PWC 2 - 2nd Ed - Feb 2014 Update

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PWC: A Guide to Forensic Accounting Investigation – 2nd Edition

Chapter 2: Psychology of the Fraudster

Feb. 2014 Update

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The Good, The Bad and The Ugly

The Good – Most people are honest. The Bad and The Ugly – Sadly, human

history and human nature tell a different story (and so do the stats). Recall the Weasel Axiom. Most societies abhor violent crime and

bodily harm. But many societies hold financial fraud as a

less reprehensible wrongdoing.

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Research & Other Information on Fraud –

Why People Commit Fraud

A Sidebar – From Joseph Wells, Principles of Fraud Examination and ACFE

course, Inside the Fraudster’s Mind

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Occupational Fraud and Abuse Research Edwin Sutherland Donald Cressey

Cressey’s Hypothesis Dr. W. Steve Albrecht Hollinger-Clark Study

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Sutherland Scorned traditional theories of

crime that blamed poverty, broken homes, and disturbed personalities.

Noted many lawbreakers were wealthy, from happy family backgrounds, and in good mental health.

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Sutherland Publishes White Collar Crime in

1939. Defines White Collar Crime as “a

crime committed by a person of respectability and high social status in the course of his occupation.”

He coined the term “white-collar crime.”

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Sutherland Sutherland explained white-collar crime

with his “theory of differential association.” He conjectured that white-collar crime was

learned behavior that is related to the environment in which a fraudster works.

Prior to Sutherland (and still applied to “street” crime), criminologists held the view that crime was genetically based, criminals beget criminal offspring.

Sutherland posited that the environment plays a role in criminal behavior (and should also apply to street crime).

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Sutherland It is clear how Sutherland’s

differential association theory can be applied to occupational offenders: Dishonest employees within an organization will eventually infect a portion of the honest ones, and honest employees will eventually have an influence on some of those who are dishonest*.

*Recall Walt Pavlo at MCI/WorldCom.

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Cressey A student of Sutherland. Cressey’s dissertation examined

embezzlers. Interviewed about 200 incarcerated

embezzlers. He called embezzlers “trust

violators.” Interested in the circumstances that

led these people to be overcome by temptation.

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Cressey Cressey’s final hypothesis was,

what is now called, the Fraud Triangle.

The Fraud Triangle legs represent: Perceived non-shareable financial

need (pressure or motive) Perceived opportunity Rationalization

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Opportunity

Pressure Rationalization

Fraud Triangle

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I. Non-Shareable Financial Problems (Pressure/Motive) Trust violators perceive that a financial

problem cannot be shared with other persons.

What is non-shareable is relative to each person (what’s non-shareable to one person is no big deal to another).

“Financial” because they generally can be solved by the theft of cash or other assets.

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I. Non-Shareable Financial Problems (Pressure/Motive) Cressey found that non-shareable

problems could be divided into 6 basic categories: Violation of ascribed obligations Problems resulting from personal failure Business reversals Physical isolation Status gaining Employer-employee relations

They tend to be status-oriented.

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I. Non-Shareable Financial Problems (Pressure/Motive) Violation of ascribed obligations: People

believe their status requires them to act in a certain manner. If a person violates this tenet, s/he has a

non-shareable problem (e.g., a crack-head CFO; this behavior just doesn’t “fit in” with what we believe a CFO should be doing).

It’s too embarrassing to admit the problem. Don’t want to lose status.

Steal to buy drugs and you don’t have to share your drug problem.

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I. Non-Shareable Financial Problems (Pressure/Motive) Problems resulting from personal

failure: Problems the trusted person feels s/he caused through bad judgment and therefore feels personally responsible for. Business venture gone bad, but not due to

economic conditions, but “own bad judgment,” “own fault,” or “own stupidity.”

Fear a loss of status.Example: John Edward’s affair (and bastard child) with Ms. Hunter (while his wife is dying of cancer) and have his aide, Andrew Young, take the blame --- what a great guy --- he could have been the US VP! Edward’s personal failure (affair & love child) had him pressure his aide to lie which is also a lie on Edward’s part.

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I. Non-Shareable Financial Problems (Pressure/Motive) Business Reversals: Problems

arising from conditions beyond the control of the violator. Business venture gone bad, but not

due to “own bad judgment,” “own fault,” or “own stupidity,” but economic conditions. (compare to previous category)

Fear loss of status. (Gotta maintain the appearance of success.)

