Economic Crime Journal from Lynchburg College

How to Catch Fraudulent Financial Reporting

Richard Scrushy, CEO of the former HealthSouth, was asked by federal prosecutors why he wasn't concerned that his company's sales were increasing while its number of facilities were decreasing. He responded that the auditors missed it too. The fact is that accounting numbers should be related to underlying business and economic realities. For example, we know that if sales increase then cost of goods sold should increase by about the same percentage. Most fraud investigators and auditors are use to looking for logical relationships between related accounts.

What is often overlooked is the relationship between financial statements and non-financial measures. Research has shown that when a company's non-financial measures like number of employees, amount of warehouse space, number of sales outlets or the number of manufacturing facilities differ significantly from financial measures, the financial statements may have been fraudulently misstated.

While many different non-financial measures may be used the one that appears to be most telling is surprising and simple; the number of employees. Measures like customer satisfaction, production capacity, retail outlets, number of distributors, number of dealers, or floor space are significant. However changes in most of them will cause a change in the number of employees. For example, if production capacity decreases then the number of production workers should also decrease. If the number of retail outlets or retail floor space increases, the number of retail employees should also increase.

The bottom line, if revenue and net income are increasing and the number of full-time equivalent employees is decreasing then be suspicious. Ask questions.

ASIS Economic Crime Council Highlights LC's Program

The American Society of Industrial Security's Economic Crime Council released a report on academic crime programs on November 1, 2009. The report provides a general overview of several multidisiplinary academic economic crime programs, analysis of the programs' course curriculum and general recomendations for colleges and universities interested in developing degree programs in the field of economic crime. Lynchburg College's Economic Crime Prevention and Investigation major was highlighted as one of the three model programs in the nation!

Fraud on Steroids

Fraud on Steroids

David Murphy, CPA, CFS, Ph.D.

You have noticed that sales still aren’t what they were last year. While the unemployment rate has declined the number of employed is still increasing. The economy just isn’t what is used to be and that hurts the bottom line. Occupational fraud, fraud committed against a company by employees, vendors or customers, can be just as damaging. A company where net income is 5 percent of sales experienced a small $10,000 fraud. The company would have to increase sales by a tremendous $200,000 to recover the lost profit!

National White Collar Crime Center data show an increase in arrests for fraud and embezzlement during the two most recent recessions. White-collar fraud arrests jumped 52% over the two years following the 1990 savings and loan crisis and the downturn. Arrests jumped 25% in the two years following the Internet bust in 2000. It appears that white-collar crime clearly picks ups when there's a downturn in the economy.

The potential for fraud increases dramatically during economic downturns and the fraud on steroids results. Fraud risk results when opportunity, rationalization and pressure are present. Opportunity results when individuals within or outside a company when they discover a method for stealing from a company and hiding the theft. It can be as simple as a vendor’s delivery person offloading boxes from the delivery truck and then tossing an unattended box back into the truck to a sophisticated computer-based accounting fraud.

However, the real concern during an economic downturn is its effect on pressure and rationalization. People commit fraud when they face financial problems that they can’t solve through normal means (financial pressure) and then find a way to rationalize their behavior. The Federal Bureau of Investigation suggests that the sharp increase in mortgage fraud, a 36 percent increase over last year, has been a desperate attempt by homeowners to maintain the standard of living they enjoyed before the economic crisis.

What should every business person do?

Make sure your internal control system is strong and strengthen it where necessary,

Monitor employee behavior for symptoms that may indicate financial pressure and that could lead to rationalization.

The reduction of the risk level associate with any one of the three fraud factors, opportunity, rationalization and pressure, is reduced.

U.S. Banking Fraud Interview

If you are interested in the current U.S. banking crisis and have thought that it might be fraud related then please view this PBS/Bill Moyers inteview http://www.pbs.org/moyers/journal/04032009/watch.html.

Financial Statement Fraud

In spite of the requirements of the Foreign Corrupt Practices Act, the Sarbanes-Oxley Act and increased enforcement by the SEC fraudulent financial reporting is an ongoing concern. The Deloitte Forensic Center produced an analysis of the 344 SEC enforcement releases related to financial statement fraud issued from 2000 through 2007. These 344 SEC releases identified 1,240 different fraud schemes.

The most “popular” methods of fraudulently misstating financial statements were: (1) revenue recognition fraud, (2) Improper disclosures, (3) manipulation of expenses, and (4) manipulation of assets. The manipulation of liabilities and the manipulation of reserves tied for 5^th place.

