Category: Accounting Profession Issues and Trends

Money Laundering and Frauds - Changing Expectations From Accountants

SAFA conference at Goa, India / December 2001

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Money Laundering and Frauds - Changing Expectations From Accountants

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1. INTRODUCTION
The accountancy profession acknowledges that it must first and foremost serve the public interest. Unfortunately, the public interest may not feel that way. Whether real or imagined, there is a gap between what the profession feels it does and what the publics feel it should do. As is a result, considerable effort has been expended by the profession to close this gap. The profession points to its standards but at times the public appears oblivious to what these standards are. Are the public expectations realistic? And do they relate to inadequate standards or inadequate performances or inadequate communication. What are the ramifications of an over-regulated profession and can such professions carry out its proper role in the capital markets.

One of the consequences of the expectation gap is the increasing exposure of auditors to prohibitive law suits. While this may satisfy plaintiffs, the level of claims has a number of consequences that can have far reaching effects beyond the audit profession. Evidence suggests that qualified individuals no longer find, auditing an attractive career, some firms are foregoing audit services altogether and certain companies in a start-up venture cannot find an auditor. Additionally insurance coverage is much harder to obtain and the cost is much higher to maintain. It is also a fact that accountancy profession has always been reactive to societal demands created sometimes by new economic order and sometimes by professional failures. For instance, audit episode like American salad swindle in the sixtees heightened the cause for more definitive and vigorous accounting and auditing standards on both sides of the Atlantic specially in the case of frauds. Again in the ninetees, fraud and money laundering activities leading to the fall of BCCI international. Maxwell Corporation, Lonhro etc prompted the legislators in UK to inact law against money laundering and the profession to issue guidance for Chartered Accountants on such activity. More specifically the profession responded in the following areas:

* Audit report standards;
* Harmonization of accounting standards and elimination of possible options.
* Consideration on auditor's role in the case of going concern and internal control, detection of fraud, monitoring of compliance with legal and environmental obligations.
* Financial communication, both in terms of contents and techniques.
* Auditing and corporate governance

The 21st Century will be marked with border-less and paperless business world. Information can now be exchanged both quickly and cheaply using online services and business transactions have been greatly facilitated through the use of digital technologies. The Asia Pacific region, in particular is experiencing enormous growth in all forms of online services and both business and government are now making extensive use of Internet. The large population of this region has been a general factor for the rapid development of e-commerce in this region in the near future.

However, experts believe that misuse of online technologies for financial gain may grow at a correspondingly rapid rate. Already Internet related frauds have become almost epidemic in US and EU and it is likely that the phenomenon will soon engulf the Asia-pacific region. Considering the seriousness of the issue CAPA in November, 2000 commissioned the Australian Institute of Criminology to assess the scale of the problem and the range of possible solutions to undertake a study of Internet related fraud as it effects business and government organizations in the Asia Pacific region. It is heartening to note that the study report has been out in October, 2001.

2. DEFINITIONS
2.1 Money Laundering

Money laundering is the process by which criminals attempt to conceal the true origin and ownership of their criminal activities. If undertaken successfully, it also allows them to maintain control over those proceeds and ultimately to provide a legitimate cover for their source of funds. Their dirty funds appear clean. It is generally linked with money required to finance cross border drug traffickings, arms deal or tax evasion or other similar crimes.

2.2 Fraud
The term fraud may be defined as intentional misrepresentation of financial information by one or more individuals among management, employees or third parties. Fraud may involve:

* Falsification or alteration of accounting records or other documents
* Misappropriation of assets or theft;
* Suppression or omission of the effects of transactions from records or documents.
* Recording of transactions without substances.
* Intentional misapplication of accounting policies or
* Willful misrepresentations of transactions or of the entity's state of affairs.

3.SOME DANGER SIGNALS
3.1 Money Laundering

* The secretive client. The client who is reluctant to provide details of identity and background or who is over plausible.
* Untypical instructions: The client who has obvious reason for using a particular firm.
* Lack of economic purpose: The client's transaction lacks or includes steps, which lack any obvious economic purpose. Or perhaps it involves a structure which appears unnecessarily complicated to achieve the declared purpose i.e subsidiaries, branches, trusts or nominees when there is no commercial justification.
* Nominees and trusts behind the fund management, transfer, disposition etc.
* Holding client's assets without convincing reason.
* Suspect territory i. e. country where drug production or trafficking may be prevalent.

