionable, which included
 Overstating commissions paid to a related party based in Dubai,
resulting in an overstatement of expenses and underreporting of
profits
 diversion of funds by giving loans of around Rs. 3353 crores
 accounting of fake invoices
All this led to default in payment to lenders, vendors, employees, airport
authority of India and lessors of aircraft. The total liabilities on which it
defaulted was Rs. 25,000 crores, including Rs. 8500 crores to lenders.
IV) Bhushan Steel was a profitable company with modern large scale plants,
but the promoters indulged in multiple fraudulent practices which were
 Transfer of borrowed funds to various related parties by way of
loans and advances
 Accounting for capital expenses that were never incurred and
misappropriation of these funds

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  The fraud amounted to Rs. 50,000 crores, and investigation agencies Human Resource
Accounting
have been able to establish that an amount of Rs. 2348 crores was
diverted to more than 200 shell companies.
V) PNB Fraud
Two diamond traders defrauded the PNB to the tune of Rs. 16,000
crores. Both of them imported rough diamonds and exported polished
diamonds. Their modus operandi was to open LCs of a large amount
without any underlying transaction. This fraudulent practice did not
come to light as these LCs were not recorded in the RTGS system of the
bank and thus evaded the reconciliation process of matching LCs with
the actual transaction.
VI) ILFS
This fraud was the largest corporate fraud in India and had the potential
to destabilise the Indian Financial System. It was the major vehicle for
infrastructure development and finance.
At the time the fraud was uncovered ILFS had a debt exposure of Rs.
91,000 crores, including Rs. 20,000 invested as debt by PF and Pension
funds. The modus operands used by the top management to perpetrate
fraud consisted of many malpractices which were
 Diversion of funds to related entities of some members of top
management
 Lending to non-creditworthy entities for consideration
 Ever greening of loan by routing funds from one group company to
another through or unrelated entity.
 Over invoicing of projects by vendors, accounting for fake expenses,
and the difference routed back to related entities of top management.
 Overstatement of profits by non-provisioning for loans, and
inappropriate recognition of project revenues.
 Large number of subsidiaries and group companies numbering 346,
which were used to route fraudulent transactions
 Non disclosure of group companies as related entity and non
disclosure of some of subsidiaries, associated and joint ventures.

ILFS was enjoying the highest credit rating, which enabled it to issue a large
amount of bonds to garner funds.

Apart from these corporate frauds, there were a number of other corporate
frauds in the last decade by companies like DHFL, PMC Bank, Yes Bank,
Cafe Coffee day, Spot Exchange of India, Ranbaxy, Kwality products,
Amrapali, CG Consumers and Coxs& Kings. In all the above cases, the
mechanisms of committing fraud were more or less identical.

Now let us briefly discuss a few of the international corporate frauds.

Waste Management Inc: a publicly traded US waste management company,

reported over $ 1.7 billion in fake earnings.
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Emerging Issues in Enron Corporation Scandal (2001): Enron US energy, commodities and
Accounting
service company had been using accounting loopholes to under report
billions of dollars of bad debts and simultaneously inflating its earnings. The
uncovering of this scandal resulted in shareholders losing $74 billion as share
price plunged from $90 to $1 in one year.

World com (2002): an American telecommunication company had inflated

its assets by $ 11 billion. The modus operandi was to under report line costs
and capitalisingon these costs, instead of treating them as an expense. This
fraud was uncovered by the company‟s internal audit department when it
found out that almost $3.8 billion were diverted to unauthorisedaccounts.
This fraud led to CEO being sentenced to 25 years in prison, loss of 30,000
jobs and $ 180 billion losses to investors.

16.5 APPLICATION OF FORENSIC

ACCOUNTING:
Fraud detection and prevention is one of the principal areas in which we find
the application of forensic accounting, but the scope of forensic accounting
has increased in recent years. Some of the specific practice areas of
application for forensic accounting are:

1. Bankruptcy, Insolvency and Reorganisation:

The services of the forensic accountant can be availed by debtors,

individuals or organisationscontemplating bankruptcy or already in
bankruptcy and creditors. In bankruptcy cases, forensic auditors mainly
perform business valuations to resolve bankruptcy filing. They often
work toward corroborating and supporting both the disclosure and the
claims. At the operational level they assist the trustee in managing the
financial affairs, identifying pre-bankruptcy transactions, searching for
hidden assets and recovering hidden funds and assets. Creditors also
used their services for the same purpose mentioned above to increase the
quantum of recovery.

2. Computer Forensic Analysis:

Nowadays, most of the transactions are done electronically, and
information regarding these can be found in files stored on location
beyond the computer infrastructure of the parties involved in the
transaction. The role of a forensic accountant is to recover and preserve
this information for evidence purposes and litigation support. The
competency of forensic accounting lies in knowing the type of electronic
information that may exist, the form and format in which it is stored, the
location of the information and the means to access the information.

