Forensic AuditCase studies

ICAI Vadodara 2013

Chetan Dalal

A WARM WELCOME TO ALL

Thank you to Vadodara Branch and members of ICAI

From Chetan Dalal

Very Important to remember: All case studies / exhibits / example are

adaptations of real life situations, and any resemblance or use of any name, logo or symbol of any entity is purely for academic purposes and to facilitate better understanding. Case studies discussed in the seminar are imaginery and at no point is there any direct or indirect implication of fraud in or by any entity referred to anywhere.

Agenda1. Forensic Audit: introduction and traits of a

forensic accountant and forensic accounting and examples of some unusual frauds in business world

2. Fraud and manipulations in excel reports3. Simple forensic tests which can be

conveniently used to detect fraud4. Red flags and early warning bells of

possible fraud5. Unusual methods of investigating

1. FORENSIC AUDIT: WHAT IT MEANS AND WHAT ARE THE TRAITS OF A GOOD FORENSIC ACCOUNTANT OR AUDITOR?

Forensic accounting is the specialty practice area of accountancy that describes engagements that result from actual or anticipated disputes or litigation. "Forensic" means "suitable for use in a court of law", and it is to that standard and potential outcome that forensic accountants generally have to work.

Forensic accountants, also referred to as forensic auditors or investigative auditors, often have to give expert evidence at the eventual trial.

Forensic Audit- Technical definition-Wikipedia, the free encyclopedia

Forensic Audit is all about examination and collection of evidence admissible in a court of law. It utilizes the following skills of CAs-

-Accounting-Auditing

-Investigating

What distinguishes a forensic audit from a normal audit? Forensic audit is issue based or related to a specific

problem It has several components and could include any or

all of the following:- Financial and accounting review- Digital forensic analysis- Field investigations - Data mining at an advanced level- Application of Interviewing skills- Technical assistance such as handwriting, specimen

signatires, QC evaluation etc

Audit relies on documentary evidence, whereas a forensic audit actually examines the reliability of documentary evidence itself

Forensic accounting emphasizes the need to look for other evidence available as well.

For example a bank manager committing suicide on desk with a suicide note under his hand

The most important traits of an investigator

Distrust the Obvious Think differently and Develop an open

mind Look from different angles and all sides.

You will get a different revelation

Common reasons why fraud goes unnoticed and forensic audits are needed

1. Fraudsters/ deceivers are Intelligent 2. Technology 3. Stale procedures syndrome4. Lack of perseverance

Use of desktop internet investigation (useful in audit too)

Use of the theory of impossibility and absurdity to detect fraud.

If an investigator habitually applies these his success rate will increase phenomenally.

Two facets which are applicable to all investigations

This is a technique you must use to conduct verifications, research and information regarding vendors, products, third parties, and almost anything you are auditing or investigating

Do this as frequently as possible to spot forgeries or establish the authenticity of third parties, entities, documents such as invoices, letters, agreements, wills, old records, title deeds, letters of guarantee, LCs, and on rare occasions forgeries in passports, treasury bonds, fixed deposit receipts from banks etc

Concept of desktop audit and investigation

Apply the theory of absurdity and impossibility When you identify what is not possible or

very unlikely, the fallacy or deceit in given submissions will be exposed.

Also, in investigations evidence is often destroyed or changed or altered or hidden. To find the supporting evidence is therefore practically difficult.

Make it a habit to think of what is not possible or impossible or unreasonable

2. MANIPULATIONS AND FRAUD IN SPREADSHEETSExample using Excel Sheets

An illustration of presentation fraud in a spreadsheet

Consider a spreadsheet containing some data of two years’ comparisons

The CEO wanted to show a good performance….Excel-Book1_cd.xlsx

Excel Forensic.xls Star-Contest-Result.xlsx

3. SOME SIMPLE FORENSIC TESTS- Juxtaposition test for testing authenticity of

documents format and content - Test of reasonableness or absurdity- Test of replication of content - Test of impossibility- Scrutiny of suspicious documents particularly those

having alterations

Test of IMPOSSIBILITY: identify events which are not possible and check them outFor example: Can be applied on volume of

stocks in a warehouse or production with actual machine capacity

Scrutiny of Alterations and suspicious documents or

large value cash paymentsForensic study of alterations – try and discern consistency of cancellations,

smudges, spaces and overwritings

In simple words it means placing side by side for comparison and spotting differences, where there should be none. This can be very effective in spotting manipulations

Juxtaposition test

Where would one apply the juxtaposition test?

Document comparisons: Contracts agreements – copies lying with different departments

Vendor letterheads, bills and letter formats- all bidders’s documents and search for common addresses, telephone numbers, fax numbers, fax/tel numbers, email addresses?

