Part C

Role of Accounting,
Regulation and Technology
affecting accounting
Contents

CH 8 Role of Accounting
CH 9 Audit and financial controls
CH 10 Identifying and preventing financial crimes
 1 The basic knowledge of fraud
2 Assessing the risk of fraud
3 Responsibility for detecting and
preventing fraud
4 Money laundering

Chapter 8 Identifying and preventing

financial crimes
Identifying and
preventing fraud
Topic 1 The basic knowledge of accounting

1.1 Definition of fraud

01
1.2 Types of fraud
1.3 Implications of fraud for the organization
1.4 Three prerequisites for fraud
1.1 Definition of fraud
Fraud is an intentional action involving the use of deception to obtain an illegal advantage.

Fraud should be distinguished from error. While fraud is an intentional action, error is
unintentional. For example, if an accountant deliberately overstates the revenue, this is fraud.
However, if an accountant miscalculates the revenue amount, this is an error.
1.2 Types of fraud

Intential
Removal of misrepresentation of
funds or assets the financial position
of the business
1.2.1 Removal of funds or assets
a. Theft of cash

Employees may steal company’s petty cash and keep the proceeds as his or her own money.
1.2.1 Removal of funds or assets
b. Theft of inventory

Employees may also steal inventories especially low-value consumption inventories, for

example, taking office stationery.

1.2.1 Removal of funds or assets
c. Payroll fraud
Payroll fraud can occur within or outside the payroll department.
• Deliberately miscalculating selected pay slips (Internal employees).
• Claiming fake overtime work pay (External employees).
• Adding a fictitious member of staff to the payroll list to allocate
extra salary (Internal employees) - ghost employee
1.2.1 Removal of funds or assets
d. Teeming and lading
This is one of the best-known methods of fraud in the sales ledger area.
Teeming and lading is the theft of cash receipts by setting subsequent receipts against the outstanding debt to
conceal the theft.

• Fail in segregation of duty in cash management and trade receivable management

 1.2.1 Removal of funds or assets
e. Fake customers
It takes place where the company does a business with fake clients. Bogus orders are set up, and goods are
despatched on credit. Then, the ‘customer’ fails to pay, and the cost is eventually written off as a bad debt.

f. Collusion with customers

Employees may collude with some clients in order to obtain illegal benefits. Foe example, a sales
manager could issue a credit note in return for a financial reward.

g. Fake provision of goods or services

Employees may gain illegal rewards for claiming supply of goods or services while not provided. For
example, by providing consultancy services. To enhance authenticity, the involved individual (often senior
staff) will set up a personal company that invoices the business for its services.
1.2.1 Removal of funds or assets
h. Meeting budgets/performance target measures
In some cases, knowing that results are unlikely to be questioned once targets have been met,
employees may pocket surplus in excess of target.

i. Manipulation of cash books

Fraudulent activities may be covered up through manipulating cash books with wrong description or
figures to match bank reconciliations.
1.2.1 Removal of funds or assets
j. Intentional misallocation of pension funds or other assets
Companies may use unauthorised pension funds or other assets to achieve their own purposes.

k. Improper disposal of assets for own purpose

Special employees can deliberately manipulate book value for purpose of
obtaining disposable assets.
Example question 1
In the context of fraud, teeming and lading is MOST likely to occur in which of

these combinations of duties?

A Payable ledger and goods inwards

B Payroll and cash handling

C Inventory and goods outward

D receivable ledger and cash receipts

1.2.2 Intentional misrepresentation
Type Description
Over-valuation It should be noted that the inventory here means the year-end figure
of inventory which could affect the financial statements. Usually, there are several
methods to overstate inventory:
(a)miscounting the inventory on purpose;
(b)deliberately omitting records, e.g. deliveries to customers and returns
from customers;
(c)recording obsolete inventory with full value in the financial
statement (not written off).
1.2.2 Intentional misrepresentation
Irrecoverable Receivable forms part of asset in the statement of financial position. To dress up
debt policy may the statement of financial position, those obviously aged receivable (that is, bad
not be enforced debts) will not be recognised. Therefore, assets can be overstated.