3. Economic Damage Calculations:

When two or more parties are involved in a transaction and action or
inaction of one of the parties causes loss or injury to the other party,
damages arise. Damages can be in the form of last earnings, lost profit or
physical loss of property. Forensic accountants are often for damage
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 calculation, as well as for reviewing and refuting damage calculation by Human Resource
Accounting
the opposing party. They also help in reaching a negotiated settlement of
damages instead of going for litigation.

4. Family Law: Forensic accountants can have several roles in cases

involving inheritance, will, Hindu undivided family (HUF) and marital
dissolution (divorce and past divorce). In cases involving inheritance,
will and Hindu undivided family, the documentation is often not
adequate, and claims of individuals are often entangled with the claims
of other individuals. Forensic accountants are often called to uncover
hidden or undisclosed sources of income or assets, entangle the claims
and reach fair valuation of assets to satisfy the claims of parties involved.

In case of marital dissolution, for the purpose of determining alimony

and child support, the earnings and expenses of each party has to be
evaluated along with the earning potential. This can be effectively done
by the forensic accountant.

5. Financial Statement Misrepresentation: The statutory auditors

examine the financial statements and determine whether the financial
statements properly report the balances, results and required disclosures.
If the internal/statutory auditors flag any issue such as overstatement,
understatement, omission and improper accounting treatment,then the
forensic accountant role comes into play. They calculate the effect such
identified issues would have on financial statements and determine the
persons and process for these improprieties. They will also uncover if
there was any underlying scheme or motive for misrepresentation.

6. Fraud Prevention, Detection and Response: This area has the most
prominent role for forensic accountants. They design the accounting and
control systems to prevent frauds, investigate frauds that have occurred,
and redesign the system with better controls and procedures to prevent
reoccurrence of frauds in the same form or potentially any other form.

Their services can be used to proactively evaluate internal control systems,

financial policies and accounting procedures.

Business Valuations: Services of forensic accountants are used to conduct

business valuation in a number of contents. The valuation may be required
when a partnership firm is dissolved, or one partner is leaving/buying the
interest of the other partners. In case of bankruptcy, the creditors have to be
paid out of the remaining assets of the bankrupt firm. The remaining assets
are valued by the forensic accountant. Similarly, in case of NPA‟s, the banks
have to have a haircut viz. receive Rs. 10,20,30,40,50 or 60 instead of Rs.
100, which was originally due from the borrower. To decide the quantum of
haircut, the expertise of a forensic accountant can be used. Nowadays,start-up
companies are becoming a part of our economic ecosystem. A venture
capitalist invests in these start-up companies based on valuation derived in
part by forensic accountants.

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Emerging Issues in
Accounting
16.6 TYPES OF FRAUDS
The origin of the fraud can be either internal or external. Frauds perpetrated
by employees and owners are referred to as internal frauds, whereas frauds
committed by outsiders viz who are not employees or owners is referred to as
external frauds. The asset misappropriation chart listing most of the probable
frauds is often referred to as fraud tree, the reason being the numerous ways
in which frauds can take place represented by branches of trees. As per the
fraud tree classification, asset misappropriation is subdivided into cash
misappropriation and inventory and all other asset misappropriation.

The Fraud Tree

Asset
Misap Inventory and
propri all other asset
Cash
ation

Larce Skimming Misuse Larcen

ny y
Of cash on hand Asset
Sales Receivabl Refunds requisitions and
es and other transfers
From the deposit
Unrecorded Write-off
schemes False sales and
Other shipping
Understate
d Lapping
Scheme Purchasing and
s Receiving

Unconcealed
Fraudulent Unconcealed
disbursements Larceny

Bailing Payroll Expense Check Register

Schemes Schemes Reimburseme tampering disbursemen
nt schemes ts

Shell Ghost Mischaracterize Forged False voids

compan employees d expenses maker
y

Non- Commission Overstated Forged False

accomplic schemes expenses endorsemen refunds
e vendor t

Personal Workers’ Fictitious Altered

purchases compensation expenses payee

Falsified Multiple Concealed

wages reimburseme checks
nts
Authorized
maker

Figure 16.2 Fraud Tree

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Cash misappropriation is the most common and consist of many ways.Fraud Human Resource
Accounting
involves an intentional deception by the individual's associations with the
business in their capacity as employees, owners, vendors, customers and
anyone else related to the business or unrelated to the business, in order to in
appropriation to obtain money or services or any asset leading to financial
loss to the business. Some of the frauds are standalone frauds committed only
once, whereas some are perpetrated over a period of time. Frauds can be
committed by an individual alone or in collusion with other individuals or
entities. An extensive classification of frauds is done by the Institute of fraud
examiners and is popularly known as the fraud tree.This fraud tree is depicted
in figure 16.2