What to Watch Out For

Revenue recognition fraud is insidious because, by overstating revenue, it makes troubled companies look profitable. It improves the net income picture on the income statement and usually overstates both assets and retained earnings on the balance sheet. The following are the most common approaches to revenue recognition fraud, and things to look out for.

Common Revenue Recognition Frauds

Type Percent of SEC Cases

Recording fictitious revenue 35%

Recognizing inappropriate revenue from swaps, round-trips or barters 16

Recognizing revenue from sales billed but not shipped 12

Recognizing revenue from contingent sales where the contingencies have not been resolved 12

Failure to establish reserves or account for refunds, exchanges or side agreements 13

Recognizing revenue when products or services are not delivered, delivered incomplete, or delivered without customer acceptance 12

Internet Fraud on the Rise

The Internet Crime Complaint Center (IC3) reported that internet fraud rose 10.5 percent in 2008 to over $264 million. The total volume of cases reported rose 33.1 percent to 275,284 cases. The IC3, which refers complaints to law enforcement agencies, was organized in 2000 by the Federal Bureau of Investigation (FBI) and the National White Collar Crime Center (NW3C).

IC3 2008 report indicates that the United States is the largest source of crime perpetrators based on complaints (66.1 percent) with a reported location, followed by the United Kingdom (10.5 percent), Nigeria (7.5 percent), Canada (3.1 percent) and with China rounding out the top five at 1.6 percent of the complaints.

The most common source of fraud complaints were:

· Non-delivery of merchandise or non-delivery of payment (32.9 percent)

· Auction fraud (25.5 percent)

· Credit/debit card fraud (9 percent)

· Confidence fraud such as Ponzi schemes (7.9 percent)

· Computer fraud 6.2 percent)

· Check fraud (5.4 percent)

· Nigerian letter fraud (2.8 percent)

· Identify theft (2.5 percent)

· Financial institution fraud (2.2 percent), and

· Criminal threats (1.9 percent).

The apparent top 10 states, accounting for about 62 percent of the internet fraud complaints in the United States, were California, New York, Florida, Texas, Washington, D.C., Washington state, Illinois, Georgia, New Jersey, and Arizona.

The IC3 has launched a public web site, LooksTooGoodToBeTrue.com, where consumers can get advice about how to recognize different forms of online fraud.

Fraud Close to Home

Terrence ("Terry") Lee Dowdell, a resident of Charlottesville, Virginia, raised millions of dollars by selling fictitious securities from 1998 through 2002 through his Vavasseur Corporation that was based in the Bahamas. His company was involved in a variation of the old Ponzi scheme. This scam, named a "prime bank securities fraud" offers investors a "special deal" by investing in a secret trading market of the world's top or prime banks. Usually neither the securities nor the secret market exist.

Dowdell told investors that his Vavasseur Corporation was purchasing short-term $1 million notes issued at a discount by Barclays Bank in the United Kingdom. He asserted that he could sell the notes at face value and realize as much as a 70 percent return on investment.

Remember when I wrote that "If a deal sounds too good to be true, then it probably is"? This is another example of that rule. The following table shows the average return on large and small company stocks from 1998 through 2002.

Average Return on Investment

	Large Company	SmallCompany
Year	Stock	Stock
1998	28.58%	-7.31%
1999	21.04%	29.97%
2000	-9.11%	-3.59
2001	-11.88	22.77%
2002	-22.10	-13.28%

Remember that over this same time period Dowdell was offering up to a 70 percent return on investment.

The SEC became concerned about Vavasseur in 2001 and Dowdell told the SEC that Vavasseur had repaid its investors and he stopped using the U.S.-based bank in Florida that had been used since the inception of the fraud. From March 2001 forward investors were told to make deposits to foreign-based banks. In November of 2001 when the SEC became aware that the fraud had continued they filed civil action against Dowdell. A U.S. District Court then froze Dowdell's U.S. bank accounts. A criminal injunction was filed against Dowdell in December of 2002. Dowdell eventually pled guilt to securities fraud and wire-fraud and was sentenced to a 15 year prison term in July of 2004.

About $38 million of investor assets were eventually recovered and the investors will receive a distribution of approximately 68 percent of the funds that they had invested.

Once again, if a deal looks too good to be true, it probably is.

Can Economic Crime Be Eliminated?

PricewaterhouseCoopers recently published its 2007 biannual study of fraud. This report covers the period from 2007 through 2008 and follows their 2005 report. The results of the current report were based on interviews with 5,400 companies in 40 countries. I think that the most important conclusion in their report was that it's nearly impossible to get rid of economic crime.

