This book is an ideal resource for beginners in the fields of fraud examination and fraud-aware auditing. Its purposes are: (1) to introduce the important elements of fraud examination as a foundation for dealing with fraud, and (2) to explain independent audits of financial statements in terms of a fraud-detection perspective. The fraud examination section (Chapters 1-5) is condensed from the Fraud Examiner's Manual (Association of Certified Fraud Examiners, 2nd edition). The auditing section (Chapters 6-12) is drawn from Auditing (Richard D. Irwin, Inc., 8th edition). The closing section--Skills and Responsibilities--contains original chapters on fraud-detection audit procedures and auditors' official responsibilities.

The goal in this book is to give practical guidance and enhance managers' and auditors' abilities to recognize, prevent, and detect financial frauds in organizations. The primary interest is spreading the word about fraud examination and enabling more people to be able to fight fraud effectively. As authors, we welcome the opportunity to bring these materials to a wide audience.

Fraud is the crime of choice in modern economies. It pays better than street crime. The physical dangers are minor. The risk of detection is not great. Punishments are usually not very serious in terms of fines and jail time. It can be carried out in a wide variety of organizations--churches, schools, governments, businesses, hospital, trade associations--any place that has money or property. A variety of locales and property targets are described in this book to acquaint managers and auditors with numerous fraud possibilities.

Frauds can be grouped in two major classifications--employee frauds and management frauds. Employee fraud--also known as internal fraud and occupational crime--refers to the actions of people taking money or property from their employers. Embezzlement, theft, and kickbacks are typical schemes designed to take advantage of an employer's trust. Management fraud--also known as fraudulent financial reporting and organizational crime--refers to the actions of managers to inflate reported earnings or assets for the purpose of deceiving parties outside the organization. Falsified financial statements are used to obtain loans, sell stock, obtain trade credit, and secure bonuses and other managerial compensation.

Fraud control is important for managers of all kinds of organizations. The crucial questions about fraud are: How is it detected? How is it investigated and resolved? What actions will help prevent it? These questions are answered with the activities known as fraud examination.

Fraud examination is a broad field that begins in the sociology of white-collar crime, incorporates elements of civil and criminal law, acknowledges the discovery potential of audit procedures, and draws intensively on a variety of investigation techniques. It consists of four principal steps: (1) Audit procedures--knowledge of accounting systems and document examination intricacies designed to find signs and signals of fraud cover-up, (2) Observation--ability to perceive evidence in a suspect's movements and activities, and to notice the importance of documents and physical evidence, (3) Exploratory interviewing--skills of extracting damaging testimony from collaborators, accomplices, and co-workers, and (4) Admission-seeking interviewing--skills of confronting the suspect for the purpose of obtaining a confession.

The first five chapters of this book provide the conceptual and technical background for fraud examination work. They deal with law and criminology directed toward an understanding of the white-collar criminal's motivation and risk. Particular characteristic schemes of both employee fraud and management fraud are detailed so managers and auditors can be aware of various manifestations of fraud. Investigation techniques are explained in a useful, how-to manner, so managers and auditors can put the lessons into practice.

CHAPTER 1 covers the law related to fraud. It defines various types of fraud, ranging from misrepresentation to embezzlement. Numerous fraud-related statutes are identified and described to provide a breadth of knowledge about the law of fraud. Features of the important corporate sentencing guidelines are explained.

CHAPTER 2 covers criminology related to fraud. Criminology is the social- psychological explanation of people and organizations in fraud activities. The chapter explains fraudulent behavior in terms of organizational crime (frauds by organizations) and occupational crime (frauds by persons against organizations).

CHAPTER 3 contains detail descriptions of employee fraud schemes. It covers cash schemes (e.g., skimming, kiting), accounts receivable schemes (e.g., lapping, write- offs), inventory schemes (e.g., embezzlement, false charges), purchasing schemes (e.g., fictitious invoices, duplicate payments), fixed asset schemes, payroll schemes, and expense account schemes. Auditors and examiners must know about the various schemes if they expect to detect and investigate them. The chapter also contains guidance on internal fraud prevention, and an appendix contains a sample fraud policy statement.

CHAPTER 4 contains detail descriptions of management fraud--the ways and means of producing misleading financial statements. Various schemes are described in terms of improper revenue recognition (e.g., misclassification, early booking, fictitious sales, manipulated percentage-of-completion accounting), inadequate disclosure of related-party transactions, improper asset valuation (e.g., inventory and accounts receivable overstatement), improper deferral of costs and expenses (e.g., omission of liabilities), and inadequate disclosure. Auditors and examiners must know about the various schemes if they expect to detect and investigate them.

CHAPTER 5 explains many aspects of fraud investigations. It concentrates on document examination and interviewing, with particular emphasis on the "tricks of the trade" for conducting interviews. Interviews are very important, and this chapter provides many practical guides. It also covers the rights of employees during investigations-- matters of lawful search, defamation, false imprisonment, and lawful surveillance. The chapter closes with guidelines for fraud examination reports.

