© d.l. crumbley 1 forensic accounting, forensic techniques, and fraud detection copyrighted 2001 d....

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© D.L. Crumbley

Forensic Accounting, Forensic Techniques, and Fraud Detection

Copyrighted 2001

D. Larry Crumbley, CPA, Cr.FAKPMG Endowed ProfessorDepartment of AccountingLouisiana State University

Baton Rouge, LA 70803225-578-6231

225-578-6201 [email protected]

Dr. Crumbley is the editor of the Journal of Forensic Accounting: Auditing, Fraud, and Taxation, former chair of the Executive Board of Accounting Advisors of the American Board of Forensic Accountants, member of the Fraud Deterrence Board, and on the AICPA’s Fraud Task Force. A frequent contributor to the Forensic Examiner, Professor Crumbley is a co-author of CCH Master Auditing Guide, 2nd Edition along with more than 45 other books. His latest book entitled Forensic and Investigative Accounting is published by Commerce Clearing House (800-224-7477). Some of his 12 educational novels have as the main character a forensic accountant. His goal is to create a television series based upon the exciting life of a forensic accountant and litigation consultant.

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Forensic Accounting Factors

• Time: Forensic accounting focuses on the past, although it may do so in order to look forward (e.g., damages, valuations).

• Purpose: Forensic accounting is performed for a specific legal forum or in anticipation of appearing before a legal forum.

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With a single clue a forensic accountant can solve a fraudulent mystery.

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One Small Clue

A former Scotland Yard scientist tried to create the world’s biggest fraud by authenticating $2.5 trillion worth of fake U.S. Treasury bonds.

When two men tried to pass off $25 million worth of the bonds in Toronto in 2001, a Mountie noticed the bonds bore the word “dollar” rather “dollars.”

Police later raided a London bank vault and discovered that the bonds had been printed with an ink jet printer that had not been invented when the bonds were allegedly produced.

Zip codes were used even though they were not introduced until 1963.

Sue Clough, “Bungling Scientist Is Jailed for Plotting World's Biggest Fraud,” News.telegraph.co.uk, January 11, 2003.

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Definition of Forensic Auditor

Someone who can look behind the facade--not accept the records at their face value--someone who has a suspicious mind that the documents he or she is looking at may not be what they purport to be and someone who has the expertise to go out and conduct very detailed interviews of individuals to develop the truth, especially if some are presumed to be lying. Robert G. Roche, a retired chief of the IRS Criminal Investigation Division of the IRS [D.W. Yockey, “So You Want to Be a Forensic Accountant,” Management Accounting, November 1988, pp. 19-23.]

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Forensic Accounting Defined

Forensic accounting is the action of identifying, recording, settling, extracting, sorting, reporting, and verifying past financial data or other accounting activities for settling current or prospective legal disputes or using such past financial data for projecting future financial data to settle legal disputes.

Source: Forensic and Investigative Accounting

---------------------------------------------------When the death of a company

occurs under mysterious circumstances, forensic accountants are essential. Other accountants look at the charts but forensic accountants actually dig into the body.

Douglas Carmichael

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Forensic Accounting Areas

Investigative AuditingLitigation Support

Forensic: Latin for “forum,” referring to a public place or court.

Black’s Law Dictionary: Forensic, belonging to the courts of justice.

Note: Corporate spooks are used to check on competitors.

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Top Niche Services

Source: J.M. Covaleski, “Many Top 100 Growth Areas Revolve Around Synergy of CPA/Attorney Relationship,” Accounting Today, March 18-April 7, 2003, p.1.

1. Business Valuations 78%

2. Estate Planning 77%

3. Litigation Support 73%

4. Mergers & Acquisitions 61%

5. Business Mgt. Wealthy clients 56%

6. Forensics/fraud 55%

7. Employee benefits 55%

8. Computer systems/consulting 53%

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Forensic Accounting vs. Fraud Auditing

Fraud Auditor: An accountant especially skilled in auditing who is generally engaged in auditing with a view toward fraud discovery, documentation, and prevention.

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“Economic crimes and fraud often do not involve obvious evidence like the smoking gun. Forensic accountants look behind the deals and handshakes and probe beyond the numbers to uncover the reality of financial situations.”Source: D.W. Squires, “Problems Solved with Forensic Accounting: A Legal Perspective,” Journal of Forensic Accounting., Vol. IV (2003),. P. 131.

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“Rather than combing torn clothing,” forensic accountants “comb through corporate books, looking for oddities that could signal swindles,” says Bruce Dubinsky. Investigations can be extremely complex, with crates and crates of documents and thousands of computer files. Investigators look for flags or patterns that would not normally occur.

Source: Mark Maremont, “Tyco Is Likely to Report New Woes,” Wall Street Journal, April 30, 2003, p. C-1.

Forensic Accountants

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Potpourri• Deutsche Bank is being sued for $1.3 billion by Bruce

Winston (one of the heirs of Harry Winston diamond dynasty) for priceless gems disappearing from a trust under their control.

• A Burlington, Kentucky city finance director is accused of embezzling more than $1.2 million to support his estranged wife and his girlfriend.

• Martin Frankel vanished with between $200 million in cash and diamonds one day. He accomplished this insurance fraud by buying poorly capitalized insurance companies, cooking the books to show increased premium value, and by including non-existing real estate and leases on the balance sheet.

• After the terrorists’ attack in New York city, about 4,500 people manipulated the broken ATM machines of a municipal employees credit union, stealing as much as $15 million.

• A U.S. Lime officer embezzled nearly $2.2 million by forging signatures of other company officers on checks, and falsifying the company’s check register to create the impression that the amounts he received went to U.S. Lime creditors.

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•As part of the securitization agreement, UC agreed to pay the principal and interest on defaulted loans.•Creditors contend that UC failed to account for the interest it was paying, and D&T should have caught the mistake earlier.•After UC wrote off $605 million in debt, the company filed for bankruptcy.• Confidential mid-court settlement.

Source: Adrian Angelette, “United Companies Settlement Reached,” Baton Rouge Advocate, October 31, 2003, pp. A-1 and A-12

Auditors Blamed (cont.)

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Forensic Accounting Knowledge Base

LAW Investigative auditing

AccountingCriminology

Forensic Accountant

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Be like

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Some accountants believe that ethics is a place in England.

Essex, U.K.------------------------------------------------------

Fraud

A statement made by Mark Twain about New England weather applies to fraud and corruption:

“It’s hard to predict, but everyone agrees there’s plenty of it.”

-----------------------------------------------As Sherlock Holmes said, “the game is afoot.”

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Fraud is Possible

The motto of a fraudster:

Anything is possible. The impossibility simply takes longer.

Biggleman’s Safe – a safe builder wrote blueprints of a unbreakable safe and locked the blueprints inside the safe.

Internal controls can be broken, often by top executives.

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White-Collar Crime: Rich People Steal

• Edwin Sutherland coined the term “white-collar crime.” [Indiana University sociology professor.]

• Sutherland believed that white-collar crime is a learned behavior, a consequence of corporate culture where regulations are regarded as harassment, and profit is the measure of the man.

• “White-collar crime violates trust and thus create distrust, and this lowers social morale and produces social disorganization on a large scale.

Cynthia Crossen, “A Thirties Revelation: Rich People Who Steal are Criminals, Too,” Wall Street Journal, October 15, 2003, p. B-1

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Tyco Prosecutor’s Closing Argument

“Remember, these are two very, very smart men; they are not charged with being stupid men,” she said of Mr. Kozlowski and Mr. Swartz. “These crimes have an element of sophistication so you can be sure that when they were committing them they built in an element of deniability.” She added: “Every good scheme has it. That is how white-collar criminals work.”

• Mistrial on April 2, 2004.

Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,” N.Y. Times, March 17, 2004, p. C-1.

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Sarbanes-Oxley Act (7-30-2002)

• Most significant change since 1934 Securities Exchange Act

• New five-member Public Company Accounting Oversight Board (PCAOB)

• Authority to set and enforce auditing, attestation, quality control and ethics (including independencies) standards for auditors of public companies.

• Empowered to inspect the auditing operations of public accounting firms that audit public companies as well as impose disciplinary and remedial sanctions for violations of the board’s rules, securities laws and professional auditing and accounting standards.

• Rotation of lead audit partner every five years.

• For now no requirement to rotate auditing firm

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Sarbanes-Oxley Act (7-30-2002)• Eight types of services outlawed:

– Bookkeeping.

– Information systems design and implementation

– Appraisals or valuation services, fairness opinions, or contribution-in-kind-reports.

– Actuarial services

– Internal audit outsourcing

– Management and human resources services

– Broker/dealer, investment adviser, and investment banking services

– Legal or expert services related to audit services

• Applies to foreign accounting firms filing with SEC.

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Incumbent Auditors

• An incumbent auditor may not perform legal services and expert services unrelated to an audit for audit clients (i.e., can not be an expert witness).

• An auditor is not prohibited from legal and expert services for nonaudit clients

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Legal Services

Under the rules, CPAs cannot provide a service for an audit client that only someone licensed to practice law can perform.

The concern this rule addresses is that the auditor would be acting as an advocate, which the SEC (partly in reliance on United States v. Arthur Young) concludes would preclude the CPA from maintaining the “objectivity and impartiality that are necessary for an audit.”

Source: T.J. Purcell, III and D. Lifson, “Tax Service After Saebanes-Oxley,” Journal of Accountancy, November, 2003, p. 37.

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Expert Service Unrelated to Audit

This covers engagements where the CPA firm’s specialized knowledge, experience and expertise support audit client positions in adversarial proceedings. The prohibition includes providing an opinion to the client or a client representative to advocate a client’s interests in litigation or in a regulatory or administrative investigation or proceeding. The rules do not define this term.

The examples involve the SEC Division of Enforcement, forensic accounting engagements for the client itself and helping the audit committee investigate potential accounting impropriety. The rules appear to reject the proposal that the advocacy prohibition be confined to public settings and allow internal investigations and fact-finding engagements for the audit committee, as well as providing factual accounts, testimony or explanations of positions taken, conclusions reached or work performed.

Source: T.J. Purcell, III and D. Lifson, “Tax Service After Saebanes-Oxley,” Journal of Accountancy, November, 2003, p. 37.

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Tax Services Not Defined

PCAOB will not define tax services, but will be inspecting them.

Representing an audit client in court could impair independence.

PCAOB “will focus on the profession’s role in both structuring and signing off on abusive tax shelter designed to make their clients’ financial statements look better.”

PCAOB’s annual inspections will examine how accounting companies audit and structure “questionable, tax-orientated transactions.”

Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C. Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,” Wall Street Journal., October 22, 2003, p. A-2.

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Acceptable Non-audit Services

• Payroll sales, property, state income, federal income and other tax-compliance services, even though the audit firm reviews the client’s work that becomes part of the financial records through the recording of a liability.

• Traditional tax planning services, such as where the CPA prepares an analysts of a transaction (lease vs. buy) and the client uses the CPA’s work product to develop the appropriate financial accounting entries.

• Analysis of clients records (with recommendations for redesign) to determine strategies for minimizing state and local income sales, property and payroll taxes.


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Acceptable Non-audit Services (cont.)

• Appraisal services undertaken for tax-compliance reasons (such as assigning values to intangible assets under IRC section 197, calculating gains on distributions of assets to shareholders under section 338 election, implementing mark-to-market values under section 475 and allocating purchase prices under section 1060), even though the company uses the derived values in part for financial statement purposes.

• Tax-consulting engagements that examine, for example, the efficiency of internal tax departments, procedures used to protest state and local property tax valuations or state income tax studies.

• “Loaning” tax staff or supervisors to an audit client for special projects or short-term personnel emergencies.


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• Designing or commenting on the tax aspects of a compensation package for specific individuals or the general management staff of the audit client-for example, reviewing the applicability of antidiscrimination provisions of IRC section 132 and the reasonable compensation and incentive compensation provisions of section 162(m).

• Meeting with prospective candidates for the tax director or CFO position to discuss the tax issues the company faces.

• Recommending that controlling shareholders sell their stock to an ESOP to take advantage of IRC section 1042; advising a client to consider an ESOP as part of a benefits package (or,if an ESOP already exists, that a client sell additional shares to it); or recommending that an estate sell its stock in an audit client to use the provisions of IRC section 303 or to otherwise efficiently administer the estate.


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• Representing the audit client in IRS exams, sales tax proceedings, state income tax audits, payroll tax audits, local government property tax proceedings and the like.

• Helping an audit client prepare requests for a ruling or changes in accounting periods or method or for determination letters on various issues from the IRS or other administrative agencies.


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Sarbanes-Oxley Act of 2002

• If you are going to be an auditor, you have to be an auditor, not an auditor and a consultant [Senator Jack Reed].

• In order to be independent, an accounting firm should not

– Audit ones own work.

– Function as part of management or an employee.

– Act as an advocate.

• No limitations are placed upon accounting firms in providing non-audit services to public companies they do not audit or any private companies.

• Audit services and non-audit services (e.g., tax) must be pre-approved by the audit committee, if not prohibited by the Act (before the non-audit service commences).

• Auditor must report to the audit committee on a timely basis.

• Cooling off period of one year for hiring an auditor if CEO and other senior officers worked for the auditor.

• There is no requirement to rotate the auditors.

• There is discussion of requiring a forensic audit irregularly. Harvey Pitt suggested this proposal.

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Sarbanes-Oxley (contd.)

• Many of the Sarbanes-Oxley’s provisions became effective July 30, 2002.

• www.tnwinc.com The Network

• Thus, SEC will control the accounting standards, not the AICPA.

• Auditors to report to audit committee, and audit committee must approve all services.

• Crime to corruptly alter, destroy, mutilate, or conceal any document with the intent to impair the object’s integrity or availability (up to 20 years).

• Statute of limitations for the discovery of fraud is now two years from the date of discovery and 5 years after the act.

• Maximum penalty for mail and wire fraud is increased from 5 to 10 years.

• Financial statement filed with SEC: certified by CEO and CFO. Maximum penalties for willful and knowingly violation: fined not more than $5 million and/or imprisonment of up to 20 years.

• Sense of Congress: CEO should sign the Federal income tax return.

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SEC’s Proposed Rules (12-5-2002)

Auditor may not1. Audit own work.2. Perform management function.3. Act as an advocate of a client.

Traditional tax preparation service okay:• preparation of tax returns.• tax compliance.• tax planning.• tax recovery.• other tax-related services.

Reviewing tax accruals is audit service.Tax Court representation would impair an auditor’s

independence.Formation of tax strategies (e.g., tax shelters) is not

okay.Unknown: Tax opinions for tax shelters.The audit committee must weigh the risk associated

with using the company auditor for tax services versus the cost savings of using the company auditor.

Source: Sheryl Stratton, “SEC Seeks Input on Defining Scope of Tax Service,” Tax Notes, December 9, 2002, pp. 1265 – 1266.

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Sarbanes-Oxley Act Creates Need For Forensic Accounting

1.To assist corporations in their quest to ensure compliance with the mandates of S-O, especially the audit committee.2.Public accounting firms must introduce forensic techniques into audits, and they may request help from forensic experts.

3.Internal auditors should introduce forensic accounting techniques into their audit programs.

-----------------------------------------------------------------SEC Chairman William Donaldson

responds to a question why there is “such appalling fraud” in business in the following manner. There are 15,000 companies out there,” and “the majority of those companies are run by honest, dedicated people.” But he admitted that “there has been in my view, a gradual erosion of corporate ethics over the bull market of the last decade, and particularly the last five years.”

Bobby Eberle, “Justice Department Celebrates One Year of Corporate Fraud Task Force,” Talon News, July 23, 2003, www.gopusa.com/news/2003/july/0723corporatefraud.shtml.

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Assistance of Forensic Accountants

1. S-O requires principal executives and financial officer to personally certify annual and quarterly reports.[Section 302]. Effective August 202.

2. Certification must cover internal controls, disclosure controls, and fraud. Need for a Chief Forensic Officer? The SEC suggests the entity assign the duties of monitoring internal controls to a specific individual. SEC suggests a disclosure committee, also.

3. Officers and directors are prohibited from influencing, coercing, manipulating, or misleading the accountant performing the independent audit.

4. Civil and criminal penalties against officers for violations of S-O.

5. Auditors workpaper retentions for five years.

6. PCAOB shall adopt auditing standards.

7. SEC may censure auditors.

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Section 404-Sarbanes-Oxley

• Beginning June 2004, large companies must have in place tight internal controls, assess the effectiveness of these controls annually, and pay for an independent assessment by external auditors.

• Need an internal control framework (e.g., COSO or similar).

• Companies are paying steep fees to fund the PCAOB.

• Audit fees have increased by as much as 30% since S/O.

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The COSO Model

1. Control environment – management’s attitude toward controls, or the “tone at the top.”

2. Risk assessment – management’s assessment of the factors that could prevent the organization from meeting its objectives.

3. Control activities – specific policies and procedures that provide a reasonable assurance that the organization will meet its objectives. The control activities should address the risks identified by management in its risk assessment.

4. Information and communication – system that allows management to evaluate progress toward meeting the organization’s objectives.

5. Monitoring – continuous monitoring of the internal control process with appropriate modification made as deemed necessary.www.erm.coso.org

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Fraudulent Financial Reporting more likely to occur if

• Firm has a poor management control philosophy.

• Weak control structures.• Strong motive for engaging in financial statement

fraud.

Poor management philosophy:• Large numbers of related party transactions.

• Continuing presence of the firm’s founder.

• Absence of a long-term institutional investor.

Source: Paul Dunn “Aspect of Management Control Philosophy that contributes to fraudulent Financial Reporting,” Journal of Forensic Accounting, Vol. IV (2003), pp. 35-60

Management Control Philosophy

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© D.L. CrumbleyRisk Assessment Benefits

A major step in a forensic audit is to conduct a risk assessment, which entails a comprehensive review and analysis of program operations in order to determine where risks exists and what those risks are.

Any operation developed during the risk assessment process provides the foundation or basis upon which management can determine the nature and type of corrective actions needed.

A risk assessment helps an auditor to target high-risk areas where the greatest vulnerabilities exist and develop recommendations to strength internal controls

Source: B.l. Derby, “Data Mining for Improper Payments,” Journal of Government Management, Winter 2003, Vol.52, No. 4, pp. 10-13.

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Fraud Risk-Assessment Process

1. Organize the assessment – integrate into organization’s existing business cycle or establish a separate cycle.

2. Determine areas to assess – conduct at company wide, business-unit, and significant-account levels.

3. Identify potential schemes and scenarios – typically affecting the industry or locations.

• Fraudulent financial reporting.

•Misappropriation of assets.

•Expenditures and liabilities for an improper purpose (cash kickbacks and corruption).

•Organization commits a fraud against employees or third parties.

•Tax fraud.

•Financial misconduct by senior management.

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Fraud Risk-Assessment Process

4. Assess likelihood of fraud•Remote•Reasonably possible•Probable5. Assess significance of risk•Inconsequential•More than inconsequential•Material6. Link antifraud controls – identify the control activities for fraud risks that are both more than likely to occur and more than inconsequential in amount.7. Apply assessment results to the audit plan – consider and document the results of the fraud assessment when developing the audit plan.

Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April, 2004, pp. 43-47

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FEI’s Costs of Compliance

Revenue First-Year Costs First-Year Hours

Less than $25 million $.28 million 1,996

$25 to $99 million $.74 million 3,080

$100 to $499 million $.78 million 5,118

$500 to $999 million $1.04 million 6,950

$1 to $4.9 billion $1.83 million 13,355

Over 5 billion $4.67 million 41,201

Source: Financial Executive Institute

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Using Work of Specialists (SAS No.73)

Specialist defined: a professional service firm or individual who possesses special skills or knowledge in a particular field other than accounting and auditing

To reply on specialist’s findings, auditor Must understand the objectives and scope of

work performed. Assumptions used must be clear to auditor. Auditor must consider the appropriateness of

utilizing the specialists findings. Auditor must test the data that client

provides to the specialist. Auditor must evaluate whether findings

support the assertions in the financial statements.

If specialist’s findings inconsistent, SAS No.73 provides additional procedures which auditor must follow.

Auditor will need copies of workpapers of specialists.

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Michael Comer’s Types of Fraud

1. Corruptions (e.g., kickbacks).

2. Conflicts of interest (e.g., drug/alcohol abuse, part-time work).

3. Theft of assets.

4. False reporting or falsifying performance (e.g., false accounts, manipulating financial results).

5. Technological abuse (e.g., computer related fraud, unauthorized Internet browsing).

Comer’s Rule: Fraud can happen to anyone at anytime.

Source: M.J. Comer, Investigating Corporate Fraud, Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5.

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Starwoods Hotels Poll of Executives

Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA Today, June 26, 2002, p. A-1.

Consider themselves to be honest in business

99%

Played with someone who cheats at golf 87%

Cheated themselves at golf 82%

Hated others who cheated at golf 82%

Believe that business and golf behaviors are parallel

72%

Starwoods Hotels interviewed 401 top executives who golf. The results are surprising.