Criminals need the same services as legitimate clients. They need audit services and a whole range of financial, tax and business advice. Even unwitting involvement in money laundering can put a firm at risk and to reduce the risk of involvement in money laundering, there are a number of procedures which every firm can follow:

* Identification: obtaining evidence of the identity of prospective clients.
* Records: Keeping records of identity documents and of transactions.
* Reporting: Ensuring that all suspicions of money laundering are reported to the appropriate authorities.
* Training. Training partners and staff, especially on how to recognize suspicious transactions and to investigate successfully i.e. forensic accounting.

3.2 Financial frauds:

The intent in a financial fraud is to divert or misdirect assets or information, while preventing the disclosure of fraud. These two requirements often cause a trail of irregularities to be left behind. These irregularities may serve to alert the astute, determined accountant, investigator, or manager.

The following are potential fraud indicators:

i.Excessive changes in accounting principles or disregard for Generally Accepted Accounting
Principles (GAAP).

ii.Excessive or unjustified changes in accounting personnel may be an attempt to prevent
employees from learning too much.

iii.The refusal/failure to allow an independent audit or subtle attempts to direct the audit or
investigation may indicate and attempt to hide problems.

iv.The excessive destruction of controlled documents should not occur, although error is often
given as the excuse. Be alert for out of sequence invoices in files or unnumbered invoices
where serial numbering is the rule. Possibilities include stolen or counterfeited documents.

v.An excessive number of photocopies of invoices in files should lead to further inquiry. It is a
simple matter to alter approved invoices with "white-out" or similar correction fluid and
copy the invoice, destroying the original. The attempt may be to manipulate the audit trail
or commit the fraud via the alternation. Secure external and internal copies for comparison.
Duplicate copies of supplier invoices could also indicate the possibility of multiple
payments of the same invoice with the checks diverted.

vi.Excessive business checks to cash or individuals. Although some checks to cash and
individuals may be necessary for convenience, an excessive percentage is questionable, since
businesses do business with one another, and checks made directly payable to the intended
party are a better receipt. When such checks show second endorsement they are highly
suspect.
vii.A pattern of second endorsements on payroll checks may indicate the normal practice of a
business cashing its employees salary checks, etc. However, it may also indicate cash
schemes or other illicit activity.

A typical second endorsement scheme involves endorsing a fictitious employees paycheck and issuing cash. Another variation involves paying a check in a certain amount, e.g. $500, for the purchase of material that will cost less, e.g. $200. The recipient endorses the check and returns it to the issuer, who gives the recipient the agreed upon lesser sum, e.g. $200. The cancelled check will be for the larger amount, and the cash voucher or disbursements book will show the larger amount going out, e.g. $500. The net result is evidence of paying a certain amount, while allowing the businessman or employee to pocket $300.

viii. Periodic or excessive conversion of cash for exchange items may be part of scheme to divert
assets and hide trails. (Exchange items include cashier's checks, money orders, etc.)

ix. Excessive cash transactions are a poor business practice, Like item 6, the question is why?

x.If assets are sold or transferred for what appears to be less than adequate consideration this may indicate a sham transaction with no economic reality. Businesses exist to make a profit and anything in contravention of this goal should be questioned.

xi.Assets are sold but possession is maintained. A real sale or a sham transaction? More than a buyer seller relationship?

xii.Post-dated checks are a possible indication of cash flow problems, or a check fraud.

xiii. Lack of sufficient vouchers and supporting documents indicate that purchases may not
have actually occurred or that merchandise may have been stolen.

xiv.Excessive bad debt write-offs may indicate a scheme for an employee to split kickbacks with
a co-conspirator on the outside.

xv.Excessive spoilage/damaged goods may indicate a scheme between certain employees and
purchasers/shippers similar to the bad debt write-off.

xvi.Excessive or unpaid loans to non-critical employees should be very carefully examined, for
they may not be loans. Documents attesting the character of the payments as a loan, even to
officers, are inadequate where fraud is suspected. All the documentation would be there.
Look for the history of repayment.

xvii. Encumbrances and liens shortly before bankruptcy could indicate the possibility of
planned or fraudulent bankruptcy.




