Management Override: Common Tactics and How to Audit For Red Flags

Management Override:
Common Tactics and How
to Audit For Red Flags
November 14, 2013
Special Guest Presenter:
David Zweighaft CPA/CFF, CFE

Copyright © 2010 White-Collar Crime 101 LLC and AuditNet LLC
Copyright © 2013 FraudResourceNet™ LLC

About Peter Goldmann, MSc., CFE
 President and Founder of White
Collar Crime 101
Publisher of White-Collar Crime
Fighter
Developer of FraudAware® antifraud training courses
Monthly columnist, The Fraud
Examiner, ACFE Newsletter

 Member of Editorial Advisory
Board, ACFE
 Author of “Fraud in the Markets” –
Explains how fraud fueled the
financial crisis.

About Jim Kaplan, MSc, CIA, CFE
President and Founder of
AuditNet®, the global resource for
auditors (now available on Apple
and Android devices)
Auditor, Web Site Guru,
Internet for Auditors Pioneer
Recipient of the IIA’s 2007
Bradford Cadmus Memorial
Award.
Author of “The Auditor’s Guide to
Internet Resources” 2nd Edition


About David Zweighaft
CPA/CFF, CFE
 Principal at DSZ Forensic Accounting
& Consulting Services LLC
 David has been practicing Litigation
Consulting and Forensic Accounting
for over 20 years
 Assisted the US Dept of Justice in
identifying and tracing asserts
 He managed the largest Swiss bank
Holocaust Asset investigation in New
York for the NYS Banking
Department


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5

Today’s Agenda
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Introduction
Fraud Statistics: The Growing Fraud Threat
Authoritative Guidance
Management Override: WHY? HOW? WHAT?
Ripped from the Headlines
Case Study and Demo
Your Questions
Conclusion


Fraud: The Big Picture
According to major accounting firms, professional fraud
examiners and law enforcement:

 Fraud jumps significantly during tough economic times
 Business losses due to fraud increased 20% in last 12
months, from $1.4 million to $1.7 million per billion dollars of
sales. (Kroll 2010/2011 Global Fraud Report)
 Average cost to for each incident of fraud is $160,000
(ACFE) Of Financial Statement fraud: $2 million
 Approx. 67% of corporate fraud committed by insiders (Kroll)
 Approx. 50% of employees who commit fraud have been
with their employers for over 5 years (ACFE)


Management Override:
Introduction


What is Management Override?
The term ‘management override’ is used in ISA 240
on fraud to refer to the ability of management and/or
those charged with governance to manipulate
accounting records and prepare fraudulent financial
statements by overriding these controls, even where
the controls might otherwise appear to be operating
effectively.
From “Right First Time with Clarified ISAs Module 4”, © ICAEW
2010



Authoritative Guidance – SAS 99
Prevention

Deterrence

Detection

 Tone at the top
 Value system (“Code of
Ethics / Conduct”)
 Positive workplace
environment
 Hiring, promoting and
retaining appropriate
employees
 Training and awareness
programs
 Confirmation / affirmation of
Code of Conduct or Ethics
 Ombudsman programs
 Whistleblower programs
 Incident response / case
management processes
 Investigative procedures
 Discipline, prosecution and
recovery guidelines

 “Active” oversight by Board
and/or Audit Committee
– Fraud risk assessment
and related measures
– Code confirmation /
affirmation process
– Management’s
involvement in financial
reporting process and
override of control
– Process to receive,
retain and treat
complaints of fraud /
unethical conduct
– Internal and external
audit effectiveness
 Internal audit
– Evaluation of adequacy /
effectiveness of internal
controls
 Disciplinary examples

 Identification and
measurement of fraud risk
(“fraud risk assessment”)
 Processes and procedures
to mitigate identified fraud
risk
 Effective internal controls at
entity and process level
 On-going monitoring
activities
 Computer-assisted audit
techniques
 Investigation of:
– Internal control
weaknesses /
breaches
– Non-response to Code
confirmation /
affirmation
– Reported issues


PCAOB Audit Standard #12
69.
Consideration of the Risk of Management Override of
Controls. The auditor's identification of fraud risks should
include the risk of management override of controls.
Note: Controls over management override are important to
effective internal control over financial reporting for all
companies, and may be particularly important at smaller
companies because of the increased involvement of senior
management in performing controls and in the period-end
financial reporting process. For smaller companies, the
controls that address the risk of management override might
be different from those at a larger company. For example, a
smaller company might rely on more detailed oversight by the
audit committee that focuses on the risk of override.

PCAOB Audit Standard #12
73.
Controls that address fraud risks include (a)
specific controls designed to mitigate specific risks of
fraud, e.g., controls to address risks of intentional
misstatement of specific accounts and (b) controls
designed to prevent, deter, and detect fraud, e.g.,
controls to promote a culture of honesty and ethical
behavior. Such controls also include those that
address the risk of management override of other
controls.


