Forensic Accounting Update Copyrighted 2001 D. Larry Crumbley, CPA, Cr

Forensic Accounting Update Copyrighted 2001 D. Larry Crumbley, CPA, Cr
Forensic Accounting Update Copyrighted D. Larry Crumbley, CPA, Cr.FA KPMG Endowed Professor Department of Accounting Louisiana State University Baton Rouge, LA Fax 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 2002 Master Auditing Guide, along with more than 45 other books. His latest book entitled Forensic and Investigative Accounting is published by Commerce Clearing House ( ). 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.

Forensic Accounting Factors
Time: Forensic accounting focuses on the past, although it may do so in order to look forward. Purpose: Forensic accounting is performed for a specific legal forum or in anticipation of presentation before a legal forum.

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

Why Growth in Forensic Accounting
Increase in fraud. Less loyalty to organization. Employee mobility. Change in societal values. Break-up of family unit. Less religious. Less ethics. Computers replacing accounting functions. External accountants are looking for new jobs. Higher insurance premiums for auditing. Auditors became sales people. Grade inflation/coursework deflation. Enron/WorldCom/Xerox.

Cynthia Cooper’s Reasons
Irrational Exuberance Capital Influx Market Bubble Short-term Focus Auditing vs. Consulting Passive Boards Inadequate Balance of Power Excessive Executive Compensation Loans to Executives Analysts and Investment Bankers Non-GAAP Financial Measures Rapid Growth through Acquisitions SEC Underfunded Moral & Ethical Leadership Source: Cynthia Cooper, L.S.U., November 24, 2003

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.

Forensic Accounting Areas
Investigative Auditing Litigation 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.

Forensic Auditing Forensic auditing is a type of auditing that specifically looks for financial misconduct, and abusive or wasteful activity. It is most commonly associated with gathering evidence that will be presented in a court of law as part of a financial crime or a fraud investigation. Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of Government Financial Management, Winter, 2003, pp

Open Job Orders Valuation Partner for NJ Forensic Firm - Roseland, NJ...up to $250K base. Key words - Matrimonial, business valuation, expert testimony, litigation support, forensic. Forensic Partner for NY firm - up to $300's base. Key words - Bankruptcy, forensic, litigation support, expert testimony,insolvency CPA a must and solid public acct. experience. Audit Partner, Houston, Texas- up to $120k base first 12 months, 60% of collection between 12&17month, 70% of collection between 17&36 month-client prefers a manager or director level candidate with good business development skills. They rather mold. No book of business required. SEC exp. a must. CPA a must. The firm ranks among the top 10 nationally in "number of public companies audited." Currently, they have 4 audit partners and will be looking to add a 5th one this fall. Revenues last year were $1.3 million and for 2003 they estimate $1.7 million. Litigation Support Manager - NY office up to $115K. One CPA firm has 5 offices, 300+ staff. CPA a must and mid size firm experience. Big 4 experience not a good fit. (Valuation, Audit and Tax Senior/Managers from big 4 and CPA, always welcomed with this client.) Forensic Senior for Southern NJ firm - up to $80K...Forensic firm has three 3 office in NJ, 7 partners, 60+ staff. CPA a plus. Audit professional from big 4 or top firm okay. Litigation Support Senior - up to $70K plus bonus...Woodbury NY (LI).The firm has 24 Partners, 230 staff, 4 offices....Forensic and litigation support and CPA firm experience a must. CPA a plus. Jessica Cardona, Executive Recruiter 218 North Wood Ave. Suite # 3Linden, NJ 07036main: direct:

Income Expectations for Forensic Accountants
Salaries start around $30,000 Senior-level government employees can earn between $75,000 to $90,000 In the private sector, one can earn between $125,000 to $150,000

Consulting Fees Forensic accountants work with attorneys, private investigators, law enforcement officers, corporate security specialists, the IRS, and the FBI. In 1999, Kessler International stated that the firm charges about $300 per hour for forensic consultations.

Top Niche Services 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 8. Computer systems/consulting 53% 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.

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. “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.

Forensic Accounting vs. Fraud Auditing
Forensic Accountant: A forensic accountant may take on fraud auditing engagements and may be a fraud auditor, but he or she will also use other accounting, consulting, and legal skills in broader engagements. In addition to accounting skills, he or she will need a working knowledge of the legal system and excellent communication skills to carry out expert testimony in the courtroom and to aid in other litigation support engagements.

Forensic vs. Fraud Audit
Google result, October 7, 2002 Forensic Audit, 6,490 hits Fraud Audit, 1,800 hits Czech TV to Undergo Forensic Audit. National Forensic Audit of SA Post Office. OPSEU Calls for Forensic Audit of Accenture. Forensic Audit Saved Ghanair $434,000. McGuinty Wants Forensic Audit of all Hydro contracts. Action Taken on Forensic Audit by Boise City Council. Harris Tories Spends $200 million to save $16 million. Pitt Wants Special Audits to Find Fraud. Mayor Orders Forensic Audit of Parks. Audit Ordered for ATSI Companies. Financial Audit Details Tobin’s Dealings.

Historical Roots of Accounting
10,000 years ago—temple priests took inventory of village livestock 3,000 B.C.—scribes recorded ruler’s wealth 1887—American Association of Public Accountants (later becoming the AICPA) was formed 1896—New York State legislated the first CPA law 1900—School of Commerce, Accounts, and Finance at New York University opens 1902—Congress calls for audit reports for large corporations 1913—Federal Reserve Board created 1913—Federal income tax law was passed 1914—Federal Trade Commission created By 1921—All states had passed laws requiring exam for CPA certificate. Source: Crumbley, Heitger, and Smith, Forensic and Investigative Accounting, CCH, (2003),

History of Financial Reports and Legal Challenges
Financial reports were created by accountants long before independent audits were mandated. Current system of accounting checks and balances is relatively recent. Before financials were audited by outside experts, the courts often handled challenges and brought in experts to give testimony. Practice of forensic accounting was common even before independent accountants were asked to certify financial statements in auditing engagements.

Specialties Within Forensic and Investigative Accounting
Employee Crime Specialist. Asset Tracing Specialist. Litigation Services Specialist and Expert Witness. Insurance Claims. Valuation Analysis. False Claims Act Violations. Due diligence investigations.

Forensic Techniques Become Popular
“In many of the large accounting blow-ups, auditors knew what was happening,” says Charles Niemeir, “but they were willing to look the other way.” There is a need to provide “incentives for people finding problems,” says Douglas Carmichael. “Right now there are no incentives for finding problems, and one who does is treated as a trouble maker.” E&Y will require its auditors to undergo about 50,000 hours of fraud-related training and another 300,000 hours of instructions on attesting to internal controls as mandated by Sarbanes-Oxley. Dennis Nally, at PricewaterhouseCoopers, says his firm has identified at least 50 high-risk clients and will add at least one forensic auditor to each. Typically, we do not have a forensic auditor on the audit team. Deloitte & Touche: Focus more on potential fraud by incorporating forensic auditors. Using new computer software for quantitative analysis. Source: Cassell Bryan Low, “Accounting Firms Attempts to Dispel the Cloud of Fraud,” Wall Street J., May 27, 2003.

