Fraud detection is more like solving a puzzle than searching for a needle in a haystack

by Patrick Müller

09.08.2022

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In an interview with Catarina Gomes de Almeida, I explained what motivates perpetrators to commit balance sheet manipulation, which warning signs to look for, when accounting fraud becomes relevant, and what preventive measures can be taken.

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Dear Mr. Müller, together with Dr. Carola Rinker and Frank Münker, you wrote the book "Accounting Fraud" to prevent balance sheet manipulation. What motivated you?
The past few years have shown that balance sheets have repeatedly been manipulated through fraudulent actions. This raises the question of how such activities are recorded in accounting. Evolving IT landscapes and complex processes allow these fraudulent transactions to be carried over into financial accounting through pre-systems and interfaces without the involvement of individual accounting staff.
In my opinion, discussions around current cases have failed to address how the actual manipulation was technically and operationally executed. Were general ledger balances manually modified during consolidation and transfer into the balance sheet and income statement structure? Was the manipulation already carried out in the accounting system? Or were the fraudulent activities entered through processes like procurement, sales, HR, or inventory management?
Several publications address accounting fraud from an economic and legal perspective. With our book, we aim to introduce the IT-systematic possibilities for manipulation in a simplified manner — simplified because we do not want to provide a guide to fraud — while also offering various warning signs and auditing possibilities. In doing so, we aim to close the technical gap and trace the origins of widely used Red Flag analyses.

The issue of balance sheet manipulation has gained new relevance through recent cases like the Wirecard scandal. What motivates perpetrators? And how is fraud facilitated?
The motivation of perpetrators varies from case to case. Manipulation can occur due to the company’s financial situation or the personal financial circumstances of individuals. Public or shareholder expectations can also play a role. However, motivation is just one of several factors that facilitate fraud. The so-called "Fraud Triangle" also highlights the internal justification of perpetrators and the opportunity they have. It’s these corporate opportunities that we address in the book.

A Look Inside the Book: Chapter and Topic Overview

(Image source: Rinker, Carola; Müller, Patrick: Münker, Frank (2022): "Accounting Fraud – Understanding Balance Sheet Manipulation in Practice and Detecting, Investigating, and Preventing It Early with Data Analysis"; page 4.)

What are the key warning signs of balance sheet manipulation that should be noted?
In addition to the classic analysis of balance sheet items and key financial figures over the course of the year, we recommend paying attention to warning signs that may arise from the company’s environment, IT systems, or transaction data.
For example, red flags can emerge from the industry-specific environment or through observation of internal organizational conditions.
Alarm bells should also ring when examining IT systems and their configurations. This could include manual interventions in automated processes or inactive organizational units.
Transaction-based warning signs can also arise when looking at digital business transactions. These red flags can appear in an imbalanced customer or product portfolio, missing attachments, or overly perfect data.

Are there specific balance sheet items particularly vulnerable to manipulation?
That depends on the company’s industry and its specific business models. In general, every item has the potential to record non-existent transactions or, vice versa, not record existing transactions. Additionally, real transactions may be recorded with incorrect valuations. For this reason, all balance sheet and income statement items should be reviewed, and it should be clarified whether each item includes individual transactions or a large volume of transactions.
Balance sheet manipulation becomes relevant when significant amounts are modified for the company. While large individual amounts on an item are easy to identify and review, items with a high volume of transactions provide opportunities to conceal fraudulent activities. In practice, this is often compared to finding a needle in a haystack. But it’s not that simple. I now think of fraud detection more like solving a puzzle because it’s not only about individual transactions but also about the connections between them and the overall picture.

A Look Inside the Book: Established process deviations or recurring operational errors as a cover for manipulation

A magnet to pull the needle out of the haystack isn’t enough. What should be done to identify such activities and prevent balance sheet manipulation?
I like a statement by Roger Odenthal, who works in the field of employee crime. According to his interpretation, economic crime, after removing all the side stories, is essentially a control offense. That means controls can be used as preventive and detective measures. When it comes to controls, the question often arises, "who controls what?" The responsibility for such controls should be clarified using the so-called "Three Lines of Defense" model. In our book, we do not focus on the division of responsibilities between operational management, risk management, and internal audit. Instead, we focus on the substantive and technical control options that can also be applied by external auditors and regulatory authorities.

For example, this involves training, auditing, adjusting, and securing process workflows. Process deviations should be continuously detected and corrected using data analysis. It is essential to apply the correct analytical methods and verify a data foundation that matches the company’s complexity.
For large companies, it is no longer sufficient to audit only financial accounting data. Instead, it is necessary to trace individual transactions back to their originating processes and then audit them. We present various methods and audit steps in the book.
Setting up a whistleblower system and conducting continuous monitoring or continuous auditing is also helpful.

Personally, I believe it’s important that the teams conducting audits possess strong data analysis skills and that management has a basic understanding of data and analytics. Often, experts from other areas are brought in for data analysis. With this "Analytics as a Service" approach, I see the risk that relevant information, domain knowledge, risk areas, analysis selection, findings, and insights could be overlooked or misjudged. While outsourcing analytics capabilities may be efficient, I do not believe it’s the right way forward.

A Look Inside the Book: Real-time Analytics as Part of Continuous Monitoring and Auditing