16.7 FRAUD ORIGIN AND ACCOUNTING

CYCLES
In order to understand the genesis of fraud and how it is perpetuated, let us
briefly discuss the five accounting cycles which are common to the
manufacturing and trading business. These cycles are
1. Sales and Collections/ Receipt Cycle
2. Purchase and Payments (Disbursement)
3. Personnel and Payroll
4. Inventory and warehousing
5. Monthly Reconciliations and Reporting

1. Sales and Collections /Receipt cycle: Sales and collections cycle consists
of making sales and collection of sales proceeds either immediately in
case of cash sales or after a period of sometime depending upon the
credit policy of the firm. This cycle is the most cash incentive cycle out
of the five cycles and most prone to frauds as the employees may have
access to and opportunity to divert customer payments in the absence of
proper internal control.

In the fraud tree classification, the frauds which can play in this cycle are
Larceny, skimming, check tampering & register disbursement. In
addition, frauds can occur through front end frauds also in this cycle. The
common ways in which frauds occur in this cycle are

Theft of cash on hand

 Employee steals the cash out rightly

 Employee uses the cash for his personal use for a period of time and
replaces the same, at the time of reconciliation or make good the
shortfall through a fictitious book entry
Theft of cash Receipts
Theft of cash receipts can be done by
 Skimming
 Larceny
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Emerging Issues in Skimming is the process by which cash is removed from the business
Accounting
before a formal entry of the cash is made in the accounting records. This
is an “off-book” scheme because the cash receipt is neither reported nor
entered in books of accounts. The common skimming schemes are

 Sales scheme
- Unrecorded sales
- Understated sales
 Account Receivables scheme
- Write off schemes
- Lapping schemes
- Unconcealed receivables
 Refund and other schemes
Under the skimming sales scheme, the sales are either unrecorded or
understated. This is true for businesses where the primary mode of
transaction is cash. Detection of theft of cash receipt schemes:

- analysecash receipts and their recording

- analysedeposit slip book
- analysesales account by an employee
- Analysethe gap between receipts from customers and the date the
payments are posted on the customer‟s account.
- Review entries in the books regarding:
Credit to inventory account to conceal unrecorded or understated sales

Write off of inventory due to lost, stolen or obsolete product.

Write off of accounts receivable

 Analysethe relationship between sales and cost of sales, sales and

sales return and allowances on sales.

2. Purchases and Payments (Disbursements) Cycle:

This cycle starts with purchasing of goods and services required by the
organisationand ends with payments for these goods and services.
Through this cycle,many can operate, resulting in fraud. An individual
working with the purchasing department may perpetrate fraud by setting
up a shell company to receive goods misdirected from the company by
false invoices. In case of processing and approving duties are segregated,
individuals can collude to perpetuated fraud? The procurement fraud is
generally a collusive employee–vendor scheme.The employee will
receive a part of gains accruing to the vendor by substituting products
inferior to contract specification, billing for work not computed, shipping
user quantities more than contracted or padding overhead expenses.
Another common, scheme is to raise an overvalued invoice by the
vendor and get it processed by the employee.

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3. Personnel and Payroll Cycle: Human Resource
Accounting
This cycle starts with the hiring of the employee, maintaining and
terminating employees. The main activities involved in the personnel and
payroll cycle is determining salary and benefit amount, monitoring and
approving employee‟s expenses and reimbursement and all other aspects
relating to compensation of employees. The typical fraud schemes
perpetrated in this cycle are:

 Payroll schemes
• Ghost employees
• Commission schemes
• Workers compensation fraud
• Falsified wages scheme
 Expense Reimbursement Scheme
Ghost employees fraud occurs when nonexistent employees or
employees who have left the organisation are added to the payrolls, and
their wages are received by another employee or group of employees
who have colluded to perpetrate the fraud. This kind of fraud is most
likely to occur in large organisations, with many employees coupled with
weak internal controls. This fraud may also occur at remote worksites
like mines, dams, railways etc.

Commission schemes are most likely committed by sales employees or

employees whose remuneration is dependent on achieving certain
targets. To perpetuate this kind of fraud, the employee either manipulates
the target to be achieved or gives an impression of the target being
achieved. For example, to achieve sales target to receive a commission,
sales personnel may execute a bulk of sales on a credit basis which later
turns into either bad debts or sales returns. Another variant of this
scheme is the dumping of products in another sales territory for which
someone else is responsible. Dumping is usually executed by offering
huge discounts, another form of revenue loss.

Workers compensation fraud is committed by falsifying injuries and

attributing them to work conditions, in order to extract insurance
claims/compensation from insurance companies or employers.