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I. Non-Shareable Financial Problems (Pressure/Motive) Physical isolation: Violator has no

one to turn to. Loner who makes a dumb move. S/he doesn’t have anyone to talk to,

etc.

Paint yourself into a corner.

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I. Non-Shareable Financial Problems (Pressure/Motive) Status gaining: The offender is

motivated by a desire to improve his/her status. Extreme example of “keeping up with the

Joneses.” Problem becomes non-shareable when

S/he can’t renounce his/her aspirations for membership in the desired group or

S/he can’t obtain the prestige symbols necessary for group membership.

Turns to fraud when s/he can’t accept lower status and can’t obtain the finer things through legitimate means.

Recall Walt Pavlo in Tone at the Top video: He wanted some tech bubble status/goodies, but couldn’t earn them legitimately (give his status at MCI/Worldcom)

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I. Non-Shareable Financial Problems (Pressure/Motive) Employer-employee relations: The

violator resents his/her status within the organization, doesn’t see a change in status on the horizon, and has no choice but to continue working for the organization. Dr. Frank: How can this be? One

can always quit. LIU story. Violator has a desire to “get even.”

Really?

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I. Non-Shareable Financial Problems (Pressure/Motive) Solving the Problem in SECRET: Cressey

found it was crucial that the violator be able to resolve the financial problem in secret. Key: It’s not the embezzlement itself that

creates the need for secrecy, it’s the circumstances that led to the embezzlement.

The CFO doesn’t keep the embezzlement secret because he’s stealing money, he’s keeping his crack addiction secret --- although the “solution” to steal is also kept secret.

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Dr. Frank Perspective But I think it’s a 2-level issue (of

secrecy) A secret problem leads to fraud which must be kept secret on 2 levels: (1) to keep the motivating problem secret and (2) to keep the fraud secret (since it was a “bad” action).

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II. Perceived Opportunity The non-shareable financial problem

creates the motive for the crime to be committed, but the employee must also perceive that he has the opportunity to commit the crime without being caught.

Two components of perceived opportunity: General information Technical skill

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II. Perceived Opportunity General Information: Simply the

knowledge that the employee’s position of trust could be violated. Hearing about embezzlements See dishonest behavior by other

employees Generally aware that positions of

trust can be violated.Sutherland’s Theory of Differential Association. Recall Walt Pavlo.

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II. Perceived Opportunity Technical Skill : Refers to the

abilities needed to commit the violation. Usually the same abilities that the

employee needs to have to obtain and keep his position in the first place.

Most embezzlers adhere to their occupational routines and job skills to perpetrate their crimes.

In essence, the perpetrator’s job and position will tend to define the type of fraud he will commit.

Recall that Walt Pavlo’s (Tone at the Top video) fraud related to accounts receivable --- the area where he worked.

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III. Rationalizations Significantly, the rationalization is a

necessary component of the crime before it takes place; in fact, it is a part of the motivation for the crime. Because the embezzler does not view

himself as a criminal, he must justify his misdeeds before he ever commits them.

The rationalization is necessary so that the perpetrator can make his illegal behavior intelligible to himself and maintain his concept of himself as a trusted person.

Financial Pressure + Able to Rationalize the Fraud + Opportunity (has access to assets) = Commit Fraud

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III. Rationalizations After the criminal act has taken place,

the rationalization will often be abandoned.

So, fraud often starts out with a rationalization and them proceeds to non-rationalized crime.

Cressey found that embezzlers generally rationalize their crimes by viewing them

1) As essentially non-criminal (borrowing)2) As justified3) As part of a general irresponsibility for

which they were not completely accountable.

“I can’t control myself.”

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III. Rationalizations Cressey found that rationalizations

tended to be linked to violators’ positions and the manner in which they committed their violations. Independent Businessmen: Own your

own firm (or partnership), etc. They “borrowed” or believed they

couldn’t steal from themselves. Fraud brought on by an “unusual

situation.”

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III. Rationalizations Long-Term Violators: Converted small

amounts over a relatively long period of time.

Tended to use the “borrowing” rationalization along with:

Keeping their families from disgrace, shame, or poverty

Theirs was a case of “necessity;” their employers were cheating them financially

Their employers were dishonest toward others and deserved to be fleeced.

