Studies in Accounting Information Systems

Studies in Accounting Information Systems

Computer Fraud

1Dr: Mohammed Shanikat , www.mohammedshanikat.synthasite.com

Learning Objectives

Explain the threats faced by modern information systems. Define fraud and describe the process one follows to perpetuate a fraud. Discuss who perpetrates fraud and why it occurs, including:

the pressures, opportunities, and rationalizations that are present in most frauds.

Define computer fraud and discuss the different computer fraud classifications.

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INTRODUCTION

Information systems are becoming increasingly more complex and society is becoming increasingly more dependent on these systems. Companies also face a growing risk of these systems being

compromised. Recent surveys indicate 67% of companies suffered a security

breach in the last year with almost 60% reporting financial losses.

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Common Threats to AIS Natural Disasters and Terrorist Threats

Software Errors and/or Equipment Malfunction

Unintentional Acts (Human Error)

Intentional Acts (Computer Crimes)

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INTRODUCTION

Companies face four types of threats to their information systems: Natural and political disasters

• Include:– Fire or excessive heat– Floods– Earthquakes– High winds– War and terrorist attack

• When a natural or political disaster strikes, many companies can be affected at the same time.– Example: Bombing of the World Trade Center in NY.

• The Defense Science Board has predicted that attacks on information systems by foreign countries, espionage agents, and terrorists will soon be widespread.

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INTRODUCTION

Companies face four types of threats to their information systems: Software errors and equipment malfunction

• Include:– Hardware or software failures– Software errors or bugs– Operating system crashes– Power outages and fluctuations– Undetected data transmission errors

• Estimated annual economic losses due to software bugs = $60 billion.

• 60% of companies studied had significant software errors in previous year.

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INTRODUCTION

Companies face four types of threats to their information systems: Unintentional acts

• Include– Accidents caused by:

• Human carelessness• Failure to follow established procedures• Poorly trained or supervised personnel

– Innocent errors or omissions– Lost, destroyed, or misplaced data– Logic errors– Systems that do not meet needs or are incapable of performing intended

tasks• Information Systems Security Assn. estimates 65% of security problems are

caused by human error.5-7

INTRODUCTION

Companies face four types of threats to their information systems: Intentional acts (computer crime)

• Include:– Sabotage– Computer fraud– Misrepresentation, false use, or unauthorized disclosure of

data– Misappropriation of assets– Financial statement fraud

• Information systems are increasingly vulnerable to these malicious attacks.

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INTRODUCTION

In this chapter we’ll discuss: The fraud process Why fraud occurs Approaches to computer fraud Specific techniques used to commit computer fraud Ways companies can deter and detect computer fraud

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THE FRAUD PROCESS

Fraud is any and all means a person uses to gain an unfair advantage over another person.

In most cases, to be considered fraudulent, an act must involve: A false statement (oral or in writing) About a material fact Knowledge that the statement was false when it was

uttered (which implies an intent to deceive) A victim relies on the statement And suffers injury or loss as a result

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THE FRAUD PROCESS Because fraudsters don’t make journal entries to record their

frauds, we can only estimate the amount of losses caused by fraudulent acts: The Association of Certified Fraud Examiners (ACFE) estimates

that total fraud losses in the United States run around 6% of annual revenues or approximately $660 billion in 2004. More than we spend on education and roads in a year. Six times what we pay for the criminal justice system.

Income tax fraud (the difference between what taxpayers owe and what they pay to the government) is estimated to be over $200 billion per year.

Fraud in the healthcare industry is estimated to exceed $100 billion a year.

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THE FRAUD PROCESS

Fraud against companies may be committed by an employee or an external party. Former and current employees (called knowledgeable

insiders) are much more likely than non-employees to perpetrate frauds (and big ones) against companies. Largely owing to their understanding of the company’s

systems and its weaknesses, which enables them to commit the fraud and cover their tracks.

Organizations must utilize controls to make it difficult for both insiders and outsiders to steal from the company.