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The Cost of Fraud

Organizations lose 6 percent of annual revenue to fraud and abuse.

Fraud and abuse costs U.S. organizations more than $600 billion annually ($4,500 per employee).

The average organization loses more than $12 a day per employee due to fraud and abuse.

Source: 2002 Wells Report

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The Cost of Fraud (cont.)

Over 80% of occupational frauds involve asset misappropriations.

Average length of a fraud scheme is 18 months.

Most common way of detecting occupational fraud is by tips from employees, customers, vendors, or anonymous sources.

Second most common detection: accident.

The most targeted asset is cash.Source: 2002 Wells Report

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Fraud Multiplier

Employee Fraud = $ for $ reduction in net income

Suppose $100,000 bottom line reduction.

Suppose 20% profit margin

How much new revenue needed to offset the lost income?

$100,000 = $500,000

20%

So ACFE says $600 billion lost per year.

$600 billion = $3 trillion needed revenue

20%

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Advantage of Compliance Spending

General Counsel Roundtable says that each $1 of compliance spending saves organizations, on average, $5.21 in heightened avoidance of legal liabilities, harm to the organization’s reputation, and lost productivity.

Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April 2004, p. 47.

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Ernst & Young Study (2000)

Leading companies and public bodies in 15 (82) countries

More than 82% (50%) have been victims of fraud in the past year.

82% (84%) of total losses can be attributed to staff.

33% (50%) of the most serious frauds were committed by the organization’s own management.

Most with company more than 5 years (25% more than 10 years).

Theft of cash and purchasing schemes (i.e., employee kickbacks) constituted the majority of frauds.

Reasons: Poor internal controls and finance directors had a limited knowledge of internal controls.

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2003 PricewaterhouseCooper Survey

• Survey to several hundred of the largest companies (with 91 responses).

• Half of the detected economic crimes at responding companies were found by auditors, but it did not distinguish between internal audits. Another 36 percent of the frauds were reported by whistle-blowers

• Although 76 percent of the United States respondents were covered by insurance, fewer than half were able to recover from their insurers. And less than a third of insured companies affected by fraud collected more than 20 percent of the amount lost.

• The average amount lost was $2.2 million, and the highest levels of economic crime were reported in Africa and North America (including Canada and the United States).

Source: J.D. Glater, “Survey Finds Fraud’s Reach in Big Business” www.nytimes.com/2002/07/08/business/08CHIE.html.

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Scienter Necessary

• To prove any type of fraud, prosecutors must show that scienter was present.

• That is, the fraudster must have known that his or her actions were intended to deceive.

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© D.L. CrumbleyFraudLegally, Black’s Law Dictionary defines fraud

as:All multifarious means which human ingenuity

can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth, and includes all surprise, trick, cunning or dissembling, and any unfair way by which another is cheated.

The four legal elements to fraud are A false representation or willful omission regarding

a material fact. The fraudster knew the representation was false. The target relied on this misappropriation. The victim suffered damages or incurred a loss.---------------------------------------------------------------------

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Institute of Internal Auditors definition: Any illegal acts characterized by deceit,

concealment, or violation of trust. These acts are not dependent upon the applications to obtain money, property, or services; to avoid payment or loss of services; or to secure personal or business advantage.

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SEC’s Definition of Fraud

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or the mails, or of any facility of any national securities exchange,

a) To employ any device, scheme, or artifice to defraud,

b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

SEC Rule 106-5

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Foreign Corrupt Practices Act of 1977

Public companies shall maintain adequate internal controls:

A) Make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of issuer; and

B) Devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that-

1) transactions are executed in accordance with management’s general or specific authorization;

2) transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements….

FCPA Section 102

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Federal Sentencing Guidelines Monitoring Mechanism

Systems reasonably designed to detect criminal conduct by its employees and other agents and by having in place and publicizing a reporting system whereby employees and other agents could report criminal conduct by others within the organization without fear of retribution.

FCPA Sec. 8A1.3(k)(5).

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Superseded SAS No. 53Accounting Fraud Referred To As

“Irregularities”

The term “irregularities” refers to intentional misstatements or omissions of amounts or disclosures in financial statements. Irregularities include fraudulent financial reporting undertaken to render financial statements misleading, sometimes called management fraud, and misappropriation of assets, sometimes called defalcations. Irregularities may involve acts such as the following:•Manipulation falsification, or alteration of accounting records or supporting documents from which financial statements are prepared.•Misrepresentation or intentional omission of events, transactions, or other significant information.•Intentional misapplication of accounting principles relating to amounts, classifications, manner of presentation, or disclosure.

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Superseded SAS No. 82Accounting Fraud Referred To As

“Misstatement”

Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users.

----------------------------------------------------------Three most important red flags according to

external/internal auditors (out of 25):1) Known history of securities law violations

(14.6%)2) Significant compensation tied to aggressive

accounting practices (12.9%)3) Management’s failure to display

appropriate attitude about internal controls (12.6%)

Source: B.A Apostolou et.al, “The Relative Importance of Management Risk Factors,” Behavioral Research in Accounting, January 1, 2001, pp. 1-24.

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SEC Staff Accounting Bulletin No.99

Fraudulent accounting entries known by senior management can not be left unadjusted merely because they are “immaterial” by some mechanical, quantitative standard (e.g., percentage of net income).

Thus materiality loophole eliminated in 1999.

Something is material if there is a substantial likelihood that a reasonable person would consider it important.

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SEC SAB No. 99 Examples

Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are—•Whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate.•Whether the misstatement masks a change in earnings or other trends.•Whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise.•Whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability.

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SEC SAB No. 99 Examples

•Whether the misstatement affects the registrant’s compliance with regulatory requirements.•Whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements.•Whether the misstatement has the effect of increasing management’s compensation - for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation.•Whether the misstatement involves concealment of an unlawful transaction.

SAB No. 99, Appendix B.

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COSO’s Most Common Fraud Methods

1. Overstatement of earnings.

2. Fictitious earnings

3. Understatement of expenses.

4. Overstatement of assets.

5. Understatement of allowances for accounts receivables.

6. Overstatements of the value of inventories by not writing down the value of obsolete goods.

7. Overstatement of property values and creation of fictitious assets.

Committee on Sponsoring Organizations.

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COSO’s Major Motives for Fraud

1. Cover up assets misappropriated for personal gain.

2. Increase the stock price to increase the benefits of insider traders and to receive higher cash proceeds when issuing new securities.

3. Obtain national stock exchange listing status or maintain minimum exchange listing requirements to avoid delisiting.

4. Avoiding a pretax loss and bolstering other financial results.

www.coso.org.

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Fraudulent Disbursements

Fraudulent disbursements account for three-quarters of the losses, and the most expensive tend to be fraudulent disbursements through billing schemes (45%).

Therefore, internal auditors seeking to get the biggest bang for their investigative bucks should begin by making sure company vendors are for real.

Check tampering (30%).

Source: J.T. Wells, “An Unholy Trinity,” Internal Auditor, April 1998, p. 33.

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© D.L. CrumbleyJoseph W. Koletar’s Opinions

“In my private-sector forensic career, I have seen few organizations that have a firm grasp on the size and components of their fraud problems. Usually they rely on incidental reports and, in turn generate incremental responses.” p. 99.

Business failures and financial statement fraud “occur because existing controls were not operating, not because they were improperly designed and installed. Often internal auditors are not permitted to do their jobs. Serious audit results impact executives, and many executives are resistant to change or feel threatened. Consequently, those who make a difference are stifled.” Barry Lipton’s letter, p. 104.

“Far too many organizations are penny wise and pound foolish in their approach to internal controls staffing and monitoring….” p. 117.--------------------------------------------------------------Michael J. Comer: “The Cow grows fat under the eyes of the owner.” p. 8.Source: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003.

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The Methods

Asset misappropriation accounted for more than four out of five offenses (80%).

Bribery and corruption constituted about 13 % of offenses.

Fraudulent statements were the smallest category of offense (most costly). $4.25 million per scheme.


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Restatements of Financial Statements

Source: “An Analysis of Restatement Matters,” Huron Consulting Group, www.huronconsultinggroup.com.

2002 - 330

2001 - 270

2000 - 233

1999 - 216

1998 - 158

Reasons for 2002 restatements:

1. Accounting rules.

2. Human and system errors.

3. Fraudulent behavior.

• Although the number of public registrants have decreased by 14% since 1999, restatements have risen by 53%. Revenue recognition was the cause of 85 of the restatements (22%) in 2002.

• Arthur Andersen had averaged 11 restatements before 2002. In 2002, they had 40, with 26 after new auditors were retained.

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Cynthia Cooper’s Suggestions

• Improve the tone at the top (e.g., a fish rots from the top).

• Robust Codes of Conduct.

• Training on Ethics/Internal Controls.

• Holistic approach to Risk Assessment/Internal Controls.

• Fraud Hotlines.

• Control self-assessment.

• Control repositories.

Source: Cynthia Cooper, L.S.U., November 24, 2003.

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Triple Fraud Sting

A Michigan woman received an e-mail from a Nigerian asking her to set up a bank account in the U.S. in order to help him steal $18 million.

She set up the bank account (to help pay the so-called bribes and fees) by allegedly embezzling $2 million from her employer during seven months in 2002.

Guess what? She never received a penny. She was indicted on 13 counts of wire fraud.

Fraud schemes are much like derivatives. They spring up, die out, and new ones are started each week.

Source: Kim Komando, “Delete These Scams – Now,” MSN Business, www.bcentral.com/articles/komando/109.asp. Reviewed June 15, 2003.

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© D.L. CrumbleyRite Aid Fraud Case Former CEO Martin Glass bragged that the

computer used to generate backdated letters had disappeared at sea. “They have no computer. The letters that were done on the computer…they do not have and never will have, unless they use a Trident submarine.”

Wrong. President Timothy Noonan was wearing a wire. He recorded 6 meetings over 10 weeks. Federal investigators heard everything.

CFO Franklyn Bergonzi: Obtained $30 million in extra profits by dunning

Rite Aid’s suppliers for merchandise that was supposedly outdated or damaged (but not so).

Another $75.6 million came from rebates from pharmaceutical firms that had yet to be earned.

Failed to report certain expenses properly. Increased the useful life of some assets.

The financial restatements wiped out $1.6 billion in profits.

KPMG agreed to pay $125 million fine.

Source: Mark Maremont, “Call To Account: Rite Aid Case Gives Early View of Fraud on Trial,” Wall Street J., June 11, 2003, p. A-6.

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The Perpetrators

First-time offenders. Losses from fraud caused by

managers and executives were 3.5 times greater than those caused by non-managerial employees.

Losses caused by men were 3 times those caused by women. [53% males; 47% females]

Losses caused by perpetrators 60 and older were 27 times those caused by perpetrators 25 or younger.

Losses caused by perpetrators with post-graduate degrees were more than 3.5 times greater than those caused by high school graduates.

Source: 2002 ACFE Report

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© D.L. CrumbleyWhite-collar criminals have these characteristics:

Likely to be married. Member of a church. Educated beyond high school. No arrest record. Age range from teens to over 60. Socially conforming. Employment tenure from 1 to 20

years. Acts alone 70% of the time.

Source: Jack Robertson, Fraud Examination for Managers and Auditors (1997).

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Other Characteristics of Occupational Fraudsters:

Inquisitive

Rule breaker

Under stress

Financial need

Big spender

Close relationship with vendors / suppliers

Egotistical

Risk taker

Hard Worker

Greedy

Disgruntled or a complainer

Overwhelming desire for personal gain

Pressured to perform

Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff, http://www.bus.lsu.edu/accounting/faculty/lcrumbley/fraudster.html

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To be a forensic auditor, you have to have a knowledge of fraud, what fraud looks like, how it works, and how and why people steal.

Source: Robert J. Lindquist

"Finding fraud is like using a metal detector at a city dump to find rare coins. You're going to have a lot of false hits."

- D. Larry Crumbley

“Fraud can be best prevented by good people asking the right questions at the right time.”

- Michael J. Comer

Quotes

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“Finding fraud is like trying to load frogs on to a wheelbarrow.”

Larry Crumbley--------------------------------------------

H.R. Davia suggests that for every three fraud events which are detected, two remain undetected, and that conclusions drawn from studying those that are detected do not necessarily apply to those whose existence has not been revealed.

Source: Davia, H.R., “Fraud Specific Auditing,” Journal of Forensic Accounting, June 2002.

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Finding fraud is like trying to herd cats and chickens.

There is a chicken catching machine (150 chickens per minute),* but there is no perfect fraud catching machine.

D. Larry Crumbley

* PH2000 mechanical chicken harvester. Scott Kilman, “Poultry in Motion: Chicken Catching Goes High Tech,” Wall Street Journal, June 4, 2003, p. A-1. Human can catch about 1,000 an hour. $200,000 cost.

Fraud Catching

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How Fraud Is Detected

1. Tips from employees (26.3%).

2. By accident (18.8%).

3. Internal audit (18.6%).

4. Internal controls (15.4%).

5. External audits (11.5%).

6. Tips from customers (8.6%).

7. Anonymous tips (6.2%).

8. Tips from vendors (5.1%).

Therefore, 46.2% from tips.

Source: 2002 Wells Report.

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Tips Are Important

Some of the biggest recent accounting scandals (e.g., WorldCom, HealthSouth, Xerox, Waste Management) involve situations where the auditors were tipped off or otherwise alerted to possible frauds but they failed to investigate them deeply enough.----------------------------------------------------

In her book Power Failure, Sherron Watkins says she talked to Jim Hecker, at Arthur Andersen, on the phone about the dangers of the Raptors and Fastow’s inherent conflict. Hecker wrote a memo to the files and forwarded copies to David Duncan and Enron’s audit partner, Debra Cash. His note: “Here is my draft memo, for your review, for ‘smoking guns’ that you can not extinguish.” p. 285.

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Finding Fraud In The Midst of a Conspiracy

When speaking about the fraud of HealthSouth, a spokesman for Ernst & Young emphasized the difficulty of detecting accounting fraud in the midst of a conspiracy of senior executives and false documentation.

An accountant testified that HealthSouth employees would move expenses of $500 to $4,999 from the income statement to the balance sheet throughout the year. Overall the SEC said about $1 billion in fixed assets were falsely entered. The employees moved only those expenses less than $5,000, because Ernst & Young automatically looked at those expenses over $5,000.

An ex-bookkeeper even sent Ernst & Young an e-mail flagging one area of the fraud, but E & Y still did not catch it. Employees actually produced false invoices when the accounting firm asked for back-up.

Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1 and A-13.

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HealthSouth

Billy Massey, 37-year-old CPA, had a wife and two children and looked like an accountant from central casting.

Massey was the personal accountant for HealthSouth’s Richard Scrushy. He was Scrushy’s personal CFO for his private interests, doing the financing, paying the bills, moving around money – and stealing some $500,000.

Massey spent the money on lavish dinners and gifts for his mistress. One week after he was found to be an embezzler and adulterer, he committed suicide.

Source: John Helyar, “The Insatiable King Richard,” Fortune, July 7, 2003, p. 78.

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You should attack fraud problems the way the fictional Sherlock Holmes approached murder cases

D. Larry Crumbley

To be a good fraud auditor, you have to be a good detective.

Source: Robert J. Lindquist

Quotes

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More forensic techniques should become a part of both external and internal auditing. But Stephen Seliskar says that “in terms of the sheer labor, the magnitude of effort, time and expense required to do a single, very focused [forensic] investigation -- as contrasted to auditing a set of the financial statements -- the difference is incredible.” It is physically impossible to conduct a generic fraud investigation of an entire business.

Source: Eric Krell, “Will Forensic Accounting Go Mainstream?” Business Finance Journal, October 2002, pp. 30-34. www.investigation.com/artilces/library/2002Articles/15.htm.

Difficult Task

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Once a forensic accountant (e.g., Cr.FA, CFE, CFFA) is engaged, Michael Kessler says that they should not be disruptive. Most employees are not aware that an investigation is taking place. We go in as just another set of auditors, favoring a Columbo-esque investigative style. “We don’t wear special windbreakers that say ‘forensic accountant.’”

Source: Eric Krell, “Will Forensic Accounting Go Mainstream?” Business Finance Journal, October 2002, pp. 30-34. www.investigation.com/articles/library/2002Articles/15.htm

Stealth

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D.R. Cressey’s Fraud Pyramid

“It was definitely the perfect fraud… unfortunately they hired the perfect investigator.”

Cartoon in M.J. Comer’s book

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• About 13% of employees are fundamentally dishonest.

• Employees out-steal shoplifters.

• About 21% of employees are honest.

• But 66% are encouraged to steal if they see others doing it without repercussion.

Source: “Studies Show 13% of employees are fundamentally dishonest,” KesslerNews, November 1, 2001, www.investigation.com/articles/library/2001articles.

---------------------------------------------------------------------------------------

• 30% of people in U.S. are dishonest.• 30% situational dishonest.• 40% are honest all of the time.

Source: R.C. Hollinger, Dishonesty in the Workplace, ParkRider, N.Y.: London House Press, 1989, pp. 1-5.

Kessler Survey (2001)

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SAS No. 99 Characteristics of Fraud

Incentives / pressures

Attitude /

Rationalization

Opportunity

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Motive Excessive spending to keep up

appearances of wealth. Other, outside business financial strains. An illicit romantic relationship. Alcohol, drug or gambling abuse

problems.

Opportunity Lack of internal controls. Perception of detection = proactive

preventative measure.

Rationalization “Borrowing” money temporarily. Justifying the theft out of a sense of

being underpaid.(“I was only taking what was mine”)

Depersonalizing the victim of the theft. (I wasn’t stealing from my boss; I was stealing from the company.”)

Fraud Pyramid

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Greed

“I don’t see many ways to eliminate greed; it is an inherent part of the human character. So antifraud measures must be aimed at educating people on the risks and the type of technical controls that they can implement.”

Alan Oliphant

Source: David G. Banks, “The Fight Against Fraud,” Internal Auditor, April 2004, pp. 36-37.

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KPMG’s Causes or Indicators of Fraud (1998)

Personal financial pressure. Substance abuse. Gambling. Real or imagined grievances. Ongoing transactions with related

parties. Increased stress. Internal pressures to meet

deadlines/budgets. Short vacations. Unusual hours.

Source: KPMG’s 1998 Fraud Survey

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How Fraud is Discovered-Singapore 2002

• Management investigation (41%).• Anonymous letter/informant (35%).• Internal controls (33%).• By chance (26%).• Internal auditor review (12%).

Source: KPMG Fraud Survey Report, 2002.

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Singapore Fraud Survey, 2002

• Management investigation, informant notification, and good internal controls rank highly as methods of fraud detection.

• 76% of the frauds were perpetrated internally [management (41%) and non-management employees (35%)]

• Poor internal controls, override of internal controls, and collusion between employees and third parties were the top three reasons cited as to why frauds were allowed to take place

• “Red flags,” which should have alerted respondents to the fraud, were present and ignored in 29% of cases.

• The main reason for not reporting fraud was lack of evidence

• The typical fraudster is predominantly male within the age group of 26-40 years and has an annual income between $15,000 to $30,000. 44% of fraudsters have tertiary educational qualifications.

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Rationalization

Sherron Watkins provides an excellent comment about rationalization with respect to Enron’s Jeff Skilling and Andy Fastow.

At what point did they turn crooked? “But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a slow erosion of values over time.”

Source: Pamela Colloff, “The Whistle-Blower,” Texas Monthly, April 2003, p. 141.

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Fraud’s Fatal Failings

85% of fraud victims never get their money or property back.

Most investigations flounder, leaving the victims to defend for themselves against counter-attacks by hostile parties.

30% of companies that fail do so because of fraud.

Source: Michael J. Comer, Investigating Corporate Fraud, Burlington, VT: Gower Publishing, 2003, p. 9.

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SAS No. 99: Brainstorming

Aims to make the auditor’s consideration of fraud seamlessly blended into the audit process and continually updated until the audit’s completion.

Brainstorming is now a required procedure to generate ideas about how fraud might be committed and concealed in the entity.

No ideas or questions are dumb.No one owns ideas.There is no hierarchy.Excessive note-taking is not allowed.

Source: Michael Ramos, “Auditors’ Responsibility for Fraud Detection,” J. of Accountancy, January, 2003, pp. 28 – 36.

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More Brainstorming

• Best to write ideas down, rather than say them out loud.

• Take plenty of breaks.• Best ideas come at the end of session.• Important to not define the problem too

narrow or too broad.• Goal should be quantity, not quality.• Geniuses develop their most innovative ideas

when they are generating the greatest number of ideas.

• No such things as bad ideas.• Many companies are great at coming up with

good ideas, but lousy at evaluating an implementing them.