Recall Mettenheimer’s warning over 140 years ago!

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III. Rationalizations Long-term violators eventually reach a

point where they are “in too deep.” The violator faces a crisis:

The rationalization cannot be maintained. The perpetrator must face facts; he is a criminal.

This conflict (rationalization vs. reality) creates a great deal of anxiety for the perpetrator.

We can use this to spot fraudsters (they tend to be very defensive when questioned about a fraud or exhibit personality changes).

May cause a perp to run (or kill himself) --- next slide

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The Rationalization Dead End Example of a perp killing

him/herself:Chris Kelly, ousted Illinois Gov.

Blagojevich’s former chief fundraiser, plead guilty to federal fraud charges (around 9/12/09) and then killed himself with an overdose of painkillers.

It seems Chris couldn’t escape the FACT that he was a scumbag --- which probably ran counter to his self-image.

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III. Rationalizations Absconders: People who take the

money and run. Tend to be physically isolated people. Tend to have lower status. Rationalize their conduct by noting that

their attempts to live honest lives has been futile (hence their low status).

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Fraud Triangle Conjuncture of Events: One of the

most fundamental observations of Cressey was that it took all three elements – pressure, opportunity, and rationalization – for the trust violation to occur. If any of the three elements is

missing, trust violation does not occur.

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Dr. W. Steve Albrecht Albrecht believes occupational

fraud perpetrators are hard to profile and that fraud is difficult to predict.

Albrecht researched “red flags” of fraud and abuse.

Albrecht developed the Fraud Scale.

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Red Flags Albrecht categorized the red flags

into two categories: Personal characteristics (pressure

related) and Organizational environment

(opportunity related). He listed 25 red flags in each

category and used internal auditors to select the top 10 in each category.

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Top 10 Personal Characteristics (Pressure Related) Red Flags

1. Living beyond their means.2. An overwhelming desire for

personal gain.3. High personal debt.4. A close association with

customers.5. Feeling pay was not

commensurate with responsibility.

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Top 10 Personal Characteristics (Pressure Related) Red Flags

6. A wheeler-dealer attitude.7. Strong challenge to beat the

system.8. Excessive gambling habits.9. Undue family or peer pressure.10. No recognition for job

performance.

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Top 10 Organization Environment (Opportunity Related) Red Flags

1. Placing too much trust in key employees.

2. Lack of proper procedures for authorization of transactions.

3. Inadequate disclosures of personal investments and incomes.

4. No separation of authorization of transactions from the custody of related assets.

5. Lack of independent checks on performance.

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Top 10 Organization Environment (Opportunity Related) Red Flags

6. Inadequate attention to details.7. No separation of custody of assets

from the accounting for those assets.8. No separation of duties between

accounting functions.9. Lack of clear lines of authority and

responsibility.10. Department that is not frequently

reviewed by internal auditors.

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Fraud Scale A subjective device to weigh three

components (pressure, opportunity, and personal integrity) to yield a likelihood of fraud; where the likelihood of fraud is increasing in pressure and opportunity and decreasing in personal integrity.

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Fraud Scale-ExamplesPressure Opportuni

tyIntegrity Fraud

Low Low High Low

Low Low Low Low/Med.

High Med. Med. Med./High

High High Low High

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Hollinger-Clark Study Looked at data from retail, hospital, and

manufacturing industries (9,175 valid employee questionnaires).

Contrary to Cressey, H-C found that employees steal primarily as a result of workplace conditions.

Why might Cressey and H-C come to different conclusions? Did they examine the same population of weasels? (While white collar criminals and street criminals both steal, they are not the same (in composition).)

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Hollinger-Clark Study Hypotheses of employee theft:

1. External economic pressures2. Young employees not as hardworking and

honest as those of the past3. Every employee can be tempted to steal

from an employer; people are greedy and dishonest by nature (Weasel Axiom)

4. Job satisfaction5. Shared formal and informal structure of

organizations (over time, the group norms – good or bad – become the standard of conduct)

Sutherland’s Theory of Differential Association.

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Hollinger-Clark Study H-C concluded that employee deviance

is caused by job dissatisfaction. They categorized employee deviance

into two groups: Acts by employees against property

(property deviance): Misuse and theft of company property.

Violations of the norms regulating acceptable levels of production (production deviance): Goldbricking, slackers, etc.