HR frauds- Juxtapose degree certificates, signatures on certificates, multiple reference letters, etc

Fictitious Expense or purchase bills. Juxtapose bills from large volume vendors

Documents lying in multiple departments- eg copies of minutes of meetings or letters or memoes issued to different departments

Signatures on important documents –

Test of absurdity or reasonableness

Think of events which may be possible but not probable. Can a

person arrive and depart at exactly the same time every day ? If

smart/swipe card analysis shows such a pattern it is likely to be a

phantom employee

4. EARLY WARNING BELLS AND RED FLAGS

Close nexus with suppliers, customers and third parties Missing records, details, etc Discrepancies in inventories, cash, and assets Behavioural indicators- chronic late sitting, arrogance and

known bad habits like gambling, alcoholic traits etc Too much of power and authority in one or few individuals Mismatch between standard of living and known sources of

income Arrears and sloppiness in bookkeeping, reconciliations etc

Common accounting manipulations likely in Cash Contras Stock in transit Accounting favours to debtors Non reversal of stale cheques to create

secret reserves Not redepositing unpaid cash expenses

such as wages, reimbursements etc Recycling of petty cash advances or IOUs

Bombay Br Delhi Br Kolkatta Chennai BOM-ser Lucknow Pune

Purchases 2076689 1427286 1041919 1972854 1017578 1723652 1993621

Staff Recruitment & Training 576109 501215 365887 547304 282293.4 553065

Travelling Exp - Foreign 493068 428969 313147 468415 241603.3 409246 473345

Repairs & Maint 437968 381032 278153 875936 214604.3 363513 420449Printing & Stationery 379100 329817 240766 360145 185759 314653 363936

Travelling Exps 301765 262536 191651 286677 147864.9 250465 289694

Tel / Mobile / Internet 116954 101750 74277.5 111106 57307.46 97071.8 112276

Electricity Charges 120000 104400 76212 114000 58800 99600 115200

Communication - FBT 106953 93049.1 67925.9 101605 52406.97 88771 102675

Discounts given 105873 92109.5 67239.9 100579 109023 87874.6 101638

Discounts on sales 206902 180005 131403 196557 101382 171729 198626

Vehicle Running & Main - R 249529 217090 158476 237053 122269.2 239548

Subscription Charges 143399 124757 91072.7 136229 70265.51 119021 137663Funds transferred- Kolkatta 250000

Funds transferred- Pune 50000Funds transferred- Chennai 125000

Funds transferred- Delhi 1437477Stock in transit to Kolkatta 500000

Security Charges 139543 121402 88623.8 132566 68376.07 115821 133961

stocks in transit 209488 182255 133046 199014 102649.1 173875 201108

Stock in transit to Bom_ser 800000 696000 508080 760000 392000 768000

Postage / Telegram 273491 237937 173694 259816 134010.6 226998 262551

Membership Fees 174086 151455 110562 165382 85302.14 144491 167123

Insurance Prem - FBT 187524 163146 119096 178148 91886.76 155645 180023

Insurance Prem - Clinical Trials 214218 186369 136050 203507 104966.6 205649

Housekeeping Services 159191 138496 101102 151231 78003.59 132129 152823

Facility Management 175044 152288 111170 166292 85771.5 145286 168042

Conference/Seminar Fees 499233 434333 317063 474271 244624.2 414363 479264

Computer Maint

AMC

Others

Sales 1427286 1241739 906469 1355922 699370.2 1184647 1370195

HO account 901195 784040 572349 856135 441585.6 747992 865147

Funds transferred from Bom 250000

Funds transferredfrom Delhi

Funds transferred from chennai 125000

Funds transferred from Pune 1437477

Stocks in transit from Bom 800000

Stocks in transit from Bom 500000

5. UNUSUAL METHODS OF INVESTIGATING

Components of a Typical Fraud Investigation Plan

R e p orting

E va lu a tio n o f E v id en ce

C o n fro n ta tio n In te rv ie w s(w ith leg a l c le ara n ce )

S tin g O p era t ion s / D e c oy T rap s / In v es tig a to rs ' B lu ff(O p tio n a l)

D ig ita l A n a lysis o f R e la tio n sh ip s & T re n ds

E v id e nce C o lle c ted In d ire c tly:F ie ld A ud it & P h ys ica l C h e cks

(O p tio n a l)

E v id e nce C o lle c te d D ire c tly:D o cu m e n ta ry T e s ts & In te rv ie w s