xviii. Excessive or insufficient freight expense relative to inventory purchased or to sales may indicate that purchases have been paid through means not reflected on the books or inventory purchased or sales made for unrecorded cash. This may also indicate the possibility of diverted assets and/or a hidden operation by management or employees.

xix. Where inventory is a material income-producing item, concern should arise when component ratios are out of acceptable limits.
e.g. Significant increase in power consumption in a manufacturing facility without a corresponding increase in production or revenue. This type of observation would apply to other ratios that are out of line with past history or industry norms, gross profit ration, etc.

xx. Failure to reconcile bank statements or a conflict of the duties on the part of the person performing the reconciliation.

xxi. An excessive number of checking accounts without a true business purpose could possibly indicate good loan and/or out-of-town cash management techniques of paying from a distant bank, or it may indicate check-kiting scheme. For the later, cash reconciliation is a must.

xxii. An excessive number of employees relative to production or a change in employees without a corresponding need/revenue increase is possibly indicative of a ghost payroll scheme for generating cash. It may be a fraud against a customer or government where contract terms call for "cost plus".

xxiii. Business dealings with no apparent economic purpose are out of the ordinary, since business exist to make a profit. Deals with companies with little or no economic viability fall in the suspect category.

xxiv. Excessive/questionable dealings with subsidiaries should alert the auditor or investigator to the possibility of questionable expenses being passed along and/or the use of payables to free up cash, etc. It also may be an attempt to generate the appearance of revenue.

xxv. Use of management fronts, such as interlocking directorates, alter-egos, etc., to conceal true ownership control and thus conceal organisational conflicts of interest.

xxvi. Inappropriate trends in relation to other events, such as a decline in the number of quality control inspectors when a large contract is received should be questioned.

xxvii. A significant lack of internal controls may indicate that a questionable practice is being hidden. Remember that one of the basic rules is that businesses exist to earn a profit. Look for actions counter to this goal.

xxviii. The lack of competitive bidding may hide kickbacks or conflict of interest situations.

xxix. Questionable and significant changes in key financial ratios indicate potential problems.


4. THEORIES OF FRAUD

A number of theoretical models have been constructed in the past in an attempt to explain why people commit fraud. Some of the key characteristics of recent models include the following:


* A perceived opportunity such as the absence of or circumvention of controls that enable fraud to be prevented or detected.
* An offender with a motivation to steal money, whether through cupidity, living beyond one's means, the existence of debts some times associated with drug or gambling addiction, presence of a financial crisis or various work related pressures.
* The presence of a rationalisation for acting illegally, such as belief that the victim can afford the loss, that the funds stolen will be repaid or that the money will be used for a good purpose by the offender; and finally.
* The absence of a capable guardian, whether through proper business administration, lack of fraud prevention resources or the absence of an effective police service or regulatory authority.

In the case of economic commerce related fraud, motivations and rationalisations remain much the same as in other case of conventional fraud, However, growth of e-commerce has created money opportunities, sometimes due to fraud prevention measures being overlooked or flaws that exist in the technological framework that support these new business models.

Furthermore, capable guardians are often absent or less effective in the online world whose transactions take place across borders, police and regulators may be unfamiliar with the technology or inadequately funded to conduct investigations and sanctions rarely imposed.

5. MAGNITUDE OF FRAUDS

5.1. General

The following statistics about fraud and white-collar crime are from the Association of Certified Fraud Examiners (US) report:

* Fraud and abuse costs US organisations more than $400 billion annually.
* The average organisation loses more than $9 per day per employee to fraud and abuse.
* The average organisations lose about 6% of its total annual revenue to fraud and abuse committed by its own employees.
* The median loss caused by mails is about $185000; by females about $48000 and thus men commit nearly 75% of the offenses.
* Losses caused by managers are four times those caused by employees.
* Median losses caused by executives are 16 times those of their employees
* The highest median losses occur in the real estate financing sector.
* Occupational fraud and abuses fall into these main categories; asset misappropriation, fraudulent statements and bribery and corruption.

5.2. Internet frauds

In carrying out an assessment of the scope of Interest fraud arising out of electronic commerce, the problem of under reporting of incidents needs to be appreciated. Often when organisations have been victimised through fraud, managers are reluctant to report the matter to the police or otherwise to seek official redress KPMG (1999), for example, found in its survey of business fraud that 33.3% of organisations surveyed failed to report frauds to the police. Business are reluctant to report fraud simply to avoid