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Hollinger-Clark Study H-C found that

about 33% (wt. avg. across all 3 industries) of employees admitted to committing some form of property deviance.

about 70% (wt. avg. across all 3 industries) of employees admitted to committing some form of production deviance.

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Hollinger-Clark Study Other Findings

No relationship between absolute income and employee theft.

A statistical relationship between employees’ concern over their financial situation and the level of theft.

Correlation between age and theft – younger employees are more likely to steal (young & dumb and not “committed” to the company).

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Hollinger-Clark Study Other Findings:

Direct relationship between employee’s position and the level of theft – thefts highest in jobs with greater access to the things of value in the organization (the DUH! factor).

Employees who are dissatisfied with their jobs (across all age groups, but especially younger workers) are most likely to steal (to right the perceived “inequity”).

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Controls are a mixed bag Can reduce theft. Can enhance the feeling of inequity and increase

the likelihood of theft. Controls often have little or no deterrent effect on

theft (they’re not deterred because they do not plan on getting caught).

The stronger the perception that theft would be detected, the less the likelihood that an employee would engage in deviant behavior. (A common finding in criminology studies – it’s about the perception of getting caught.)

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Increasing internal security presence does not seem appropriate (could worsen things).

Same kind of employees who engage in other workplace deviance are also principally the ones who engage in employee theft (a “type” of person?).

Weasels in many aspects of their lives --- crosses over into their professional/work life.

Liars lie, cheaters cheat, and fraudsters commit fraud; and they tend to be the same kind of person --- scumbags.

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Hydraulic Effect: Efforts to reduce employee theft without reducing its underlying causes (e.g., employee dissatisfaction, lack of ethics), results in increases in other deviant behavior.

If a company pushes down theft, that action may push up goldbricking.

Increased mgt. sensitivity to its employees reduces all forms of workplace deviance.

Special attention should be afforded young employees.

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10 Critical Thinking Errors of Unethical Behavior (ACFE course)

Most people who commit fraud or other unethical acts find themselves wandering off their moral course.

Interestingly, the ways in which such ethical lapses occur generally fall within several broad and recognizable categories; including the following ……..

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1. Rationalization: Justification that a person provides for his/her actions. “What I’m doing is okay because

…. “ Frauds are about lies, and the

lying starts with lying to yourself --- “It’s okay because …… “

We’ll talk much more about this later.

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2. Instant Gratification: A desire for wealth without patience to earn it honestly. People might become overwhelmed by a

financial need or desire and – being accustomed to instant gratification in other aspects of his/her life – turn to white collar crime as a means of instantly gaining wealth, rather than taking the traditional route involving hard work and perseverance.

Red Flag: Impulsive spending habits, especially when coupled with living beyond one’s means.

Recall Walt Pavlo again. I’ve heard the phrase, “feasting on envy;” wanting stuff, but not willing to work hard to get it.

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3. Disregard for Authority of Rules: When someone lacks respect for authority or believes that the rules are unreasonable, purposeless, or not valuable, he/she might be inclined to disregard authority figures and the rules they are tasked to enforce.

Psychopaths fit here.

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4. Being Overly Optimistic: Often creates a sense that one is invulnerable and incapable of failure (hubris). Sometimes an individual thinks

he/she is smarter or better that his/her peers and therefore can get away with fraud.

Can also be bred out of situational or environmental factors (steal $5 and nobody notices, steal $10, steal $50, steal $100, and so on ---- until you get caught).

This is why many frauds start out as a trickle and end up a waterfall.

BIG Giant Ego Hypothesis

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5. Entitlement: General belief that “the world owes me something” or “I deserve it.” This is a powerful motivator for fraud. Some business leaders convince

themselves that they are entitled to live a certain lifestyle by virtue of their positions.

Again, psychopaths fit here.

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5. Entitlement: Per The Declaration of Independence,

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

Notice that you are entitled to life and liberty.

And to pursue happiness --- not guaranteed happiness (that might be had by getting “stuff”).

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6. Lack of Remorse: Often manifests itself in fraudsters as a disregard for the consequences of their actions, even when they know they’ve done something wrong and caused harm to others. May be due to personality disorders

(psychopathy --- next class).

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6. Lack of Remorse: Or, people who just don’t give a sh*t

--- they simply don’t care if they cause harm to others or their employing organization --- they think their personal needs or desires are more important than anyone else’s and therefore, they experience no regret when they hurt others out of selfishness.