Falsified wages scheme involve employees claiming remunerations for

hours not worked and includes falsifying of timesheets and timecards.

An expense reimbursement scheme involves claiming false expenses.

These kinds of schemes are of four types, viz. mischaracterisedexpenses,
overstated expenses, fictitious expenses and multiple expenses. Out of
pocket expenses related to the business are reimbursable, like travel,
lodging and meals. These expenses, when not done for business purpose
but still claimed as business expenses, are referred to as mischaracterised
expenses. In an overstated expense reimbursement scheme, inflated bills
are submitted by modifying expense receipts. Other methods include
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over purchasing and benefiting from refunds and discounts.
Emerging Issues in Sometimes the employee, in whose name expenses are to be reimbursed, may
Accounting
not be involved. However, the person processing the reimbursement may
insert a false claim and process it and pay the actual amount requested to the
employee and pocket the extra expense, which was inserted fraudulently. In a
fictitious reimbursement scheme, an employee request reimbursement for
wholly fictitious expense. In case of multiple reimbursements, employee
requests reimbursement for the same expense multiple times by submitting
claims to different authorities.

16.8 FRAUDULENT FINANCIAL REPORTING

SCHEMES
Over reporting and under-reporting of revenues are the two methods used by
the business depending upon the motivation of the people running the
business. Under-reporting is generally resorted by sole proprietorship firms,
partnership firms and Private Limited Companies with a motive to evade
taxes like GST (previously this constituted of excise duty, sales tax, Value
added tax and various other taxes) and Income tax. Overstatement of
revenues may not strictly be treated as fraud, but it does distort a company‟s
true financial performance in order to exhibit the desired result.Principles
governing recording of revenues are not rigid and flexibility is always
allowed but when this flexibility is exploited to distort the true picture of the
company, revenue reporting abuses occur.

Financial statement frauds would improperly reflect one or more of the

following basic accounting elements viz. assets, liabilities, equity, income
and expense. Since modern day accounting is based on double entry
bookkeeping, misstatement would result in two or more of these basic
elements being misstated.

The following methods are used for overstating revenues

 Accelerating shipments
 Keeping books open in order to record sales often made at the end of the
accounting period
 recognisingtransactions as sales which are not yet sales examples include
consignment sales not yet sold to the end user, sales with a special
condition, certain file and hold transactions, products shipped for trial or
evaluation purpose
 Swaps or round trip trades and related party transactions
 Non-adjustment in gross sales by understatement of returns, discounts
and markdowns
 Fictitious sales
Revenue Recognition Detection Techniques

Variety of techniques can be used to detect anomalies in the revenue

recognition process ranging from inquiry and analytical tests. Some of these
techniques are:

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 Seek information from the marketing, sales and finance Human Resource
Accounting
department,analysehow and when revenue targets were achieved and
critically analysethe sales that occurred near the end of the accounting
period.
 Through cut off testing, determine whether sales were accelerated or
decelerated. This can be found out by
- Examining purchase orders, invoices and shipping documents
- Comparing the billed volumes with shipping volumes
- analysingending inventory
- Examining documents for pre and post dating
- Examining logistics and warehousing documents looking for large
shipments near the period end, significant returns and bill and hold
transactions.
 analyselarge transactions
 Near the end of an accounting period
 With a new customer
 With a related party
 analyse new customers making large purchases
 Confirms physical location of purchasing entity
 Review transactions after the closure of the accounting period for
evidence of invoicing and payment or cancellation or return of goods.
 Seek confirmation from customers regarding volumes, amount, dates and
side agreements and pay.

16.9 IMPROPER REVENUE RECOGNITIONS

Side Agreements: Sales is often made on pre-agreed terms and conditions
and formalisedin terms of the agreement. Managers and executives may
modify, revoke or amend the terms of the sale, without proper
authorisationoutside the recognisedsales process or reporting channels. The
common modifications include purchase return rights, extended credit period,
refund or exchange on return. These modifications may impact revenue
recognitions, viz. there is a probability of advance revenue recognitions if
there is purchase return.

Roundtrip Transactions: Roundtrip transactions are the transactions between

two or more economic entities, and these transactions do not yield and
business or economic benefit for the entities involved. The underlying
motivation for entering into these transactions is to inflate the revenues or
create an appearance of strong sales growth.

Roundtrip transactions may include two-way sales between two companies

for the same amount within a short period of time, or it may involve a loan,
advance or investment in one entity so that the other entity can purchase
goods from the company making loan or investment.

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Emerging Issues in Bill and Hold: Under this scheme, the sale is recorded in books, but delivery
Accounting
and transfer of ownership have not yet occurred as on that date.