In spite of an increased awareness on the part of the public of white collar crime and fraud the overall incidence of fraud remained constant from their 2005 to 2007 report and was 6 percent higher than in 2003. In addition about half of the surveyed companies reported being victim to fraud with asset misappropriate being the most common. The average direct cost of fraud was reported to be $3.2 million. In addition, over 80 percent of the companies who reported fraud indicated that they had suffered significant collateral damage as well. The collateral damage included damage to the brand, staff morale, external business relations, increased regulatory costs, and damage to their relationship with government regulators. To put that into perspective the average loss in a bank robbery in the United States, as reported by local police departments in their Uniform Crime Reports, is about $4,000. White collar crime is much more lucrative than bank robbery.

Companies don't do a good job in detecting fraud either. Take a look at the fraud detection statistics below:

Fraud detected by chance	41%
Fraud reported by insiders	21
Fraud reported by outsiders	14
Fraud reported by hotline	8
Detected by corporate controls or auditors	16

Obviously businesses do not do a very good job of preventing or detecting fraud. Lynchburg College has an exciting new major in Economic Crime Prevention and Investigation. Be part of the solution to the fraud problem.

Madoff and Ponzi

Bernard (Bernie) Madoff, the former Nasdaq chairman was charged in late 2008 with massive fraud. He pleaded guilty this month (March, 2009) to eleven criminal accounts for orchestrating the biggest investment fraud, $65 billion, in Wall Street history and was jailed to await a sentence that will probably keep him in prison for the rest of his life. His fraud has been described as a "Ponzi Scheme", so who was Ponzi and what is a Ponzi scheme?

Charles Ponzi emigrated from Italy to the United States in 1903. He implemented a scam that took him from anonymity to being a well-known Boston millionaire in six months in 1920. Profits in his company were supposed to come from exchanging international postal reply coupons (IRC). The purpose of the postal reply coupon was to allow someone in one country to send it to a correspondent in another country, who could use it to pay the postage of a reply. IRCs were priced at the cost of postage in the country of purchase, but could be exchanged for stamps to cover the cost of postage in the country where redeemed. There was profit potential if these values were different. In essence, he was going to by IRCs in countries where postal prices were low, and convert them in countries where the postal rates were higher. This looks like a simple case of price arbitrage.

High inflation in Italy after World War I had decreased the cost, in U.S. dollars of IRCs in Italy. Ponzi claimed a return of 400 percent after paying transaction costs. He explained his scam to others and marketed the idea through his Security Exchange Company promising a 50 percent return on investment in 45 days or double your money in 90 days. About 40,000 people invested about $15 million in the Security Exchange Company. Ponzi robbed Peter to pay Paul. He used the cash received from later investors to pay off the early investors, giving the illusion of actual above-market returns. In the end only a third of that money was returned to the investors.

Ponzi's world started to fall apart in July, 1920 Clarence Barron, the publisher of Barron financial newspaper noted that Ponzi wasn't investing with his own company and that 160,000,000 postal reply coupons would have to be in circulation to cover the investments made with the Securities Exchange Company. However, only about 27,000 coupons were actually circulating. Ponzi was arrested on August 12, 1920, under 86 Federal indictments for mail fraud. He was released from prison in 1934 and was deported to Italy.

Remember the old saying, "What goes around comes around."? Ponzi didn't invent the scheme, in fact Charles Dickens describes it in his 1857 novel Little Dorrit. Ponzi however lent his name to it because of the size of his fraud. Remember, if an investment looks to good to be true, it probably is.

New Credit Card Scam

According to the National White Collar Crime Center a new telephone credit card scam is being perpetrated on individuals. The victim answers a phone call and someone says, “Hello, this is (name), and I am calling from Visa or MasterCard and my badge number is 12345. Your card ending in 9999 has been flagged for an unusual purchase pattern, and I am calling to verify this would be your card issued by (name of bank). Did you purchase an Anti-telemarketing Device for $497.99 from (company name) in Arizona?” When victim responds that no such purchase had been made then the perpetrator continues by saying, “We will be issuing a credit to your account. This is a company that we have been watching and they have been charging fraudulent purchases just under the $500 limit that flags most cards. Before your next statement the credit advise will be sent to (gives victim’s address), is that correct?” After confirming the address the caller asks the victim to verify the CVV code on the back of the card by saying, “I need to confirm that you are still in possession of your credit card. Would you please confirm the three number security code on the back of your credit card by reading the numbers to me?” The perpetrator already knew the victim’s name, address, and credit card number. Once the perpetrator has the CVV code he or she is able to assume the victim’s identity and fully utilize the card.

Never reveal confidential information over the phone or via the internet. If you receive a phone call requesting your credit card information hang up immediately and call the 800 number on the back of your credit card and report the incident.