Polling Question 1
The three main elements of guidance for fighting
management override according to SAS 99 are (choose all
that apply)
A. Detection
B. Awareness
C. Deterrence
D. Investigation
E. Prevention



Assessing the Risk of
Management Override
Management override is very difficult to detect.
However, an audit committee can take actions to address the
risk of management override of controls:
 Maintaining an appropriate level of skepticism,
 Strengthening committee understanding of the business,
 Brainstorming about fraud risks,
 Using the code of conduct to assess financial reporting
culture,
 Ensuring the entity cultivates a vigorous whistleblower
program, and
 Developing a broad information and feedback network.
Management Override of Internal Control: The Achilles’ Heel of Fraud Prevention © 2005, AICPA


Assessing the Risk of
Management Override (cont’d)
 It is impossible to have controls In place that are sufficient to

totally eliminate the Risk of Management Override (RMO)
 Controls to prevent, or detect and correct, such risks must be
in place to minimize the risk, such as controls over the
authorization and processing of journals and other adjustments
to the financial statements.
 May include incentives or pressures for individuals to misrepresent the results or financial position of the entity such as:
 for personal gain (salary, promotion, bonuses, continued
employment, etc);
 for gain on disposal of the entity or its business;
 to meet expectations or targets;
 to avoid tax;
 to obtain finance or to satisfy the requirements of lenders or
other third parties.

Common Characteristics of
Management Override
 Top Side Journal Entries – Timing, amounts,

nature of the accounts and complexity of the
entries
 Collusion – Related to the size if the entity
 Undue Influence over Accounting/Financial

Reporting Staff – Use of system access and
authorization controls


Testing for Journal Entries
When selecting items for testing, the auditor must
consider:
 Whether there are any fraud risk factors that may help
the auditor identify specific classes of
 Journal entries and other adjustments for testing;
 The effectiveness of controls over the preparation and
posting of journal entries and other adjustments.
 This may reduce the extent of substantive testing
necessary, provided that the auditor has tested
 the operating effectiveness of the controls;
 the characteristics of fraudulent journal entries or
other adjustments.

Polling Question 2
Maintaining a healthy level of skepticism will do little to
help the audit committee address the risk of management
override.
A. True
B. False



Indicators of inappropriate journal entries may include
entries:
 made to unrelated, unusual, or seldom-used accounts
or without identifying account numbers;
 made by individuals who typically do not make journal
entries
 recorded at the end of the period or as post-closing
entries that have little or no explanation or description
 containing round numbers or consistent ending
numbers.
 the nature and complexity of the accounts.


(cont’d)
Inappropriate journal entries or adjustments may be
applied to accounts that:
 contain transactions that are inherently complex or
unusual in nature;
 contain significant estimates and period-end
adjustments;
 have been prone to misstatements in the past;
 have not been reconciled on a timely basis or contain
unreconciled differences;
 contain inter-company transactions; and
 are otherwise associated with an identified risk of
material misstatement due to fraud.

Collusion
What is COLLUSION?
In order for there to be collusion there must be present:
(1) a secret agreement,
(2) involve two or more persons,
(3) the intent to defraud a third party and
(4) give a deceptive appearance of the transaction they
engage in.


Basis for Undue Influence
The 5 basis of power
(http://learnaboutfraud.wordpress.com/2011/09/16/5-bases-ofpower-influencing-to-collude/)
In relation to the perpetration of a fraud scheme, the alleged
fraudster will desire to carry out their fraud scheme (their will),
along with convincing another individual to do the alleged
fraudster’s bidding, without regard towards the other individual’s
wishes (resistance).
So how does a fraud perpetrator accomplish getting another
person to participate in their fraud scheme?
The answer is …….

Basis for Undue Influence
(cont’d)
…The answer is power, influence and coercion
 Reward power - The fraudster’s ability to provide a benefit to
the accomplice.
 Coercive power - The fraudster’s ability to punish the
accomplice if there is resistance.
 Expert power - The fraudster’s perceived expertise or
knowledge.
 Legitimate power - The fraudster’s legitimate right to exercise
authority over the accomplice.
 Referent power - The extent of the accomplice to identify with
the fraudster.