The public accounting profession stands accused of not looking hard enough for fraud in the independent audits of financial statements. Independent auditors acknowledge responsibilities for detecting material fraud that produces misleading financial statements, but they have said little about any responsibility to try to detect employee fraud. No manuals exist to specify fraud detection procedures, excepting those in the private hands of forensic accounting consulting firms and the forensic services divisions of CPA firms. The general audit staffs have very little technical guidance. In general, independent auditors do not put a high priority on detection of employee fraud and management fraud.

CPA firms have faced hundreds of lawsuits involving their association with allegedly misleading financial statements. Damages aggregating billions of dollars have been sought by aggrieved plaintiffs. At the same time, accounting firms' clients have lost millions if not billions of dollars to internal frauds. A large proportion of U.S. corporations have experienced serious frauds by trusted insiders. If fraud-aware independent auditors had detected signs of even a small portion of these fraud, clients could have saved large sums.

The chapters in this section build upon the foundation of fraud examination (Chapters 1-5) and concentrate on ways and means independent auditors can pay attention to fraud potential by performing fraud-detecting procedures. The chapters introduce fraud-aware independent auditing, cover technical details of internal control, and explain procedural applications for various accounts in the context of business operations.

CHAPTER 6 is the introduction to fraud awareness auditing. It contains an overview of a fraud "model" (i.e., motive, opportunity, and lack of integrity) and some thoughts on fraud prevention through enlightened management. Fraud detection is presented in terms of documents, sources of information, and "extended procedures." Five case stories tell tales about fraud situations and related audit detection potential.

CHAPTER 7 is an introduction to auditors' concepts of internal control--a crucial feature in business operations. Internal control holds a special relevance for fraud awareness auditing. Frauds occur most often when people have an opportunity made easy by lack of control checks and supervision. The chapter describes various segregations of duties and error-checking techniques often mentioned in connection with fraud investigations.

CHAPTERS 8-12 carry a consistent organization. They contain detail descriptions of transactions, data sources, control, and audit procedures in the major business activities. The chapters cover cash collections and receivables (Chapter 8), cash disbursements and payables (Chapter 9), payroll (Chapter 10), cost accounting (Chapter 11), and investments, liabilities, and equities (Chapter 12). The general principles of transaction processing and control are specified for particular business areas. The coverage is most appropriate for auditors who need to slant their audit knowledge toward fraud detection. The case stories in each chapter are particularly informative about fraud situations and audit detection potential. These chapters are not about "fraud auditing," which is conducted after allegations of fraud are known, much like a full-blown fraud examination. Instead, the emphasis is on the potential for fraud detection in the ordinary course of an independent audit. In many respects, this fraud awareness auditing can be applied in internal and governmental audit assignments.

Auditors need to expand the frontier of audit procedures. Few readily-available sources contain descriptions of fraud-detecting procedures auditors might perform. Many of these are well-known implements in fraud examiners' toolkits. Independent auditors, internal auditors, and government auditors have produced statements of expectations and responsibilities--the "rule book" of auditor behavior, but these fall short of practical technical guidance. Chapters in this section deal with both these areas.

CHAPTER 13 contains specifications and explanations of fraud detection audit procedures. The procedures are organized like an audit program with sections on cash receipts-sales-accounts receivable, cash disbursements-purchasing-accounts payable, inventory, payroll, employee expense accounts, property-plant-equipment, and income taxes. They are expressed in practical, how-to-do-it terms, ready for transfer to audit field work.

CHAPTER 14 explains the fraud-related standards in the professional literature of independent auditors (American Institute of Certified Public Accountants), internal auditors (The Institute of Internal Auditors, Inc.), government auditors (U.S. General Accounting Office Generally Accepted Government Auditing Standards), and fraud examiners (Association of Certified Fraud Examiners). For each organization, the standards are expressed in terms of specific requirements. These standards represent the official current state of fraud detection auditing.

CHAPTER 15 (Analysis of Digit and Number Patterns) was contributed by Professor Mark Nigrini, the foremost expert on the technology and practice of Digital Analysis. This methodology permits clever scanning of large numerical data sets for oddities that can signal fraudulent transactions.

What has the past shown? What is the present situation? What does the future hold? These questions are provocative. This book is not the last word on fraud examination and auditing. Developments will proceed, and changes will occur. However, for the time being, the present states of fraud examination and auditing knowledge are important entries in the fight against white-collar crime in organizations all over the world.

I deeply appreciate all the contributors to the fields of fraud examination and auditing. They are too numerous to mention here by name without risk of omitting important people. However, in particular, I thank the Association of Fraud Examiners for permission to use material from the Fraud Examiner's Manual, and I thank the Richard D. Irwin company for permission to condense and reprint certain chapters from Auditing. Without their cooperation, this book would not have been possible. Nevertheless, I remain responsible for errors of commission and omission and for the zeal in the desire to emphasize all aspects of efforts to improve fraud examination and auditing.

Jack C. Robertson

Austin, Texas