Source: A.S. Wellner, “Strategies: A Perfect Brainstorm,” Inc. Magazine, October 2003, pp. 31-35

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Potential Pitfalls

• Group domination: one or two participants dominating the process can quickly squelch the creative energies of the groups as a whole, reducing the likelihood the team will identify any actual fraud risks.

• Social loafing: participants disengage from the process, expecting other team members to pick up the slack.

• Groupthink: team members become so concerned with reaching consensus that they fail to realistically evaluate all ideas or suggestions.

• Group shift: avoid allowing the team to take an extreme position on fraud risk.

Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,” Journal of Accountancy, December 2003, pp. 33-34.

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Three Types of Brainstorming

• Open brainstorming: unstructured; few rules; free-for-all; someone should record ideas.

• Round-robin brainstorming: start with no talking, silent period; assigned homework ahead; each individual presents own ideas; each member has a turn.

• Electronic brainstorming: shortens meetings, increases ideas, and reduces personalizing ideas because an idea’s author remains anonymous.

Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,” Journal of Accountancy, December 2003, pp. 33-34.

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How Management Overrides Controls (SAS No. 99)

Recording fictitious journal entries (especially near end of quarter or year).

Intentionally biasing assumptions and judgments used to estimate accounts (e.g., pension plan assumptions or bad debt allowances).

Altering records and terms related to important and unusual transactions.

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Overriding Internal Controls?

Saddam’s son presented a note with his father’s signature to the Iraqi Central Bank which resulted in a world record bank theft of $1 billion. A team of workers took two hours to load $900 million in U.S. $100 bills and $100 million in Euros into three tractor trailer trucks. This dirty deed was done before the employees came to work. Was this a straight bank robbery or an example of overriding internal controls by a high official?

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Bias Assumptions

• There are almost as many oil/gas reserve definitions as there are countries.

• During the first week of January 2004, Royal Dutch/Shell Group slashed its estimates of oil reserves by 20% or about 3.9 billion barrels of oil.

• Stock fell 9%.• Shell, Exxon/Mobil, and

Chevron/Texaco make the estimates themselves.

Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves Prove Unrefined,” Wall Street Journal, January 14, 2004, p. C-4

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Shell Board Kept In the Dark

• One memo drafted on February 11, 2002, warned that about one billion barrels of oil-equivalent reserves appeared not to be in compliance with SEC guidelines.

• Board learned of information only in early January 2004.

• Chairman Sir Philip was ousted in early March 2004.

• Most of the misstated reserves were recorded from 1997 to 2000, when Sir Philip was in change of exploration and production.

• Oil/gas reserves were increased (not by discovery) by changing its accounting.

Source: Stephen Labaton and Jeff Gerth, “At Shell, New Accounting and Rosier Oil Outlook,” New York Times, March 12, 2004, pp. A-1 and C-4.

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Wildcatting

The SEC has recently adopted the proactive strategy of “wildcatting” where investigations into entire industries and business sectors are begun after evidence emerges from only one company in the group regarding financial reporting problems.

Over time, the PCAOB will probably be able to identify peculiarities within existing or evolving industries that require either standard setting or regulatory attention, or both.

Source: Berton, L., “U.S. Accounting Watchdogs Try to Shut Barn Door,” Bloomberg.com, April 2, 2004; J.H. Edwards, “Audit Committees: The Last Best Hope,” Journal of Forensic Accounting, Vol. IV (2004), pp. 1-20.

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Expensing Stock Options: Black Scholes Model

If risk-free rate higher Option value higher

If dividend yield higher Option value lower

If expected life longer Option value higher

If volatility higher Option value higher

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Most Firms Underreport

• They fool around with the assumptions to keep fair value down.

• Only about 10% are truth tellers.• Most companies are underreporting

volatility.• Only 8 firms did not use Black-Scholes.

Source: L.D. Holder, W. Mayew, M.C. McAnally, and C.D. Weaver, “Employee Stock Option Valuation: How Reliable are Black-Scholes Disclosures,” working papers, March 5, 2004

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Journal Entries at Year End

Apparently, Arthur Andersen was given limited access to the general ledger at WorldCom, which had a $11 billion fraud (largest accounting fraud in history). Most of the original entries for online costs were properly placed into expense accounts.However, near the end of the period these entries were reversed. One such entry was as follows:Other Long-term Assets $629,000,000Construction in Progress $142,000,000

Operating Line Costs $771,000,000

The support for this entry was a yellow post-it note.WorldCom’s outside auditors refused to respond to some of Cynthia Cooper’s questions and told her that the firm had approved of some of the accounting methods she questioned.

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Yellow Peril

• Fourth Quarter of 1999: "The $239 million [international line cost accrual release] was entered in WorldCom's general ledger ... The only support recorded for the entry was '$239,000,000,' written on a Post-it Note and attached to a printout of the entry."

• Third Quarter of 2001: "Myers gave Sethi a Post-it Note that said 'Assume $742 million.' Later, Myers and Sethi had a conversation confirming that $742 million identified on the Post-it Note was the line cost capitalization entry for the quarter.”

http://thestreet.com/pf/markets/dumbestgm/10093441.html

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Yellow Peril

• First Quarter of 2002: "In Capital Reporting, Myers told Sethi to go see Vinson, who would have the amount to be capitalized. When Sethi did so, Vinson handed him a Post-it Note that had the $818 million adjustment on it. Brian Higgins once again refused to make the necessary allocation for the first-quarter 2002 capitalization entry. Despite his growing concerns, Sethi made the allocation because he was concerned that his immigration status would be jeopardized if he lost his job."

• First Quarter 2002: "$109.4 million was taken from the general accrual account that Vinson set up and reclassified to several SG&A balance sheet accounts in five large, round-dollar amounts. The only supporting documentation that we were able to locate for these entries was a Post-it Note listing the various SG&A accounts and the amounts that should be taken from the Vinson account." http://thestreet.com/pf/markets/dumbestgm/10093441.html

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WorldCom Fraud MassiveAt least 40 people knew about the fraud.They were afraid to talk.Scott Sullivan handed out $10,000

checks to 7 involved individuals.Altered key documents and denied

Andersen access to the database where most of the sensitive numbers were stored.

Andersen did not complain about denied access.

Cynthia Cooper ignored her boss and started doing financial audits, looking at the financial information the company was reporting.

Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,” Wall Street J., June 10, 2003, p. 3.

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WorldCom Fraud Massive (contd.)

David Schneedan, CFO at a division, refused to release reserves twice.

E-mail from David Myers, WorldCom comptroller, to Schneedan:“I guess the only way I am going to get this booked is to fly to DC and book it myself. Book it right now; I can not wait another minute.”

Buddy Gates [director of general accounting] said to an employee complaining about a large accounting discrepancy:“Show those numbers to the damn auditors, and I’ll throw you out the f_____ window.”

Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,” Wall Street J., June 10, 2003, p. 3.

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Data Mining Found WorldCom Mess

Auditors should perform all of the analytics themselves, and they must be educated in fraud detection and introduced to data mining techniques. When the concept of data mining is brought up, audit managers cringe and argue that they cannot afford to employ statisticians.

However, while there is data mining software that requires a statistician’s level of expertise (such as IBM’s Intelligent Miner), there also are products, such as WizSoft Inc., that can be employed by most auditors who are acquainted with the fundamentals of Microsoft Office and who are curious as to why they obtained their audit results.

Source: Bob Denker, “Data Mining and the Auditor’s Responsibility,” Information Systems Audit and Control Association InfoBytes.

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Fraudulent financial reporting may occur by the following:

Manipulation, falsification, or alteration of accounting records, or supporting documents from which financial statements are prepared.

Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information.

Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

Source: SAS No. 99, “Consideration of Fraud in a Financial Statement Audit,” New York: AICPA

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Parmalat Deceptions

• Parmalat, an Italian diary company, had a nonexistence Bank of America bank account worth $4.83 billion. A SEC lawsuit asserts that Parmalat “engaged in one of the largest and most brazen corporate financial frauds in history.”

• Apparently, the auditors Grant Thornton relied on a fake Bank of America confirmation prepared by the company.

• SAS No. 99 does not prohibit clients from preparing confirmations.

• The fraud continued for more than a decade. At least $9 billion unaccounted for.

• Therefore, the audited company should not be in control of the confirmation process.

• The owner treated the public company as if it was his own bank account.

• An unaware phone operator was the fake chief executive of more than 25 affiliated companies.

• Some $3.6 billion in bonds claimed to be repurchased had not really been bought.

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Falsification

Enron’s crude oil trading operation based in Valhalla, New York was fictitious, according to one auditor.

“It was pretend. It was a playhouse. There were a lot of expensive people working there, and it was impressive looking, but it wasn’t legitimate work.

The traders were keeping two sets of books, one for legitimate purposes – to show Enron and auditors from Arthur Andersen – one other set in which to record their ill-gotten gains.

Source: Mimi Swartz and Sherron Watkins, Power Failure, New York: Doubleday, 2003, p.31.

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SAS No. 99 Ways to Overcome the Risk of Management Override of

Controls

Examining journal entries and other adjustments, especially near the end of the quarter.

Reviewing accounting estimates for bias, including a retrospective review of significant management estimates.

Evaluating the business rationale for significant unusual transactions.

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Examine Journal Entries

Enron issued $1.2 billion of stock to special purpose entities and recorded a $1.2 billion notes receivable (rather than a contra account to stockholders equity). Both assets and owners equity were overstated by $1.2 billion.

HealthSouth allegedly overstated profits by at least $14 billion by billing Medicare for physical – therapy services the company never performed. The company submitted falsified documents to Medicare to verify the claims over 10 years.

E&Y collected $2.6 million from HealthSouth (as audit-related fees) to check the cleanliness and physical appearances of 1,800 facilities. A 50- point checklist was used by dozens of junior-level accountants in unannounced visits. For 2000, E&Y audit fee, $1.03 million; other fees, $2.65 million.

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TRUTH

Given the right pressures, opportunities, and rationalizations, many employees are capable of committing fraud.

Bev Harris says that fraudsters and embezzlers are the nicest people in the world:

Wide-eyed mothers of preschoolers. Your best friend. CPAs with impeccable resumes. People who profess deep religious commitments. Your partner. Loyal business managers who arrive early, stay late, and never take a vacation. And sometimes, even FAMILY MEMBERS. So if you’re looking for a sinister waxed mustache and shifty eyes, you’re in for a surprise – scoundrels come in every description.

Source: “How to Unbezzle A Fortune,” www.talion.com/embezzle.htm, p. 1.

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SAS No. 99 Types of Fraud

Unlike errors, fraud is intentional and most often involves deliberate concealment of facts by mgt., employees, or third parties

Fraudulent Financial Reporting: does not follow GAAP (e.g., recording fictitious sales)

Misappropriation of Assets: embezzling receipts, stealing assets, or causing an entity to pay for goods or services that have not been received.

Often accomplished by false or misleading records or documents, possibly created by circumventing internal controls.

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Comparison of Auditing and Forensic Examination

Source: Apostolou, B, “Course 992003: Fundamentals of Fraud Detection and Prevention,” www.education.smartpros.com, 1998.

Issue Audit Forensic Examination

Timing Recurring: audits are conducted on a regular basis

Nonrecurring: fraud examinations are nonrecurring. They are conducted only with sufficient predication.

Scope General: collection of sufficient, competent data to support the opinion rendered.

Specific: the fraud examination is conducted to resolve specific allegations.

Objective Opinion: express opinion on financial statements

Affix blame: determine if fraud occurred and who is responsible. Adversarial in nature.

Methodology Audit techniques applied primarily to financial data.

Fraud examination techniques include document examination, public record searches, and interviews.

Presumption Professional skepticism Proof to support or refute an allegation of fraud.

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Materiality Unimportant

“Auditing is governed by materiality. In investigative accounting, it is the opposite. I am looking for one transaction that will be the key. The one transaction that is a little different, no matter how small the difference, and that will open the door.”

Lorraine Horton, owner of L. Horton & Associates in Kingston, R.I.-----------------------------------------------------------------------------------------------------

“Fraud usually starts small. It begins with little amounts, because the perpetrator is going to test the system. If they get away with it, then they keep on increasing and increasing it.”

Robert J. DiPasquale

Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28.

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Forensic Accounting v. Auditing

“Forensic accounting is very different from auditing in that there is no template to use. There are no set rules. You don’t know when you go into a job how it is going to be.”

Lorraine Horton, Kingston, R.I------------------------------------------------------------------------------

“Forensic accounting “is a very competitive field. What is interesting is that you may be a good accountant, but not a good forensic accountant. The training and the way you look at transactions are different.”

Robert J. DiPasquale, Parsippany, N.J.----------------------------------------------------------“Unlike auditing, lower-level staff often can’t be used for an engagement. They normally will not spot anything out of the ordinary, and an experienced person should be the one testifying as well as doing the investigative work.”

Lorraine Horton, Kingston, R.I.

Source; H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28.

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The Good, The Biased, and Ugly Results Auditors are vulnerable to “unconscious bias,”

because accounting is subjective and the relationship between accounting firms and clients are often tight (or internal auditors v. audited units).

Auditor may unintentionally distort the numbers in ways to mask a company’s true financial picture [or a unit].

Psychological studies show that our desires have a powerful influence on the ways we interpret information.

We tend to discount information that contradicts the conclusions we wish to reach.

Five structural aspects of accounting create opportunity for bias to influence judgment.

Ambiguity. Attachment (They hire and fire us). Approval. Familiarity (Not willing to harm friends). Discounting (focus on immediate events).

Source: M.H. Bazerman et.al, “Why Good Accountants Do Bad Audits,” Harvard Business Review, November 2002.

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Assessment of Internal Controls

The PCAOB believes that an attestation is an expert’s communication of a conclusion about the reliability of someone else’s assertion (e.g., a financial statement audit is a form of attestation).

S-O Act Section 404(b) states that an auditor’s attestation of management’s assessment of internal controls is not a separate engagement. Instead, PCAOB states that an “integrated audit results in two audit opinions: one on internal control over financial reporting and one on the financial statements.”

------------------------------------------------------

PCAOB 2004 budget: $103 million.

Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.

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Internal Controls

PCAOB states that internal controls over financial reporting includes company policies and those procedures “designed and operated to provide reasonable assurance - -a high, but not absolute, level of assurance - - about the reliability of a company’s financial reporting and its process for preparing financial statements in accordance with generally accepted accounting principles.”

Also included are those policies and procedures for “the maintenance of accounting records, the authorization of receipts and disbursements, and the safeguarding of assets.”

Even the PCAOB believes that internal controls “cannot provide absolute assurance of achieving financial reporting objectives because of inherent limitations (e.g., a process that involves human diligence and compliance can be intentionally circumvented).”


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The Costs and Benefits of Internal Controls

Reliable financial reporting adds value and also can offset risks in a manner that is cost-beneficial to a company.Evaluating a company’s internal control over financial reporting is sometimes costly, but also has many far-reaching benefits.

Some of the benefits of a company developing, maintaining, and improving its system of internal controls include identification cost-effective procedures, reducing costs of processing accounting information, increasing productivity of the company’s financial function, and simplifying financial control systems.

The primary benefit, however, is to provide the company, its management, its board and audit committee, and its owners, and other stakeholders with a reasonable basis to rely on the company’s financial reporting.


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Auditing Internal Controls

The audit of internal controls includes these steps:

1. Planning the audit.

2. Evaluating the process management used to perform its assessment of internal control effectiveness.

3. Obtaining an understanding of the internal controls.

4. Evaluating the effectiveness of both the design and operation of the internal controls.

5. Forming an opinion about whether internal controls over financial reporting is effective.


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Anti-Fraud Program

An auditor must perform “company-wide anti-fraud programs and controls and work related to other controls that have a pervasive effect on the company, such as general controls over the company’s electronic data processing.”

Further, the auditor must “obtain directly the ‘principle evidence’ about the effectiveness of internal controls.”


------------------------------------------------------------------------------------

The world is not the way they tell you it is.

Adam Smith, in the “Money Game.”

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Walkthroughs

An auditor must perform “walkthroughs” of a business’ significant processes. PCAOB suggest that an auditor should confirm his or her understanding by performing procedures that include making inquires of and observing the personnel that actually perform the controls; reviewing documents that are used in, and that result from, the application of the controls; and comparing supporting documents (for example, sales invoices, contracts, and bills of lading) to the accounting records.”

According to PCAOB, in a walkthrough an auditor traces “company transactions and events – both those that are routine and recurring and those that are unusual – from origination, through the company’s accounting and information systems and financial report preparation processes, to their being reported in the company’s financial statements.” Auditors should perform their own walkthroughs which provides auditors with appropriate evidence to make an intelligent assessment of internal controls.


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Material Weaknesses

PCAOB provides several strong indicators that material weaknesses exist in internal controls:

• Ineffective oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee.

• Material misstatement in the financial statements not initially identified by the company’s internal controls.

• Significant deficiencies that have been communicated to management and the audit committee but that remain uncorrected after a reasonable period of time.


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Traditional Traditional AuditAudit

Traditional Traditional InvestigatiInvestigati

onon

Pre SAS 99Pre SAS 99

Auditing Auditing StandardsStandards

Consulting Consulting StandardsStandards

SAS 99SAS 99

Traditional Traditional InvestigatioInvestigatio

nn

Forensic Forensic Procedures Procedures in the Audit in the Audit EnvironmenEnvironmen

tt

Post SAS 99

Auditing Auditing StandardStandard

ss

ConsultinConsulting g

StandardStandardss

Source: Ronald L. Durkin et.al, Litigation and Dispute Resolution Services Subcommittee, Incorporating Forensic Procedures in an Audit Environment, AICPA, 2003, Fraud Task Force.

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Steps Toward Forensic Audit

Traditional audit [forensic techniques & fraud prevention program].

If suspect fraud, bring in-house forensic talent into the audit.

If no in-house talent or fraud complex, engage an outside forensic accountant (e.g., Cr.FA, CFFA, or CFE).

As audit moves toward forensic investigation, auditor must comply with litigation services standards (consulting).

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AICPA Audit Committee Toolkit

“In some situations, it may be necessary for an organization to look beyond the independent audit team for expertise in the fraud area. In such cases, CPA forensic accounting consultants can provide additional assurance or advanced expertise, since they have special training and experience in fraud prevention, deterrence, investigation, and detection.

Forensic accounting consultants may also provide fresh insights into the organization’s operation, control systems, and risks. The work of forensic accounting consultants may also provide comfort for the organization’s CEO and CFO, who are required to file certifications under Sarbanes-Oxley.”

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Types of Forensic Engagements

Determine if fraud is occurring. Support criminal or civil action against

dishonest individuals. Form a basis for terminating a

dishonest employee. Support an insurance claim. Support defense of an accused

employee. Determine whether assets or income

were hidden by a party to a legal proceeding (such as a bankruptcy or divorce).

Identify internal controls to prevent it from happening again.

Source: D.R. Carmichael, et. al, Fraud Detection, 5th, Fort Worth: Practitioners Publishing, 2002, p. 2 – 4.

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Two Major Types of Fraud Investigations

• Reactive: Some reason to suspect fraud, or occurs after a significant loss.

• Proactive: First, preventive approach as a result of normal operations (e.g., review of internal controls or identify areas of fraud exposure). There is no reason to suspect fraud. Second, to detect indicia of fraud.

Source: H.R. Davia, “ Fraud Specific Audting,” Journal of Forensic Accounting, Vol. 111, 2002, pp. 111-120

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Fraud Deterrence Review

• Analysis of selected records and operating statistics.

• Identify operating and control weaknesses.

• Proactively identify the control structure in place to help prevent fraud and operate efficiently.

• Not an audit; does not express an opinion as to financial statements.

• May not find all fraud especially where two or more people secretively agree to purposely deceive with false statements or by falsifying documents.

[Always get a comprehensive, signed engagement letter defining objectives.]

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Source: Michael Kurland, How to Solve A Murder: Macmillan, 1995, pp. 7-8

Guilt Pyramid

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Koletar’s Murder vs. Fraud Comparison

Fraud is committed for only one reason - - greed.

Fraud is committed in the workplace, where there should be tighter controls.

Those committing fraud return to the scene of their crime time and time again, often for many years.

Fraud tends to be accumulative, getting bigger with time.

Fraudsters wear the same employee badges we do and eat in the same cafeterias.

Normally, there is a victim available with a fraud, with detailed knowledge about the perp, technique, and motive.

Since the penalties are less severe for fraud, the possibilities for cooperation is increased.

Source: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003, p. 153.

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Source: KPMG Fraud Study

How Fraud Occurs

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Types of Fraud

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Certain Fraud is Increasing

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Measures Helpful in Preventing Fraud

1. Strong Internal Controls (1.62)

2. Background checks of new employees (3.70)

3. Regular fraud audit (3.97)

4. Established fraud policies (4.08)

5. Willingness of companies to prosecute (4.47)

6. Ethical training for employees (4.86)

7. Anonymous fraud reporting mechanisms (5.02)

8. Workplace surveillance (6.07)

1 = Most effective

8 = Least effective


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Auditors Must be Alert for:

ConcealmentCollusionEvidenceConfirmationsForgeryAnalytical relationships

Source: Gary Zeune, “The Pros and Cons.”