Popular (cont.) KPMG is adding more than 300 forensic professionals, including some with FBI training, to take part in routine training. Doug Carmichael, Chief Auditor for Peek-uh-boo, faults auditors for not adopting forensic techniques. Carmichael wishes more “test of details,” not relying on test of controls. He wishes more shoe-leather work. Shoe-leather work is what we do! Kris Frieswick, “How Audits Must Change,” CFO July 2003, p.48

This need for the forensic accountant is demonstrated by this passage from The CBS Murders:
Margaret Barbera was very good with numbers. She could take a balance sheet, a set of account books, invoices, bills, and more, juggle and manipulate the figures and, presto, thousands become millions, losses become profits, profits become losses, sales soared or fell, whatever her employer desired, and it would take an expert auditor knowing precisely where to look and what to look for to figure out what she’d done, and even then, it still might slip by. Professor Cramer was in front of the auditing class quoting a passage from The CBS Murders, by Richard Hammer. [p. 67 in Trap Doors].

Forensic Accountants “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.

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.

Potpourri (contd …) In December 2002, two Van Gogh paintings were stolen from the Van Gogh Museum in Amsterdam. Two weeks earlier there was a multimillion-dollar gem heist from a Dutch diamond exhibition at the Museum in the Hague. During 2002, as many as 2,000 churches and other groups put as much as $18,000 each into a church fraud scam ran by a Georgia minister. In 2000, Rent Way’s CAO artificially reduced the company’s expenses by $127 million. WorldCom’s external auditors missed about $11 billion improperly booked items. Ahold NV, a Dutch company, said a U.S. unit had overstated revenues by $880 million by booking more discounts from suppliers than actually received. Average big city resident caught on videotape about 75 times a day. Common in workplace and stores.

Six Areas of Litigation Services
Damages Lost profits Lost value Lost cash flow Lost revenue Extra cost Antitrust Analysis Price-fixing Market share, market definition Pricing below cost Dumping and other price distribution Anti-competition actions Monopolization Accounting Bankruptcy Tracing Contract cost and claims Regulated industries Frauds (civil and criminal) Historical analyses Family law Valuation Business and professional practices Pension Intangibles Property General Consulting Actuarial analyses Statistical analyses Projections Industrial engineering Market analyses Computer consulting Analyses Tax bases Cost allocations Tax treatment of specific transactions Source: Management Advisory Services Technical Consulting Practice Aid 7: Litigation Services, (AICPA, 1986)

Definition A forensic accountant has extensive experience in investigations to determine solutions to disputed accounting matters, to write expert reports on their investigation, and to appear in court as expert witnesses. Zeph Telpner and Michael Mostek A normal accountant is like a guarddog (e.g., a bulldog); a forensic accountant is like a bloodhound; an internal auditor is like a seeing-and-eye dog (e.g., monitoring and guiding management), a corporate accountant is a mix breed, and a governmental accountant is an afghan. D. Larry Crumbley

Auditors Blamed: Deep Pockets
Trustee for United Companies (UC) said that Deloitte and Touche was guilty of negligence, malpractice, misrepresentation, breach of duty, and fraud. D & T failed to warn United Companies of all of the losses it would absorb if the people who took out the loans defaulted, because the accounting firm was making millions and millions of dollars in fees. Loan practice called securitization or bundled high-interest loans. $685 million in liability damages. Plaintiff’s Attorney: Role of auditors is to act as watchdogs for companies. “A good watchdog barks when somebody comes into the yard. D & T is supposed to bark when there is a problem.” Defendant’s Attorney: “The problem was much larger than a watchdog could handle. Can a watchdog stop your house from getting hit by a hurricane? Of course not.” Source: Adrian Angelette, “Auditors Blamed, “Baton Rouge Advocate, October 23, 2003, pp. A-1 and a-8

Auditors Blamed (cont.)
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

Forensic Accounting Knowledge Base
LAW Investigative auditing Accounting Criminology Forensic Accountant

Forensic Accountant Forensic Accountant’s Knowledge Base Law Computer
Investigative Auditing Criminology Forensic Accountant Computer Science Accounting © Hugh M. Christensen

Threads of Forensic Accounting
Forensic accounting (or at least accounting expert witnessing) can be traced as far back as 1817 to a court decision. [Meyer v. Sefton] In 1824, a young accountant by the name of James McCleland started business in Glasgow, Scotland and issued a circular that advertised various classes of expert witness engagements he was prepared to undertake. In 1856 in England, the audit of corporations became required.

Forensic Accounting in Print
Articles on arbitration, fraud, investigation, and expert witnesses began appearing in the late 1800s. After a comment in 1925 by the Chairman of the U.S. Board of Tax Appeal, The Journal of Accountancy proposed that educational institutions should start including in their curricula the study of the law of evidence. The first forensic accounting book appeared in 1982.

Investigative Accountants
Initially called investigative accounting, many of the forensic techniques, such as the net worth method, were developed by IRS agents to detect tax evaders. Infamous mobster, Al Capone, was caught when Special Agents of the IRS stepped in and charged him with tax evasion. Accountants caused the crime czar’s career to come to an end.

Investigative Techniques
“You know how it goes,” I said. “You get a case. You just keep poking around, see what scurries out.” p. 144. “How,” Susan said, “on earth are you going to unravel all of that?” “Same way you do therapy,” I said. “Which is?” “Find a thread, follow it where it leads, and keep on doing it.” “Sometimes it leads to another thread.” “Often,” I said. “And then you follow that thread.” “Yep.” “Like a game,” Susan said. “For both of us,” I said. Susan nodded. “Yes,” she said, “tracking down of a person or an idea or an evasion.” pp. 270 – 271. Source: R.B. Parker, Widow’s Walk, Berkley Books, 2002.

Government Created FA Generally, forensic accounting was created by government agencies, and Government agencies have caused the growth in forensic accounting.

FBI and Forensics During WWII, the FBI employed approximately 500 agents who were accountants. In 1960, about 700 FBI agents were Special Agent Accountants. Today, there are more than 600 FBI agents with accounting backgrounds. The FBI has a Financial Crimes Section that investigates money laundering, Internet crimes, financial institutions fraud, and any other economic crime.