I refer to these people as a-holes.

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7. Peer or Financial Pressure: People view this pressure as a problem they have to solve – no matter the method

8. Inadequate Fear of Punishment: Punishment will never completely deter crime, but fraudsters often lack the fear of punishment that most people feel and may not know the penalty for the fraud they are considering. So, companies should communicate (loudly)

the policy for handling frauds.

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9. Egoism: Refers to arrogance and narcissism (defn: excessive concern for oneself without exaggerated feelings of self-importance). In fraudsters, egoism is often a blend

of arrogance, pride, and narcissism that fuels a person’s desire to commit a crime.

Often viewed as a challenge to “beat the system.”

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10. Diffusion of Harm: Fraudster believes that the fraud affecting a large group does not harm any one person much, if at all. Pump-and-Dump schemes and Ponzi

schemes are examples of frauds frequently used by fraudsters who hold the belief that the diffusion of harm minimizes the severity.

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WHY DID THEY DO IT? Generally, the following 4 factors

compel people to commit fraud:1. Personality2. External pressures3. Personal situation4. Corporate culture

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Common Motivations for Fraud Greed (among the most common reason

given for why people commit corporate fraud – ACFE report)

Sense of entitlement Desire for power/ego Need Challenge Fear Anger Personality disorders

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End of Research and Other Information on Fraud Sidebar.

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Sociology and Criminology Psychologists and sociologists

have tried to understand the inner workings of people who commit white-collar crime. Old theories tried to link white-collar

criminals to biological and psychological flaws associated with the lower classes and social misfits. (The prevalent theories relating to common criminals.)

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Sociology and Criminology Edwin Sutherland (White Collar Crime,

1939) argued that an individual’s personality has no relevance to a propensity to commit white-collar crime. Economic crimes originate from the

situations and social bonds within an organization (“process of differential association”) --- it’s more a learned behavior.

In addition, he noted that economic crime encompasses upper-class, socially well-adjusted people.

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Sociology and Criminology Others suggested that financial

fraud is an inevitable feature of capitalism, in which the culture of competition promotes and justifies the pursuit of material self-interest, often at the expense of others and even in violation of the law. (I think this is crap. It’s not capitalism per se; it’s that people are weasels, period --- see next slide.)

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Sociology and Criminology People cheat under socialist

regimes & communist regimes & theocratic regimes, etc. --- it’s all about diverting resources from others to yourself.

Egypt’s Mubarak (ousted president, Feb. 2011) is estimated to be worth $70 billion and believed he diverted more than $60 billion of U.S. aid to Egypt over 30 years.

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Sociology and Criminology Research concludes that two factors

should be considered in analyzing the psychology and personality of fraudsters: The biological qualities of an individual,

which vary widely and influence behavior, including social behavior.

The social qualities that are derived from and in turn shape how the individual deals with other people.

Nature

Nurture

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Sociology and Criminology So, three general types of fraudster

have been observed: Calculating criminals who want to

compete and to assert themselves. Situation-dependent criminals who are

desperate to save themselves, their families, or their companies from catastrophe.

Power brokers who are highly placed corporate criminals.

Psychopaths reside in this category.

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Calculating Criminals Calculating criminals are predators. Tend to be repeat offenders. Higher-than-average intelligence. Relatively well educated. Usually begin their careers in crime

later in life than other criminals. Risk takers. Lack feelings of anxiety or empathy.

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Calculating Criminals Predators

Develop considerable skills and make a career of deceiving people (as though it were just another career track to follow).

Are dangerous and cause great harm.

Once in place, are hard to detect.See Case 1, Bob Davies; p. 49/27

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Calculating Criminals Fraud deterrence and detection

controls are often robust enough to stop other types of white-collar criminals, but they may not stop the predator.

The best defense against predators is a thorough background check before hiring --- since they tend to be repeat offenders. (Key element of an anitfraud program.)

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Situation-Dependent Criminals The vast majority of white-collar

criminals are not predators, they are ordinary people who commit crimes without the intent to harm others.

Characterized as “the more common, run-of-the-mill, garden-variety” offenders that account for the bulk of fraud --- not the Bernie Madoff types.