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THE FRAUD PROCESS

Fraud perpetrators are often referred to as white-collar criminals. Distinguishes them from violent criminals, although some

white-collar crime can ultimately have violent outcomes, such as: Perpetrators or their victims committing suicide. Healthcare patients killed because of alteration of

information, etc., that can result in their deaths.

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THE FRAUD PROCESS

Three types of occupational fraud: Misappropriation of assets

• Involves theft, embezzlement, or misuse of company assets for personal gain.

• Examples include billing schemes وهمية check ,فواتيرtampering الشكيات .skimming, and theft of inventory ,تجير

• In the 2004 Report to the Nation on Occupational Fraud and Abuse, 92.7% of occupational frauds involved asset misappropriation at a median cost of $93,000.

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THE FRAUD PROCESS

Three types of occupational fraud: Misappropriation of assets Corruption

• Corruption involves the wrongful use of a position, contrary to the responsibilities of that position, to procure a benefit.

• Examples include kickback schemes and conflict of interest schemes.

• About 30.1% of occupational frauds include corruption schemes at a median cost of $250,000.

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THE FRAUD PROCESS

Three types of occupational fraud: Misappropriation of assets Corruption Fraudulent statements

• Financial statement fraud involves misstating the financial condition of an entity by intentionally misstating amounts or disclosures in order to deceive users.

• Financial statements can be misstated as a result of intentional efforts to deceive or as a result of undetected asset misappropriations that are so large that they cause misstatement.

• About 7.9% of occupational frauds involve fraudulent statements at a median cost of $1 million. (The median pales in comparison to the maximum cost.)

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THE FRAUD PROCESS A typical employee fraud has a number of important elements or

characteristics: The fraud perpetrator must gain the trust or confidence of the

person or company being defrauded in order to commit and conceal the fraud.

Instead of using a gun, knife, or physical force, fraudsters use weapons of deceit and misinformation.

Frauds tend to start as the result of a perceived need on the part of the employee and then escalate from need to greed. Most fraudsters can’t stop once they get started, and their frauds grow in size.

The fraudsters often growينشأ careless مباالة or عدمoverconfident المفرطة .over time الثقة

Fraudsters tend to spend what they steal. Very few save it. In time, the sheer magnitude of the frauds may lead to

detection. The most significant contributing factor in most employee

frauds is the absence of internal controls and/or the failure to enforce existing controls.

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THE FRAUD PROCESS The National Commission on Fraudulent Financial Reporting

(aka, the Treadway Commission) defined fraudulent financial reporting as intentional or reckless conduct مسؤؤل غير ,سلوكwhether by act or omission, that results in materially misleading financial statements.

Financial statements can be falsified to: Deceive investors and creditors Cause a company’s stock price to rise Meet cash flow needs Hide company losses and problems

Fraudulent financial reporting is of great concern to independent auditors, because undetected frauds lead to half of the lawsuits against auditors.

In the case of Enron, a financial statement fraud led to the total elimination of Arthur Andersen, a premiere international public accounting firm 5-19

THE FRAUD PROCESS

Common approaches to “cooking the books” include: Recording fictitious revenues Recording revenues prematurely Recording expenses in later periods Overstating inventories or fixed assets (WorldCom) Concealing losses and liabilities

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THE FRAUD PROCESS

The Treadway Commission recommended four actions to reduce the possibility of fraudulent financial reporting: Establish an organizational environment that

contributes to the integrity of the financial reporting process.

Identify and understand the factors that lead to fraudulent financial reporting.

Assess the risk of fraudulent financial reporting within the company.

Design and implement internal controls to provide reasonable assurance that fraudulent financial reporting is prevented.

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THE FRAUD PROCESS

SAS 99: The Auditor’s Responsibility to Detect Fraud In 1997, SAS-82, Consideration of Fraud in a Financial

Statement Audit, was issued to clarify the auditor’s responsibility to detect fraud

A revision to SAS-82, SAS-99, was issued in December 2002. SAS-99 requires auditors to:

Understand fraud• Auditors can’t effectively audit something they don’t understand.• SAS-99 also indicated that auditors are not lawyers and “do not make legal

determinations of whether fraud has occurred.”• The external auditor’s interest specifically relates to acts that result in a

material misstatement of the financial statements.• Note that SAS-99 relates to external auditors. Internal auditors will have a

more extensive interest in fraud than just those that impact financial statements.