Universities Max Lourie, stated that colleges and universities should begin to teach forensic accounting: The colleges and schools of accountancy should begin to teach forensic accounting. No doubt, and this is as it should be, it will first be taught at a graduate level. In those colleges and universities where there is both a school of accountancy and a school of law, joint classes in forensic accounting and accounting jurisprudence could be held, just as in one university, where the school of medicine had joint classes with the school of law, and the future doctors appeared as expert witnesses at trials conducted by the law students. Source: Max Lourie, (1953) “Forensic Accounting,” New York CPA, November, pp

Universities (cont.) Accounting departments clearly have been slow to follow this old advice. Buckhoff and Schrader’s study found “that adding a forensic accounting course to the accounting curriculum can greatly benefit the three major stakeholders in accounting education: academic institutions, students, and employers of accounting graduates.” Source: T.A. Buckhoff and R.W. Schrader (2000), “The Teaching of Forensic Accounting,” Journal of Forensic Accounting, Vol. 1, No. 1, p. 135.

Curriculum Content Professors Practitioners Rank Mean
1 4.56 Fundamentals of Fraud 4.36 2 4.48 Financial statement fraud 3 4.22 4.35 Types of fraud (employees,management) 8 4.06 4 4.29 Cooking the books and problems in accounting 6 4.10 5 4.27 Three Elements of fraud 16 3.94 4.26 Anti-fraud controls 7 4.08 4.25 Internal control evaluation 4.13 4.21 Theory and methodology of fraud examination 4.15 9 4.16 Principles of ethics and corporate code of conduct 10 Fraud detection and deterrence 12 4.00 4.05 Analytical Review procedures 4.03 21 3.79 Effective report writing 4.23 25 3.62 Techniques in locating hidden assets 17 3.95 40 3.17 Shareholder litigation 45 2.90 Expert testimony and expert witness techniques 32 3.50 46 2.85 Litigation consulting techniques 29 3.56

Father of Forensic Accounting:
Maurice E. Peloubet (1946) Pretenders: Max Lourie (1953) Robert Lindquist (1986)* * Repeated, First sentence in N. Brennan and J. Hennessy, Forensic Accounting, 2001, p. 5.

Phrase “Forensic Accounting” Is Born
Maurice E. Peloubet coined the phrase in print in 1946. Max Lourie wrote an article and also claimed to coin the phrase, seven years after Peloubet (1953). Lourie’s article voiced three important positions: An accountant should not have to attend law school to learn the art of expert testimony Colleges and universities should deliver forensic accounting training Forensic accounting reference books and textbooks should be developed for students

The Essence of Forensic Accounting by Maurice Peloubet (1946):
“The preparation of data for and the appearance before government agencies as a witness to facts, to accounting principles, or to the application of accounting principles is essentially forensic accounting practice rather than advocacy.” Modern Version “Let’s face it, we in the forensic profession labor in an obscure corner of the vineyard. We are the carefully selected, trusted, highly trained guardians of one of the last great secrets remaining on the face of the earth - - the $600 billion, more or less annual problem nobody knows about.” Joseph W. Koletar, Fraud Exposed, John Wiley & Sons, Inc 2003, p. 228.

Knowledge, Skills and Abilities Needed by Forensic Accountant
Law, legal system, courts, and courtroom procedure Financial statement fraud Corporate governance, shareholder rights and litigation, securities laws, and protections Report writing and communication Criminal law and procedure Computer fraud and cybercrime Human factors involved in intelligence gathering, interview techniques and understanding the motivations for fraud and other criminal activities Ethical issues in business Business valuation

Be like

Panel on Audit Effectiveness
In 1998, the Public Oversight Board appointed the Panel on Audit Effectiveness to review and evaluate how independent audits of the financial statements of public companies are performed and to assess whether recent trends in audit practices serve the public interest. In 2000, the Panel issues a 200-page report, Report and Recommendations, which includes a recommendation that auditors should perform forensic-type procedures during every audit to enhance the prospects of detecting material financial statement fraud.

AICPA Fraud Task Force Report
In 2003, the AICPA’s Litigation and Dispute Resolution Services Subcommittee issued a report of its Fraud Task Force entitled, “Incorporating Forensic Procedures in an Audit Environment.” The report covers the professional standards that apply when forensic procedures are employed in an audit and explains the various means of gathering evidence through the use of forensic procedures and investigative techniques.

Accountant’s Role in Fraud Detection
In the early 1980s, companies began to use computers to perform their record keeping Intense competition caused auditing fees to fall as much as 50% from the mid-1980s to the mid-1990s. Auditors cut costs by reducing the process of reviewing hundreds of corporate accounts. They grew more reliant on internal controls. Top executives were able to circumvent internal controls and manipulate the records. This lead to situations such as Enron, WorldCom, Xerox, Adelphia Communication, and the fall of Arthur Andersen in the early 2000s.

Accountant’s Role in Fraud Detection
Due to the financial disaster of companies such as Enron and WorldCom, there will be an increase of forensic techniques in audits and an increase in fees. Some accounting experts believe that every audit engagement should include much more skepticism and detailed review of transactions. Other accounting experts suggest that only special engagements specifically targeting fraud can adequately and effectively root out the problem.

Forensic-Type Organizations
American College of Forensic Examiners (2750 E. Sunshine, Springfield, MO 65804; ; DABFA and Cr.FA; 2000) Certified Fraud Examiners (Association of CFEs, The Gregor Bldg., 716 West Avenue Austin, TX 78701; ; Forensic Accounting Society Of North America (FASNA, 8712 W. Dodge Road, Suite 200, Omaha, NE, 68114; ). Certified Forensic Financial Analyst (NACVA, Salt Lake City, Utah 84106; ). Also, Certified Fraud Deterrence (CFD) analyst. National Litigation Support Services Association (NLSSA, III East Wacker Drive, Suite 990, Chicago, IL 60601; ). Not-for-profit. Network of Independent Forensic Accountants ( English group of 16 specialist accounting practices. Canadian Institute of Chartered Accountants (CICA) – CA.IFA – Alliance for Excellence in Investigative Accounting. Certified Forensic Investigator (CFI) – Canada Early 1980’s. Certified Fraud Specialist (CFS), not-for-profit, educational anti-fraud corporation located in Sacramento, Calif., for those dealing in white-collar crime, fraud, and abuse issues. Association of Certified Fraud Specialists.

Forensic-Type Organizations
The American College of Forensic Examiners located in Springfield, Missouri, introduced a Certified Forensic Accountant (Cr.FA) designation in A not-for-profit educational body that provides advanced training to its members, composed of twelve boards. One board is the American Board of Forensic Accounting. The Certified Forensic Accountant, Cr.FA, is an advanced credential that recognizes the expertise in forensic accounting for accountants who have achieved additional training, experience, education, knowledge or skill in forensic accounting and have met all of their State Board of Accountancy requirements. Two categories of professionals may apply to attain the Certified Forensic Accountant, Cr.FA status: A person with a Bachelor’s degree in Business or ten years of accounting related experience who does not hold an accounting-related certificate (CPA, CMA, CFFA, CVA etc.) must pass Exam 1 and Exam 2. A person with an accounting-related certificate (CPA, CMA, CFFA, CVA, etc.) must pass Exam 2 only.