Polling Question 3
Red flags of possible M/O include (choose all that apply)
A. Entries made by individuals who typically do not make
journal entries
B. Entries recorded at the end of the period or as post-closing
C. Entries containing round numbers or consistent ending
numbers.
D. All of the above


Management Override –
Examples

Ripped from the Headlines


Real World Examples
WHO

SCHEME

TYPE OF
OVERRIDE

HOW
DISCOVERED

Worldcom

Improper Capitalization of
Expenses

Collusion, J/Es,
Influence

Internal Audit

Enron

Off-Balance Sheet
Special Purpose Entities

Collusion, J/Es,
Influence

Internal Audit

Computer
Associates

35-day Accounting Periods

Collusion, J/Es

Tip to the NY
Times

Barings
Bank

Unrecorded Trading Losses

No Segregation
of Duties

Regulatory
Investigation

Cendant

Inflated Revenues, Improper
Charges Against Reserves

Collusion, J/Es

Post
Acquisition

Comptronix

CEO, COO, CFO Overstated
Income and Inventory

Collusion, J/Es

Confession to
Board


Real World Examples (cont’d)

WHO

J/Es

Collusion

Influence

Other

No. of
Participants

Worldcom

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



Many

Enron







Many

Computer Associates

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

Many

Barings Bank



Cendant

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

5

Comptronix





3

No SoD

1


Data Analysis - Forensic Audit

Data Analysis Techniques


Case Study
Background
 The Out-of-Control Controller
 Perpetrator failed to reconcile accounts
 Cost to the Company: $6.8 M over 4 years
 Fraudster Profile
 Financial Operations Sr VP; Male
 Prepared fictitious support for account reconciliations
 Directed staff to post fraudulent J/Es to the G/L
 No monitoring or oversight of his work


Case Study: Undue Influence &
Segregation of Duties E-mail


Case Study Background
 The Out-of-Control Controller

(cont’d)

Additional Tests – Segregation of Duties
 Matching Journal Entry originators to

authorizers
 Identifying emails to staff instructing them to post

fictitious Journal Entries


Polling Question 4
Management power is an essential element to override of
controls. Such power can come in which of the following
forms (choose all that apply)
A. Reward power
B. Coercive power
C. Expert power
D. Legitimate power
E. All of the above


Demo – Access and
Authorization Controls Testing
Demo: Matching Data Fields for Segregation of
Duties Testing
Learn How to:
Match Journal Entry Initiators to Authorizers to Identify
Segregation of Duty Violations


Additional Tests
Who Entered the Journal
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Summarize journal entries based on who entered the journal (i.e., the person listed
as the one who typed in the journal entry) to determine if he or she is authorized to
do so. Identifying who entered the data can become a bit complicated if data entry
clerks are inputting the information rather than an authorized manager.

What Was Entered
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

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Summarize journal entries by account and repetitive extracts (e.g., more than 50
instances) and unique account sequences used in the journal entry based on the
first five debit and credit postings.
Extract nonstandard or manual journal entries for further analysis rather than
extracting an entry from a created system, such as an accounts payable ledger
posting.
Stratify the size of journal entries based on the journal entry amount, using the
debit side of the transaction.
Summarize general ledger activity on the amount field based on the absolute value
of the debit or credit to identify top occurring amounts.


Additional Tests (cont’d)
When the Journal Was Entered
 Extract journal entries posted on weekends and holidays.
 Extract journal entries that were made immediately following the end of the fiscalyear. Summarize journal entry credits and debits processed by day, month, and
year.
Where the Journal Was Entered
 Extract journal entries made to suspense accounts and summarize them based on
the person entering the journal entry and their corresponding account numbers.
 Extract journal entries to general ledger accounts that are problematic or complex
based on past issues at the company or the industry in general (e.g., accounting
journal errors subsequently corrected by accounting staff or auditors) by reviewing
previous audits or by asking management to determine past issues.
 Extract debits in revenue and summarize them by their corresponding general
ledger accounts.


Additional Tests (cont’d)
Why the Journal Was Entered
 Extract all general ledger transaction amounts, such as debits or credits, that
exceed the average amounts for the general ledger account by a specified
percentage — five times the average is the default.
 Extract journal entries that equate to round multiples of 10,000, 100,000, and
1,000,000.
 Extract journal entries using key texts, such as "plug" and "net-to-zero," anywhere
in the record. Extract JE’s that are made just below set accounting department
approval limits, especially multiple entries of amounts below such limits.
 Extract journal entries illustrating reclassification of expenses either by credit to an
expense account and no corresponding debit to another expense account, or debit
to the revenue account and no corresponding credit to another revenue account.
 Extract journal entries with other major classification changes in the area of assets,
liabilities, net worth, and unbalanced fund transfers.
 Extract other major classification changes in the area of assets, liabilities, net
worth, and unbalanced fund transfers.


Polling Question 5
Among the most important preventive measures with
regard to M/O is:
A. Board oversight
B. Segregation of duties
C. Delegation of authority
D. Job rotation


Questions?
 Any Questions?
Don’t be Shy!


Thank You!
Website: http://www.fraudresourcenet.com
Jim Kaplan
FraudResourceNet™
800-385-1625
jkaplan@fraudresourcenet.com
Peter Goldmann
FraudResourceNet™
800-440-2261
pgoldmann@fraudresourcenet.com
David Zweighaft
dzweighaft@dszforensic.com
212-699-0901

Coming Up This Month
 Using Data Analysis to Detect and
Prevent P-Card Fraud, Nov. 20


Management Override: Common Tactics and How to Audit For Red Flags

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