Defi ning the objec t ive & C rys ta llization o f the terms o f referenc e

Thirteen point programme to detect symptoms of fraud during

audit of financial statements 1. Secret reserve search2. Mirror image evaluation approach to find inconsistent results3. Relative Size Factor in stocks, debtors, creditors to detect error or

manipulation4. Illogical events- loans taken when huge liquid assets are available such

as fixed deposits5. Impossibility of certain results based on events known 6. Duplicate Numbers- could stem from error or fraud 7. Cash /stock shortages indicated by illogical withdrawing/purchasing8. Negative asset / expense balances could be errors or fraud9. Ghost workers search10. Use Test Packs to check software bugs where audit train is invisible11. Benford’s theorem test results12. Spreadsheet forensics and Ratio Analysis for trends13. Physical verifications of assets, processes, and walk through tests,

including tiger team tests

Forensic Testing of spreadsheet data eg even MIS reports can be falsified

The excel UFSRD methodU- unhideF- font colorationS-Show FormulaR- rectify and replaceD-duplication check

..\collections\financialsA.xls

SPACE TIME DIMENSIONBOTH SPACE AND TIME OFFER TESTING

YARDSTICKS FOR AUDIT PURPOSES. e.g. How much quantity can be stored in a

warehouse, container, truck, box can be very useful for corroborative tests of inventory, sales, purchases.

Time can be used in several ways, time of transaction, time taken for the transaction, time difference between two events etc.

Case Study

A robbery took place in a mall in January 2006

Thieves broke in through the door

They stole case worth more than Rs. 40 lacs

Police complaint lodged

Police made inquiries with staff, neighbourhood

Findings of the Police

They concluded that this was the work of a local gang of thieves operating in the area and this mall was the latest victim

They suspected that some employee may have helped but could not get specific clues against anyone

They recommended better locks and greater security. Case virtually closed

Management appointed auditors who were specialised investigators more for studying controls and recommending preventive measures

Auditors spot red flags

The time element indicated that the thieves had only 20 minutes to complete the robbery while the patrolling guards were circling the mall.

How could they throw about all contents of all drawers?

Where did they have time to steal a few cell phone handsets which were on a different floor?

The alarm had been switch off. Therefore it was certain that someone had helped them

The door that was broken was done with crude tools- not the work of a professional gang

Out of two safes only one was broken into and robbed. The second was left untouched?

Findings good but inadequate to point out any means of

recovery

Auditors try a new approach

The use the space time dimension approach IDEA_DATA.xls

Amazing findings- Late night sales

The log in id was traced – the store manager. On being questioned he confessed

There was no robbery- it was a stage managed robbery to cover up stock shortages

The shortages were built up over a period of time. The store manager panicked when he was told that a stock taking was to take place

He converted the stock shortages into ‘artificial’ sales by entering sales at midnight along with his accomplice the head cashier during the previous two nights. This resulted into stock shortages being converted into cash shortages.

This shortage was then palmed off as robbery by breaking open the door and throwing papers and documents in the cash room to make it look like a robbery

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Relative Size Factor (RSF)

Use of mathematical tools

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Relevance

Scrutiny of individual parties account is humanly ineffective.

It highlights all unusual fluctuations which may be stemming from frauds or errors

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What is RSF ?

RSF is the ratio of Largest Number to the Second Largest Number of a relevant set.

RSF = Largest Number Second Largest Number

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RSF- Relative Size Factor

RSF= highest value divided by the second highest value in a ledger account of debtors, or creditors

Even a comparison of prices, quantities or values in an inventory

If the RSF > 10, chances of error or fraud are great

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How does RSF Work ?

Any set of transactions take place in certain range. E.g. A vendor XYZ may have normal pattern of bill value range of Rs. 13k to 50k.

If there is any stray instance of single transaction which is way beyond the normal range than that ought to be looked into. E.g. in above case, if there is bill of Rs. 5 lacs.

RSF is above case will give a ratio of 10 (I.e. ratio of Rs. 5lac to Rs. 0.50 lacs)

These single instances could be cases where there is some foul play.

Types of frauds that RSF can unearth

Data entry mistakesAlterations in decimalsWrong coding with masters (vendors,

customers, employees, etc.)Revenue items charged to capital accounts

and vice versaExcess payments in payroll

Useful algorithm

Luhn’s algorithmFor verifying correctness of credit cards

and other cards which have been generated using the check sum digit

Tiger Team Tests

Tests used to assess the robustness of a system by actually carrying out penetration tests or walk through tests of processes as in ethical hacking for IT process testing

Surprise Repetitive Tests Surprise tests lose their sting when an

auditee can predict an auditor’s plan

Timing is very effective: one way to throw a suspected auditee completely off guard is to repeat a test in quick succession. Complacency, cover-ups and even frauds are likely to be exposed in the repeat test.

Tests of processes, operations and controls across similar units

Anomalies should be explained, else something is amiss:

- Case of discounts in chocolate shops- Case of repairs to moulds in two identical

processing units

Mirror Imaging tests

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