Tracking Accounting Fraudsters with Modern Prevention

by Patrick Müller

03.11.2022

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What do modern prevention options for internal and external auditors look like for detecting and preventing balance sheet manipulation? Or, put another way: How do you identify invoices written on a typewriter?

In recent years, balance sheets have repeatedly been manipulated through fraudulent actions. This raises the question of how such activities are recorded in accounting. Expanding 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 discussions about recent cases, the examination of how the actual manipulation was technically and operationally performed is often missing. Were the balances of general ledger accounts manually altered during consolidation and transfer into the balance sheet and income statement structure? Was manipulation carried out directly in the accounting system? Or were fraudulent transactions entered through processes such as procurement, sales, HR, or inventory management?

How does the money end up in the war chest?

Balance sheet manipulation becomes relevant when significant amounts are altered for the company. While large individual transactions are easy to identify and review, positions with many transactions provide an opportunity to conceal fraudulent activities within the mass of data. In practice, this is often compared to looking for a needle in a haystack. But it’s not that simple. We now associate fraud detection more with solving a puzzle since it’s not only about the individual transactions but also about understanding the connections between them and the overall picture that emerges.

Practical example: How invoices without purchase orders can be used to fill general ledger or bank accounts.

In practice, it sometimes happens that departments place orders by phone or email without involving the procurement department. When invoicing occurs, the department typically involves the accounting team and requests payment of the invoice. In this case, accounting records an invoice without a purchase order and automatically generates accounting records with the corresponding entries. This process is illustrated as Scenario 1 below. If the correct inventory or expense type is selected, Scenario 1 will not raise any issues from an accounting perspective. However, procurement decisions and control mechanisms are bypassed. This approach has been used in known fraud cases to obtain payouts on fraudulent bank accounts by using fictitious and self-created invoices, so we recommend minimizing such practices.

The situation becomes critical from an accounting perspective when a process is split (see Scenario 2). In the first procurement process, a goods receipt is recorded for an existing purchase order, automatically generating the accounting document with the inventory increase and posting it to the goods receipt/invoice receipt (GR/IR) clearing account. So far, so good, as this can be linked and documented as a real transaction. If the incoming invoice is not assigned to the already started process No. 1 but, as in Scenario 1, a creditor invoice without a purchase order is created as a second process, an additional inventory increase occurs. While process No. 2 is consistent and does not cause any accounting issues, the accounting entry generated by process No. 1 leads to a misrepresentation.

If Scenario 2 occurs by mistake, it can be classified as an operational error. However, if it happens intentionally, it can be considered balance sheet manipulation. The benefit of this manipulation and how the two manipulated accounts – inventory and GR/IR clearing – are handled remain open. At a later stage, this created account balance could be deliberately rebooked to manipulate selected balance sheet items or adjust other accounts under audit.

A look into the book: Invoices without purchase orders as established process deviations and their possible consequences

(Image source: Rinker, Carola; Müller, Patrick: Münker, Frank (2022): "Accounting Fraud – Understanding Balance Sheet Manipulation in Practice and Detecting, Investigating, and Preventing It Early Using Data Analysis"; page 70.)

Recommendations for analyzing complex relationships in business process and accounting data as preventive measures

Our primary focus is on substantive and technical control options. For example, this involves training, auditing, adjusting, and securing process workflows. Process deviations should be continuously detected and corrected using data analysis. It's essential to apply the correct analytical methods and verify a data foundation that matches the company’s complexity. For large companies, we believe it’s no longer sufficient to only audit financial accounting data. Instead, it’s necessary to trace individual transactions back to their originating processes and then audit them. We present various methods and audit steps in our recently published book.

Additionally, setting up a whistleblower system and conducting continuous monitoring or continuous auditing can be beneficial. Tips from employees and business partners can help detect early indications or suspicions of fraud. In practice, experience has shown that there are always people aware of manipulations, such as accounting staff who notice irregularities. If there is a whistleblower system in place, reporting becomes easier, and the long-term damage is reduced compared to situations where employees have no way to report.

Another early detection method, triggered by data, comes from the continuous audits performed by risk management or internal audit. Each system on its own is an asset. Furthermore, applying the 'sharing is caring' principle by exchanging insights and suspicions between the second and third lines of defense in a trust-based and appropriate manner allows for new preventive and data-focused analyses or controls to be derived and carried out fully automatically and in real-time.

We personally believe that teams conducting audits should have strong data analysis skills and that management should have basic knowledge of data and analytics. Often, experts from other areas are brought in for data analysis or programming. With this 'Analytics as a Service' approach, we see the risk that relevant information, domain knowledge, risk areas, analysis selection, findings, and insights could be overlooked or misinterpreted. While outsourcing analytics competence may be efficient, we don’t believe it’s the best approach.

In addition to training in accounting and (digital) auditing, we recommend that risk management and internal audit staff also experience what it’s like to be on the 'wrong side' of things – in other words, see how some of the more absurd scenarios play out in real life. This shift in perspective from audit to intentional fraud helps when assessing processes and permissions and simulating where, how, and how much damage can be done. We also present several examples in our recently published book.

A look into the book: Chapter and topic overview