Forensic-Type Organizations (contd..)
Cr.FA literature indicates that the certificate would benefit the following people: Accountants Consultants Internal Auditors IRS Auditors GAO Auditors FBI Agents [Of the 12,000 agents worldwide, about 15% have accounting backgrounds.] Defense department auditors SEC accountants Bankruptcy specialists Lawyers Professors Bank examiners Chief financial officers Valuators of closely-held business

Quotes “A lawsuit is like a parachute jump; you have to get it right the first time.” - Hal Rosenthal “The party who has command of the paper trail most often controls in the courtroom.” - D. Larry Crumbley

Foreign Language “Accounting concepts are a foreign language to some lawyers in almost all cases, and to almost all lawyers in some cases.” U.S. v. Kovel., 296 F.2d 922 (CA-2, 1961)

Three Branches of Government
Executive (regulations) Legislative law [takes precedence] Judicial law [a referee]

Civil Procedure Body of rules and practices by which justice is handed out by the legal system. Federal Rules of Civil Procedure (FRCP): governs U.S. district courts.* Federal Rules of Criminal Procedure. Federal Rules of Evidence. * Find at

Hard To Convict You have to remember one thing, and that is the fact that our laws aren’t designed to punish guilty people; they’re intended to protect innocent people. E.J. McMillan, The Audit, Churchton, MD: Harwood Publishing, 2000, p. 259. Robert Durst in Galveston, Texas admitted killing his neighbor, cutting up the body, and tossing the pieces in trash bags in the Gulf. He was found innocent.

Hard To Convict I have never come to terms with a system based on the principle that it is better to let a hundred guilty people go free rather than wrongly convict one innocent person. It’s okay for people to be victimized again and again as long as no one is mistakenly locked up. Clinton McKinzie, The Edge of Justice, New York: Bantam Dell, 2002.

“Well you do what you do, and you pay for your sins.”
Tim McGraw’s Position “Well you do what you do, and you pay for your sins.” Tim McGraw’s “Red Ragtop”

Knowledge of Legal Concepts Necessary
Since forensic accounting is often used in legal forums, forensic accountants must be familiar with legal concepts and procedures. Nothing spoils a great case quicker than the lack of evidence. Expert opinions are evidence. FRE 702. Source: D.W. Squires, “Problems Solved With Forensic Accounting: A Legal Perspective,” Journal of Forensic Accounting, Vol. IV, 2003, p. 132.

Pleadings Complaint – Plaintiff files.
Service of Process – served on defendant. Answer – Defendant must admit or deny allegations. Sharp v. U.S., 199 F. Supp. 743 (D.Del 1961), aff’d 203 F.2d 783 (3rd Cir. 1962).

Expert Witnessing Our purpose: Assist the trier of the facts.
Question of Facts v. Question of Law [not always clear]. Negligence may be either.

Frequent Terms (1) Appellant (Petitioner) (Plaintiff): Person filing suit. Respondent (Defendant): Person sued. Stare decisis: case once decided, will control. Doctrine of precedential authority: follow prior case only where issues/facts are essentially the same. Judge not required to follow judicial precedent beyond own jurisdiction.

Frequent Terms (2) Res judicata (collateral estoppel): Once case or issue resolved, matter precluded from being litigated again. Law of the case: Once issue decided one way, if not properly challenged, will not be reconsidered. Full Faith and Credit Clause: Court in one state must honor and enforce judgment of another state. Venue: The appropriate court to bring a dispute (cause of action occurs or where crime committed).

Frequent Terms (3) Pro se: Party representing himself or herself.
Per curiam: Decision of the whole court. en banc: decision rendered by full court. Concurring opinion: Agrees with court’s conclusion, but… Dissenting opinion: Disagrees with majority. Dicta (Dictum): incidental facts; not binding on future cases.

Frequent Terms (4) Affirmed (Aff’d; Aff’g): agrees with lower court.
Reversed (rev’d; rev’g): disagrees with lower court. Writ of Certiorari: Asks Supreme Court to hear your case. Cert. Granted Cert. Den. Remand: Vacate the lower court decision and send back for further considerations Overruling: Does not impact either party in the earlier case. Overrules a previous case

Frequent Terms (5) Ad hoc: for one particular or special purpose (e.g., an Ad hoc committee) Ad valorem: According to value (e.g., in tax, assessment of taxes based on property value). Bona fide: in good faith and without fraud or deceit. Covenant: an agreement or promise to do or not to do something. Dejure: in law or lawful; legitimate. Deposition: A written statement of a witness under oath, often question/answer

Frequent Terms (6) Enjoin: to command or instruct with authority (e.g., judge can enjoin someone to do or not to do something). Habeas corpus (writ of): procedure to determine if authorities can hold a person in custody. Nolo contendere: a party does not wish to fight or continue; person will not fight a charge. Parol evidence: renders any evidence of a prior understanding of a party to a contract invalid if it contradicts the term of a written document.

Frequent Terms (7) Brief – written arguments supported by citations of court decisions, statutes, and other authorities. Stipulation – voluntary agreement before trial between opposing parties concerning the disposition of certain facts or points. Amicus-curiae – a brief filed by a party not directly related to a lawsuit. Habeas corpus – a writ which permits a prisoner to challenge a conviction on constitutional grounds. Executor/executrix – one appointed by a will to execute the provisions. Ex parte hearing – court hears only one side of an issue. Special Master – appointed by a court or judge to decide certain facts, etc.

Frequent Terms (8) Subpoena ad testificandum – command to appear and testify as a witness. Default judgment – judgment won by the plaintiff because the defendant failed to respond to a summons or appear at trial. De novo – new; a new proceeding without regard to prior legal actions. Double jeopardy – prohibition in the U.S. Constitution, 5th amendment, against trying a citizen twice for the same crime. Enabling act – legislation by which an administrative agency is created and powers are delegated to it. Jurisdiction – power of a court to hear and decide the issues in a case and to bind the parties. Long-arm statute – a state law extending personal jurisdiction over out-of-state persons (including corporations).

Frequent Terms (9) Pleadings – papers in court, with copies to other parties, in preparation for bringing or defending a lawsuit. Scienter – with intent to deceive; with guilty knowledge. Voir dire – jury selection process; lawyers and judges ask. Actus reus – brought about the criminal act. Mens rea – caused the criminal act with guilty knowledge; state of mind indicating culpability. Staples v. U.S., 511 U.S. 600 (1994). Preponderance of the evidence – greater than 50%. Civil trial. Clear and convincing evidence – ca 70%. Beyond a reasonable doubt – greater than 95%. Criminal trial.