“Things are not what you think they are.” Al Pacino, “The Recruit.”

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SAS No. 99 Recommendations

• Brainstorming.• Increased emphasis on professional

skepticism.• Discussions with management.• Unpredictable audit tests.• Responding to management override

of controls.

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Public Company Accounting Oversight Board (PCAOB)

• The Sarbanes-Oxley Act of 2002 created a new, five-member oversight group called the PCAOB.

• The PCAOB is empowered to set accounting standards that establish auditing, quality control, and ethical standards for accountants.

• The PCAOB is also empowered to adopt or amend standards issued or recommended by private accounting industry groups or to adopt its own standards independent of such private industry standards or recommendations.

• http://www.pcaob.us, to get free subscription to PCAOB Update.

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Internal Auditors and Fraud Detection

The Institute of Internal Auditors’ Due Professional Care Standard (Section 280) assigns the internal auditor the task of assisting in the control of fraud by examining and evaluating the adequacy and effectiveness of the internal control system.

However, Section 280 says that management has the primary responsibility for the deterrence of fraud, and management is responsible for establishing and maintaining the control systems. In general, internal auditors are more concerned with employee fraud than with management and other external fraud.

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When Fraud Is Discovered

1. Notify management or the board when the incidence of significant fraud has been established to a reasonable certainty.

2. If the results of a fraud investigation indicate that previously undiscovered fraud materially adversely affected previous financial statements, for one or more years, the internal auditor should inform appropriate management and the audit committee of the board of directors of the discovery.

3. A written report should include all findings, conclusions, recommendations, and corrective actions taken.

4. A draft of the written report should be submitted to legal counsel for review, especially where the internal auditor chooses to invoke client privilege.

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Audit Committee

The audit committee is the subcommittee of an organization’s board of director’s charged with overseeing the organization’s financial reporting and internal control processes. The audit committee’s biggest responsibility is monitoring the component parts of the audit process.

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Management’s Role

The Sarbanes-Oxley Act of 2002 mandates that CEOs and CFOs certify in periodic reports containing financial statements filed with the SEC the appropriateness of financial statements and disclosures.

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Audit Tests

The Panel on Audit Effectiveness recommended that surprise or unpredictable elements should be incorporated into audit tests, including:

– Recounts of inventory and unannounced visits to locations

– Interviews of financial and nonfinancial client personnel in different locations

– Requests for written confirmations from client employees regarding matters about which they have made representations to the auditors

– Tests of accounts not normally preformed annually

– Tests of accounts traditionally or frequently deemed “low risk”

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SAS No. 99: SKEPTICISM

An attitude that includes a questioning mind and a critical assessment of audit evidence.

An auditor is instructed to conduct an audit “with a questioning mind that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity.”

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SKEPTICISM

Ronald Reagan said with respect to Russia, “Trust, but verify.”

FA’s motto should be “Trust no one; question everything; verify.”

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SAS No. 99: Questions for Management

Whether management has knowledge of any fraud that has been perpetrated or any alleged or suspected fraud.

Whether management is aware of allegations of fraud, for example, because of communications from employees, former employees, analysts, short sellers, or other investors.

Management’s understanding about the risks of fraud in the entity, including any specific fraud risks the entity has identified or account balances or classes of transactions for which a risk of fraud may be likely to exist.

Programs and controls the entity has established to mitigate specific fraud risks the entity has identified, or that otherwise help prevent, deter, and detect fraud, and how management monitors those programs and controls.

For an entity with multiple locations, (a) the nature and extent of monitoring of operating locations or business segments, and (b) whether there are particular operating locations or business segments for which a risk of fraud may be more likely to exist.

Whether and how management communicates to employees its views on business practices and ethical behavior.

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BE SKEPTICAL

Assume there may be wrong doing.

The person may not be truthful. The document may be altered. The document may be a forgery. Officers may override internal

controls. Try to think like a crook. Think outside the box.

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Think Like A Crook

• Know your enemy as you know yourself, and you can fight a hundred battles with no danger of defeat.” Chinese Proverb.

• Military leaders study past battles.

• Football and basketball teams study game films of their opponents.

• Chess players try to anticipate the moves of their opponent.

Examples: If contracts above $40,000 are normally audited each year, check the contracts between $30,000-$40,000.

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Think Outside the Box

American astronauts returning from space complained that they could not write with their pens in zero gravity. NASA set aside $1 million to develop a sophisticated pen that would function in space.

The Russians encountered the same problem. What did they do?

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Covert AspectsAttitudesFeelings (Fear, Anger, etc.)ValuesNormsInteractionSupportivenessSatisfaction

Overt AspectsHierarchyFinancial ResourcesGoals of the OrganizationSkills and Abilities of PersonnelTechnological StatePerformance Measurement

Behavioral Considerations

Water line

Thinking as a Forensic Auditor

Structural Considerations

The Iceberg Theory of Fraud

Source: G.J. Bologna and R.J. Lindquist, Fraud Auditing and Forensic Accounting, 2nd Edition, New York: John Wiley, 1995, pp. 36-37

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Behavioral Concepts Important

“Not all fraud schemes can effectively be detected using data-driven approaches.

Instances of corruption-bribery, kickbacks, and the like – and collusion consistently involve circumvention of controls.

Searching relevant transaction data for patterns and unexplained relationships often fails to yield results because the information may not be recorded, per se, by the system.

Behavioral concepts and qualitative factors frequently allow the auditor to look beyond the data, both with respect to data that is there and the data that isn’t.”

Source: S. Ramamoorti and S. Curtis, “Procurement Fraud & Data Analytics, “Journal of Government Financial Management, Winter 2003, Vol. 52, No. 4, pp. 16-24.

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Investigative Techniques

“Facts weren’t the most important part of an investigation, the glue was. He said the glue was made of instinct, imagination, sometimes guesswork and most times just plain luck.” (p. 163).

--------------------------------------------------

“In his job, he [Bosch] learned a lot about people from their rooms, the way they lived. Often the people could no longer tell him themselves. So he learned from his observations and believed that he was good at it.” (p. 31).

--------------------------------------------------Michael Connelly, The Black Ice, St. Martin’s Paperbacks, 1993.

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Three Major Phases of Fraud

1. The Act itself.

2. The concealment of the fraud (in financial statements).

3. Conversion of stolen assets to personal use.

One can study any one of these phases.

Examples:

Things being stolen: conduct surveillance and catch perp.

If liabilities being hidden, look at financial statements for concealment.

If perp has unexpected change in financial status, look for source of wealth.

Source: Cindy Durtschi, “The Tallahassee Bean Counters: A Problem-Based Learning Case in Forensic Audit,” Issues in Accounting Education, Vol. 18, No. 2, May 2003, pp. 137-173.

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Be Proactive

Fraud hotline (reduce fraud losses by 50%).

Suggestion boxes. Make everyone take vacations. People at top must set ethical tone. Widely known code of conduct. Check those employee references. Reconcile all bank statements. Count the cash twice in the same

day. Unannounced inventory counts. Fraud risk assessment (CFD).

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Changing the Culture

“The idea is to change the culture. We work very closely with audit committees and management to build up their fraud awareness. We also talk about the leading practices that an organization should have. That could be a code of conduct, and we help the audit committee understand its oversight responsibilities.”

Richard Girgenti, KPMG

Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accounting, February 2004, pp. 23-28.

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Hot Lines – Sarbanes-Oxley

Audit Committee (AC) must provide a mechanism for employees to remain anonymous when reporting concerns about accounting and auditing problems.

AC must provide a process for the receipt, retention, and treatment of complaints regarding accounting problems (Section 301, S-O).

Annual report must contain a statement regarding the effectiveness of internal controls.

Employees have the right to sue companies for whistle-blowing retaliation.

Managers found guilty of retaliation face penalties, including up to 10 years in prison.

See The Network, www.tnwinc.com/hotlines

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Inside v. Outside Hotlines

“Organizations with fraud hotlines cut their losses by 50% per scheme

- The Wells Report

EthicsLine and The Network, Inc. (800-357-5137) www.tnwinc.com

ComplianceLine of Compliance Concepts, Inc. (800-617-0415) www.complianceline.com

Cor-Tech of Management Communication Systems, Inc. (612-926-7988) www.getintouch.com

Edcor (888-222-9950) www.edcor.com

Ethicspoint, Inc. (866-297-0224) www.ethicspoint.com

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Ethics Programs/Background Checking

Stephen J. Burns: “If only on paper, corporate business ethics programs exist in most large international companies. Unfortunately, many of these efforts would have to be regarded as meaningless.”

The good news is there is no more effective and, in the long run, efficient process to select employees than through the use of a professional, fair, well-designed, and well-run background and selection program. Basic background inquiries for about $50 per person.” J.W. Koletar, p. 141.

“There are also companies and vendors who will sell or design software programs that permit an organization’s own human resources (HR) department to do these checks themselves.” Koletar, p. 141.

Sources: Burns, “Combating Corruption,” Internal Auditor, June 1997, p. 56; J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003

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Fraud Risk Assessment

Ernst & Young report found that organizations that had not performed fraud vulnerability reviews were almost two-thirds more likely to have suffered a fraud within the past 12 months. J.W. Koletar, p. 167.

A company should have a fraud risk assessment performed of their controls, procedures, systems, and operations. J.W. Koletar, p. 166.

Sources: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003

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Whistle-BlowingIt almost always turns out badly for the whistle-blower. Often they regret it. They lose their job, have family problems, or they are shunted off to the side. The kiss of death for a career to get a reputation as someone who is not a team player.

Fate of Recent Whistle-BlowersName Company Allegations Personal

OutcomeCompany Outcome

David Chacon Salmon Smith Barney

Improper IPO allotments

Left firm, filed lawsuit

Subject of congressional and NASD probes

Cynthia Cooper WorldCom Massive accounting fraud

Talking to U.S. Justice Department

Forced into bankruptcy

Roy Olofson Global Crossing Round-trip trades and improper accounting

Fired, filed lawsuit


Barron Stone Duke Energy Improper accounting

Forced to change jobs at Duke

Awaiting results of an audit

Sherron Watkins

Enron Massive acctg. Fraud

Testified to Congress


Source: Joseph McCafferty, “Whistle-Blowing, Talk or Walk,” CFO, October 2002, pp. 90-91.

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Sherron Watkins had a very real reason to be concerned about the corporate behemoth she had decided to challenge. At the time she wrote the memo, she was concerned about her personal safety. She was concerned enough to store in a lockbox a copy of the memo she sent Kenneth Lay. She wanted to ensure that the memo was somewhere safe, where it could not be destroyed

Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91

-------------------------------------------------------------------------------------------

Today the SEC is getting 1,300 complaints per day from whistleblowers, compared to 1,300 per year in 1996.

Source: Krane, H., “Securities Law Update,” California Lawyer, February 2004.

Danger of Whistle-Blowing

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Precise Observation and Careful Intervention.

Passion is the enemy of Precision.

Daryl Zero, the world’s greatest detective in the movie Zero Effect, has the appropriate mottos for FAs:

Daryl Zero

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Some Take-Aways

Need to really understand the business unit. What they really do.

Have a mandatory vacation policy. Rotation of assignments. Have a written/signed ethics policy. Do things differently each time you

audit a unit. Do not tell client what you are doing. Hard to find fraud in the books.

Look/listen. Look for life style changes. Do not rely on internal controls to deter

fraud. Auditors should have control of the

confirmation process. When checking endorsements, be

careful with the ones with only the account number (may have a fake name on the account).

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More Take-Aways Check employee references/resume. Stop giving the employee/client the

answer when you ask a question. Zero tolerance for allowing

employee/executive to get away with anything.

Always reconcile the bank statements.

Try to think like a criminal. Get inside the criminal’s mind. Be a

detective. Do not assume you have honest

employees. Bond employees.

Source: Gary Zeune

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Code of Ethics Required by Sarbanes-Oxley

Section 406: Public issuer has to adopt a code of ethics for senior financial officers to deter wrong –doing and to promote

1. Honest and ethical conduct.2. Full, fair, accurate, timely and

understandable disclosure in SEC filings.

3. Compliance with government laws, rules, and regulations.

4. Prompt internal reporting code violations;

5. Accountability for adherence to the code.

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Check References and Resume

Fraud 101: Fraudsters can change their job and address, but they can not change who they are.

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Integrity Testing

Pre-employment drug testing. Post-employment drug testing

more sensitive. Pre-employment polygraph

tests prohibited by 1988 Act (Federal, State, Local Governments and Federal Contractors exempted from the Act).

Written integrity tests.

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Lavish Executive Pay Many of the companies indicted by

the SEC after Enron had one thing in common: CEOs were making about 75% above their peers.

The common thread among the companies with the worst corporate governance is richly compensated top executives, as per the Corporate Library, Portland, Maine governance-research firm. Hefty pay checks and perks to current or former chief executives.

Poor BODs have in common: an inability to say no to current or former chief executives.

Source: Monica Langley, “Big Companies Get Low Marks for Lavish Executive Pay,” Wall Street J., June 9, 2003, p. C-1.

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Tyco’s Payments to Executives

The accountant, Sheila Rex, testified that Tyco had three accounts where Mr. Dennis Kozlowski’s spending was recorded – his Key Employee Loan account, intended to help pay taxes on restricted stock after it was vested; a relocation account, where mortgages and other house-related spending were logged; and a third account, for short-term loans, to be paid back within 30 days.

Ms. Rex told jurors the accounting department had procedures for recording spending by Mr. Kozlowski. Mr. Swartz and other senior executives. Mr. Kozlowski’s relocation loans were listed under “Note Receivable Employee A,” Ms. Rex said, Mr. Swartz was “Note Receivable Employee C.”

The third account, where Sardinia expenses were logged, was “Notes Receivables LDK,” Ms. Rex said.

She also described the way forgiven loans were accounted for on Tyco’s books, including $38.5 million that was forgiven in 1999. Of that amount; Mr. Kozlowski received $25 million; Mr. Swartz, $12.5 million; and an events planner, Barbara Jacques, $1 million.

Source: Bloomberg News, “Accountant at Tyco Tells of Payments to Executives,” New York Times, November 11, 2003, C-3.

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$6,000 Shower Curtain

In Dennis Kozlowski’s $18 million apartment on Fifth Avenue in Manhattan paid from Tyco International funds.• $6,000 shower curtain in maid’s room.• Art work by French Impressionists.• $15,000 umbrella stand.• $70,000 salary for maid, with two $10,000 bonuses.•Borrowed $13.5 million for a yacht and $5 million for a diamond ring for his wife.•$2 million birthday party for wife.•$30,000 worth of opera glasses.

Although PWC auditor testified that he reviewed some of the disputed loans and compensation, he did not determine if approved by the BOD. “That wasn’t part of our auditing procedures.”

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Acted With Criminal Intent

•Government used coverup conspiracy to obtain conviction of 5 former Rite Aid executives accused of accounting fraud.•Martha Stewart was charged with and convicted for obstructing investigations into her conduct and securities fraud (not insider trading).•The two Tyco executives (CEO and CFO) used as their defense that they were open about their conduct. “What kind of fraud can you have when you don’t try to conceal it?”•Prosecutors of the Tyco executives argued that they hid the disputed bonuses and loans from two important groups: company directors and shareholders. Also, employees who helped process the disputed items shared in the largesse; thus they had incentives to not ask too many questions.

Mark Maremont, “Kozowski’s Defense Strategy: Big Spending Was No Secret,” WSJ, February 9, 2004, pp. A-1 and A-23.

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No Crime Being Committed?

Prosecutor Ann Donnelly said this about the argument that the Tyco executives committed no crime because they were committed in plain view:

“Simply a red herring. Theft that occurs at a corporation on this level has to be on the books and records; there is no other way to steal the money.”

Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,” N.Y.Times, March 17, 2004, p. C-9

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To Find Compensation Data

www.monster.com www.careerjournal.com www.overseasjobs.com www.careerbuilder.com www.salary.com www.jobsmart.com

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Internal and External Fraud

Internal Fraud ExternalEmployee Management Check Forgery

Stock theft

Misappropriation of cash/assets

Lapping

Check forgery

Expense account

Petty cash

Kickbacks

Loans/investments

Lapping

Expense accounts

False financial statements

Misappropriation of cash/assets

Unnecessary purchase

Check forgery

Kickbacks

Ghost vendors

Diversion of sales

Check Forgery

False insurance claims

Credit card fraud

False invoices

Product substitution

Bribes/secret commission

Bid rigging/price fixing

False representation of funds

Shoplifting

Source: KPMG, Fraud Awareness Survey, Dublin: KPMG, 1995, pp. 10-12.

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External Fraud-Shoplifting

It’s not just stars (e.g., Bess Myerson, Hedy Lamarr, and may be Winona Ryder). Why, each year, ordinary people shoplift $13 billion of lipstick, batteries, and bikinis from stores.

800,000 times a day the thrills and temptations win over fear – a product of the late 19th century with the larger stores.

Source: Jerry Adler, “The Thrill of Theft,” Newsweek, February, 2002.

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Three M’s of Financial Reporting Fraud

• Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared

• Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information

• Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure

Source: Zab Rezaee, Financial Statement Fraud, 2002, John Wiley.

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Earnings Management

Earnings management may be defined as the “purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.”

– Katharine Schipper, “Commentary on Earnings Management,” Accounting Horizon, December 1989,

p. 92.

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The difference between earnings management and financial statement fraud is the thickness of a prison wall.

D. Larry Crumbley

The difference between earnings management and financial statement fraud is like the difference between lightning and a lightning bug.

D. Larry Crumbley

Earnings Management

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Companies that consist solely of independent directors and meet at least four times a year are likely to have lower non-audit service fees. L.J. Abbott et.al, “An Empirical Investigation of Audit Fees, Non-Audit Fees, and Audit Committees,” Contemporary Accounting Research, Summer, 2003, p. 230.

An auditor who is also an industry specialist further enhances the credibility of accounting information (e.g., less earnings management). G.V. Krishnan, “Does Big 6 Auditor Industry Expertise Constrain Earnings Management?” Accounting Horizons, Vol. 17, Supplement 2003, p. 15.

Earnings Management

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Lower perceptions of earnings quality lead investors to more thoroughly examine a firm’s audited financial statements. A more thorough analysis of a firm’s financial statements lead investors to lower their assessment of the firm’s earnings quality. F.D. Dodge, “Investors perceptions of Earnings Quality, Auditor Independence, and the Usefulness of Audited Financial Information,” p. 46.

Found no evidence that short sellers trade on the basis of information contained in accruals. Scott Richardson, “Earnings Quality and Short Sellers,” p. 49.

Earnings Management

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Small companies tend to more frequently manage earnings to avoid losses than large companies. Auditors type appears insignificant.

Brain Lee and Ben Choi, “Company Size, Auditor type, and Earnings Management.” Journal of Forensic Accounting, Vol. 3 (2002), pp. 27-50

Earnings Management

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•Pro forma means “as if,” so pro forma earnings means earnings that would have been reported had the corporation been using alternative methods (e.g., everything but the bad stuff). •“Today, however, pro forma numbers are seldom published for the purpose of informing investors and creditors in a better manner. Instead, these disclosures have become a way of underminding orthodox accounting by not recognizing a variety of items as expenses.”•Examples: Goodwill never declines. Moving expenses and losses from operating items to so-called nonrecurring items. Kodak has taken one-time charges every year for the past 12 years (to improve PE ratio).•Contrast the income with the firm’s operating cash flow.

Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003

Professor Ketz’s Shoddy Accounting Practices

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Do the Sniff Test – This one’s subjective, but it’s powerful. Essentially, if something looks wrong, and management can’t provide a convincing explanation, it probably is wrong. Trust your gut.Remember that Cash is Always King – Does accounting gobbledygook make your head spin? Fear not – there is one very simple thing you can do: Keep an eye on cash flow. Over time, increases in a company’s cash flow from operations should roughly track increases in net income. If you see cash from operations decline even as net income keeps marching upward – or if cash from operations increases much more slowly than net income – watch out.Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11, 2004.

Spotting Financial Fakery

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Beware Overstuffed Warehouse – When inventories begin rising faster than sales, trouble is likely on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that’s usually more the exception than the rule.Keep an Eye on Accounts Receivable – Roughly speaking, watch A/R as a percentage of sales, and watch the growth rate in A/R relative to the growth rate of sales. If A/R is moving up much faster than sales, something may be amiss.

Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11, 2004.


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Watch the Honeypot – Companies in the midst of big changes will often take a huge charge – which Wall Street is supposed to look right through, because, hey, it’s a one – time thing – to set up a “restructuring reserve,” and then slowly reverse some of the charge later on. This technique is known as a “honeypot,” because the company can dip into it whenever its operational results aren’t looking so great.

Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11, 2004.


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Companies hide debt by these techniques:1. Using the equity method (rather than

Trading Security and Available for Sale methods). Nets the assets and liabilities of the investee.

2. Lease accounting (arguing that leases are operating leases). Understates 10 to 15% .

3. Pension accounting – netting of the projected benefit obligation and the pension assets. Must unnet them.

4. Hiding debt inside Special – Purpose Entities – trillions of dollars of SPE debt is off the books (e.g., securitization, SPE borrowings, synthetic leases).

Readers can make analytical adjustments by searching footnotes for 1,2, and 3. But no disclosures for asset securitization, SPE borrowings, and synthetic leases.

Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003

Hiding Debt

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• A Parmalat subsidiary issues a security of 500 million euros, and buyer makes an irrevocable commitment to convert debt into equity in 2008.

• Balance sheet treats 500 million euros transaction as $523.8 million in funds for capital increase.

• Amount rolled into a single entry of $764 million which encompasses minority interest funds for capital increase and shareholder equity.

• On consolidation under equity method shown as $523.8 million equity.

• Therefore, debt into equity.• Of Parmalat $18 billion debt, nearly $16

billion was not disclosed. Until mid-2003, Parmalat received a clean bill of health from auditors.

Source: Henry Sender, “Parmalat Unit May Offer Accounting Clues,” Wall Street Journal, January 29, 2004, p. C-5

Water Into Wine

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Interagency Corporate Fraud Task Force was formed in July 2002.

To coordinate investigations into alleged misconduct at major corporations (e.g., Adelphia Communication and Quest Communications).

To equip local staffs with the expertise and resources to obtain indictments.

In the past accounting fraud has been difficult to prosecute, but lawyers now believe many common accounting restatements can put corporate executives at risk for jail time.

According to John K. Markey, “With the new Sarbanes-Oxley requirement to have strong internal controls and officer certification of financial statements, the bar has been lowered on the ‘knew or should have known’ standard,” says Markey. “The presumption will be that the CFO must have known if something has gone wrong.”

The Department of Justice is now encouraging prosecutors to “flip” lower level participants to get the “big guys.” The FBI has an agency-staffed hotline that should “generate four or five new corporate fraud cases each month.”

Source: Alix Nyberg, “Fraud Squad,” CFO, April 2003, pp. 36-44

Corporate Fraud Task Force

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The following 17 offices (with the then holders) make up the Task Force, with the Deputy Attorney General as the chairperson:Larry Thompson, Deputy Attorney General (leader)Robert Mueller, Director of the Federal Bureau of InvestigationMichael Chertoff, Assistant Attorney General for the DOJ’s Criminal DivisionEileen O’Connor, Assistant Attorney General for the DOJ’s Tax DivisionJames Comey, U.S Attorney for the Southern District of New YorkRoslynn Mauskopf, U.S. Attorney for the Eastern District of New YorkPatrick Fitzgerald, U.S. Attorney for the Northern District of IllinoisMichael Shelby, U.S. Attorney for the Southern District of TexasKevin Ryan, U.S. Attorney for the Northern District of CaliforniaDebra Yang, U.S. Attorney for the Central District of CaliforniaJohn Snow, Secretary of the TreasuryElaine Chao, Secretary of LaborWilliam Donaldson, Chairman of the Securities and Exchange CommissionJames Newsome, Chairman of the Commodity Futures Trading CommissionPatrick Wood III, Chairman of the Federal Energy Regulatory CommissionMichael Powell, Chairman of the Federal Communications CommissionLee Heath, Chief Postal Inspector of the U.S. Postal Inspection Service

Corporate Fraud Task Force…

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IndictmentsAdaptec

•US v. Michael Allen Ofstedahl Indictment Adelphia

•US v John J. Rigas, Timothy J. Rigas, Michael J. Rigas, James R. Brown, Michael C. Mulcahey Sealed Complaint •Indictment

Allfirst•US v. John M. Rusnak Indictment, June 5, 2002

Alliance•US v. Susan Denice Browne, Charles Edward Browne, Laurence Crowell Leafer, David Lee Halsey, Braccus Lucien Giavanno, Jonathan Walter Lang Indictment

Anicom •US v. Carl Putnam, Donald Welchko, John Figurelli, Daryl Spinell, Ronald Bandyk, and Renee Levault Indictment

AremisSoft •US v. Lycourgos K. Kyprianou, Roys S. Poyiadjis, and M.C. Mathews Indictment •US v. Roys S. Poyiadjis Indictment

Biocontrol •US v. Fred E. Cooper Information

Capital City Bank •US v. Clinton Odell Weidner II, and David C. Wittig First Superseding Indictment

Capital Consultants •US v. Dean Kirkland, Gary Kirkland, Robert Legino Indictment, August 22, 2002

Cendant •US v. Walter A. Forbes and E. Kirk Shelton Superseding Indictment

Commercial Financial •US v. Jay Lowell Jones Information, September 13, 2002 •US v. William R. Bartmann Indictment, December 12, 2002

Countrymark •US v. David Heath Swanson Superseding Indictment

Critical Path •US v. Jonathan A. Beck Information •US v. Kevin P. Clark Information •US v. Timothy J. Ganley Indictment •US v. David A. Thatcher Information

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IndictmentseConnect

•US v. Thomas S. Hughes First Superseding Indictment •Complaint Affidavit

Enron •US v. Jeffrey S. Richter Information

FLP Capital Group •US v. Frank L. Peitz, Daniel B. Benson, Peter A. Loutos, Sr., Robert D. Paladino, Randall W. Law, and Monica M. Iles Indictment

FPA Medical Management •US v. Steven Mark Lash Indictment

Health Maintenance•US v. Clifford G. Baird Information, July 29, 2002•US v. Donavon C. Claflin Information, July 29, 2002•US v. Kevin L. Lawrence Indictment, July 31, 2002•US v. Kevin McCarthy Information, July 19, 2002•US v. James N. Wuensche Information, November 26, 2002

HealthSouth •US v. Angela C. Ayers, Cathy C. Edwards, Rebecca Kay Morgan, Virginia B. Valentine Information•US v. Aaron Beam Information•US v. Emery Harris Information•US v. Kenneth K. Livesay Information•US v. Michael Martin Information•US v. Malcolm McVay Information

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James Comey (U.S. Attorney): “Just following orders is not an excuse for breaking the law.”

• Betty Vinson, accountant for WorldCom, was asked by her bosses to make false accounting entries; initially she refused but eventually caved.

• “Over the course of six quarters she continued to make the illegal entries transferring expenses to capital accounts to bolster WorldCom’s profits at the request of her superiors. At the end of 18 months, she had helped falsify at least $3.7 billion in profits.”

• She eventually confessed, hoping to be a witness. A more aggressive prosecutor made her a target. She and another accountant, Troy Normand, pleaded guilty to two criminal counts, carrying a maximum charge of 15 years in prison.

• “When an employee’s livelihood is on the line, it’s tough to say no to a powerful boss.”

Just Say No

Source: Susan Pulliam, “A Staffer Ordered to Commit Fraud Balked, Then Caved,” Wall Street Journal, June 23, 2003, p. A-1.

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Fraud Identifiers to Spot Fraudsters

• Large ego

• Substance abuse problems or gambling addiction

• Living beyond apparent means

• Self-absorption

• Hardworking/taking few vacations

• Under financial pressure (e.g., heavy borrowings)

• Sudden mood changes.

Source: G.E. Moulton, “Profile of a Fraudster,” Deloitte Touche Tohatsu, www.deloitte.com, 1994.

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Audit Procedures

Audit evidence is gathered in two fieldwork stages:

1. internal control testing phase

2. account balance testing phase

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Definitions

• Materiality is the measure of whether something is significant enough to change an investor’s investment decision.

• Control risk is risk that a material error in the balance or transaction class will not be prevented or detected.

• Inherent risk is risk that an account or transactions contain material misstatements before the effects of the controls.

• Detection risk is risk that audit procedures will not turn up material error when it exists.

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External Auditors and Fraud Detection

•Although auditors have previously had the responsibility to detect material misstatement caused by fraud, SAS No. 82 details more precisely what is required to fulfill those responsibilities. •Now, auditors must specifically assess and respond to the risk of material misstatement due to fraud and must assess that risk from the perspective of the broad categories in the SAS.•External auditors have to satisfy new documentation and communication requirements. Superseded by SAS No. 99.

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Statement of Financial Accounting Concepts No. 2

Provides nine qualities and characteristics that make financial information useful for investors, creditors, analysts, and other users of financial information• Relevance.• Timeliness.• Reliability.• Verifiability.• Representational faithfulness.• Neutrality.• Comparability and Consistency.• Materiality.• Feasibility or Costs or Benefits.•Transparency.

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Types of Financial Statement Fraud Schemes

Three professors have broken financial statement fraud schemes into these ten types:

1. Fictitious and/or overstated revenues and assets (e.g., nonordered or cancelled goods). Sunbeam created revenues by contingent sales, a bill-and-hold strategy, and accelerated sales. Digital Lightware, Inc. recognized fraudulent billings.

2. Premature Revenue Recognition (e.g., holding books open).

3. Misclassified Revenues and Assets (e.g., combining restricted cash accounts with unrestricted cash accounts). School districts and universities may engage in this strategy with dedicated funds.

Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud Types and Auditor Litigation,” The Accounting Review, October 1998, pp. 503-532.

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Types of Financial Statement Fraud Schemes (contd …)

4. Fictitious Assets and/or Reductions of Expenses/Liabilities (e.g., recording consigned inventory as inventory). Cendant Corporation created fictitious revenues, and Knowledge Ware inflated revenues with phony software sales.

5. Overvalued Assets or Undervalued Expenses/Liabilities (e.g., insufficient allowance for bad debts).

6. Omitted or Undervalued Liabilities (e.g., understated pension expenses).

7. Omitted or Improper Disclosures (e.g., stock option expense estimates).

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Types of Financial Statement Fraud Schemes (contd …)

8. Equity fraud (e.g., recording nonrecurring and unusual income or expense in equity).

9. Related-Party Transactions (e.g., fictitious sales to related parties). Enron had many related-party transactions.

10. Financial Fraud Going the Wrong Way (e.g., for tax purposes reducing income or increasing expenses).

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Wrong Way Earnings Management

Freddie Mac understated past earnings as much as $5 billion.

Certain transactions and accounting policies were “implemented with a view to their effect on earnings” (e.g., to smooth earnings).

Restatements will result in higher earnings in prior periods but lower earnings in future periods.

Employees appeared to knowingly violate accounting rules in an effort to manipulate earnings.

Source: Patrick Barta and J.D. McKinnon, “Freddie Mac Profits May Have Been Low By Up to $4.5 Billion,” Wall Street J., June 26, 2003, pp. C-1 and C-11.

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Tax Issues: Freddie Mac

• The company used a so-called linked swaps to shift at least $420 million into the future.

• Internal report said the linked swaps had minimal business justifications other than the shifting of operating earnings.

• Company’s recent disclosure: potential additional tax liability as much as $750 million, plus interest.

Source: Dawn Kopecki and J.D. Mckinnon, “IRS Probes Tax Issues at Freddie Mac,” Wall Street Journal, October 22, 2003, p.A-6.

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Seven Investigative Techniques

1. Public document review and background investigation (non-financial documents).

2. Interviews of knowledgeable persons.

3. Confidential sources.

4. Laboratory analysis of physical and electronic evidence.

5. Physical and electronic surveillance.

6. Undercover operations.

7. Analysis of financial transactions.Source: R.A. Nossen, The Detection, Investigation and

Prosecution of Financial Crimes, Thoth Books, 1993.

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Financial Fraud Detection Tools

• Interviewing the executives• Analytics• Percentage analysis

– Horizontal analysis

– Vertical analysis

– Ratio analysis

• Using checklists to help detect fraud– SAS checklist

– Attitudes/Rationalizations checklist

– Audit test activities checklist

– Miscellaneous fraud indicator checklist

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© D.L. CrumbleyInvestigative Activities A forensic accountant must be careful not to

misrepresent either the identity or the purpose of the contact with a questionable party.

Surveillance is not an activity which accountants normally perform (e.g., may need a private investigator’s license).

Typical state statute requires a PI license for: “the investigation by a person or persons for the purpose of obtaining information with reference to any of the following: the causes and origin of, or responsibility for, … damage or injuries to real or personal property; the business of securing evidence to be used before investigating committees or boards of award or arbitration or in the trial of civil or criminal cases and the preparation therefore….”

In Florida, Legal Opinion 97-9 provides that any person who holds a professional license under the laws of this state, and when such person is providing services or expert advice in the profession or occupation in which that person is so licensed, is exempt from private investigator licensing requirements. Thus, a licensed accountant (e.g., CPA) would be permitted to perform forensic accounting without a private investigator’s license.

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Public Document Review• Real and personal property records.• Corporate and partnership records.• Civil and criminal records.• Stock trading activities.

Laboratory Analysis• Analyzing fingerprints.• Forged signatures.• Fictitious or altered documents.• Mirror imaging or copying hard

drives/company servers.• Use clear cellophane bags for paper

documents.

Investigative Techniques

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The double entry method of accounting possesses a peculiar elegance; results of operations are presented from two differing points of view – an income statement, presenting results over time, from period A through period B; the second point-of-view presented is always a balance sheet, which is nothing more than a “Kodak moment,” simple snapshot of things remaining on hand at the end of period B.

Part of the perverse and peculiar elegance of the double-entry system is that distortion of one point-of-view requires distortion in the other. Sooner or later, the distortion of a balance sheet, that Kodak snapshot, becomes visible to the naked eye. The distortion becomes discernable through various tests and measures – and audit procedures.

In other words, you can put off the inevitable, but only for so long. Six months. A year maybe. In really egregious situations, perhaps longer. If there are many parties in collusion, or if the fraud is very complex, perhaps it can be put off far longer. In time, though, the balance sheet puffery bursts of its own accord.

Even a tick can swell only so far.


The Magic of the Double Entry System

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• Enron’s management figured an ingenious method of overriding the double-entry of accounting. They simply ignored it.

• It remains the simplest, most elegant financial fraud. Enron created special-purpose entities (SPEs) and pledged Enron stock – just pieces of paper.

• If the SPE was successful, they recognized income.

• When the SPE had huge losses they issued more paper. Debts were filed off-balance sheet in the partnerships.

Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 92-93.

So Get Two, Three, Four Ticks

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• Enron’s management figured an ingenious method of overriding the double-entry system of accountancy. They simply ignored it.

• It remains the simplest, most elegant financial fraud. Enron created special-purpose entities (SPEs) and pledged Enron stock—just pieces of paper.

• If the SPE was successful, they recognized income.

• Debts in the partnerships were kept off the Enron balance sheet.

• When the SPE had huge losses, they issued more paper. Debts were held off-balance sheet in the partnerships.


So Get Two, Three, Four Ticks

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Analytical Procedures

Analytical procedures involve the study or comparison of the relationship between two or more measures for the purpose of establishing the reasonableness of each one compared. Five types of analytical procedures help find unusual trends or relationships, errors, or fraud:

• Horizontal or Percentage Analysis • Vertical Analysis• Variance Analysis• Ratio Analysis or Benchmarking• Comparison with other operating

information

Source: D.L. Crumbley, J.J. O’Shaughnessy, and D.E. Ziegenfuss, 2002 U.S. Master Auditing Guide, Chicago: Commerce Clearing House, 2002, p. 592.

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Sales v. Net Income Forensic accountants should compare the trend in sales with the trend in net income.

For example, from 1999 to 2001, HealthSouth’s net income increased nearly 500%, but revenues grew only 5%. On March 19, 2003, the SEC said that HealthSouth faked at least $1.4 billion in profits since 1999 under the auditing eyes of Ernst & Young.

The SEC said that HealthSouth started cooking its numbers in 1986, which Ernst & Young failed to find over 17 years. HealthSouth also inflated its cash balances.

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Horizontal Analysis

Suppose advertising in the base year was $100,000 and advertising in the next three years was $120,000, $140,000, and $180,000. A horizontal comparison expressed as a percentage of the base year amount of $100,000 would appear as follows:

Year 4 Year 3 Year 2 Year 1

DollarAmount

$180,000 $140,000 $120,000 $100,000

Horizontal Comparison

180% 140% 120% 100%

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Red Flags with Horizontal Analysis

• When deferred revenues (on the balance sheet) rise sharply, a company may be having trouble delivering its products as promised (Cendant Corp.).

• If either accounts receivable or inventory is rising faster than revenue, the company may not be selling its goods as fast as needed or may be having trouble collecting money from customers. For example, in 1997 Sunbeam’s revenue grew less than 1% but accounts receivable jumped 23 percent and inventory grew by 40 percent. Six months later in 1998 the company shocked investors by reporting a $43 million loss.

• If cash from operations is increasing or decreasing at a different rate than net income, the company may be being manipulated.

• Falling reserves for bad debts in relation to account receivables falsely boosts income (cookie jar accounting).

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More Red Flags

• Look for aggressive revenue recognition policies (Qwest Communication, $1.1 billion in 1999-2001). Beware of hockey stick pattern.

• Beware of the ever-present nonrecurring charges (e.g., Kodak for past 12 years).

• Check for regular changes to reserves, depreciation, amortization, or comprehensive income policy.

• Related-party transactions (e.g., Enron).• Complex financial products (e.g.,

derivatives).• Unsupported top-side entries (e.g.,

WorldCom).• Underfunded defined pension plans.• Unreasonable management compensation.Source: Scott Green, “Fighting Financial Reporting Fraud,”

Internal Auditor, December 2003, pp. 58-63.

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Five Statistically Significant Ratios

• Use the ratios for two successive fiscal years.

• Convert into indexes for benchmarking.• All indexes should be close to one.Day’s Sales in Receivable Index:

(Accounts Receivable t / Sales t )

(Accounts Receivable t-1 / Sales t-1)

Index for manipulators: 1.5 to 1--------------------------------------------------------Gross Margin Index:

[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]

[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]

Index for manipulators = 1.2 to 1--------------------------------------------------------Source: M.D. Beneish, “The Detection of Earnings

Manipulation,” Financial Analysts Journal, September/October, 1999. t-1 = prior year.

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Asset Quality Index =

1- (Current Assets t + Net Fixed Assets t )

Total Assets t

1 - (Current Assets t-1 + Net Fixed Assets t-1)

Total Assets t-1

Index for manipulators = 1.25 to 1-----------------------------------------------------------------

Sales Growth Index : Sales t / Sales t-1

Manipulators: 60%Non manipulators 10%

Source: M.D. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, September/October, 1999. t-1 = prior year.

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Total Accruals to Total Assets =

Δ Working Capital t - Δ Cash t - Δ Current Taxes Payable t - Δ Current Portion of LTD t - Δ Accumulated depreciation and amortization t

Total Assets t

TATA for manipulators: .031

TATA for non manipulators: .018

Source: M.D. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, September/October, 1999. LTD = Long-term debt.

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A Charles Lundelius Example

Comparison to peer group benchmarks:

Characteristic MPS Peer group % over peers

DSRI 1.56 1.03 51%

GMI 2.00 1.10 82%

AQI 1.23 1.04 18%

SGI 1.50 1.20 25%

TATA 0.10 0.05 100%

Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p.

129.

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Ratio Analysis

1. Current ratio =

Current assets (cash and equivalents, receivables and inventories) Current liabilities (payables, accruals, taxes, and debt due in 1 year)

2. Quick ratio = Cash and equivalents plus receivables

Current liabilities

3. Working capital = Current assets – Current liabilities

4. Inventory turnover = Cost of goods sold Average inventory

The number of days inventory is on hand can be calculated as

365

Inventory turnover

5. Receivables turnover = Net credit sales

Average receivables

6. Gross Margin = 1 – Cost of goods sold

Sales

www.smartmoney.com

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7. Expense ratio = Selling general and administrative expenses

Sales

8. Operating margin = Operating income

Sales

9. Profit margin = Net income before extraordinary items

Sales

10. Interest coverage ratio = Income before interest and taxes

Fixed charges

11. Margin of safety = Income after fixed charges before income taxes

Sales

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12. Debt-to-equity ratio = Total current and long-term + capitalized leases

Total stockholder’s equity

Or

Total debt at book value Total debt and preferred stock + common stock at market

13. Return on assets (ROA) = Net income

Average total assets

Or

Earnings before interest and taxes Average total assets

14. Return on equity (ROE) = Net income

Average common equity

15. Return on invested capital = Earnings before interest and taxes

Average invested capital

16. Number of years to pay off debt by application of internally generated cash flows

= Total fixed obligations Operating cash flows

17. Ratio of senior debt to capital = Total senior debt

Subordinated debt + net worth

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Excel Spreadsheet Sherron Watkins discovered the Enron fraud in 2001 when she was again working under Andy Fastow, CFO. She took a simple inventory, using an Excel spreadsheet to calculate which of the division’s assets were profitable and which were unprofitable.