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THE FRAUD PROCESS

A revision to SAS-82, SAS-99, was issued in December 2002. SAS-99 requires auditors to: Understand fraud Discuss the risks of material fraudulent

misstatements• While planning the audit, members of the audit team should discuss how and where the company’s financial statements might be susceptible to fraud.

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THE FRAUD PROCESS A revision to SAS-82, SAS-99, was issued in December 2002. SAS-

99 requires auditors to: Understand fraud Discuss the risks of material fraudulent misstatements Obtain information

• The audit team must gather evidence about the existence of fraud by:– Looking for fraud risk factors– Testing company records– Asking management, the audit committee, and others if they know

of any past or current fraud or of fraud risks the organization faces.• Special care needs to be exercised in examining revenue accounts,

since they are particularly popular fraud targets.

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99 requires auditors to: Understand fraud Discuss the risks of material fraudulent misstatements Obtain information Identify, assess, and respond to risks

• Use the gathered information to identify, assess, and respond to risks.

• Auditors can respond by varying the nature, timing, and extent of auditing procedures they perform.

• They should also carefully evaluate risks related to management override of controls.

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99 requires auditors to: Understand fraud Discuss the risks of material fraudulent misstatements Obtain information Identify, assess, and respond to risks Evaluate the results of their audit tests

• Auditors must assess the risk of fraud throughout the audit.• When the audit is complete, they must evaluate whether any

identified misstatements indicate the presence of fraud.• If so, they should determine the impact on the financial

statements and the audit.

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99 requires auditors to: Understand fraud Discuss the risks of material fraudulent misstatements Obtain information Identify, assess, and respond to risks Evaluate the results of their audit tests Communicate findings. Auditors communicate their fraud

findings to management, the audit committee, and others== Document their audit work. Auditors must document their

compliance with SAS-99 requirements Incorporate a technology focus• SAS-99 recognizes that technology impacts fraud risks and

notes opportunities that auditors have to use technology-oriented tools and techniques to design fraud auditing procedures.

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Why fraud occursWHO COMMITS FRAUD AND WHY

Researchers have compared the psychological and demographic characteristics of three groups of people: White-collar criminals Violent criminals The general public

They found: Significant differences between violent and white-collar criminals. Few differences between white-collar criminals and the general public

White-collar criminals tend to mirror the general public in: Education Age Religion Marriage Length of employment Psychological makeup 5-28

WHO COMMITS FRAUD AND WHY

Perpetrators of computer fraud tend to be younger and possess more computer knowledge, experience, and skills.

Hackers and computer fraud perps tend to be more motivated by: Curiosity فضول A quest for knowledge The desire to learn how things work The challenge of beating the system

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They may view their actions as a game rather than dishonest behavior.

Another motivation may be to gain stature in the hacking community.

Some see themselves as revolutionaries spreading a message of anarchy and freedom.

But a growing number want to profit financially. To do so, they may sell data to: Spammers Organized crime Other hackers The intelligence community

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Some fraud perpetrators are disgruntled and unhappy with their jobs and are seeking revenge against their employers.

Others are regarded as ideal, hard-working employees in positions of trust.

Most have no prior criminal record.

So why are they willing to risk everything?

Criminologist Donald Cressey, interviewed 200+ convicted white-collar criminals in an attempt to determine the common threads in their crimes. As a result of his research, he determined that three factors were present in the commission of each crime. These three factors have come to be known as the fraud triangle. Pressure Opportunity Rationalization

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The “Fraud Triangle”Donald Cressey

Pres

sure

Opportunity

Rationalization32

Pressures

Pressure Cressey referred to this pressure as a

“perceived non-shareable need.” The pressure could be related to finances,

emotions, lifestyle, or some combination.

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Pressures The most common pressures were:

- Not being able to pay one’s debts, nor admit it to one’s employer, family, or friends (which makes in non-shareable). May be associated with vices, such as drugs, gambling, mistresses, etc

- Fear of loss of status because of a personal failure. Example would be mismanagement of a personal investment or retirement fund

- Business reversals. Not many people can walk away from a failing business.

