2013-05-07 Nonprofit Fraud: Part II

Thrive. Grow. Achieve.
Nonprofit Fraud: What
You Need to Know
Part II: The Detection
Lawrence J. Hoffman, CPA/CFF, CVA, CFE
Senior Partner, & Director of Forensic Consulting Services
May 7, 2013

OBJECTIVES
NONPROFIT FRAUD: THREE-PART SERIES
PART I: THE FRAUD
• Why it is important that you are educated in fraud
• The magnitude of fraud in nonprofits
• The types of frauds in nonprofits
• Why does fraud occur in nonprofits
• Some important fraud prevention measures
PART II: THE DETECTION
• Why do people commit fraud?
• How is fraud detected?
• Who are the fraud perpetrators?
• Fraud detection techniques
• What should you do when you uncover fraud?
PART III: THE PREVENTION
• Fraud risk assessments
• Setting the tone at the top and your board of directors
• What are the best preventative measures and controls?
• The five critical takeaways!
Part II: The Detection * Page 2

AGENDA
• Why do people commit fraud?
• How is fraud detected?
• Who are the perpetrators?
• Fraud detection techniques
• What should you do when you uncover a fraud?

WHY DO PEOPLE COMMIT FRAUD?
THREE REASONS WHY PEOPLE COMMIT CRIMES
• Economics  $$$$$
• Passion  love, lust, a cause (religious beliefs)
• Mental instability  nuts

THE FRAUD TRIANGLE
Rationalization
(frame of mind or
ethical character)
Opportunity
(lack of controls)
Pressure / Incentive (The
“Unshareable” Need)

THE FRAUD TRIANGLE
THE FRAUD TRIANGLE ORIGINATED FROM
DR. DONALD CRESSEY'S HYPOTHESIS:
“Trusted persons become trust violators when they conceive of
themselves as having a financial problem which is non-
shareable, are aware this problem can be secretly resolved by
violation of the position of financial trust, and are able to apply to
their own conduct in that situation verbalizations which enable
them to adjust their conceptions of themselves as trusted
persons with their conceptions of themselves as users of the
entrusted funds or property.1 ”
1DONALD R. CRESSEY, OTHER PEOPLE'S MONEY
(MONTCLAIR: PATTERSON SMITH, 1973) P. 30.

PRESSURE / INCENTIVE
(THE NEED, PERCEIVED OR ACTUAL)
• Financial pressure and debts
• Greed – need for high lifestyle-living beyond their means
• Feed a habit – gambling, drugs, other addictive behaviors
• Retribution / vendetta – feels abused or exploited-holds a
grudge
• Make earnings target or financial metric (bonuses)
• Need for praise and gratification
• Competitive pressures – keep your job
• Medical issues of family or self

OPPORTUNITY (PERCEIVED)
• Weak or non-existent internal controls – lack of segregation of
duties
• Has sufficient access to assets and information that enables
the crime
• Has assessed that that the fraud can be committed and also
successfully concealed
• Too much trust placed in person or position. (Remember: trust
is not an internal control!)
• Poor communication within organization
• Lack of oversight and supervision
• Lack of disciplinary action for previous frauds

RATIONALIZATION (A WAY TO RATIONALIZE THE
BEHAVIOR AS ACCEPTABLE)
• “I am just borrowing the money and will repay it”
• “I’ll stop once I pay off my debts”
• “The company won’t even realize this amount is gone; it’s not
that much”
• They feel they deserve it: “I am getting underpaid and am
underappreciated”
• “Management is ‘living high,’ while I am oppressed”
• “Everyone’s doing it, I am no different”
• “It is for a good purpose”
• They need the money

HOW IS FRAUD DETECTED?
• The detection of fraud involves the ability to recognize in a
timely manner whether fraud has occurred or is occurring
• However, a properly designed and executed audit may still
NOT detect material fraud, especially one involving:
– Forgery
– Deliberate failure to record transactions
– Intentional misrepresentations
– Collusion
• Ability to detect fraud depends on:
– Skillfulness of perpetrator
– Frequency and extent of manipulation
– Degree of collusion
– Relative size of individual amounts manipulated
– Seniority of individuals involved