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Situation-Dependent Criminals They look like us! Typical White-Collar Criminal (ACFE):

Older (> 30 years) 55% male, 45% female An appearance of a stable family situation Above-average (postgrad) education Less likely to have a criminal record Good psychological health Position of trust Detailed knowledge of accounting systems and their

weaknesses Prior accounting experience

Recall ACFE stats on fraudsters

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Situation-Dependent Criminals People often display disbelief

regarding these criminals when discussing a fraud. “Oh, no, it couldn’t be Anne. She’s

been with us for 20 years. She’s always assisting others with their duties. She’s pleasant and rarely takes time off. My wife and I have been to her home. Our daughters are on the same soccer team.”

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Situation-Dependent Criminals Victims may believe that what

she or he knows, or thinks she or he knows, about a fraudster’s character eliminates him/her from the list of suspects of fraud . . . . . . .

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Situation-Dependent Criminals

. . . . . However, fraud examiners know that: It’s NOT the case that nice

people are white-collar criminals,

Rather, most white-collar criminals give the appearance of being nice people.

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Power Brokers Power brokers show characteristics

of predators and Situation-dependent criminals, but they are different enough to deserve a category all their own.

It’s the combination of predator characteristics and the circumstances of their positions that lead these people to commit financial crimes.

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Power Brokers These highly-placed criminals are the

ones that cause us to ask the question: “How could this respected business leader have been so deluded as to believe that he could usurp the financial resources of their company to line their own pockets and deceive so many people?”

It ties into the Big Giant Ego Hypothesis.

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No Intent to Harm Generally speaking, situation-dependent

criminals carry out their frauds with no intention to do any harm.

It is critical to an understanding of the psychology of such people to accept this key point: most of them carry out their frauds with no intention to doing any harm, and they believe – they are able to convince themselves – that what they are doing is not wrong.

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Case 3: Middle Mgr. Middle mgr. gets laid-off, he was making

$85,000, unemployed for 14 months, eventually found a lower paying job, daughter gets hurt and needs plastic surgery (not covered by insurance), mother-in-law gets sick and has to move in (and he must add another room to the house), and his wife is pregnant HUGE Pressure.

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Case 3: Middle Mgr. Under this duress, many people

may find that their customary ethical behavior may seem beside the point when criminal opportunities seemingly provide solutions to complex personal problems.

What would you do?

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No Intent to Harm These people may convince

themselves that They are doing it for the “good of the

company,” or They deserve the spoils they seize

because they rationalize their crimes as immaterial, innocent, or deserved – but not wrong.

Many frauds start out as a trickle and end up a waterfall (start small, end big).

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Six Basic Forms of Rationalization for Fraudulent Behavior

1. I only borrowed it --- I was going to put it back.

2. It’s a grey area and my action is acceptable.

3. Everyone is doing it.4. I deserve it.5. I need it.6. It’s not for me, it’s for others (the

company, the stockholders, my family, etc.).

Case 2

Case 4

Case 4

Case 1

Case 3

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Six Basic Forms of Rationalization for Fraudulent Behavior

Burn the 6 forms of rationalizations into your brain.

If you go into fraud investigation, you will see these 6 rationalizations over & over again!

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CASE 4: Foundation Fraud Exec. Director of a foundation charged

personal expenses to the foundation (school books, car repair, groceries, flight to Miami for her and her family, etc.).

The Board and others were confused, puzzled, shocked, surprised, blah, blah.

Were these clerical errors, misunderstandings, or the work of a weasel?

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CASE 4: Foundation Fraud Eventually, the FAIs uncovered

unauthorized expenditures of at least $90,000 (including private school tuition for the Exec. Director’s kids).

Now, that the weasel has been identified, what’s next?

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The Next Step in the FAI Once a fraudster has been

identified, FAIs should next*: Look for additional schemes Look for coconspirators Look to see what the targets have

touched and test those areas * From the ACFE’s Fraud Examiners Manual.

If they are willing to cheat in Area A, they’ll probably cheat in Area B.

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CASE 4: Foundation Fraud So, now the FAIs thought about

what the Exec. Director “touches” and the other possibilities for fraud.

They learned she was involved in fund raising --- so now they have to examine incoming donations. This can be very difficult since any

fraud would probably be an off-the-book fraud (the donors might only be know to her).

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CASE 4: Foundation Fraud How would you get a handle on

donations converted to the Exec. Director’s private use? In general --- you need to connect her to

situations where she could be in personal contact with donors.