- Physical isolation. When an individual is isolated, physically or psychologically, almost any pressure becomes non-shareable

- Status gaining. Many frauds are motivated by nothing more than a perceived need to keep up with the Joneses. The problem is that there is always a richer “Jones” down the street and the pressure continues to mount, as do the resulting thefts

- Difficulties in employer-employee relations. May create pressure to get revenge, take the money you feel is rightfully owed to you, etc

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Pressure What’s important here is the perception of the pressure.

There might be a number of people who could and would help a tentative fraudster out of his financial woes.

But as long as he perceives that he cannot share his burden, the pressure is present.

Research has also found that an individual’s propensity to commit fraud is more related to how much he worries about his financial position than his actual position.

The millionaire who frets a lot about his financial condition is more likely to commit fraud than the guy who doesn’t have two dimes to rub together but isn’t worried about it.

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Pressure Financial statement fraud is distinct from other types of fraud in

that the individuals who commit the fraud are not the direct beneficiaries. The company is the direct beneficiary. The perpetrators are typically indirect beneficiaries.

In the case of financial statement frauds, common pressures include: To prop up earnings or stock price so that management can:

Receive performance-related compensation. Preserve or improve personal wealth held in company stock or

stock options. Keep their jobs.

To cover the inability to generate cash flow. To obtain financing. To appear to comply with bond covenants or other agreements. May be opposite of propping up earnings in cases involving

income-tax motivations, government contracts, or regulation.5-36

Pressure

Employee

Financial

Emotional Lifest

yle• Motivation or incentive to commit fraud

•Types:1.Employee

• Financial• Emotional• Lifestyle

2.Financial• Industry

conditions• Management

characteristics

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Financial Reportin

g

Industry Conditio

ns

Mgmt Characteristics

Fraud Triangle: Opportunity

Opportunity is the opening or gateway that allows an individual to: Commit the fraud Conceal the fraud Convert the proceeds

Committing the fraud might involve acts such as: Misappropriating assets. Issuing deceptive financial statements. Accepting a bribe in order to make an arrangement that is not

in the company’s best interest

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Opportunity

Opportunity

Commit

Conceal Conv

ert• Condition or situation that allows a person or organization to:

1.Commit the fraud

2.Conceal the fraud

• Lapping• Kiting

3.Convert the theft or misrepresentation to personal gain 5-40

Opportunity

Concealing the fraud often takes more time and effort and leaves more evidence than the actual theft or misrepresentation.

Examples of concealment efforts: Charge a stolen asset to an expense account or to an

account receivable that is about to be written off. Create a ghost employee who receives an extra

paycheck.

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Opportunity Examples of concealment efforts:

Lapping.

Steal a payment from Customer A. Apply Customer B’s payment to Customer A’s account so Customer A won’t get a late notice. Apply Customer C’s payment to Customer B’s account, so Customer B won’t get a late notice, etc.

Kiting. Creates “cash” by transferring money between banks.

Requires multiple bank accounts.

Basic scheme: Write a check on the account of Bank A. Bank A doesn’t have sufficient funds to cover the check, so

write a check from an account in Bank B to be deposited in Bank A.

Bank B doesn’t have sufficient funds to cover the check, so write a check from an account in Bank C to be deposited in Bank B, etc

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Opportunity

Unless the target of the theft is cash, then the stolen goods must be converted to cash or some form that is beneficial to the perpetrator. Checks can be converted through alterations, forged

endorsements, check washing, etc. Non-cash assets can be sold (online auctions are a favorite

forum) or returned to the company for cash

If the fraud is a financial statement fraud, then the gains received may include: I have to keep my job. The value of my stock or stock options rose. I received a raise, promotion, or bonus. I have power.

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There are many opportunities that enable fraud. Some of the most common are: Lack of internal controls Failure to enforce controls (the most prevalent

reason) Excessive trust in key employees Incompetent supervisory personnel Inattention to details Inadequate staff

Opportunity

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Opportunity Internal controls that may be lacking or un-enforced include:

Authorization procedures Clear lines of authority Adequate supervision Adequate documents and records A system to safeguard assets Independent checks on performance Separation of duties

One control feature that many companies lack is a background check on all potential employees.