The Federal Judicial System
SUPREME COURT 9 Judges U.S. COURT OF APPEALS Federal Circuit (Created in 1982 by a congressional statute; formed by merging the Court of Claims and the Court of Custom and Patent Appeals; sit in panels of three on cases involving customs, copyright, trademarks, and patents.) U.S. COURT OF APPEALS 12 Circuits (Three-judge panels, not the entire circuit court, hear most cases.) U.S. DISTRICT COURTS 50 States Washington, D.C., Puerto Rico, Virgin Islands, Guam U.S. Tax Court 19 judges, with 1 judge hearing most tax cases ADMINISTRATIVE AGENCIES (In some cases, appeals to a U.S. District Court, instead of the circuit courts.) U.S. Court of Federal Claims and some special agencies (e.g., Board of Contract Appeals, Patent/Trademark Boards, and Merit Systems Board) U.S. COURT OF INTERNATIONALTRADE (Created in 1980, formerly the U.S. District Court, instead of the circuit courts.) U.S. BANKRUPTCY COURTS U.S. MAGISTRATES

Facts Determination The Seventh Circuit had this to say about a trial court’s right to determine facts: The trial court … has ‘the best opportunity to observe the verbal and nonverbal behavior of the witnesses focusing on the subject[s]’ reactions and responses to the interrogatories, their facial expressions, attitudes, tone of voice, eye contact, posture and body movements, as well as confused and nervous speech patterns in contrast with merely looking at the cold pages of an appellate record. Source: United States v. Duarte, 1 F.3d 644, 651 (CA-7, 1993), cert. denied, 510 U.S. 1058, 126 L.Ed. 2d 688, 114 S. Ct. 724 (1994).

Helpfulness Helpfulness to the trier of the facts is the ultimate touchstone for the admissibility of expert testimony. To be helpful the (1) witness must be qualified as an expert, (2) expert must have a reasonable factual basis for the testimony, (3) testimony must be based upon reliable methods, and (4) testimony must be relevant to the facts in dispute. Accounting testimony can be the subject of expert testimony. Sources: In Re Paoli Railroad Yard PCB Litigation, 916 F.2d 857 (CA-3, 1990). Fed. Rul. Evidence 702 and 703; General Electric Co. v. Joiner, 522 U.S. 136 (1997). Computer Systems Engineering, Inc. v. Qantel Corp., 740 F.2d 67 (CA ).

The Judge Controls A 2000 dispute involved an alleged Ponzi scheme where a defendant sold airline tickets procured by debtors using frequent flier miles purchased by brokers. The defendant relied on an expert who was a CPA, a bankruptcy trustee, an insolvency accountant, and a fraud investigator with substantial experience and impressive qualifications and credentials. The judge, Herbert A. Ross, was not impressed with this expert, F. Wayne Elggren, employed by Arthur Andersen. At trial Mr. E questioned the experts of the trustee and the expert of the plaintiff (who had no CPA or certification). Mr. E found numerous faults with the methodology and analysis of the trustee and the plaintiff’s expert, E. Jayne MacPhee. Mr. E concluded his argument by stating there was too much unaccounted for cash and profits from the ticket business to claim it was a sham or Ponzi scheme. He relied on a “smoking gun” of $9 million in ticket revenues. Ms. MacPhee found only $6 million and the trustee only $4.8 million. The judge said that Mr. E had misunderstood or had been misadvised about the context of the $9 million of ticket sales “He [Elggren] is hoisted on his own petard when he uses it to analyze the debtors’ business history.” The rest of his criticisms are of “such small size or consequence, or so speculative or inclusive, that they are akin to straining at gnats.”

The Judge Controls The judge had this to say about MacPhee’s lack of a CPA degree or certification in certain accounting fraud detection professional organizations and Mr. E’s criticism of her: The type of expertise truly needed in this case is someone who can take poorly kept, incomplete records, involving commingled funds, and reconstruct the business out of them. MacPhee has training in accounting matters and experience in forensic accounting situations. She has worked as an accounting analyst reconstructing what really happened in the M&L Business Machine case, one of the major Ponzi schemes to reach the bankruptcy courts. Experience and training, despite the lack of a specific degree or designation, qualify her to render an expert opinion on accounting matters related to the reconstruction or analysis of business records, especially when a Ponzi-type business, with commingling of funds, is suspected. While she does not have the credentials of belonging to all the professional groups that Mr. E does, she has accounting training and experience in working on Ponzi cases, and has done an admirable job in assisting the court in understanding debtors’ operations - - a much more intellectually honest job than Mr. E at that. She qualifies as an expert in reconstructive accounting in a situation where the books and records are incomplete and not up to standards, and the funds of the debtors are commingled.

The Judge Controls Likewise, the trustee, even though he is a party, may qualify as an expert, even though his bias can be challenged. He is a CPA and a panel trustee in Alaska, which have given him on-the-job experience in understanding and reconstructing financial transactions. Judge Ross concluded as follows: In short, I find that Mr. E’s report is based on substantial factual mistakes, speculation, innuendo, and inferences which are not supported by full explanations and analysis. It is not worthy of an expert of his caliber, nor worthy of admission as evidence in this case. His expert opinion will be excluded. Source: In re Bonham, 55 Fed. Rul. Evidence Serv. (Callaghan) 419; 2000 Bankr. Lexis 727.

Motion: Requests a rule or order in favor of the applicant
Motions Motion: Requests a rule or order in favor of the applicant Motion to dismiss: The moving party is requesting that a cause of action be dismissed because the alleged facts, even if proven, do not constitute a valid legal claim. Motion for a directed verdict: The moving party requests at trial that a cause of action be dismissed because the party with the burden of proof has failed to establish sufficient facts so that a reasonable fact finder (e.g., the jury) could find in the claimant’s favor. For example, in a complex toxic tort case, the plaintiff’s only expert witness is barred from testifying as to causation under the Daubert rule. After the plaintiff rests, the defense moves for a directed verdict on the grounds that the plaintiff has not submitted sufficient proof of causation through an expert witness. Motion for judgment notwithstanding the verdict: This motion is made by the losing party after an adverse jury verdict. The moving party is asking that the judge reverse the verdict of the jury. These motions may be granted if the judge determines that the jury verdict had no reasonable support in fact or was contrary to law. Motion for a continuance: The moving party is requesting that a scheduled event, for example a hearing or trial, be postponed or continued to a later date. Motion in limine: The moving party is requesting that evidence it expects the opposing side to offer be held inadmissible. For example, a party may make a motion in limine to exclude the testimony of an expert for failure to comply with the Daubert rule. Motion for summary judgment: The moving party is requesting, prior to trial, and based solely on documentary evidence (including expert deposition transcripts, reports, and affidavits), that the court grant judgment in its favor because no material facts are in dispute. This device is used to throw a case out of court without it ever getting to the jury. Many times a lawyer with a weak case will seek to survive summary judgment in order to be able to settle the case on favorable terms over the threat of a jury trial. Source: Babitsky et. al, The Comprehensive Forensic Manual, Seak, Inc.,

Discovery: process of getting information from the other party
Fed. R. Civ. Pro. 26(b)(1). Parties may obtain discovery regarding any matter, not privileged, which is relevant to the subject matter involved in the pending action, whether it relates to the claim or defense of the party seeking discovery or to the claim or defense of any other party, including the existence, description, nature, custody, condition, and location of any books, documents, or other tangible things and the identity and location of any persons having knowledge of any discoverable matter. The information sought need not be admissible at trial if the information sought appears reasonably calculated to lead to the discovery of admissible evidence.