Altering Shipping Documentation: Through a false shipping document, a

company may falsely record sales or by altering genuine shipping document
(commonly altering dates or terms of payment), a company can inflate
revenue in a specific accounting period instead of the subsequent accounting
period.

Agreement to „Sell Through‟ Product - In this scheme, sale agreements

include contingent terms which are based on the future performance of the
buyer (commonly distributors and resellers). To understand this, suppose
company A sells to distributors B & C goods with the condition that B & C
will make payment only when they have further sold the goods. Now
company A books the sale the moment goods are transferred to B & C. This
will increase the sales figures through no actual sales have been made to
customer or end user. These agreements are similar to consignment sales. A
sale should not be recorded until the goods are sold to a third party with no
additional contingent sales term.

Upfront fees – Some sale transaction requires the customer to pay upfront
consideration for services that would be provided over a period of time
spanning over several accounting periods. In order to manipulate earnings,
companies recognisethese fees as revenue soon as the transactions are entered
into and sometimes even indulge in falsification or modification of
accounting records. A prudent approach, in this case, would be to
recogniseonly the revenue for the services provided in the specific accounting
period.

Holding, Accounting periods Open: Accounting periods are well defined

under the various acts, but the companies in order to show better results, keep
the books open, to include transactions that happen after the accounting
period. This scheme commonly involves recording sales, cash receipts etc.
That occurs after the end of the reporting period. This scheme is often
operated either by falsification or modification of accounting documents like
the date on shipping documents, purchase orders, bank statements, cash
reconciliations, cash receipts, journals etc.

Non-recording of sales provision or allowances: Some sales transactions

include a provision of return of purchased goods by the purchaser companies
shall create provisions for these kinds of transactions to reduce gross sales to
account for future sales return. By failing to create provision for sales return,
companies can overstate revenues. This scheme is operated by falsification or
modification of documents on which accounting entries are made.

 Inventory Schemes :

Inflating/deflating the value of inventory - Inventory valuation can be

manipulated in a number of ways, depending on the motive involved. If tax
evasion avoidance is the motive, inventories would be undervalued.
Inventories would be overvalued to show inventory gains, and if inventories
are kept as collateral for bank loans, the motive would be to avail a higher
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loan amount. The common ways in which inventory value is manipulated are Human Resource
Accounting
moving inventories between locations to fictitiously inflate/deflate inventory
quantities, postponing/ propounding, and under/over reporting of write-offs
and reserves for obsolesce, manipulating unit valuation and improper
inventory capitalisation.

 Of site or Fictitious Inventory:

Companies may create /destroy inventory by falsifying journal entries,

receiving and shipping reports, purchase orders, sales invoices. Companies
indulge in these schemes to decrease/increase the cost of sales as a
percentage of sales.

16.10 OTHER FINANCIAL REPORTING

SCHEMES
Fraudulent Audit Confirmation: Audit confirmation gives assurance to the
stakeholder regarding the authenticity of financial statements. However, a
large part of the audit confirmation is based on the records and information
provided by the company even in case of sales, cash, accounts receivables,
debt and liabilities where third party confirmation is obtained by the auditor,
is not an assurance that factual information will be provided by third parties
as they may act in collusion with the company.

Refreshed Receivables: As a prudent practice, companies need to make

provisions for bad and doubtful receivables (debts owed to them), but in
order to avoid making provisions and write-offs which decreases profits,
companies refresh the ageing (old) receivables and improperly represent them
as receivables which are current in natures. This scheme operates by crediting
the receivable account of the customer and allowed to repurchase goods on
credit. In this scheme, no physical transfer of goods takes place. Other
methods used in the schemes are modification of dates of invoices in the
account receivable system, which results in a restart of the ageing process in
receivables.

Promotional Allowance Manipulations: Sellers often provide rebates,

incentives or other credit to customers to purchase products in volume. These
incentives can be in the form of volume discounts, reimbursement for special
handling, co-advertising reimbursement, slotting fuss etc.

These incentives are based on sales going to be achieved in future, and to

decide on the quantum of these incentives, certain estimates are to be made.
These estimates can be manipulated or biased. When the company operates a
promotional allowance scheme, there are chances of early recognitions of
revenue or taking into consideration the cost of rebates or credits to be given
to the buyer resulting in inflated sales figures.

Off-Balance sheet entities and Liabilities: When companies borrow funds

through off balance sheet entities or special purpose entities, so that these
borrowed funds are not reflected on the company‟s balance sheet. However,
some schemes are designed in a way to conceal debt and misstate liabilities
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Emerging Issues in on the balance sheet. Concealment of debt also hasan impact on the income
Accounting
statement as the concealed debt has to be serviced. Since liability is not on
the balance sheet, therefore, on interest is also charged to the income
statement thereby inflating the profits.