Management may allow fraud by: Not getting involved in the design or enforcement of internal

controls; Inattention or carelessness; Overriding controls; and/or Using their power to compel subordinates to carry out the fraud

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The Fraud Triangle

Pressure

Opportunity

Rationalization

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Rationalizations

How many people do you know who regard themselves as being unprincipled or sleazy (رخيص)?

It is important to understand that fraudsters do not regard themselves as unprincipled. In general, they regard themselves as highly principled

individuals. That view of themselves is important to them. The only way they can commit their frauds and maintain

their self image as principled individuals is to create rationalizations that recast their actions as “morally acceptable” behaviors.

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Rationalizations

These rationalizations take many forms, including: I was just borrowing the money. It wasn’t really hurting anyone. (Corporations

are often seen as non-persons, therefore crimes against them are not hurting “anyone.”)

Everybody does it. I’ve worked for them for 35 years and been

underpaid all that time. I wasn’t stealing; I was only taking what was owed to me.

I didn’t take it for myself. I needed it to pay my child’s medical bills.

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Rationalizations

Creators of worms and viruses often use rationalizations like: The malicious code helped expose security

flaws, so I did a good service. It was an accident. It was not my fault—just an experiment that

went bad. It was the user’s fault because they didn’t keep

their security up to date. If the code didn’t alter or delete any of their

files, then what’s the problem?5-53

Rationalizations

Rationalizati

on

Justification

Attitude

Lack of Peronal Integrity

justification of illegal behavior

1.Justification• I am not

being dishonest.

2.Attitude• I don’t need

to be honest.

3.Lack of personal integrity

• Theft is valued higher than honesty or integrity.

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Fraud occuers when:

Fraud occurs when: People have perceived, non-shareable pressures; The opportunity gateway is left open; and They can rationalize their actions to reduce the moral

impact in their minds (i.e., they have low integrity). Fraud is much less likely to occur when:

There is . Unfortunately, there is usually a mixture of these

forces in play, and it can be very difficult to determine the pressures that may apply to an individual and the rationalizations he/she may be able to produce.

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APPROACHES TO COMPUTER FRAUD The U.S. Department of Justice defines computer fraud as

any illegal act for which knowledge of computer technology is essential for its: Perpetration; Investigation; or Prosecution

Computer fraud includes the following: Unauthorized theft, use, access, modification, copying, and

destruction of software or data. Theft of money by altering computer records. Theft of computer time. Theft or destruction of computer hardware. Use or the conspiracy to use computer resources to commit a

felony. Intent to illegally obtain information or tangible property through

the use of computers. 5-56

APPROACHES TO COMPUTER FRAUD In using a computer, fraud perpetrators can steal:

More of something In less time With less effort

They may also leave very little evidence, which can make these crimes more difficult to detect.

Computer systems are particularly vulnerable to computer crimes for several reasons: Company databases can be huge and access privileges can be

difficult to create and enforce. Consequently, individuals can steal, destroy, or alter massive amounts of data in very little time.

Organizations often want employees, customers, suppliers, and others to have access to their system from inside the organization and without. This access also creates vulnerability.

Computer programs only need to be altered once, and they will operate that way until: The system is no longer in use; or Someone notices. 5-57

APPROACHES TO COMPUTER FRAUD

Modern systems are accessed by PCs, which are inherently more vulnerable to security risks and difficult to control. It is hard to control physical access to each PC. PCs are portable, and if they are stolen, the data and access

capabilities go with them. PCs tend to be located in user departments, where one

person may perform multiple functions that should be segregated.

PC users tend to be more oblivious to security concerns.

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Computer systems face a number of unique challenges: Reliability (accuracy and completeness) Equipment failure Environmental dependency (power, water damage, fire) Vulnerability to electromagnetic interference and

interruption Eavesdropping Misrouting

Organizations that track computer fraud estimate that most U.S. businesses have been victimized by at least one incident of computer fraud.