Analyze her expense reports and correlate with churches, etc. near hotels she stayed at, etc.*

Call churches and use an audit pretense to ask about donations to the foundation.

For each church, etc. where she might have made an appeal for money, look for a deposit from the church, etc.

* See next slide.

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CASE 4: Foundation Fraud The FAIs found something. A

church in Dallas had given the Exec. Director a donation of $10,000. The FAIs had the church send them a

copy of the check (front and back). The check had no endorsement, but it

did have the Exec. Director’s personal account number. Gotcha!

With one, there are probably more.

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CASE 4: Foundation Fraud Weasels aren’t necessarily that smart. She should have left those items off her

expense report - weasels are often also little piggies --- submit an expense for hotel & food, say $500, steal $10,000; set nailed; get zero + jail time --- OR, forget the hotel & food (don’t submit), steal $10,000; get away with it; net $9,500 + NO jail time. Which option do you prefer?

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CASE 4: Foundation Fraud The Board was stunned and not

ready to take the matter to the prosecutor. “There has to be a reasonable

explanation for the allegations,” some Board members said. (Yea, the Exec. Dir. is a weasel.)

Plus, they were worried about adverse publicity if the information went public.

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CASE 4: Foundation Fraud The next step is to prepare for an

admission-seeking interview in an attempt to get the Exec. Dir. to admit to the thefts.

She did confess and rationalized as follows: “I only borrowed the money and had

every intention of paying it back.” (See Rationalization #1 earlier.)

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CASE 4: Foundation Fraud She did confess and rationalized as

follows: She needed to circulate in high

society to solicit donations from well-to-do people, so she needed to live the lifestyle, including having her kids attend the same private school as the wealthy people’s kids.

She believed her taking “only a little” to meet these needs was not wrong.Rationalization #6: It’s not for me, it’s for the

Foundation.

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Rationalization You must understand how

rationalizations underlie white-collar crime.

Rationalization cuts right to the heart of the psychology of the fraudster: The ability of fraudsters to convince themselves that what they are doing is acceptable enables otherwise good people to do stupid things.

We all engage in rationalizations daily (a form of lying to yourself).

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Rationalization

Rationalization starts with a lie --- a lie to yourself!

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Rationalization It’s important that you contemplate

potential rationalizations when you examine transactions --- what would allow someone to steal X or misreport Y, even though they appear to be a regular person?

Later we’ll see that understanding the perp’s rationalization is important to doing a successful admission-seeking interview.

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Rationalization-a recent example

People are searching for a villain relating to the subprime meltdown.

Angelo Mozilo, founder and CEO of Countrywide Financial, the largest U.S. mortgage lender and the source of so many of the bad home loans that have gummed up the global financial system, has been identified as a potential villain.

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Rationalization-a recent example Countrywide’s easy underwriting culture

invited nothing short of business suicide: an astonishing 7.2% of its mortgages were delinquent, while foreclosures more that doubled in a year.

Mozilo pocketed nearly $400 million in the past 6 years, and took $115 million when Bank of America purchased Countrywide.

At 9/12/11 BoA was in deep financial trouble (reducing its workforce by 30,000) and some link the problems to its acquisition of Countrywide.

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Rationalization-a recent example*

Mozilo’s response: “We have provided over 25 million families with an opportunity to have a home of their own, to build equity, and to utilize that equity to have the best life possible in our great country.” See, it’s not for me, it’s for you ---

rationalization #6.* Business Week, 2/4/2008, p. 77 & CNNMoney.com, 3/7/2008

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Understand the Mind of the Fraudster The more auditors understand why

criminals do what they do, the better prepared they may be to determine the evidence required to uncover fraud.

Professional skepticism, a focus on the fact that smart people may do dumb things, and a focus on the conditions under which white-collar criminals may act will help auditors uncover fraud.

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Conclusion Keep in mind, when designing controls

and when auditing, “Locks on doors keep out honest people.” Predators often circumvent controls --- they

actively seek to “get into a locked house.” The best fraud deterrence mechanism is

simple: Create the expectation in your organization that wrongdoers will be caught and that punishment will be swift and commensurate with the offense. The emphasis on expectation is important.

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Conclusion

People must believe they will be penalized --- S3

Swift Sure Severe

Documents

PWC 2 - 2nd Ed - Feb 2014 Update