She discovered the special purpose entities called Raptors, off-the-books partnerships. Enron had hidden hundreds of millions of losses by borrowing money from Raptors and promising to pay the loans back with Enron stock. Enron was hedging risks in its left pocket with money from its right pocket.

As the value of Enron stock fell and the losses in the Raptors mounted, Enron had to add more and more stock because Enron had risked 97% of the losses, and Arthur Andersen had agreed to the accounting.

Source: Mimi Swartz and Sherron Watkins, Power Failure, New York: Doubleday, 2003, p. 269.

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Interviewing Executives One way to detect fraud is to interview company personnel. The AICPA

Fraud Task Force provides an interviewing template of 13 questions for CEOs, CFOs, and Controllers.

1. Explain the purpose of interview- need to assess risk and comply with audit responsibilities

2. Inquire whether they are aware of any instances of fraud within their organization- Do they have reason to believe that fraud may have occurred or is occurring?

3. Has the CEO or CFO ever approved an accounting treatment for transactions that were not appropriate?

4. Have there been any instances where someone has attempted to inflate assets or revenue or deliberately understate liabilities and expenses?

5. Is there any member of management that has a direct interest or indirect interest in any customer, vendor, competitor, supplier or lender?

6. Is any member of management related to any other member of management?

7. Does anyone in the company have any personal, financial or other problems that might affect their job performance?

8. If there was an area within the company that might be vulnerable to fraud, what would that be?

9. Has anyone within the accounting department been let go or resigned within the past year?

10.Is there anyone in management that appears to be living a lifestyle beyond their means? – expensive cars, trips, jewelry, vices

11.Has anyone been involved in civil or criminal proceedings or filed bankruptcy

12.Does the company have a strong ethics policy? 13.Has anyone ever been fired for committing fraud against the company?

Source: Ronald L. Durkin et. al, “Incorporating Forensic Procedures in an Audit Environment,” Litigation and Dispute Resolution Services Subcommittee, New York: AICPA, 2003.

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Selecting the Right Interviewees

“Someone knows what is going on. If you tune in, you will get a feel for it.”

Lorraine Horton, Kingston, R.I.

--------------------------------------------------------------“It is important that you select the right person

to interview, and be conversant in interviewing techniques. For instances, pick someone from customer complaints or an employee who didn’t get a raise for two years, as they would be likely to provide the needed information.”

R.J. DiPasquale, Parsippany, N.J.

Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28

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Listen to rouges and whistle blowers who complain.

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Interview vs. Interrogation

• Interview-non-accusatory process where person asks questions to develop factual information (e.g., who, what, when, where, how).

• Interrogation-accusatory interview to obtain an admission of guilt.

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Advantage and Disadvantages

Advantages of an interview (non-accusatory)

• Facilitates the development of cooperation.

• Easier to develop rapport.• More effective way of developing usable

information.Disadvantages of Interrogation• Interviewee may be alienated and refuse to

speak to anyone later.• If interviewee will not speak to anyone,

ability to obtain information or admission is diminished.

Source: John E.Reed Associates, Inc.

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Verbal and Nonverbal Behavior

Verbal behavior includes not only words, but timing, pitch, rate, and clarity of the responses.

Nonverbal behavior includes body movement, position changes gestures, eye contact, and facial expressions.

See “Interviewing & Interrogation,” The Reid Technique, John E.Reid Associates, Inc., L.E.R.C Law Enforcements.

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Nonverbal Language

• 60% of communication is nonverbal.• Previous contact with person helpful.• During President Bill Clinton’s testimony

he touched his nose several times when he was lying, but did not touch his nose during truthful testimony.

• Two-thirds of truthful interviewees cross their legs.

Source: “Lying 101: There May Be Nonverbal Indicators of Lying,” http://members.tripod.com/nwacc_communication/id25.htm.

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Posture Language

Truthful• Frontally aligned.• Upright or forward.• Open (perhaps crossed legs).• Dynamic, comfortable changes.

Deceptive• Non-frontally aligned.• Slouched, retracted or leaning.• Barriers (crossed arms, purse in lap).• Frozen and rigid.

Source: John E. Reid Associates, Inc.

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Some Lying Signs • Covering mouth with hand.• Rubbing nose.• Frequent blinking.• Biting lip.• Moving or tapping foot.• Crossing arms.• Leaning forward.• Handling objects (e.g., pencil, pen).• Avoiding eye contact or averting eyes.• Clearing the throat.• Closing and opening coat.• Picking at lint on clothing.• Playing with collar.• Moving away.• Shrug gestures.• Slow response.• Higher pitch.• Long answer.• Gap between words becomes longer.• Non-words such as uh.

Source: “Lying 101: There May Be Nonverbal Indicators of Lying,” http://members.tripod.com/nwacc_communication/id25.htm.

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Interviewing Techniques

“Bosch didn’t say anything. He knew that sometimes when he was quiet, the person he needed information from would eventually fill the silence.” (pp. 5-6).

--------------------------------------------“Just listen. You are a detective.

Detectives are supposed to listen. You once told me that solving murders are getting people to talk and just listening to them.” (pp. 92-93).

--------------------------------------------------

Source: Michael Connelly, The Black Ice, St. Martin’s Paperback, 1993.

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Progression of Interpersonal Communication

Investigative Communication Type

Investigative Conversation

Structured Investigative Interviewing

Basic Forensic Interrogation

Advanced Forensic Interrogation

Time Requirements

Flexible Thirty minutes to one hour

Three to six hours

Three to six hours

Required Environment

Flexible Private setting

Intimate setting

Intimate setting

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Skill/Training Requirements

Minimal training required. Preferable to have training in active listening skills, question formulation and basic behavior analysis as well as psychology of investigative discourse.

Minimum fifteen hours training in structured interview formats and behavior analysis.

Minimum fifteen hours interviewing training plus thirty hours of training in Reid Nine Steps.*

Minimum standards for structured formats and basic interrogation as well as minimum ten hours of advanced training.

*Inbau, F.E., Reid, J. E. & Budkley, J.P. (1986) Criminal Interrogation and Confessions, third edition (Baltimore, Williams and Wilkins).

Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I. 02911.

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Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I. 02911.

Appropriate Use and Restrictions

When you are looking for direction in an investigation. Result is a gamble rather than a predictable outcome

When you have established the need for a formal investigation and are interacting with witnesses, victims, complainants or suspects. Must accept information as it is presented without

confrontation.

When you are interacting with an uncooperative suspect and require a truthful account of that person’s guilt. Make use of perception manipulation and as such requires comprehensive quality control.

Most desirous form for uncooperative suspects of severe offences or suspects who may be emotionally unstable. Does not use perception manipulation and therefore beneficial when you need to identify true motivation for the offence.

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John Baldwin found in 600 investigative interviews that 35.7 percent of suspects confessed from the outset and an additional 16.2 percent confessed initially to part of the allegation.“Police Interviewing Techniques,” British Journal of Criminology, Vol. 33, 1993.

William Morrisette Believes that “an investigator who properly identifies and implements the appropriate investigative communication type should be able to achieve an 85 percent confession rate through basic interrogation and a 95 percent rate by way of advanced interrogation.”

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HealthSouth’s Richard Scrushy

• The beauty of acquisition accounting – perfectly legal - - was the room it allowed for all sorts of gimmicks and restatements, masking true operating performance.

• Enter Richard Scrushy (HealthSouth). Allegedly King Richard and 11 other co-conspirators were called the “family.” From 1997 through mid-2002, the SEC says HealthSouth overstated its earnings by $2.5 billion - - 2,500% higher than true earnings. [By 1/21/04, $2.5 to $4.6 billion.]

• Scrushy allegedly met monthly with company financial executives, and he would say, “If we are not making the numbers, go figure it out.”

• Lower-level bean counters then inflated assets and used other creative accounting to plug the difference. They overstated profits by at least $1.4 billion by billing Medicare for physical-therapy services the company never performed. They submitted falsified documents to Medicare to verify the claims.


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Non-Audit Fees

• E&Y classified $1.3 million as an audit-related fee for HealthSouth in 2001, which was called pristine audit janitorial inspections.

• These “audits” included checking toilets, parking lots, and other parts of HealthSouth facilities for cleanliness (50-point questionnaire).

• Fortune said E&Y missed billions in financial fraud, but they were great at finding dust bunnies in their white-glove tests.


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Look For Fraud Symptoms

•Source Documents.

•Journal Entries.

•Accounting Ledgers.

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Source Documents

• Checks.

• Employee time cards.

• Sales invoices.

• Shipping documents.

• Expense invoices.

• Purchase documents.

• Credit card receipts.

• Register tapes.

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Source Documents Fraud Symptoms

•Photocopies of missing documents.

•Counterfeit/false documents.

•Excessive voids/credits.

•Second endorsements.

•Duplicate payments.

•Large numbers of reconciling items.

•Older items on bank reconciliations.

•Ghost employees.

•Lost register tapes.

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Journal Entries Fraud Symptoms

•Out-of-balance.

•Lacking supporting documents.

•Unexplained adjustments.

•Unusual/numerous entries at end of period.

•Written entries in computer environment.

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Ledger Fraud Symptoms

•Underlying assets disagree.

•Subsidiary ledger different than general ledger.

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AICPA Top 10 Technologies Task Force

The task force found the following top ten technologies for 2004 in descending order of importance:

1. Information Security. The hardware, software, processes and procedures in place to protect an organization’s systems. It includes firewalls, anti-virus, password management, patches and locked facilities, among others.

2. Spam Technology (new). The use of technology to reduce or eliminate unwanted e-mail. Technologies range from confirmation of the sender via ISP lookup to methods where the recipient accepts e-mail only from specific senders.

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3. Digital Optimization (new). Also known as “The Paperless Office.” The process of capturing and managing documents electronically (i.e., PDF and other formats).

4. Database and Application Integration (new). The ability to update one field and have it automatically synchronize between databases. An example would be the transfer of data between disparate systems.

5. Wireless Technologies. The transfer of voice of data from one machine to another via the airwaves without physical connectivity.

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6. Disaster Recovery. The development, monitoring and updating of the process by which organizations plan for continuity of their business in the event of a loss of business information resources due to theft, weather damage, accidents or malicious destruction.

7. Data Mining (new). The methods by which a user can sift through volumes of data to find specific answers.

8. Virtual Office (new). The technologies, processes and procedures that allow personnel to work effectively, either individually or with others, regardless of physical location.

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9. Business Exchange Technology (new). The natural evolution from EDI to greater business transaction and data exchange via the Internet using datasets that are transported easily between programs and databases (e.g., XBRL).

10. Messaging Applications (new). Application that permit users to communicate electronically, including e-mail, voicemail and instant messaging.

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Using Technology to Gather Evidence

• Drill-down functionality• Electronic imaging• Benford’s law• Digital Analysis Tests and Statistics

(DATAS)• Data warehousing/mining• Inductive vs. deductive method

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Technology is Here

“Extensive knowledge and use of technology is an absolute necessity. The ability to go into an electronic image and download information, and to get information from systems that don’t talk to each other. All the accumulated information can then be reviewed for financial improprieties.”

Bret Lacativo, Southlake, Texas

-------------------------------------------------------“We use off-the-shelf software (IDEA) to

import large databases, read different data files, set up queries, and compare database files such as addresses, telephone numbers, and Social Security numbers. This process will tell us, for example, if a purchase order was done on Saturday or Sunday when the company isn’t open.”

Cal Klausner, Bethesda, Md.

H.W. Wolosky, “Forensic Accounting to the Forefront, “ Practical Accountant, February 2004, pp. 23-28

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Data Analysis vs. Data Mining Software

• ACL, IDEA, and SAS are data analysis (DA) software used to ensure the integrity of data, to program continuous monitoring, and to detect fraudulent transactions.

• DA requires a program to be set up and run against the data. The program is written by auditors (i. e., humans) who may be prejudice in the routines that are executed.

• Data Mining finds patterns and subtle relationships in data.

• Wiz Rule (from WizSoft, Inc.) and IBM’s Intelligent Miner are data mining software.

Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.

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Wiz Rule Data Auditing Tool• Based upon date mining.• Performs complex analysis of data,

finding errors, inconsistencies, and situations that require further investigation.

• WizRule reveals all the if-then rules, mathematical formula rules, and spelling irregularities.

• Divides situations deviating from the rules into data entry errors and suspicious errors.

• Can be used in auditing, fraud detection, data scrubbing, and due diligence reviews.

• Learning curve is short.• Cost license is $1,395 and yearly

maintenance fee is $279.

Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.

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Technology Commits Fraud

“Technology was used to commit fraud in selling pools of credit card debt. A cooked formula was embedded in software by the seller of the debt to analyze the quality of debt for the purchaser, so no matter what debt came out, it had a good collection ratio, and the purchaser was willing to pay more. Only by analyzing the software coding was the fraud discovered,”

Cal Klausner, Bethesda Md.

------------------------------------------------------------

The trend toward paperless systems hinders a CPA’s ability to find fraud. For example, many banks are no longer sending out checks

Roberts J. DiPasquale

H.W. Wolosky, “Forensic Accounting to the Forefront, “ Practical Accountant, February 2004, pp. 23-28

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Computer-Assisted Audit Techniques

Parallel simulation – actual company data are processed using auditor – controlled software program. Does not contaminate data.

Test data – dummy transactions are prepared by the auditor and processed under auditor control by the client’s computer program. Simple, quick, and inexpensive.

Integrated test facility – creates a small subsystem within the regular IT system. Can create errors in clients files.

Continuous monitoring of online real time systems – use test data to test controls. Contamination can occur.

Tagging Transactions – place indicators or tags on selected transactions and trace through the system.

Source: Boynton et.al, Modern Auditing, 7th Edition., 396-398.

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Types of Misappropriations

• Embezzlement• Cash and check

schemes– Larceny of cash– Skimming– Swapping checks

for cash– Check tampering– Kiting– Credit card refund

and cancellation schemes

• Accounts receivable fraud– Lapping– Fictitious

receivables– Borrowing against

accounts receivable

• Inventory fraud– Stealing inventory– Short shipments

with full prices

• Fictitious disbursements– Doctored sales

figures– Sham payments– Price

manipulations: land flipping, pump and dump, and cybersmearing

– Money laundering– Bid rigging

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Some Employee Schemes

• Embezzlement/skimming involves converting business receipts to one’s personal use and benefit, by such techniques as cash register thefts, understated/unrecorded sales, theft of incoming checks etc.

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Some Skimming Schemes (off-book)

• Unrecorded sales.• Theft of incoming checks.• Swapping checks for cash.

Auditing Suggestions• Compare receipts with deposits.• Surprise Cash Count.• Investigate customers complaints.• Gross profit analysis (also for money laundering).• Check for reversing transactions, altered cash counts,

and register tapes that are “lost.”

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© D.L. CrumbleyPreventive Measures

• Segregation of duties, mandatory vacations, and rotation of duties help prevent cash larceny.

• Review and analyze each journal entry to the cash account.

• Two windows at drive-through restaurants.

• Signs: Free meal if no receipt.• Blank checks and the automatic

check signing machine should be kept in a safe place from employees.

• Pre-numbered checks should be logged and restricted to one responsible employee. Require two signatures on cashier checks.

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Kiting: building up balances in bank accounts based upon floating checks drawn against similar accounts in other banks. Wire transferring makes kiting easier.

Auditing Suggestions

• Look for frequent deposits and checks in the same amount.

• Large deposits on Fridays.

• Short time lag between deposits/withdrawals.

• Bank reconciliation audit [cut-off bank statement].

Some Employee Schemes (contd …)

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Cut-off Bank Statement

• Shorter period of time (10-20 days).

• Bank statement sent directly to fraud auditors.

• Compare the cancelled checks, etc. with the cut-off bank statement.

• Helpful for finding kiting and lapping.


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Other Cash Schemes

• Theft of checks (bottom or middle of checks).

• Checks may be intercepted or payee altered (washing checks).

• Forged endorsements (disappearing ink).

• Stolen credit cards.

• Refund schemes.

• Kickback schemes.

Cash Schemes

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Paul J. Silvester, former state treasurer for Connecticut, admitted accepting cash kickbacks in return for placing millions of dollars in state pension investments with certain equity funds.

Mr. Silvester was sentenced to 51 months in prison for taking bribes in return for investing $527.5 million from the state pension fund in five investment funds.

Source: Marc Santora, “After Help in Corruption Cases, Central Figure Gets 51 Months,” N.Y. Times, November 21, 2003, p. C-12.

Kickback Example

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Former Bank of America executive Luca Sala told investigators that over 7 years he took $27 million in a kickback scheme involving Parmalat.

He obtained the monies by a kickback arrangement with an outside broker who helped organize bond issues from Parmalat.

Mr. Sala (corporate finance head) helped organize several bond placements for Parmalat for which the bank regularly received fees.

Source: A. Galloni and C. Mollenkamp, “Ex-Parmalat Banker Admits Stealing $27 Million,” WSJ, February 27, 2004, p. A-3.

Parmalat Kickback Scheme

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• A television station’s former accounting director pleaded guilty to stealing more $1.8 million from her employees and spending it on jewelry, paintings, and fur coats.

• She would overpay the station’s travel bills and divert the refunds to her own credit card bills and personal accounts.

• She was sentenced to 7 ½ years in prison on a single count of theft from CBS affiliate WBBM – TV

Source: AP, “Ex-Accountant at CBS Affiliate Sentenced,” Las Vegas Sun, November 5, 2003.

Refund Schemes

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• Lapping.

• Fictitious receivables [for a fictitious sale], which is later written off.

• Borrowing against receivables (use receivable as collateral).

• Improper posting of credits against receivables.

Accounts Receivables Schemes

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Lapping• Recording of payment on a customer’s

account some time after receipt of payment. Later covered with receipt from another customer (robbing Peter to pay Paul).

• Lapping is more successful where one employee has both custody of cash and record keeping responsibility.

Audit Steps• Independently verifying customers who

do not pay.• Reviewing write-offs.

• Reviewing customers’ complaints.

Lapping

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• Compare the checks on a sample of deposit slips to the details of the customers’ credits that are listed on the day’s posting to the customer’s account receivables.

Lapping (cont.)

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Reducing Bad Debts Before MCI was acquired by WorldCom,

Walter Paulo a billing manager, had to reduce a $180 million bad debt expense down to $15 million.

Eventually MCI had to write-off $650 million in bad debt.

His schemes:• Allow a customer to sign a promissory note

to turn the receivable into a short-term asset.• Redacting invoices.• Developing interpretations to explain why

some items are aged so long.• Using questionable codes.• Used unapplied cash to cover. Arthur Andersen did not audit the smaller bad

debt accounts where the questionable accounts occurred (e.g., the third tier).

Paulo said that the AA auditors were young, inexperienced, and fresh out of college.

Source: J.M. Jacka, “An Environment for Fraud,” Internal Auditor, April 2004, pp. 49-52

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Inventory Fraud

• Stealing inventory/supplies for personal use or for sale at flea markets/garage sales.

• Kickback schemes (vendor/supplier and an employee). Sale of unreported inventory or at inflated prices.

• Use renumbered inventory tags matched to count sheets; use count procedures for work-in-progress items; separate duties between purchasing and logging receipts of shipments

Audit Steps for Inventory Fraud

• Check for same vendors.

• Prices higher than other vendors.

• Purchasing agent does not take vacation.

• Only photocopies of invoices are available.

• Age of inventory.

• Inventory turnover

• There is data-mining software.

Inventory

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• Farrah Daly was charged with stealing at least 39 diamonds (1 to 3 carats), one at a time over several years from a diamond sorting area.

• She and her husband allegedly had friends and others sell the approximately $500,000 worth of diamonds at pawn shops and jewelry stores.

Source: AP, “Ohio Woman Accused of Stealing Diamonds,” Las Vegas Sun, November 10, 2003.

Stealing Diamond Inventory

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Payroll Schemes

• Ghost Employee: A person on the payroll who does not work for that company.

• False Workers’ Compensation claims: Fake injury to collect disability payments.

• Commission schemes: Falsify amount of sales or the commission rate.

• Falsify hours and salary: Exaggerate the time one works or adjusts own salary.

Payroll

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Fictitious Disbursements• Multiple payments to same payee.• Multiple payees for the same product or

service.• Ghosts on the payroll.• Inflated invoices.• Shell companies and/or fictitious persons.• Bogus claims (e.g., health care fraud and

insurance claims).• Overstate refunds or bogus refunds at

cash register.• Many fictitious expense schemes (e.g.,

meals, mileage, sharing taxi, claiming business expenses never taken).

• Duplicate reimbursements.• Overpayment of wages.

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Other Fraud Schemes

• Stealing inventory/scrap.

• Stealing property.

• Theft of proprietary assets.

• Personal use of assets.

• Shoplifting.

• False down grading of products.

• A land flip involves a situation where a company decides to purchase land for a project. A person or group will find the land and buy it under a front name or company. The fraudster then increases the price of the land before selling it to the company.