Privilege: discovery may not be made of privileged matters
Attorney – client Husband – wife Physician – patient Government secrets Ordained clergyman-parishioner Attorney work product [But not experts who will testify]

Elements of the Attorney-Client Privilege
Communication. Between attorney and client. For obtaining legal advice or services. Intended to be confidential. Privilege is not waived. [Be careful with s and cell phones.] U.S. v. United Shoe Machine Corp., 89 F. Supp. 358 (D. Mass. 1950)

Protecting Work Product Privilege
Attorney should directly retain the consultant. Agreement should be between attorney and expert. Expert should obtain facts through, or at direction of the attorney. Investigation should be done at the direction of attorney. Attorney included when meeting with client. Source: Zeph Telpner and Michael Mostek, Expert Witnessing in Forensic Accounting, Boca Raton, FL: CRC Press, pp. 209 – 237.

SAMPLE AGREEMENT Our understanding is that you have retained us as consulting experts. If you decide to change our status to that of testifying experts, we will return all documents, records and any work product to you and request from you only those documents and records necessary for our testimony.

Accountant Privilege (§7525)
Taxpayer’s communications made to federally authorized tax practitioners (e.g., lawyers, CPAs, enrolled agents) Applies only to tax advice: given by an individual regarding a matter that is within that individual’s authority to practice as a federally authorized tax practitioner under Treasury Circular 230. I.R.C. §7525(a)(3)(B)

Accountant Privilege (§7525)
Contains many exceptions, either poorly or not at all defined, thus limiting the privilege’s effectiveness in protecting the confidentiality of taxpayer communication. Can not be asserted in (1) criminal tax matters, (2) investigations by regulatory agencies, and (3) tax advice regarding the promotion of corporate tax shelters. Source: R.J. Buchanan, “Corporate Tax Shelter Exception to the Accounting Client Privilege,” Tax Notes, September 16, 2002, p

Accountant Privilege contd …
Tax practitioners are not entitled to privilege when they are doing other than lawyers’ work. Information provided to a practitioner for purposes of preparing a client’s tax return is not privileged. U.S. v. Frederick, 182 F.3d 496 (CA-7,1999) Federal District Court: Most tax advice falls into the category of return preparation for which there is no privilege [U.S. v. KPMG, No (D. D.C. Dec.20, 2002)] The practice of tax is not the practice of law (U.S. v. KPMG).

Bureau of Prison’s Rule
A new Bureau of Prison’s (BOP) rule which permits federal law enforcement agencies to eavesdrop on confidential attorney-client communications of persons in custody of the Department of Justice (DOJ) under certain circumstances, without federal judicial oversight. This rule means that forensic accountants and others hired by attorneys to assist in providing legal services must be on their guard to avoid disclosure of confidential information. Source: Carl Pacini, “Privileged Communications Between Forensic Accountants, Attorney, and Clients Threatened by Federal Rule.” 28 C.F.R. §§ 500, 501 (2002): Prevention of Acts of Violence and Terrorism, 66 Fed. Reg. 55,062 (Oct. 31, 2001).

Evidence KPMG is fighting clients about questionable tax-shelter products. The IRS disclosed s dated March 14, 1998, in a Tax Court case involving an estate in litigation against the IRS. The s document discussions among high level KPMG executives about a product known as FLIP. One of the s referred to the product’s “troublesome issues.” s created on a company’s system belongs to the company. evidence has been used in cases involving accounting fraud, harassment, antitrust, discrimination, retaliation, whistle-blowing, insider trading, trade secrets, and more. Discovery is broad: instant messages, web visit logs, hard drives, PDA’s, pagers, voice mail, laptops, back up tapes, and cell phones call records. Source: Rita Risser, “ = Evidence: How to Protect Yourself,” Fair Measures.

E-mail Evidence (cont.)
In October, 2003, a special master recommended to federal court that KPMG does not have to produce many tax-shelter documents. In mid-October 2003, a federal judge blocked prosecutors from using an that she wrote to her attorney as evidence in her upcoming trial. She had forwarded the same to her daughter the next day after sending it to her attorney. Source: Rita Risser, “ = Evidence: How to Protect Yourself,” Fair Measures.

Best Practices Know and follow employer policies.
Assume a boss or judge is reading your . Don’t send s in anger. Do not be sarcastic. Don’t send or receive jokes from work. Insure mail lists are current for confidential information limit copies. Do not mark ‘Attorney-Client’ unless authorized. Don’t mark ‘Company Confidential’ unless authorized. Source: Rita Risser, “ = Evidence: How to Protect Yourself,” Fair Measures.

IRS Summons Accountants have very little protection under federal law from the enforcement of IRS Summons. Couch v. U.S., 409 U.S. 322 (1973). U.S. v. Arthur Young & Co., 465 U.S. 805 (1984).

Methods of Discovery Interrogatories: Written questions [FRCP 33(a) – max. 25 / 30 days]. Requests for Production of Documents. Depositions [FRCP 30(a): limits each side to 10]. Subpoenas duces tecum: request for specified documents for inspection and copying (especially from people not parties to a lawsuit, e.g., expert witnesses). Physical examination. Production of tangible things and entry upon land.

Civil Trial Jury selection and Pre-Trial Motions. Opening Statements.
Burden of Proof: In Civil trial, preponderance of evidence – 51% or greater. Sometimes, higher clear and convincing evidence. For the opinion of an expert to be admissible, it must meet the 51% test: “My opinion is based upon a reasonable degree of scientific (or medical or economic or accounting) certainty.” Otherwise, opinion may be stricken from evidence.

Four Phases of Interrogation at Trial
Direct Examination – friendly attorney – no leading questions. Cross-examination – opposing attorney – credibility of the witness and generally what was covered in direct. Leading questions O.K. Redirect examination – friendly attorney gives expert opportunity to clear up confusion. Recross-examination – not required. New matters subject to recross-exam. Own attorney has right for last words with expert.

Leading Questions Didn’t the defendant appear to you to be stealing money from the cash register? A question that suggests a desired answer (e.g., yes or no). Leading questions can be directed to opposing parties and adverse witnesses during examination. Better questions: How much money was the defendant taking from the cash register? How can you estimate that amount? How was she taking the money?