2012 REPORT TO THE NATIONS ON OCCUPATIONAL FRAUD AND ABUSE

KEY TAKEAWAY: ESTABLISH POLICIES,
PROCEDURES AND MECHANISMS FOR TIPS!
• Employees
• Vendors
• Customers
• Other stakeholders

WHO ARE THE PERPETRATORS?
THE FACES OF FRAUD

TYPICAL PROFILE
• Usually living above their means or has an addictive need
• Does not have a prior criminal conviction or charged with a fraud
• Has a position of trust and responsibility
• Most likely a male between the age of 31 to 45
• Is well educated
• Understands and skillfully uses technology
• Usually comes across as a nice person, charming
• Usually well respected
• They usually spend everything they steal!
• 80% will buy a new car!

FRAUD PERPETRATORS ARE NOT CAREER CRIMINALS

FRAUD PERPETRATORS DO NOT HAVE A PRIOR HISTORY OF
BEING PUNISHED OR TERMINATED BY AN EMPLOYER FOR A
FRAUD-RELATED OFFENSE

FRAUD PERPETRATOR IS TYPICALLY AN EMPLOYEE OR
MANAGER

LARGER LOSSES WITH THE OWNER/EXECUTIVE

MALES TEND TO ACCOUNT FOR ABOUT TWO-THIRDS OF
ALL FRAUD CASES

TYPICALLY BETWEEN AGES 31 AND 45

AMOUNT OF LOSS ROSE WITH AGE!

LOSS WAS GREATER WITH TENURE OF PERPETRATOR

MORE THAN HALF HAD A COLLEGE DEGREE OR HIGHER!

ACCOUNTING DEPARTMENT TOPS THE LIST!

WHO DID THE FBI PROFILE WITH
THESE SYMPTOMS AND SIGNS?
• Anger and arrogance
• Capable of acting witty and charming
• Good at flattery and manipulating other people’s emotions
• Disregards the safety of self and others
• Does not show any guilt
• Lies, steals, and fights often
• Breaks the law repeatedly
• Substance abuse and/or legal problems

BERNIE’S JAIL CELL

Madoff says “he is happier in prison than he was on the outside
because he no longer lives in fear of being arrested and knows
he will die in prison.”

ANTISOCIAL PERSONALITY DISORDER (ASPD OR APD)
• A psychiatric condition in which a person manipulates, exploits,
or violates the rights of others
• Usually begins in childhood or early adolescence and
continues into adulthood
• “Boomerang Personality”-everything you throw at them, they
throw back at you. It is always the other person’s fault. Will not
accept responsibility
• Person with no conscience
• Is usually criminal
• Also referred to as “sociopaths” and “psychopaths”

SOCIOPATHS
• Are unable to experience emotional responses for other people
outside of their own personal interests
• Psychological inability to show emotion or caring for others
• While a sociopath can feel emotion, it is (even if it results in
care for another), because they find it viable for themselves as
opposed to what would be termed as selflessness

THE DILEMMA
• Everyone has to a degree a propensity to commit a crime!
• 93-95% of the population may commit a crime
• 5-7% are hard-core white collar criminals
• We are interested in the severity of the propensity of the 93-
95% and definitely don’t want the 5-7% working for us!

THE SYNTONIC SYNDROME
Five key characteristics of the hard-core white collar
criminal (5-7%)
• Ego-syntonic: “not my fault-ism”, where they re-arrange
events to be continually interpreted in their favor, often at the
expense of another person (vs. “ego-dystonic”)
• Personality disorders: the person probably has a
psychological problem called a personality disorder
• High IQ: the person has a high IQ
• Differential treatment: the person treats different people
differently within organization, usually based on who can give
them what they want. Bottom line: people are carefully
manipulated
• Controls decisions: the person seeks to control – or create –
the (decision-making) process, especially in areas where they
can personally benefit

FRAUD DETECTION TECHNIQUES
RED FLAGS
BEHAVIOR FLAGS
• Financial difficulties
• Living beyond means relative to known income level
• Family problems
• Serious addiction to drugs, alcohol, or gambling
• An unwillingness to share duties or allow others to help
• Defensive behavior-overly nervous when questioned
• A refusal to take vacations or very short vacations
• Over-devotion to the job-working a lot of overtime and
weekends-never calls in sick or misses work!
• A close personal relationship with vendors or customers
• Change in behavior
• Rule breakers

LIVING BEYOND MEANS #1!