• Money laundering is the use of techniques to take money that comes from one source, hide that source, and make the funds available in another setting so that the funds can be used without incurring legal restrictions or penalties.

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Other Fraud Schemes (contd …)

• A ponzi scheme is a pyramid-type technique where early investors are paid with new money collected from future investors, who lose their investments.

• Bid rigging occurs when a vendor is given an unfair advantage in an open competition for a certain contract.

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Ponzi Scheme Example

• Women Helping Women group hosted invitation – only “birthday parties” that promised $40,000 in the future to each woman who invested $5,000.

• Some of the women received the pay-off, but most lost out.

• $12 million pyramid schemes.

• Cheryl Bean, the leader, given 3 years probation, ordered to pay $15,000 in restitution, and $10,000 to a charity fund.

Source: AP, “Pyramid Scheme Leader Pleads No Contest,” Las Vegas Sun, November 8, 2003.

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Hammersmith Trust Ponzi Scheme

• Hundreds of sophisticated investors put $100 million in this prime banking scheme that promised as much as 1,600% annual return.

• The scheme revolved around the so-called international prime banking instruments (e.g., high-yield commercial paper or secret bank debenture programs). There is no market for prime bank instruments.

• “Not a single dime is invested in anything – save the fraudulent pyramid itself, with some money going from one investor to the other in the form of purported “interest” and “return of principal “payments – while most of it sticks to the pyramid or rather, to the people running the pyramid.”

Source: John Anderson, “Take The Money & Run,” Smart Money, December 2003, pp. 122-130.

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Bid Rigging or Bid Pooling

• Sherman Antitrust Act – illegal restraint of trade. Felony. Substantial fines and up to three years.

• Group of dealers choose one dealer to bid on items. Later the dealers themselves bid on the items bought and they, therefore, share the profits.

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Bid Rigging Red Flags

• Low turnout of auction attendees.• Winking, hand signals or other similar signs

among dealers after the bidding is opened.• A uniformity to the bidding. For example,

Dealer One bids on a particular lot and buys it with little or no activity, and then Dealer Two buys another lot, again with little or no competition.

• Difficulty getting things going.• A lot of handshaking and other signs of

recognition among several dealers before or after the auction takes place.

• An air of silence throughout the auction since auctions are generally noisy – or conversely, a lot of conversation among bidders during the sale of lots they normally should be bidding on.

• Low competition among known dealers who normally bid strongly against one another.

Source: www.harryrinker.com/bidrigging: The Official Government Auction Guide.

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Forensic Auditing Steps

• Count the Petty Cash Twice in a Day

• Investigate Suppliers (Vendors)

• Investigate Customers’ Complaints.

• Examine Endorsements on Canceled Checks

• Add Up the Accounts Receivable Subsidiary

• Audit General Journal Entries

• Match Payroll to Life and Medical Insurance Deductions

Source: Jack C. Robertson, Fraud Examination for Managers and Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216.

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Forensic Auditing Steps (contd …)

• Match Payroll to Social Security Numbers

• Match Payroll with Addresses

• Retrieve Customer’s Checks

• Use Marked Coins and Currency

• Measure Deposit Lag Time

• Document Examination

• Inquiry, Ask Questions

• Covert Surveillance

Source: Jack C. Robertson, Fraud Examination for Managers and Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216.

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Class Discussion

How can you defraud your own organization, working either from the inside or outside?

-------------------------------------------

“Fraudsters … identify and exploit weaknesses specific to the organization.”

Herling, D.J., and J. Turner, “Fraud: Effective Use of Legal Remedies for Corruption,” 9th International Anti-Corruption Conference, October 13, 1999. PowerPoint presentation slide 56. http:// www.transparency.org/iacc/9th_iacc/papers/day3/ws1/dnld/d3ws1_djherling.ppt

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© D.L. CrumbleyRed Flags or Fraud Identifiers

• Earnings problem: downward trend in earnings

• Reduced cash flow: If net income is moving up while cash flow from operations is drifting downward, something may be wrong.

• Excessive debt: the amount of stockholders' or owners' equity should significantly exceed the amount of debt.

• Overstated inventories (California Micro) and receivables (BDO Seidman): If accounts receivables exceeds 15 percent of annual sales and inventory exceeds 25 percent of cost of goods sold, be careful.

• Inventory plugging: Record sales to other chains as if they were retail sales rather than wholesale chains (e.g., Crazy Eddie).

• Balancing Act: Inventory, sales, and receivables usually move in tandem because customers do not pay up front if they can avoid it.

• CPA Switching: Firms in the midst of financial distress switch auditors more frequently than healthy companies.

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Red Flags or Fraud Identifiers (contd…)

• Hyped Sales: hyped sales by using his ample personal fortune to fund purchases.

• Reducing Expenses: Rent-Way reduced the company’s expenses—a reduction of $127 million.

• Ebitda: Earnings before interest, taxes, depreciation, and amortization is a popular valuation method for capital-intensive industries.

• Off-Balance Sheet Items: Enron had more than 2,500 offshore accounts and around 850 special purpose entities.

• Unconsolidated Entities: Enron did not tell Arthur Andersen that certain limited partnerships did not have enough outside equity and more than $700 million in debt should have been included on Enron’s statements.

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• Creative or Strange Accounts: For their 1997 fiscal year, America Online, Inc. showed $385 million in assets on its balance sheet called deferred subscriber acquisition costs.

• Pension Plans • Reserve Estimates • Personal Piggy Bank: Family member

owners may use a corporation as a personal piggy bank at the expense of public investors and creditors.

• Barter deals: A number of Internet companies used barter transactions (or non-cash transactions) to increase their revenues.

Red Flags or Fraud Identifiers (contd…)

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Barter Deals

AOL created ad revenues out of thin air. With an obsession to get advertising revenue in the door, “nobody there appears to have paid much attention to whether the business deals at issue were really producing ad ‘revenues’ by any acceptable definition….”

At least $90 million of revenues were expunged by mid-2003, with another $400 million contested.

Source: C.J. Loomis, “Why AOL’s Accounting Problems Keep Popping Up,” Fortune, April 28, 2003, p. 86.

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IRS’s Forensic Analysis

•IRS Commissioner Mark W. Everson said that the role of the IRS in the HealthSouth matter was to trace the flow of money. “IRS agents in this case used the same comprehensive financial analysis that we use in criminal tax investigations to document million of dollars in transactions through dozens of financial institutions, including banks and brokerage firms,” Everson said.•“The IRS will use its financial expertise to help the government hold accountable those executives who engage in fraud,” Everson said. “Our investigation supports the money-laundering charges as well as the forfeiture counts against Mr. Scrushy involving a staggering sum of money – over a quarter of a billion dollars – which he accumulated during a seven-year period,”•“This money went to support a lavish lifestyle, one few Americans could possibly imagine,” the Commissioner continued. “With his ill-gotten gains, Mr. Scrushy purchased multiple estates, racing and leisure boats, fine art by such artists as Picasso, Miro, and Renoir, cars including a Lamborghini and a Rolls-Royce, and extravagant jewelry, such as a 22-carat diamond ring.”

Source: Amy Hamilton, “Everson Publicizes Criminal Charges Against HealthSouth CEO,” Tax Notes, November 10, 2003, p. 671.

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Lifestyle Probes

The lifestyle of a taxpayer or employee may give clues as to the possibilities of unreported income. Obvious lifestyle changes may indicate fraud and unreported income:

– Lavish residence– Expensive cars and boats– Vacation home– Private schools for children– Exotic vacations

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IRS Financial Status Audits

If someone is spending beyond his or her apparent means, there should be concern. If a forensic accountant suspects fraud or unreported income, a form of financial audit may be appropriate that will enable the investigator to check the lifestyles of the possible perpetrators.

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Forensic Audit Approaches Used

by the IRS• Direct methods involve probing missing

income by pointing to specific items of income that do not appear on the tax return. In direct methods, the agents use conventional auditing techniques such as looking for canceled checks of customers, deed records of real estate transactions, public records and other direct evidence of unreported income.

• Indirect methods use economic reality and financial status techniques in which the taxpayer’s finances are reconstructed through circumstantial evidence.

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Indirect Methods

An indirect method should be used when:• The taxpayer has inadequate books and

records• The books do not clearly reflect taxable

income• There is a reason to believe that the

taxpayer has omitted taxable income• There is a significant increase in year-to-

year net worth• Gross profit percentages change

significantly for that particular business• The taxpayer’s expenses (both business

and personal) exceed reported income and there is no obvious cause for the difference

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Market Segment Specialization Program

The Market Segment Specialization Program focuses on developing highly trained examiners for a particular market segment. An integral part of the approach used is the development and publication of Audit Technique Guides.

These Guides contain examination techniques, common and unique industry issues, business practices, industry terminology, and other information to assist examiners in performing examinations. A forensic accountant can use this resource to learn about a particular industry.http://www.irs.gov/business/small/article/0,,id=108149,00.html

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Minimum Income Probes

• For nonbusiness returns, an agent question the taxpayer or representative about possible sources of income other than reported on the return. If there is no other information in the file indicating potential unreported income, the minimum income probe is met.

• For taxpayers who are self-employed and file a Schedule C or F, an analysis is made of tax return information to determine if reported income is sufficient to support the taxpayer’s financial activities.

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Cash TA cash T is an analysis of all of the cash received by the taxpayer and all of the cash spent by the taxpayer over a period of time. The theory of the cash T is that if a taxpayer’s expenditures during a given year exceed reported income, and the source of the funds for such expenditures is unexplained, such excess amount represent unreported income or possible fraud.

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Preliminary Cash-T

Gross Receipts: Business Expenses:

Schedule C $120,000 Schedule C $95,000

Preliminary Understatement

Personal Living Expenses

$60,000 $155,000

$35,000

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The cash hoard defense is illustrated in the Edwin Edwards’ gambling corruption trial in 2000. An IRS agent testified that Edwards spent hundreds of thousands of dollars more in cash than he reported in earnings.

On Monday, jurors got another avalanche of numbers as prosecutors tried to prove their charge that Edwards hid money he extorted from riverboat casino owners.

A financial analyst testified for the prosecution about how the former governor spent his cash, testimony the defense challenged every step of the way.

Don Semesky, a special agent for the Internal Revenue Service, used a chart to show that Edwards spent $872,000 more in cash than he reported receiving from 1986 to 1997.

Preliminary Cash-T (contd …)

Source: C. Baughman, “Prosecution Concludes Case In Edwards’ Trial,” The Advocate Online, April 4, 2000.

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Semesky said Edwards started 1986 with $82,000 in cash. He based that figure on Edwards’ own testimony in an unrelated trial in 1985.

In the current trial, Edwards testified he always had between $250,000 and $500,000 in cash during the mid-1980s. Using $250,000 as a starting point, Semesky said, Edwards still spent $704,000 more in that period than he reported receiving.

“I believe the evidence in this case is that Mr. Edwards received cash from other, unreported sources,” Semesky told prosecutor Mike Magner.

In either calculation, Edwards started spending more cash in 1996, Semesky said. He agreed with Magner’s allegation that the increase in spending coincided with Edwards getting extortion payments from Robert Guidry.


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Guidry, the former owner of the Treasure Chest casino in Kenner, testified he paid Edwards and his son along with Edwards’ former, aide Andrew Martin, $100,000 a month from early 1996 until August 1997.

Like he did with Laura East, Small wasted little time attacking Semesky’s numbers, which were displayed for the jury on a chart.

Semesky’s total for cash spent by Edwards included $383,500 the FBI seized from his safe-deposit box on April 29, 1997.

Edwards testified that cash was left over from $400,000 Eddie DeBartolo Jr. had given him in a legitimate business deal on March 12, 1997. He said it was primarily to prepare for a gambling election in Bossier City, where DeBartolo was applying to put in a casino boat.


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DeBartolo, who has pleaded guilty in the case, testified for the prosecution that Edwards extorted the $400,000 from him.

But while Semesky showed the $383,500 as cash spent, he did not show the $400,000 from DeBartolo as cash received, Small said.

“Isn’t it a fact that you screwed up and you missed the $400,000?” Small asked Semesky.

“Mr. Small, you’re not understanding the concept of this chart,” Semesky said. “The government’s contention in this case is that it (the $400,000) came from extorted payments.”

The purpose of the chart was to show legal sources of cash, Semesky said. That included $1,586,800 in net gambling winnings Edwards had from 1986 until 1997, he said.


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But Small said the cash shortfall that Semesky found - - about $872,000 - - could be made up by starting with $500,000 in cash in 1986, as Edwards testified he might have had.

Add the $400,000 from DeBartolo and the shortfall disappears, Small said.

Later in 1997, DeBartolo reported to the IRS he had given Edwards the money, Small said.

But Semesky maintained that the $400,000 could not be counted as a legitimate source of cash.

“It doesn’t belong on that schedule,” he said.


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Source and Application of Funds Method

(Expenditure Approach)

This technique is a variation of the net worth method that shows increases and decreases in a taxpayer’s accounts at the end of the year. The format of this method is to list the applications of funds first and then subtract the sources. If the taxpayer’s applications exceed his or her known cash receipts (including cash on hand at the beginning of the year), any difference may be unreported income.

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Source/Application of Funds

Application of funds: 2002 2003

Bank balance increase

Down payment on home

Closing costs on home

Purchase of SUV

Rent payment (4 months)

Mortgage payment

Down payment on boat

Credit card payments

Miscellaneous (living)

Balance

$7,300

15,000

3,700

17,600

2,000

4,200

-

14,000

11,500

75,300

$29,500

-

-

-

-

8,400

10,000

38,800

37,000

$123,700

Known sources of funds:

Cash on hand

Salary

Consulting

Dividends and interest

Loan proceeds

Balance

Net unreported funds

$3,600

49,500

7,000

3,000

0

$63,100

$12,200

$1,700

53,000

13,000

3,000

7,000

$77,700

$46,000

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Net Worth Method

The net worth method is a common indirect balance sheet approach to estimating income. To use the net worth method, an IRS agent or forensic accountant must:

1. Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of a period

2. Add nondeductible living expenses to the increase in net worth

3. Account for any difference between reported income and the increase in net worth during the year as (a) nontaxable income and (b) unidentified differences

Hollard v. U.S., 348 U.S. 121 (1954).

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Net Worth Example

Total assets (at cost)

Less: Total liabilities

Net worth, end of the year

Net worth at beginning of year

Increase or decrease in net worth

Add: living expenditures

Estimated Income

Less: Known sources of income

Unexplained income

$1,200,000

(550,000)

650,000

530,000

120,000

145,000

265,000

(130,000)

$135,000

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Net Worth Application

2003 2004 2005

Calculated Net Worth1

Computed Net Worth2

Net Asset increase

Unexplained net worth increase

Income

Expenses

Net asset increase

$225,000

225,000

0

11,000

$62,000

51,000

$11,000

$421,000

310,000

$111,000

21,000

$90,000

$81,000

60,000

$21,000

$610,000

420,000

$190,000

23,000

$167,000

$87,000

64,000

$23,000

1 Actual Net Worth recalculated based upon actual assets less liabilities.2 Net Worth based upon reported income less expenses.

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Non-Tax Net Worth Use

In a narcotics conspiracy trial, defendant argued that the expert auditor should have to followed the net worth method to prove that defendant’s wealth is disproportionate to his reported income.

Holland need not be followed in non-tax cases. Unlike tax prosecutions, narcotics conspiracy charges do not involve financial gain as necessary elements of offense, so less stringent standards are allowable.

U.S. v. Cuervo, No. 02-2898 (CA-8, 2004).

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Bank Deposit Method

The bank deposit method looks at the funds deposited during the year. This method attempts to reconstruct gross taxable receipts rather than adjusted.

Gleckman v. U.S., 80 F.2d 394(CA-8, 1935).

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Formula for Bank Deposit Method

Total deposits to all accountsLess: Transfers and re-deposits= Net depositsplus: Cash Expenditures= All total receiptsless: Funds from known sources= Funds from unknown sources

$195,00021,000

174,00068,000

242,000119,000123,000

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Formula for Expenditure Method

Expendituresless: Known sources of income= Unknown sources of income

$210,000115,000$95,000

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© D.L. CrumbleyPercentage of Markup Method Gross Profit on Sales Formula

Sales per books Gross profit percentageGross profit as recomputed

$100,000 25%

$25,000

Sales on Cost of Sales Formula Cost of Sales-Percentage of Sales Price

Cost of Product ACost of Product B

$10,000$20,000

Cost of Sales – Percent of Selling Price

Product AProduct B

25%50%

Recompiled Sales of products A and B

Product AProduct BSales as recomputed

$40,000$40,000$80,000

(10,000/.25)(20,000/.5)

Restaurant SalesNumber of waitersAverage sales per waiterCustomer’s tip percentageWaitress tip income as recomputed

$90,0003

30,00010%

$3,000

Ratio Analysis Formula

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Unit and Volume of Sales Method

Average sales price per machineNumber of machines manufacturedTotal sales as recomputedTotal sales per returnUnreported sales:

Suppose:Beginning inventoryEnding inventory

$9001,100

$990,000720,000

$270,000

$220,000$250,000

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© D.L. CrumbleySome Exercises

30) Given the following facts about Sammie Bright, calculate his preliminary understatement using the Cash-T method.Schedule C expenses $102,000Personal living expenses 59,000Schedule C receipts 112,000

31) Based upon the following facts about Phil Tizzard, in Sour Lakes, Texas, calculate any unexplained net worth increase (if any):

Computed Net worth (reported income less expenses)

$520,000Calculated Net worth (actual net worth recalculated upon actual assets less liabilities) $618,000 Income

$93,000 Expenses $67,000

32) Ben Lautenberg is a waiter in Las Vegas, and reports tip income of $4,200 for the year. The restaurant sales where he works were $360,000 and there were 5 waiters. Assume that the waiters have about the same amount of sales. Compute Ben’s tip income recomputed if customers’ tip percentage is approximately 11%

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Other TechniquesA check spread deals with

disbursements and may be used when a target uses checking accounts. George A. Manning says the following information is needed to perform a check spread: date, payee, check number, amount, bank from, bank to, first endorsement, second endorsement, and second signatory. Check spreads show patterns of activities and can gather data for the net worth method.

A deposit spread deals with the receipts into a checking account, and shows patterns of activities and gathers data for the net worth and expenditures methods.

Credit card spreads may be used for legal and stolen credit cards to show where a target has been geographically over time.

Source: G.A. Manning, Financial Investigation and Forensic Accounting, Boca Raton, FL: CRC Press, 1999, pp. 196-198.

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Tax Fraud

Tax fraud is somewhat different than legal fraud. The Supreme Court in Spies v. U.S. provides some badges of tax fraud:

• Abnormal cash dealings.• False entries in records or creation of

false documents such as invoices.• Duplicate set of books.• Concealing assets or sources of

income.• Fictitious transactions.• Expenses not deducted to divert

attention from unreported income.• Destruction of books or records.

Source: 317 U.S. 492 (1943).

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Bradford v. Commissioner provides other badges of fraud:

• Understatement of income.• Inadequate records.• Failure to file tax returns.• Implausible or inconsistent

explanations of behavior.• Concealing assets.• Failure to cooperate with tax

authorities.• Engaging in illegal activities.• Attempting to conceal illegal activities.• Dealing in cash.• Failing to make estimated tax

payments.• Many of these badges and others may

be found in the Internal Revenue Manual. Source: 796 F. 2d 303 (CA-9, 1986).

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Tax Fraud Schemes • Slavery Reparation Credit – 80,000

claims in 2001, totaling $2.7 billion. IRS paid out $30 million.

• Social Security Refund – promoters tell taxpayers they can recover all of their FICA and Medicare taxes paid. Typical charge: $100 plus 10% of the refund.

• Home – based businesses – claim deductions for home – based businesses (i.e., hobby losses).

• Domestic and foreign trust schemes charges range from $5,000 to $70,000

• Many frivolous protestor theories.

See: S.F. Holub, “Tax Fraud and Tax Protesters,” The Tax Adviser, December 2002, pp. 790-792.

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Venue for Tax Fraud

Criminal Tax Fraud: Federal District Court

Civil Tax Fraud:

• Federal District Court.

• U.S. Tax Court.

• Federal Claims.

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© D.L. CrumbleyFraud vs. Avoidance

• U.S. companies paid Caltex excessive amounts for Indonesian Crude Oil ($4.55 per barrel).

• Therefore, excessive dividend income, with foreign tax credits and cost of sales deductions on U.S. income tax returns.

• To compensate Caltex for the extra taxes it paid, Indonesian Government provided Caltex with oil in excess of the amount called for under the formal production-sharing contract.

• Total Federal and State taxes avoidance of $8.6 billion and $433 million.

Source: J.D. Gramlich and J.E. Wheeler, “How Chevron, Texaco, and Indonesian Government Structured Transactions to Avoid Billions in U.S. Income Taxes,” Accounting Horizons, June 2003, pp. 107-122.