Improper Asset Valuation capitalisationof Expenses: Financial statements are

supposed to provide a true and fair picture of the state of affairs of the
company. Improper treatment of expenses can lead to an increase in assets if
the revenue expenses are treated as capital expenses leading to inflated
profits. Apart from this,ghost debtor‟s scheme is also used to inflate the asset
side and simultaneously siphon off the money from the company.

Phoney investment deals: These schemes are designed to inflate assets and
earnings. They operate by deliberately overstating existing investments or
creating fictitious investment accounts. Investments can also be intentionally
misclassified, leading to improper recognition of gains or failure to
recogniselosses. These schemes are also used to hide or defer losses arising
from sales or permanent write down from impairments.

Adding back outstanding cheque to cash: In order to inflate the ending cash
balance of an accounting period, outstanding cheques may be added to cash
balances or the cheques issued but not mailed or presented to the bank by the
counterparty can also be added to the cash balance & Intercompany
manipulations unjustified consolidation entries: Nowadays, most of the
companies operate through subsidiaries and other companies in which they
have controlling stakes. In preparation of final accounts of holding company
account of subsidiaries and subsidiary companies, the accounts have to be
consolidated during the financial closing. Sometimes unjustified or fictitious
consolidation entries are passed with limited accounting documentation or
explanation. These schemes are operated to over /under state various balances
or legitimisefictitious transactions.
Related Parties transactions and Disclosure Frauds: Related parties
transactions are to be disclosed in a fair and transparent manner. This
includes when related party transactions are done with an attempt to create
fictitious transactions with the intent to increase reported revenues or assets.

16.11 IT TOOLS FOR FRAUD DETECTION

Now a day‟s most of the financial transactions are done through electronic
devices, and authorisationfor these transactions is also more or less in
electronic form. “Forensic computing is the process of identifying,
preserving, analysingand presenting digital evidence in a manner that is
legally acceptable in the court of law”. For this purpose, many IT tools and
softwares are used. Some of these softwares commonly used are as follows:

Helix is software based on Knoppix (a variant of Linux) which is used to

acquire forensically sound images of hard drives and hard drive partitions of
systems.

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ACL Desktop, also known as Audit Command Language, is a tool to read Human Resource
Accounting
and analysevarious types of tiles scattered across multiple databases on
different platforms. A unique feature of ACL is its ability to maintain data
integrity as its method of accessing the data is read-only access. Due to this
feature, source data is never changed, altered or deleted.

Ultra Block is forensic write blocker hardware that prevents modification in

data accessed for forensic accounting. Since the authenticity of data is very
important in case of data being submitted to a court of law as evidence use of
ultra block hardware prevents the data from being modified or altered when
the data is accessed and analysed.

Password kit forensic is a tool to find all the password protected items on a
computer system and gain access to these items using decryption and
password recovery algorithms.

Categorisation of Fraud Detection Methods

Chance
Detection
Non-Technology
Based Hotline-
Based
Tip Received
Fraud
Fortuitous
Detection
Tip
Discovery
Computerized
Sampling
(Traditional)
Technology Methods
Financial
Based
Statement
Analysis ‘Bad Guy’
Lists
Strategic
Behavioural
Methods People
Analysis Data Mining
Focused
Software
Inductive
Transaction
Analysis
Focused Digital Analysis
(Benford’s
Law)
Deductive
Analysis Strategic
Fraud
Detection

16.12 METHODS O F FRAUD DETECTION

There are two main methods used to detect fraud which is supervised and
unsupervised.

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Emerging Issues in 1. Supervised Method: In this method, fraud detection is based on the
Accounting
dynamics of the previous frauds committed. This method makes use of
prior data and information. The prior data and information, also called
labelled information, consists of both genuine and fraudulent
transactions. Based on prior data, models are constructed and trained to
discriminate between genuine and fraudulent transactions. The basic
assumption of these models is that the pattern of past frauds will persist
for the present and future also.

Since this method is based on the fraud structure of the past events, this
method may not work due to over fitting to the training dataset or
unknown fraud types. The robustness of these methods also comes into
question during extension, re-utilisationand adaptation. For this system
to be dynamically extendable and adjustable new information must be
fed into the model and retrained. Another drawback of this method is the
uneven class size of legitimate and fraudulent transactions. The
legitimate transactions outnumber the fraudulent transaction, and
according to some studies, about 0.08 percent of observed transactions
are fraudulent. Now, if this method classifies all fraudulent transactions
as genuine, the error rate is going to be minuscule which can be
misleading.

2. Unsupervised Methods: These methods are based on the identification of

outliers which are detected through data mining techniques. Change in
behaviour and frequency of transaction is detected by suspicion scoring
systems which are based on the if-then type of outlier rules. These rules
are based on experiential knowledge. When the pattern in data does not
conform to the expected pattern or some anomalous data pattern is
detected, it is an indication for further probe. The criteria to detect
outliers are not fixed but may change for various reasons such as cost
and efficiency. This method is similar to the human‟s cognitive decision
process, enabling the auditor‟s to understand the process and adjust the
model if necessary.