LIVING BEYOND MEANS FUELED BY ASSET MISAPPROPRIATION!

FINANCIAL AND BUSINESS FLAGS
• Business is inexplicably unprofitable
• Company is having cash flow problems
• Under capitalized
• Financial statements are always late
• Financial statement trends/ratios are inconsistent and do not
make sense
• Financial records and books are in disarray and always out of
balance
• Management’s operating and financial decisions are
dominated by a single person or a few persons acting in
concert
• Background checks are not conducted on key employees
• High turnover of management and/or key accounting personnel
• Management displays a propensity to take undue risks

FINANCIAL AND BUSINESS FLAGS (continued)
• Accounting personnel exhibit inexperience or laxity in
performing their duties
• Numerous banks and accounts
• Frequent change in independent auditors/accounting firm
• Management places undue pressures on the auditors, through
fees and unreasonable deadlines
• Frequent legal matters
• Frequent change in legal counsel and multiple law firms
• Operates on a “crisis” basis
• Fire people quickly if they don’t do what they want
• Significant transactions with related parties
• Problems with governmental and regulatory agencies

INTERNAL CONTROL FLAGS
• A single employee controls the company finances and
accounting-lack of segregation of duties!
• Bank accounts are not timely reconciled and not reviewed by
someone independent of preparer
• Invoices are paid without verifying receipt or purchase
authorizations
• Reimbursements are not supported by receipts or other
supporting documentation
• Excessive sales voids and credit memos
• Missing deposit slips and/or cancelled checks
• Unexplained inventory shortages or adjustments
• Subsidiary account balances not reconciled
• Unexplained and numerous end-of-period adjusting entries

INTERNAL CONTROL FLAGS (continued)
• A single employee controls the company finances and
accounting
• Bank accounts are not timely reconciled and not reviewed by
someone independent of preparer
• Missing documents
• Altered documents
• Photocopy of documents when originals should be available

PREVENTIVE VS. DETECTIVE
CONTROLS

PREVENTIVE CONTROLS
Preventive controls attempt to deter or prevent undesirable
events from occurring. They are proactive controls that help
prevent a loss.
DETECTIVE CONTROLS
Detective controls, on the other hand, attempt to detect
undesirable acts. The provide evidence that a loss has occurred
but do not prevent a loss from occurring.
Detective techniques should be used to uncover fraud events
when preventive measures fail or unmitigated risks are realized.

PREVENTIVE CONTROLS
• Segregations of duties with well defined job descriptions and
policies and procedures
• Job rotation
• Mandatory vacations
• Obtaining pre-approval on transactions before processing
• Require dual signatures on checks above a certain amount
• Using document control numbers to account for all
transactions-checks, purchase orders, invoices etc…
• Matching and comparing documents
• Testing clerical accuracy
• Physical controls over cash, checks, signatures, inventory and
other assets
• Computer passwords and access controls to prevent
unauthorized electronic access

PREVENTIVE CONTROLS (CONTINUED)
• Back up financial files daily
• Pre-employment background investigations
• Employee training programs-fraud prevention
• Prosecute the guilty

DETECTIVE CONTROLS
• Whistleblower Policies and Hotlines (TIPS!!!)
• Management and supervisory reviews and approvals
• Reconciliations
• Independent review of bank reconciliations and supporting
documents-cancelled checks
• Independent review of vendor control file for suspicious
vendors
• Independent review of payroll files for suspicious employees.
• Investigate customer and vendor complaints promptly
• Physical inspections/counts
• Financial analysis, budget vs. actual
• Data analysis, data mining and continuous auditing techniques
• Other technology tools
• Audits-external, internal, surprise

WHAT SHOULD YOU DO WHEN YOU
UNCOVER FRAUD?
• BE AWARE OF WARNING SIGNS
• REPORT IRREGULARITIES, SPECIFICALLY:
– If someone you work with asks you to do something that is
illegal or unethical
– If you suspect that someone— regardless of rank or
position—is committing fraud or abuse