Chevron Texaco

Caltex (Indonesian companies)

50%50%

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Financial Statement Fraud May Serve Many Purposes:

1. Obtaining credit, long-term financing, or additional capital investment based on misleading financial statements;

2. Maintaining or creating favorable stock value;

3. Concealing deficiencies in performance;

4. Hiding improper business transactions (e.g., fictitious sales or misrepresented assets); and

5. Resolving temporary financial difficulties (e.g., insufficient cash flow, unfavorable business decisions, defense control in maintaining prestige).

Source: Zab Rezaee, Financial Statement Fraud, New York: John Wiley & Sons, 2002.

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Management may also engage in financial statement fraud to obtain

personal benefits of:

1. Increasing compensation through higher reported earnings;

2. Enhancing value of personal holding of company stock such as stock-based compensation;

3. Converting the company’s assets for personal use; and

4. Obtaining a promotion or maintaining the current position within the company.

Source: Zab Rezaee, Financial Statement Fraud, New York: John Wiley & Sons, 2002.

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KPMG provides 10 steps to follow when an organization finds or suspects fraud:

1. Shut the door! Keep assets secure until you can provide appropriate long-term security.

2. Safeguard the evidence. Ensure that all records and documents necessary for an investigation remain intact and are not altered by you or anyone else.

3. Notify your insurer. Failure to notify may negate your coverage.

4. Call a professional. Do not confront or terminate the employment of a suspected perpetrator without first consulting your legal advisor.

5. Prioritize your objectives. What’s most important: punishment, loss recovery, prevention, detection of future occurrences?

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KPMG’s 10 steps to follow contd..

6. Consider prosecution. Before you make the call, weigh the plusses and minuses and determine if your insurance company requires prosecution.

7. Terminate business relations. If the fraud is external, business relations with the suspect individual or organization should be terminated.

8. Seek advice and assistance. An important consideration is whether you have the knowledge and resources necessary to effectively manage the process.

9. Prepare a witness list. It is important that statements be taken before a “party line” can develop.

10. Consider the message. Whatever you do will affect future situations. Now may be the time to change the way your business operates.

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Punishment for fraud and recovery of stolen funds are so rare, prevention is the only viable course of action.

Frank W. Abagnale

30 years ago Abagnale cashed $2.5 million in fraudulent checks in every state and 26 foreign countries. Was later associated with the FBI for 25 years.

Catch Me If You Can

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Although large frauds may be reported to law enforcement agencies, smaller frauds are often not reported.

This failure to report fraud incidents and the reluctance of police to aggressively tackle the issue only empowers the perps and diminishes the victims. Ultimately, these unreported incidents are precursors to larger and larger acts of violence. If we do not deal with simple crimes, we will eventually have to deal with homicide.

Source: Stephen Doherty, “How Can Workplace Violence Be Deterred,” Security Management, April 2002, p. 134.

Fraudsters Should Be Prosecuted

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State and Local Government Susceptibility

Government bankruptcy is an important issue for fraud prevention and detection because likes business corporations and organizations, governments facing severe financial difficulties can be fertile ground for fraud. Government bankruptcy also may trigger an investigation in order to determine if fraud has contributed to such financial distress.

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The Office of Management and Budget reported that in fiscal year 2001 the federal government paid out $20 billion in erroneous payments.

On June 19, 2003: We analyzed a portion of the programs and already know that erroneous payments exceeded $35 billion a year.” Office of Mgt. And Budget

Governmental Frauds

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The Internet site of Ashcraft & Gerel indicates that 10 percent of the U.S. annual budget is paid to companies or persons who are defrauding the government.*•Ashcraft & Gerel, “Whistle Blower Litigation Under The Federal False Claims Act - - Qui Tam Claims,” www.ashcraftandgerel.com/whistleb.html#History

--------------------------------------------------------------

2002 Wells Report: 25% of fraud incidents occurred in government agencies, with a $48,000 median loss (.25 times $600 billion = $150 billion).

Governmental Frauds

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•The Ministry of Social Development was defrauded of $1.1 million by a trusted employee.•The employee created 67 fictitious invoices for payment over 28 months, at a time when there had been changes in management or at the time of the month when there was pressure to approve payment of accounts payable.•Another employee noticed his own signature apparently forged on a document.

Source: Helen Bishop and Ashley Burrows, “Fraud in New Zealand Government Despite Auditor General’s Warning,” Journal of Government Financial Management, Winter 2003, Vol. 52, No. 4, pp. 42-46.

New Zealand Government Fraud

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The ________ in 2002, improperly recorded some expenses, kept “inappropriate balances” in some accounts, and failed to verify how much money it was collecting in transaction fees.

While this government agency’s overall internal controls were “effective,” their financial reports are not presented in accordance with applicable federal accounting requirements.

This agency did not properly record capital leases for computer hardware and did not properly account for its software licensing fees and other in-house expenses. They need to do a better job of tracking transaction fees.

Government Quiz 101

Source: Deborah Soloman, “SEC’s Own Accounting Requires Tightening, Internal Audit Says,” Wall Street J., July 3, 2003, A-2.

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An Oct. 14, 2002, New York Times article by Joel Brinkley stated that “auditors studying the financial records of federal government departments find may of them so disorganized, even chaotic, that the agencies cannot account for tens of billion of dollars.” So how did the agencies make their books balance? Through the magic of top-side balancing entries.

The Forest Services, a division of the U.S. Department of Agriculture, tried to balance its books at the end of the 2001 fiscal year. It booked more than 15,337 adjusting entries, debits, and credits totaling more than $11 billion gross. Auditors determined that 73 percent of these adjustments, totaling $7.9 billion, were unsupported.

The U.S. Department of Defense alone entered an unsubstantiated balance adjustment totaling $1.1 trillion in 2000, down from $2.3 trillion the prior year.

Source: Scott Green, “Fighting Financial Reporting Fraud,” Internal Auditor, December 2003, pp. 58-65.

Top-Side Entries: Smoking Gun

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•Governmental Accounting Standards Board: nonprofit agency charged with setting GAAP for state and local governments.•Although GASB has no authority to set law, many public agencies follow its standards.•Statement No. 34 retains the fund accounting focus (good for budgeting and short-term focus), but adds government-wide financial statements (e.g., account for all assets and liabilities).•Requires capitalization and depreciation of infrastructure assests.•Goes from the Governmental Funds Statements to the Statement of Net Assets and Statement of Activities.•Goes from the modified accrual statements to the full accrual statements.•New Management Discussion and Analysis (MD & A) Statement – a narrative discussion of any significant changes in the overall financial picture of a given agency.Source: K. Middaugh, “The Great GASB,” Government Technology, October 2003, pp. 50-52.

GASB Statement No. 34

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Qui Tam Suits

• The Qui Tam suit allows any concerned citizen to seek relief in the name of the government.

• Many whistle-blowers initially file qui tam suits to get a dispute on the books and started.

• Once a qui tam suit is initiated, the U.S. Department of Justice evaluates the case to see whether the DOJ believes there are sound reasons to pursue the conflict.

• Whatever parts of the qui tam suit the U.S. DOJ does not take, a whistle-blower and his or attorney can continue to litigate.

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Taxpayers Against Fraud

The Taxpayers Against Fraud has an Internet site called “The False Claims Act Legal Center.” Their Qui Tam Attorney Network assists attorneys in their efforts to provide effective representation to qui tam plaintiffs. This group disseminates information about the False Claims Act and qui tam provision.

An attorney may request an amicus brief submission. They state that enforcement of the False Claims Act and its qui tam provisions have returned more than $12 billion to the U.S. Treasury over the past 17 years ($2.1 billion in 2003 fiscal year).

Whistle-blowers paid $319 million in 2003 fiscal year (up to 25% of judgment).

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Assess Financial Health

Ratio Purpose Negative Indicator

Financial Position:

Unrestricted Net AssetsExpenses

Measures a government’s ability to provide basic government services

Decreasing

Financial Performance:

Change in Net AssetsTotal Net Assets

(General Revenues + Transfers) / Expenses

Measures a government’s financial performance during the current fiscal year by comparing the change in the Net Assets derived from the Statement of Activities to the total net assets.

Measures the extent to which the cost of services are paid for out of general revenues.

Decreasing

Decreasing

Liquidity: (Cash + Current Investments + Receivables) / Current Liabilities

Measures the extent to which current liabilities are covered by the more liquid current assets.

Decreasing

Solvency: Long-term Debt / Assets

(Change in Net Assets + Interest Expense) / Interest Expense

Measures a government’s long-term financial viability by comparing the extent to which assets are financed by incurring long-term debt.

Measures the government’s ability to generate a stream of inflows sufficient to make interest payments.

Increasing

Decreasing

Source: B.A. Chaney, D.M. Mead, and K.R. Schermann, “The New Governmental Reporting Model,” Journal of Governmental Management, Spring 2002, p. 29.

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Early Warning Signals of Possible Trouble for Municipal Entities

1. Current year operating deficit2. Two consecutive years of Operating Fund deficit3. Current year operating deficit that is larger than the

previous year’s deficit4. A General Fund deficit in the current year – balance sheet –

current position5. A current General Fund deficit (two or more years in the

last five)6. Short-term debt outstanding at the end of the fiscal year,

greater than five percent of main Operating Fund Revenues7. A two-year trend of increasing short-term debt outstanding

at fiscal year end8. Short-term interest and current year-end service greater

than 20 percent of total revenues9. Property taxes greater than 90 percent of the tax limit10.Debt outstanding greater than 90 percent of the debt limit11.Total property tax collections less than 92 percent of total

levy12.A trend of decreasing tax collections – two consecutive

years in a three-year trend13.Declining market valuations – two consecutive years –

three-year trend14.Expanding annual unfunded pension obligations Source: H.C. Grossman and T.E. Wilson, “Assessing Financial

Health,” Handbook of Governmental Accounting & Finance, Somerset, N.J.: John Wiley & Sons, 1992, pp. 38-1 to 38-13.

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© D.L. CrumbleyAssess Financial Health of Governmental Units

Ratios Negative Indicator

Credit Industry Benchmark

Cash and investments/current liabilities

Decreasing Less than 1%

Operating surplus (deficit)/total revenue

Decreasing 5% or consecutive

Elastic revenue (sales, utilities, other elastic taxes)/total revenue

Decreasing Varies

State and federal aid / total revenue

Increasing Varies

Current liabilities/total revenue Increasing 5%

Uncollected property taxes/ current tax levy

Increasing Greater than 8%

Fixed costs/ total expenditures Increasing Varies

Debt service/total revenue Increasing Greater than 20%

Tax levy/tax limit Increasing Greater than 90%

Debt outstanding/debt limit Increasing Greater than 90%

Source: S.M. Winckler and Dewey Ward, “Can City Hall Go Broke? The Going Concern Issue,” Journal of Accountancy, May 1984.

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© D.L. CrumbleyOffice of New York State Comptroller

Indicator 1: Revenue and Expenditures Per Capita

Recurring Revenues Per Capita

a. Gross Revenues

Population

b. Gross Expenditures

Population

c. Recurring Revenues (Gross Revenues – One-Time Revenues)

Population

Negative Trend: Indicator 1b increasing faster than indicator 1a or 1c.

Indicator 2: Real Property Taxes Receivable

Real Property Taxes Receivable

Real Property Tax Revenue

Negative Trend: The percentage increases over time.

Indicator 3: Fixed Costs – Personal Services and Debt Service

a. Salaries and Fringe Benefits

Gross Expenditures

b. Debt Service Expenditures

Gross Expenditures

c. Salaries and Fringe Benefits + Debt Service

Gross Expenditures

Negative Trend: Percentages increasing over time.

Some analysts use a variation of the 3b ratio based upon debt service expenditures as a percentage of revenues. A ratio of 25% for debt service expenditures to “own source” revenues is considered a danger signal.*

* J.R. Razek et. al, Introduction to Governmental and Not-For-Profit Accounting, Prentice-Hall, 2000, p. 412.

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Indicator 4: Operating Surplus/Deficit

a. Gross Revenues – Gross Expenditures

Gross Expenditures

b. Gross Revenues – Gross Expenditures – One-Time Revenues

Gross Expenditures

Negative Trend: Percentages decreasing over time.

Indicator 5: Unreserved Fund Balance and Appropriated Fund Balance

a. Unreserved Fund Balance

Gross Expenditures

b. Appropriated Fund Balance

Gross Expenditures

Negative Trend: Percentages decreasing over time.

Deficits in major funds in excess of 1.5% of fund expenditures or $50,000 (whichever is greater) are generally causes for concern. Some analysts use a variation of this ratio: the budgetary cushion. Here the fund balance is compared to revenues. The greater the fund balance as a percentage of revenues, the more likely a local government may weather hard times. A good rule of thumb is that a fund balance should be at least 5% of revenues.[1] [1] J.R. Razek et. al, op. cit., p. 411.

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Indicator 6: LiquidityCash and Investment as a Percentage of Current LiabilitiesCash and Investments as a Percentage of Gross Monthly Expendituresa. Cash and Investments

Current Liabilitiesb. Cash and Investments

Gross Expenditures/12Negative Trend: Percentages decreasing over time.

A government should generally have year-end cash equal to about 50% of current liabilities and 75% of average monthly expenditures. A governmental accounting textbook states that this quick ratio (or acid test) omits receivables and amounts due from other funds because of difficulties converting them into cash. They suggest that a large state government should consider a quick ratio of less than 50 percent as an indicator of financial stress.*

Indicator 7: Long-Term DebtLong-Term DebtPopulation

Negative Trend: Percentage increase over timeNote: An increase in #7 would likely trigger a future increase in #3 formula as well as a decrease in #8.

Indicator 8: Capital OutlayCapital Outlay Gross Expenditures

Negative Trend: Percentage decreasing over timeNote: This eighth indicator is an early warning sign of financial stress.

* Razek and Hosch, ibid., p.411.

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Office of New York State Comptroller

Indicator 9: Current Liabilities

Current Liabilities

Gross Revenues

Negative Trend: Percentage increasing over time

Indicator 10: Intergovernmental Revenues

Intergovernmental Revenues

Gross Revenues

Negative Trend: Percentage increasing over time.

Indicator 11: Economic Assistance Costs

Economic Assistance Cost

Gross Expenditures

Negative Trend: Percentage increasing over time.

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© D.L. Crumbley

Office of New York State Comptroller

Indicator 12: Public Safety

Public Safety Cost

Gross Expenditures


Indicator 13: Tax Limit Exhausted

Tax Levy

Tax Limit


The tax limit is the maximum amount of taxes that can be levied based upon some statutory authority.

Indicator 14: Debt Limit Exhausted

Total Debt Subject to Limit

Debt Limit


Debt limit is the maximum amount of debt that can be issued under applicable statutory authority. Compare this ratio with indicators 3 and 7.

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© D.L. Crumbley

1. You have the following data for a city in the southwest. Calculate the quick ratio. Is this ratio favorable or unfavorable?

Current Liabilities $28 million

Cash $27 million

Investments (current) $36 million

Accounts Receivables $12 million

Due from other funds $2.5 million

2. You have the following information about a mid-west city. Calculate the ratios of fund balance to revenues and determine if they are favorable or unfavorable.

General Fund $62 million

Unreserved Fund $54 million

General Fund Revenues $401 million

3. You determine the following data about a local government in the southeast. Determine the ratios of unreserved fund balance and reserved fund balance to total revenues. Are these ratios favorable?

Revenues from Property Taxes $36 million

Unreserved Fund Balance $5 million

Reserved Fund Balance $3.5 million

4. Assume the following facts about a local government. Determine the Tax Limit Exhausted and the Debt Limit Exhausted ratios.

Tax Limit $11 million

Debt Limit $13 million

Tax Levy $8.5 million

Total Debt subject to Limit $9 million

5. Assume that Debt Service Expenditures is $16.2 million and Total Revenues is $70.1 million. Calculate the Debt Service/total revenue ratio. Is the ratio favorable?

Some Exercises

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© D.L. Crumbley

6. Determine if the following situations are negative indicators of the financial health of a government unit.

a. Cash and investments divided by current liabilities ratio is decreasing over several years.

b. Current liabilities divided by total revenues ratio is decreasing.

c. Fixed costs divided by total expenditures ratio is increasing.

d. Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time.

e. Debt Service expenditures as a percentage of revenues is greater than 25%.

f. Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time.

g. Gross Revenues – Gross Expenditures : Decreasing over time.

Gross Expenditures

h. The debt service expenditures as a percentage of revenues is 25% or larger.

i. A fund balance is greater than 10% of revenues.

j. Unreserved fund balance divided by gross expenditures ratio is decreasing over time.

k. The quick ratio of a large state government is 2.2 to 1.

l. Long-Term Debt divided by population ratio is decreasing over time.

m.Current Liabilities divided by Gross Revenues ratio is increasing over time.

n. Tax Levy divided by Tax Limit ratio is decreasing over time.

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© D.L. Crumbley

6. Determine if the following situations are negative indicators of the financial health of a government unit.

a. Cash and investments divided by current liabilities ratio is decreasing over several years. Negative

b. Current liabilities divided by total revenues ratio is decreasing. Positive

c. Fixed costs divided by total expenditures ratio is increasing. Negative

d. Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time. Negative

e. Debt Service expenditures as a percentage of revenues is greater than 25%. Negative

f. Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time. Positive

g. Gross Revenues – Gross Expenditures : Decreasing over time.Gross Expenditures Negative

h. The debt service expenditures as a percentage of revenues is 25% or larger. Negative

i. A fund balance is greater than 10% of revenues. Favorablej. Unreserved fund balance divided by gross expenditures ratio is

decreasing over time. Negativek. The quick ratio of a large state government is 2.2 to 1. Favorablel. Long-Term Debt divided by population ratio is decreasing over

time. Favorablem.Current Liabilities divided by Gross Revenues ratio is increasing

over time. Negativen. Tax Levy divided by Tax Limit ratio is decreasing over time.

Favorable

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© D.L. Crumbley

Not-For-Profits• There are more than 1 million not-for-

profits in the U.S.

• Often there is little segregation of duties.

• They often deal in an atmosphere of trust, with employees having little accounting and business experience.

• Difficult to estimate and control the cash contributions and revenues (e.g., Salvation Army’s Christmas kettles take in $1,000 - $1,500 per day).

• Fountains at charitable organizations may take in several thousand dollars in coins.

• The Non Profit Times (www.nptimes.com).

• Some people believe the Sarbanes-Oxley Act will be imposed on large not-for-profits.

• Moral: Do not go to a hospital that you are giving away money to in your will.

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© D.L. Crumbley

Fraud in Not-for-Profit Organizations

The website of Clark, Schaefer, Hackett & Company states the following reasons not-for-profit organizations become targets of fraud:

Many smaller not-for-profits just don’t have the personnel size required for a real segregation of duties. They often don’t require much approval for disbursements.

And, when fraud is discovered, they frequently don’t prosecute it very aggressively because of the perceived negative publicity.

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© D.L. Crumbley

Blue Cross Overcharged

•Two men supplied hundreds of phony invoices to Blue Cross from 1996-2001 in a scheme to defraud more than $14 million.

•Prosecutors said V.J. Croce and Joseph Quattrone overcharged Blue Cross for building-maintenance supplies and repairs.

•Two men convicted, receiving eight years in jail and $9.2 in restitution.

Source: AP, “Men in Blue Cross Fraud Case Sentenced,” Las Vegas Sun, January 17, 2004.

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© D.L. Crumbley

Red Flags of Fraud for NPOs

•Budget cutbacks.•High turnover.•Refusal to take legitimate perks (e.g., vacations).•Overemphasis on short-term fund-raising goals.•Poorly monitored remote event or promotional locations.•Bounced checks.•Things don’t add up.•Anonymous tips.•Lifestyle or behavior changes.•Inattention to details.•Not conducting background checks on anyone handling money.•Keeping problems a secret.•Failing to investigate and then prosecute to the fullest extent of the law.

K. Anne Midkiff, “Catching the Warning Signs of Fraud in NPOs,” Journal of Accountancy, January 2004, p. 28.

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Don’t Volunteer For Trouble

Dos and Don’tsIf you volunteer CPA services to an NPO, do• Avoid the appearance of impropriety.• Check the volunteer liability statutes in your state.• Examine the NPO’s internal controls, bylaws and

procedures.• Educate yourself about how the organization operates.• Attend board orientation and understand job

descriptions.• Attend as many board meetings as you possibly can and

document votes and discussions.• Make sure the organization has proper insurance

coverage.• Be prepared to contribute time, talent and resources.Your follow-through is important, so don’t• Skip board meetings.• Rubber-stamp decisions.• Sign checks without documentation.• Ignore employee complaints of discrimination or sexual

misconduct.• Serve if you are unable to regularly attend meetings.

Source: Joan Sompayrac, “Don’t Volunteer for Trouble,” Journal of Accountancy, January 2003, p. 82.

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