The results generated by the unsupervised method are not direct evidence
of any fraud, but they merely tell that the flagged transactions do not fit
into the data pattern, which may be either due to error or fraud.

16.13 FORENSIC AUDIT TECHNIQUES:

A normal financial audit confirms that the financial statements gave a true
and fair picture of the state of affairs of the company and complied with all
cable laws and accounting policies. During the course of the audit, auditors
may come across transactions that are not normal in nature or are not backed
with sufficient documentary evidence. To investigate these anomalies,
forensic audit is done. Some of the techniques involved in forensic auditing
to examine the frauds are:

1. Testing Internal Controls: Most organisations have internal controls in

place, but there are certain weak links that are exploited by the fraudsters
to commit fraud. A good initial forensic auditing technique is to
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 understand and analyse the internal controls of an organisation and find Human Resource
Accounting
possible ways to circumvent the controls. This will give a fair idea to the
auditor of the possible path of the fraudster.

2. Trend Analysis: Most of the companies grow at a normal rate, and the
various transactions required to accomplish the business task also exhibit
a certain trend. Sudden spikes and troughs in the trend of these variables
indicate something unusual and are worth investigating. During the
forensic investigation, the auditor should review the organisation's
historical norms and analyse the outlier events in the context of historical
norms.

3. Digital Forensic Examination: Digital forensic examination is one of the

most important techniques for fraud investigation as digital trails are
difficult to cover up and manipulate. A close scrutiny of phone logs,
official emails, accounting records and company databases will uncover
many hidden facts. A digital forensic examination is quite a compelling
job and may require the assistance of computer and database specialists
to assist the accounting and financial auditor.

4. Face to Face Interview: It is always a good idea to understand

organisational dynamics and the process dynamics before undertaking a
forensic audit. Face to face interview with the executives and managers
is an effective tool to accomplish this. The information provided by them
can direct the audit in the right direction. Most of them would have
information about the event and have a perspective without being
directly connected to the event/ fraud.

5. Full Financial Audit: Before commencing forensic audit, it is important

to conduct a full financial and accounting audit which involves bank
statement reconciliations, scrutiny of vendor contracts and payment,
verification of sales and purchase, review of tax returns and other filings
with the public authorities. The findings of the financial audit give a lead
to forensic auditors to identify suspicious transactions and trace them
back to potential perpetrators.

6. Application of Benford‟s Law: Benford‟s law is a mathematical tool to

determine whether the variable under study (suspicious transactions) is a
case of unintentional error or fraud. The basic premise on which this law
operates is that fabricated figures (an indicator of fraud) possess a
different pattern from random figures which are generated from normal
business transactions.