UNCOVER FRAUD?
• Follow your organizations fraud policy
• Report through hotline or other anonymous reporting
mechanism
• Anonymous letter to company official
• Share your concern with your immediate supervisor or
organization’s audit committee
• Do not confront the suspected perpetrator
• Do not investigate the matter on your own

UNCOVER FRAUD?
• Organization management should retain counsel-
attorney/client privilege
• Employers have a duty to investigate promptly and thoroughly
• Counsel should retain a forensic expert to assist in the
investigation
• Employee (suspect) may be suspended with or without pay-
but do it swiftly if enough predication is present
• Employee (suspect) access to offices, computer systems,
banking, communications and other access rights and
privileges should be suspended or terminated
• Preserve evidence
• Understand legal implications
• Inform your insurance carriers

UNCOVER FRAUD?
• Objectives of the investigation should be conducted with
integrity, fairness, impartiality and respect and include:
– Gathering the facts
– Determining the merits of the complaint
– Complying with legal obligations
– Maintaining confidentiality
– Preserving the reputations of individuals and the
organization
– Taking proper remedial action
– Avoiding liability
– Preventing future claims and incidences

UNCOVER FRAUD?
• Everyone in an organization is responsible for fighting fraud.
• Be alert to potential fraud.
• Report any suspicions to your organization

WHAT YOU NEED TO KNOW ABOUT FRAUD
THE FIVE MOST IMPORTANT TAKEAWAYS – AGAIN!
1. Trust is not an internal control!
– Establish, to the extent possible, controls and procedures that eliminate the
element of trust
– Always segregate the custody of the asset with the recordkeeping for the asset
2. Set the tone from the top!
– “If you are stealing, your employees are stealing!”
– E.g., office supplies, expense reports, etc.
3. Know your employees!
– Background investigations and public records checks before hiring
– Meet and establish a baseline relationship
4. Institute a fraud policy
– No tolerance
– Will prosecute
5. Establish a hotline for tips
– Number one method for detecting fraud!
– Can outsource

HOW CAN RAFFA ASSIST YOU IN
PREVENTING AND DETECTING FRAUD?
FORENSIC CONSULTING SERVICES
• Pre-hire investigations and background checks
• Fraud risk assessment
• Internal control / program review
• Fraud awareness training
• Fraud prevention programs and policies implementation
• Due diligence investigations
• Fraud investigations

SOME AREAS WE WILL BE GOING OVER IN
OUR OTHER PRESENTATION
PART III: THE PREVENTION –
JUNE 5, 2013, 12:00-2:00 P.M.
• Fraud risk assessments
• Setting the tone at the top and your board of directors
• What are the best preventative measures and controls?
• The five critical takeaways!

RESOURCES AND SUGGESTED READING
• 2012 Report to the Nations on Occupational Fraud and Abuse,
Association of Certified Fraud Examiners,
http://www.acfe.com/rttn.aspx
• “The American Fraud Report,” www.jpsimsconsulting.com
• The CPA’s Handbook of Fraud and Commercial Crime Prevention,
AICPA
• Managing the Business Risk of Fraud: A Practical Guide; AICPA,
ITA, and ACFE; https://na.theiia.org/standards-
guidance/Public%20Documents/fraud%20paper.pdf