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APPROACHES TO COMPUTER FRAUD These frauds cost billions of dollars each year, and their

frequency is increasing because: Not everyone agrees on what constitutes computer fraud.

Many don’t believe that taking an unlicensed copy of software is computer fraud. (It is and can result in prosecution.)

Some don’t think it’s a crime to browse through someone else’s computer if their intentions aren’t malicious.

Many computer frauds go undetected. An estimated 80–90% of frauds that are uncovered are not

reported because of fear of: Adverse publicity Copycats Loss of customer confidence

There are a growing number of competent computer users, and they are aided by easier access to remote computers through the Internet and other data networks.

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Some folks believe “it can’t happen to us.” Many networks have a low level of security. Instructions on how to perpetrate computer crimes and abuses

are readily available on the Internet. Law enforcement is unable to keep up with the growing number

of frauds. The total dollar value of losses is difficult to calculate.

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Computer fraud classification Frauds can be categorized according to the data processing

model: Input Processor Computer instructions Stored data Output

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COMPUTER FRAUD CLASSIFICATIONS

ProcessorFraud

InputFraud

OutputFraud

DataFraud

ComputerInstructions

Fraud5-63


Input Fraud The simplest and most common way to commit a fraud is

to alter computer input. Requires little computer skills. Perpetrator only needs to understand how the system

operates Can take a number of forms, including:

Disbursement frauds Inventory frauds Payroll frauds Cash receipt frauds Fictitious refund fraud

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APPROACHES TO COMPUTER FRAUD Input Fraud Can take a number of forms, including:

Disbursement frauds. The perpetrator causes a company to:1. Pay too much for ordered goods; or2. Pay for goods never ordered Inventory frauds. The perpetrator enters data into the system

to show that stolen inventory has been scrapped Payroll frauds. Perpetrators may enter data to:1. Increase their salaries2. Create a fictitious employee3. Retain a terminated employee on the records Cash receipt frauds. The perpetrator hides the theft by

falsifying system input. EXAMPLE: Cash of $200 is received. The perpetrator records a cash receipt of $150 and pockets the $50 difference

Fictitious refund fraud. The perpetrator files for an undeserved refund, such as a tax refund 5-65


Processor fraud Involves computer fraud committed through

unauthorized system use. Includes theft of computer time and services. Incidents could involve employees:

Surfing the Internet; Using the company computer to conduct personal

business; or Using the company computer to conduct a competing

business.

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APPROACHES TO COMPUTER FRAUD In one example, an agriculture college at a major state

university was experiencing very sluggish (slow) performance from its server.

Upon investigating, IT personnel discovered that an individual outside the United States had effectively hijacked the college’s server to both store some of his/her research data and process it.

The college eliminated the individual’s data and blocked future access to the system.

The individual subsequently contacted college personnel to protest the destruction of the data.

Demonstrates both: How a processor fraud can be committed. How oblivious users can sometimes be to the unethical or

illegal nature of their activities.67


Computer instructions fraud Involves tampering with the software that processes company

data. May include:

Modifying the software Making illegal copies Using it in an unauthorized manner

Also might include developing a software program or module to carry out an unauthorized activity.

Computer instruction fraud used to be one of the least common types of frauds because it required specialized knowledge about computer programming beyond the scope of most users.

Today these frauds are more frequent—courtesy of Web pages that instruct users on how to create viruses and other schemes.

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Data fraud Involves:

Altering or damaging a company’s data files; or Copying, using, or searching the data files without

authorization. In many cases, disgruntled employees have scrambled,

altered, or destroyed data files. Theft of data often occurs so that perpetrators can

sell the data. Most identity thefts occur when insiders in financial

institutions, credit agencies, etc., steal and sell financial information about individuals from their employer’s database.

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Output fraud Involves stealing or misusing system output. Output is usually displayed on a screen or printed on

paper. Unless properly safeguarded, screen output can easily be

read from a remote location using inexpensive electronic gear.

This output is also subject to prying eyes and unauthorized copying.

Fraud perpetrators can use computers and peripheral devices to create counterfeit outputs, such as checks.

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Studies in Accounting Information Systems

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