Getting Paid The other side schedules a deposition, deposes you, and does not pay you a reasonable fee. Who is required to pay you? Fed. R. Civ. Pro. 26(b)(4)(c): The party seeking discovery pays the expert a reasonable fee for time spent in responding to discovery.

Incentive Test A(n) ______ is a device used by courts to have disputing parties to agree in advance of a trial to facts, evidence, etc. A(n) _____ _____ brief is filed by a party not directly related to a lawsuit. The _____ _____ doctrine states that a case once decided will control. The appropriate court to bring a dispute is called _____ . ______ is opinions of a judge which goes beyond the facts before the court and are not binding on future courts as precedent. A higher court ______ a lower court decision and sends it back for further consideration. You file a writ of ______ to ask the Supreme Court to hear your dispute. _____ _____ refers to a decision of the full court. A ________ is a written statement of a witness under oath, often in a question/answer format.

Incentive Test The ____ _____ is preliminary questioning by the court (or lawyer) of jurors to determine competency. A motion in _____ is a request before trial that evidence (or expert) of opposing side is inadmissible. The complaint and answer would be called the _____ . The _____ is the person sued. A subpoena _____ _____ is a command to produce documents to a court that become evidence. A subpoena _____ _____ is a command to appear and testify as a witness. A(n) _____ _____ is appointed by a court or judge to decide certain facts, etc. Models, forms, and exhibits would be considered ______ evidence. ______ ______ means a party is representing himself.

Incentive Test A(n) stipulation is a device used by courts to have disputing parties to agree in advance of a trial to facts, evidence, etc. A(n) amicus curiae brief is filed by a party not directly related to a lawsuit. The stare decisis doctrine states that a case once decided will control. The appropriate court to bring a dispute is called venue . Dicta is opinions of a judge which goes beyond the facts before the court and are not binding on future courts as precedent. A higher court remands a lower court decision and sends it back for further consideration. You file a writ of certiorari to ask the Supreme Court to hear your dispute. En banc refers to a decision of the full court. A deposition is a written statement of a witness under oath, often in a question/answer format.

Incentive Test The voir dire is preliminary questioning by the court (or lawyer) of jurors to determine competency. A motion in limine is a request before trial that evidence (or expert) of opposing side is inadmissible. The complaint and answer would be called the pleadings . The respondent is the person sued (defendant). A subpoena duces tecum is a command to produce documents to a court that become evidence. A subpoena ad testificandum is a command to appear and testify as a witness. A(n) special master is appointed by a court or judge to decide certain facts, etc. Models, forms, and exhibits would be considered demonstrative evidence. Pro se means a party is representing himself.

Evidence “Anything perceivable by the five senses, and any proof such as testimony of witnesses, records, documents, facts, data, or tangible objects legally presented at trial to prove a contention and induce a belief in the minds of a jury.” Black’s Law Dictionary A trial is too important to put in the hands of the jury. Runaway Jury.

Best Evidence Rule Under the best evidence rule (also referred to as the original writing rule), to prove the contents of a writing, recording, or photograph, the original writing, recording, or photograph usually must be presented.

Two Types of Evidence Direct evidence: directly proves a fact at issue, without the need for an inference or presumption (e.g., testimony of a witness). Circumstantial: a fact or issue may be proved indirectly (e.g., a person was present at the time of the theft). Law does not value circumstantial evidence any less than direct evidence.

Ensuring Admissibility
Assume that documents or other evidence one handles may be used in a legal proceeding. Do not mark, staple, or otherwise alter the document. Record how you obtained the evidence and who handled it. Keep evidence in a secure location – fireproof safes or locked cabinets. If possible, avoid putting your or other investigators fingerprints on the document. Use see-through holders. Internal auditors at WorldCom worked at night and put much of the records on personal CD ROMS (e.g., bought own CD burner).

Ink Analysis Martha Stewart may be undone by a blue ballpoint pen.
Stockbroker belatedly inserted a note to help cover up Ms. Stewart’s improper stock trading. Blue ballpoint ink used is different from ink elsewhere on the trading worksheet. Prosecutors used forensic ink analysis in Rite Aid case to show that certain documents were backdated (ink used to sign letter was not commercially available until 3 months after the letter was dated). Impossible to match an ink sample to a particular printer, and matching to a brand of printer may be impossible. Laserjet printer even tricker. Fraudsters: use pencil. Source: Mark Maremont, “In Corporate Crimes, Paper Trail Often Leads to Ink Analysts’ Door,” Wall Street J., July 1, 2003, p. A-1.

Deductive vs. Inductive
Deductive: one goes from general to specific; fairly simple and economical. Inductive: one starts with specific experiences and then draws inferences. Deductive Approach Inductive Approach Generic data mining Custom data mining Digital analysis Analysis of all data Discovery sampling Generic software Custom software For smaller organizations For larger organizations Basic features Sophisticated features Easy to learn Requires advanced skills Relatively inexpensive More expensive Source: W.S. Albrecht and C.C. Albrecht, “Root Out Financial Deception,” Journal of Accountancy (April 2002), p. 33.

High Tech Is Best Studies show that the average person retains as much as 87% of information presented visually and as little as 10% for information given orally. Computer animations are even more persuasive. Both types of delivery impact the weight given to evidence by jurors (or judges). Use visual aids, computer animations, and other visual help whenever possible while on the stand. Source: David Yale, “Computers on the Witness Stand,” Univ. of Conn. Law School, Fall 1996,

Important Visual Rules
Storyboard your testimony (series of sketches). Do not overdo it. Design illustration so jurors can take away the message in 5 seconds. Title should give your conclusion. Color is important. Put the most important information in the top right-hand corner of the chart. Do not simply enlarge document. Highlight important stuff. Practice with your exhibits. Source: D.S. Scott and R. Laguzza, “Communication With The Jury,“ Litigation Services Handbook, John Wiley, 2001, pp.15-2 and 15-3.

Benford’s Law Distribution of initial digits in natural numbers is not random Predictable pattern: There is software to detect potentially invented numbers in many situations 1= 30.1% 2= 17.6% 3= 12.5% 4= 9.7% 5= 7.9% 6= 6.7% 7= 5.8% 8= 5.1% 9= 4.6%

Benford’s Law Uses Investments sales/purchases Check register.
Sales history/Price history. 401 contributions. Inventory unit costs. Expenses accounts. Wire transfer information. Life insurance policy values. Bad debt expenses. Asset/liability accounts. Source: Richard Lanza, “Digital Analysis- Real World Example,” IT Audit, July 1, 1999,pp. 1-9.