QUESTIONS AND ANSWERS

BIOGRAPHY
• 35 years of consulting, audit, accounting and tax experience in the public and private
sectors.
• Started career with a Big-Four international accounting firm in Washington, DC.
• Founded a regional certified public accounting and consulting firm in 1982 and grew it to
on of the Washington, DC’s largest firms in seven years. Merged his practice with Raffa
P.C. in 2008.
• Managed and conducted audit and accounting engagements ranging from small privately
held to large publicly held businesses in various industries, including multi-national
businesses, nonprofit organizations, and governmental entities and agencies.
• Performed economic and financial analysis, including projections and forecasts, in support
of litigation and claims for lost earnings and profits, business interruption, shareholder
disputes, patent and trademark infringements, bankruptcy and restructuring, and structural
settlements; assistance with interrogatories, document requests and depositions; and
serving as an expert and consulting witness.
• Performed and supervised business valuations for both public and closely held companies
in a variety of industries, individuals and estates, family limited partnerships and limited
liability companies, including valuations for business combinations (SFAS 141R), mergers,
acquisitions, and divestitures, estate and gift taxes, marital dissolution proceedings, buy-
sell agreements, intangible assets and intellectual property, purchase price allocations,
goodwill (SFAS 142) and long-lived asset (SFAS 144) impairment, fair value accounting
(SFAS 157), cheap stock (IRC 409A), stock-based compensation (SFAS 123R), phantom
stock and employee stock ownership plans.
• Conducted and led teams of forensic accountants on fraud audits and investigations,
including fraudulent financial statements, misappropriations of assets and embezzlements;
money laundering, kickbacks, bribery and conflicts of interest; insurance claims;
bankruptcy; financial institutions and loan fraud. Also has conducted fraud risk
assessments, anti-fraud programs, and fraud training and education.
LAWRENCE J. HOFFMAN,
CPA/CFF, CVA, CFE
SENIOR PARTNER
RAFFA, P.C.
1899 L STREET, NW
WASHINGTON, DC 20036
TEL. 202-822-5408
FAX 202-822-0669
LHOFFMAN@RAFFA.COM

BIOGRAPHY
• Assisted companies and nonprofits with restructuring and turnaround situations, including
recapitalizations, reorganizations and liquidations. Advised entities on Chapters 11 and 7,
bankruptcy filings and proceedings and non-judicial workouts. Developed and
administered crisis management plans, cash flows, liquidation and turnaround analysis,
debt restructuring and creditor negotiations, and turnaround plans.
• Formulated strategic short- and long-term business and financial planning for various
business organizations and served as interim “C” level positions, including for a major
North American sports league, European and U.S. aircraft manufacturer, aviation charter
airline and travel company, and a multi-chain quick service food chain.
• Formulated syndication strategies and prepared business plans and private placement
offerings, including financial forecasts, market research and analysis, due diligence,
securities pricing and structuring for various public and private securities offerings,
including SEC filing.
• Founded and developed a regional NASD licensed broker dealer investment banking firm.
Placed over $150 million in debt and equity and represented over $200 million in merger
and acquisition transactions.
• Founded and developed two private equity funds in excess of $10 million, including
investments in early stage and mature emerging companies in the form of debt and equity.
Portfolio investments included aviation, food and hospitality, software and technology,
telecommunications, sports and entertainment, banking and financial institutions,
healthcare, and wholesale and retail.
• Co-founded and managed various real estate acquisition, ownership, and operating
entities, including commercial office buildings, shopping centers, flex warehouses,
residential housing and developed land.
• Performed tax and financial consulting services for individuals and closely held
businesses.
• Instructor in audit, accounting, finance, and forensic accounting.
CPA/CFF, CVA, CFE
SENIOR PARTNER

BIOGRAPHY
CPA/CFF, CVA, CFE
SENIOR PARTNER
EDUCATION & CERTIFICATIONS
• Bachelor of Science, Accounting – Mount St. Mary’s University
• Certified Public Accountant (CPA)
• Certified Fraud Examiner (CFE)
• Certified in Financial Forensics (CFF)
• Certified Valuation Analyst (CVA)
• Private Investigator (PI), Virginia
• Series 7 General Securities Representative (not active)
• Series 24 General Securities Principal (not active)
• Series 63 Uniform Securities Agent (not active)
PROFESSIONAL ASSOCIATIONS & AFFILIATIONS
• American Institute of Certified Public Accountants, Member
• Virginia Society of Certified Public Accountants
• Association of Certified Fraud Examiners
• National Association of Certified Valuation Analysts
• Institute of Business Appraisers
PERSONAL INTERESTS
• Private pilot with instrument, multi-engine, high performance complex and aircraft ratings
• Golf and fishing
• Reading and politics

2013-05-07 Nonprofit Fraud: Part II

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2013-05-07 Nonprofit Fraud: Part II