Once a series of transactions is identified as suspected transactions, the

left-most digit of the figure is extracted of all transactions of that
particular variable and summarisedfor the entire population. Next, the
observed count percentage of the left-most digit is calculated and then
Benford‟s set is applied to carry out a parametric test known as the Z
test, which is used to determine whether two population means are
different when the variances are known, and the sample size is large.
Here the two population sets are Benford‟s percentage numbers for the
first digit and observed numbers for the first digit. 419
Emerging Issues in If the observed data confirms the percentage of Benford‟s law, it implies
Accounting
that the observed data is Benford set, and there is a 68% chance of no
error or fraud. Similar sets had been developed by Benford for 2, 3 and
last digit as well.
This method can be used for the analysis of credit card transactions,
purchase orders, loan sanctioning authority to sanction loans below Rs.
5,00,000 and any amount above that has to be referred to the circle
office. Looking just below the approval threshold provides a potential to
discover loan fraud. If the loan fraud is being perpetuated, it would be
interesting to observe first figure 4 and first two figures 49, and their
repeated occurrence may signal potential fraud. Taking another example
where any purchase above Rs. 35,000 would require a purchase order.
Here too, looking at the first figure 3 and the second figure 4 can reveal
any anomalies, manipulations or fraud involving this cut-off.
7. Theory of Relative Size Factor (RSF): The application of this theory can
highlight unusual fluctuations in the data series under observation, and
these unusual fluctuations than can be further analysed to determine
whether unusual fluctuation is genuine error or fraud. RSF is the ratio of
the largest number to the second largest number in the data series. In
practice, there exist certain limits for each entity, such as vendors,
customers and employees. These limits may be pre-defined based on
historical data or may be derived from the available data. Based on these
limits, stray cases that are way beyond the normal range shall be
investigated further for the detection of anomalies or outliers. The values
that fall outside the pre-defined range are suspected to be either fraud or
error. These values need to be correlated with other variables to find the
relationship and classify them as either error or fraud
8. Computer-Assisted Auditing Tools: These audit tools (softwares) are
designed to access data of audit significance from client‟s information
system without depending on the client‟s accounting personnel. Since
these are automated tools, the chances of data manipulation are minimal
until and unless the information system itself is needed with manipulated
data. These tools are capable of :
 Testing details of transactions and balances
 Identifying inconsistencies or significant fluctuations
 Testing general as well as application controls of computer
systems(Data security and integrity)
 Extracting sample data for audit verification
 Re calculation of calculations done by clients computer
9. Data Analysis Ratios: Financial ratios indicate the financial health of a
company similarly, data analysis ratios for key numeric fields provides
an indication of the fraud health by analysing and identifying possible
symptoms of fraud. Commonly used ratios are
 The ratio of highest value to the lowest value
 The ratio of the highest to the second highest value
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  The ratio of the current year to the previous year. Human Resource
Accounting
The variables used in the ratio can be costs, production, the volume of
sales, labour hours, expenses under various heads etc.
10. Beneish Ratios: These ratios are used to distinguish between fraudulent
financial reports and non manipulated financial reports.The following
ratios are used.
 Days‟ sales in receivable index
(Accounts receivable in time t/sales in time t)/ (Accounts receivable in
time t-1/sales in time t-1)
In the case of manipulators, this index would be near 1.465, whereas in
the case of non-manipulators, the mean index is going to be 1.031
 Gross Margin Index
(Gross margin in time t-1/Sales in time t-1)/(Gross margin in time t/Sales
in time t)
In the case of manipulators, this index would be near 1.193, whereas in
the case of non-manipulators, the mean index is going to be 1.014
 Asset quality index
{(current assets in time t +Net fixed assets in time t)/(total assets in time
t)}/ {(current assets in time t-1 +Net fixed assets in time t-1)/(total assets
in time t-1)}
In the case of manipulators, this index would be near 1.254, whereas in
the case of non-manipulators, the mean index is going to be 1.039
 Sales Index
Sales in time t/ sales in time t-1
In the case of manipulators, this index would be near 1.607, whereas in
the case of non-manipulators, the mean index is going to be 1.134

16.14 SUMMARY
The last few decades have seen frauds of severe magnitude resulting in loss
of billions of dollars and loss of investors‟ confidence. The techniques used
to get to the bottom of the fraud schemes, investigations and preparation of
evidence suitable for a court of law are collectively referred to as forensic
accounting. Forensic accounting is a multidisciplinary field requiring the
application of skills for many fields like accountancy, computers and law.
The fraud triangle specifies the conditions which if present, can lead to fraud.
The applications of forensic accounting are wide-ranging and are just not
confined to companies. Corporate frauds have been extensively classified,
and this classification is popularly referred to as fraud tree.Apart from the
frauds happening in the normal functioning of the business, fraudulent
financial statements is also a major fraud.

421
Emerging Issues in
Accounting
16.15 SELF-ASSESSMENT QUESTIONS.
1. What is forensic accounting? Provide an overview of recent corporate
frauds.
2. What do you understand by the fraud triangle?
3. In the context of Fraud Triangle explain the role of pressure and
opportunity in perpetuating fraud.
4. Discuss the major corporate frauds of the last two decades.
5. Explain the application of forensic accounting.
6. What are the various types of frauds? How are they classified under
fraud tree?
7. What kind of frauds can occur in the sales and receipt cycle?
8. Explain the potential of fraud occurrence in Personnel and Payroll cycle.
9. What do you understand by fraudulent financial reporting scheme?
10. What are the IT tools used for fraud detection?
11. Explain the various forensic audit techniques.

REFERENCES
Handbook of Forensic Accounting and Fraud Prevention, Global Forensic
Audit & Investigation (A Division of Meridien Business Consultants Pvt.
Ltd.)

Reverink Arjan (2016): Financial Fraud: A Literature Review, MPIFG

Discussion Paper, No. 165, Max Planck Institute for the study of societies,
cologne.

Pedneault Stephen, Rudewicz Frank, Sheetz Michael & Silverstone Howard

(2012), Forensic Accounting and Fraud Investigation, John Wiley & Sons,
Inc.

Golden W. Thomas, Skalak L. Steven, Clayton M. Mona, Pill S. Jessica

(2011) A guide to Forensic Accounting Investigation, 2dn ed Price water
House Coopers & John Wiley & Sons Inc., Hoboken, New Jersey.

Fraud A guide to its prevention, detection and investigation, Price water

house Coopers, Australia.

Sample listing of fraud schemes (2009), Deloitte Touche Tohmatsu India

Private Limited.

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