Overstating Revenues can be overstated through fictitious sales, and there are several methods
revenues relating to fictitious sales:
(a)deliberately generating invoices with wrong content (e.g. prices or numbers);
(b)overcharging customers with those discounted goods;
(c)selling goods and promising to buy back in the future.
1.2.2 Intentional misrepresentation
Manipulation of To boost the sales, the year-end sales may be deliberately over-
years end events invoiced. And the related credit notes will be issued at the start of next year.

Understating Manipulation of expenses can affect profits directly.

expenses Overstatement of expenses can result in understatement of profits, while
understatement of expenses can lead to overstatement of profits.
1.2.2 Intentional misrepresentation
Manipulation of Firstly, it should be known that the figure of depreciation will
depreciation affect both of profit in the statement of profit or loss and value
figures of assets in statement of financial position. Secondly, the
calculation of depreciation relies on several factors which are
mainly based on accountants’ judgment, for example, useful
life.
As a result, it is convenient for accountants to take advantage
of the discretion on depreciation policy to affect financial
statements.
1.3 Implications of fraud for the organisation

Removal of funds or Misrepresentation of

assets from a business the financial position

Immediate Overstated
implications results

Long term Understated

effects results
 1.3.1 Removal of funds or assets from a business
(a) Immediate financial implications

-The working capital and the net asset are impaired

- Profits are diluted and return for shareholders is lower.

(b) Long-term effects on company performance

- Fraud makes it difficult for company to operate effectively;
- Fraud can even result in collapses of a successful business.
1.3.2 Intentional misrepresentation
(a) Overstated results
- Overstated results, especially overstated profits, will lead
to excessive distribution of dividends given to shareholders, which may
arise two negative effects.
misleading signals for stakeholders (investors/suppliers)

shortage of working capital

1.3.2 Intentional misrepresentation
(b) Understated results
Understated results inversely bring reduced investor return, which sends out false
signal to stakeholders.
Thus, the company may face the risk of restriction on loan and slump of share price.
And even worse, there might be fines from tax authorities.
Example question 2
In a recent audit, it was discovered that ABC Co deliberately overstated its receivable.
Because aged receivable who are obviously not going to pay has not been written off.

Which of the following is a possible implication of this type of fraud?

A receivable will be undervalued
B Capital will be understated

C Reported profit will be higher than it should be

1.4 Three prerequisites for fraud

Dishonesty Motivation Opportunity

Preconditions for fraud

Prerequisite Description
Dishonesty It is a subjective quality and is a tendency to act in ways that contravene
accepted norms. Dishonesty can be prevented by careful screening and
references checking (see chapter 13).
Motivation This is likely to involve a consideration whether a given action is
(see chapter worthwhile, which means balancing the potential rewards in relation to
17) the potential sanctions.
Motivation for fraud could be prevented by provision of good working
conditions and effective grievance procedures. Training could also be
used to address the serious sanctions of violating corporate requirements.

Opportunity This can be a ‘loophole’ in the regulation and control system that allows
the fraudulent activities to occur undetected.

Opportunity can be prevented in several ways, for example:

a) Effective internal control;
b) Continuous monitoring and review of all controls
Topic 2 Assessing the risk of fraud
2.1 External factors
01 2.2 Internal factors
2.3 Business factors
2.4 Personal factors
2.5 Potential for computer fraud
2.6 Systems for detecting and preventing fraud
2. Assessing the risk of fraud
Different perspectives to identify risk, firstly:

External Internal
factors factors

Business Personnel
risks risks
2.1 External factors
It means the general environment in which the business operates, for example:

Economic
Cycle of
✓ Luxury Fierce recession/
✓ Retail degree depression
✓ Building

Competition Economic
Industry
2.2 Internal factors

Changing
operating Rapid
Restructuring environment growth

New products New (the firm itself) New

and processes personnel

New New
information technology
system
2.3 Business risks
• profitability diverge obviously from the industry level

• poor reputation from the market about the company

• complex structure of business units

2.4 Personnel risks
• Secretive behavior

• luxurious life style

• lack of rest for employees (long hours or untaken holidays)

• autocratic management approach

• poor staff morale (‘motivation’ of fraud is high from the resentment towards the
firm/ ‘opportunity’ may occur because of breakdown of internal control)
 2.5 Potential for computer fraud

Computer hackers Technology limitation

on detecting risk (fail to keep up
with the development in computer technology)

Insufficient skills Preference for

of (senior) management handy process
than tight control
2.6 General prevention policies
2.6.1 General prevention policies
(a) Emphasizing ethics in formal codes of ethics (see CH 6)

(b) Personnel controls (strict recruitment policy /performance interview (see CH 12)

(c) Ongoing training (see CH 12)

2.6 Systems for detecting and preventing fraud
2.6.2 Specific prevention policies
(a) SPAMSOAP/PAPAMOSS
(b) Standard procedures
(c) Holidays
(d) Whistle-blowing
(e) Evolving control systems
Topic 3 Responsibility for detecting and
preventing fraud
3.1 The responsibilities of directors
01
3.2 The responsibilities of the audit committee
3.3 The role of the internal audit
3.4 The role of the external auditor
3.1 The responsibilities of directors
• The responsibilities of directors
a. Ensure the activities of the business are conducted honestly

b. Establish arrangements to prevent and detect fraud

c. Ensure reliable financial information

It is the responsibility of the directors to take reasonable steps to detect and prevent fraud and error.
3.2 The responsibilities of the audit committee
• The responsibilities of the audit committee
It is recommended that the audit committee should review the company's internal control and risk
management systems.
3.3 The role of the internal audit

• The role of the internal audit

The internal auditors should make recommendations to improve controls with the purpose of detecting fraud
in the future.
3.4 The role of the external auditor
• The role of the external auditor
The responsibility of external auditors are only to express an opinion on whether the financial statements give a
true and fair review of the company’s situation.

If the auditors become aware during the audit that certain fraud or error may exist, they should document
their findings and report to management. At the same time, in the case of fraud, the auditors should consider
whether the matter need to be reported to an appropriate authority in the public interest.
 3.4 The role of the external auditor
• The role of the external auditor
- If yes, they need to request the directors to make the report; if the directors refuse to do so, or the fraud casts
doubt on the integrity of the directors, the auditors should make the report themselves.

- If the auditors believe that the financial statements are affected by fraud or error, they should qualify their
reports accordingly.
Example question 3
Consider the following two statements:
(1) The management and those charged with governance take the primary responsibility for fraud and error.
(2)The internal auditors should have sufficient knowledge to evaluate the risk of fraud and design the control
system with the purpose of detecting fraud in the future.

Which of these options is/are correct?

A. 1 only B. 2 only C. Both D. Neither
Example question 4
In relation to fraud prevention, which of the following statements is correct in respect of the role of the
external auditor?
A.The external auditor has primary responsibility for preventing and detecting fraud and is accountable
to the shareholders for this.
B.The external auditor must ensure that all internal systems are capable of detecting every type of
fraud.
C.The work of the external auditor has nothing to do with fraud prevention, so the external auditor has no
responsibility in this aspect
D.The external auditor's procedures should provide reasonable assurance that misstatements arising
from fraud will be identified
Topic 4 Money laundering

4.1 Definition of money laundering

01
4.2 Steps of Money laundering
4.3 Categories of criminal offences of money laundering
4.4 Methods of detecting and preventing money laundering
4.1 Definition of money laundering
Money laundering is the transfer of the 'dirty' money and assets that have been criminally obtained
into 'clean' money and assets that have no link to criminal activity, it constitutes any financial
transactions whose purpose is to conceal the origins of the proceeds of criminal activity
4.2 Steps of Money laundering
Three steps of money laundering
• Placement: initial disposal of proceeds
• Layering: transfer
• Integration: the money has the legal appearance
4.3 Categories of criminal offences of money laundering
• Laundering

• Failure to report (failure to disclose suspicion of money laudering )

• Tipping off (disclosing information to money launderer)

4.4 Methods of detecting and preventing money laundering

a) Ongoing monitoring and risk assessment of unusual transactions

b) Ensuring all customers are identified by appropriate customer due diligence.
c) Set a special role which is named as Money Laundering Reporting Officer (MLRO).
d) Maintaining full and up to date records.