Computer Forensics Important
Joan Feldman: “Within three years, I’m sure all evidence collected in discovery will be electronic-based.” President of Computer Forensic, Inc. (Seattle). Players from three areas: Accounting-forensic units of big CPA firms. Data-recovery and computer-repair specialists, Litigation support services. “Corporate investigations used to mean following a paper trial, but these days many follow an electronic one. Increasing demand for the skill and technology necessary to unearth digital secrets has led to the birth of a small but growing industry: computer forensics.” “They can dig up and documents that seemingly have been deleted, determine what web sites were visited and which key words were used to get there.” Source: Ellen Byron, “Computer Forensics Sleuths: Help in Rooting Out Fraud,” Career Journal, Wall Street J., reviewed June 16,

Computer Forensics Primer
Defined: acquiring and analyzing digital evidence in a manner that protects the integrity of the evidence to investigate a potential fraud. Currently only 5% of fraud investigations use electronic data in investigations. This low percentage is likely because much of the collected digital evidence is forensically unusable. SAS No. 99: In an IT environment, it may be necessary for the auditor to employ computer-assisted audit techniques (for example, report writers, software or data extraction tool, or other system-based techniques) to identify the journal entries and other adjustments to be tested. [par. 61]. Source: G.S. Smith, “Computer Forensic: Helping to Achieve The Auditors Mission,” Working Paper, December 2003.

Data Extraction v. Data Investigation
There is a difference between the procedures used for traditional data extraction (i.e., data mining) and data investigation for evidentiary purpose. With traditional data extraction, tools such as Interactive Data Extraction and Analysis (IDEA) or ACL software are used to interactively extract, sample, and analyze data. Yet simply checking a client’s files or the cross comparing data, files for forensic investigations are damaged. Such actions are similar to sending a housekeeper in to tidy up a murder crime scene before the forensic investigative team is allowed to start analyzing the evidence. For forensic purposes, software tools collect digital data without changing it. After the data is collected, it is analyzed. Examples of forensic software tools are Encase, SafeBack, or Ontrack’s Easy Recovery software. Increasing the time lag between initial fraud suspicions and the recovery of the related digital data makes the evidence less valuable. Source: G.S. Smith, “Computer Forensics: Helping to Achieve The Auditor’s Mission,” Working Paper, December 2003.

Data Mining Data mining is an information extraction technique designed to discover hidden facts or red flags that may indicate previously undetected fraud, abuse, waste, or mismanagement. Using a combination of statistical analysis algorithms, exploratory analyses, modeling techniques and data base technology, data mining finds patterns and subtle relationships in data. One can not push a button and expect the software to pick the one bad apple out of the panel. Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of Government Financial Management, Winter, 2003 Vol. 52, No. 4, p. 11.

Evidence (varies) All relevant evidence is admissible, unless inadmissible due to another rule of evidence. Rule 403: probative value is substantially outweighed by the danger of unfair prejudice, confusion of the issues, misleading the jury, or by considerations of undue delay, waste of time, or needless presentation of cumulative evidence.

Rule 701. Opinion Testimony by Lay Witnesses
If the witness is not testifying as an expert, the witness, testimony in the form of opinions or inferences is limited to those opinions or inferences which are (a) rationally based on the perception of the witness, and (b) helpful to a clear understanding of the witness’ testimony or the determination of a fact in issue, and (c) not based on scientific, technical, or other specialized knowledge within the scope of Rule 702.

Federal Rules of Evidence 702 – 705 (deal with expert witnesses)
Rule Testimony by Experts "If scientific, technical or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education may testify thereto in the form of an opinion or otherwise; if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.” (amendment in bold) Fed.R.Evid. Rule 702 requires the Trial Court to perform the gatekeeper role described in Daubert regarding all expert testimony Proffered expert testimony must be both relevant and reliable to be admissible

Federal Rules of Evidence Section 702 Comparative Analysis
Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001. Generally, if you meet the applicable AICPA professional standards, you probably meet Rule 702.

Rule 703 - Basis of Opinion Testimony by Experts
“The facts or data in the particular case upon which an expert bases an opinion or inference may be those perceived by or made known to him at or before the hearing. If of a type reasonably relied upon by experts in the particular field in forming opinions or inferences upon the subject, the facts or data need not be admissible in evidence.” Sources of information an expert may use include: Firsthand knowledge Information admitted into evidence during the trial Information made known to the expert before the trial The facts themselves need not be admissible as evidence if they are “of a type reasonably relied upon by experts in a particular field.”

Rule 704 - Opinion on Ultimate Issue
"Testimony in the form of an opinion or inference otherwise admissible is not objectionable because it embraces an ultimate issue to be decided by the trier of fact." The ultimate issue is that which is pivotal for the defendant or the plaintiff and determines the outcome. Rule Disclosure of Facts or Data Underlying Expert Opinion "In civil cases, the expert may testify in terms of an opinion or inference and give his reasons therefore without prior disclosure of the underlying facts or data, unless the court rules otherwise. The expert may in any event be required to disclose the underlying facts or data on cross-examination.” Experts are, generally, allowed to testify about their opinions or give reasons for their opinions without first testifying about the underlying facts or data. The court may require the expert to disclose the underlying facts or data during cross-examination.

Rule 706 – Court-Appointed Experts
The Court has the authority to appoint an expert whom all parties may cross-examine when: The Court believes the experts for the litigants are “hired guns,” and their testimony is unreliable or prejudicial. The proffered expert opinions have failed to adequately explain the complex issues upon which the Court must decide. The Court has ultimate discretion regarding the admissibility of all expert testimony

Special Master and Court Appointed Experts
A court may appoint someone (e.g., a financial expert) to determine certain facts in a dispute. They may be appointed pre-trial, during trial, or post-trial to oversee one or more aspects of a dispute. Appellate courts generally hold that special masters are reserved for special or unique circumstances. Special Masters can be subject to Daubert challenges.

Rules of Evidence The rules of evidence are the rules governing the admissibility of evidence in a legal proceeding and the weight to be given to evidence that is admitted.

What Is Evidence? Evidence is testimony, writings, and material objects offered to prove an alleged fact or proposition. Direct evidence is evidence that directly proves a fact at issue, without the need for any inference or presumption (e.g., copy of a check that has been altered). Circumstantial evidence is evidence from which a fact at issue may be proved indirectly (e.g., bank records show a deposit of unknown origin).

Relevancy and its limits (evidence)
a) Rule 401 – Definition of “Relevant Evidence” Evidence is relevant if it tends to prove or disprove an alleged fact. b) Rule 402 – Relevant Evidence Generally Admissible; Irrelevant Evidence Inadmissible It is the attorney’s responsibility to insure that sufficient evidence is admitted at trial to support the expert’s opinion. c) Rule 403 – Exclusion of Relevant Evidence on Grounds of Prejudice, Confusion, or Waste of Time Relevant evidence may be excluded if it is prejudicial, needlessly cumulative, threatens to confuse or mislead the jury, or causes an unnecessary delay or waste of time.

Evidence Prima facie evidence: unless overcome by other evidence, suffices as proof of a fact in a dispute. Probative evidence: testimony which establishes or contributes toward truth. Parol evidence rule: an agreement in writing can not be modified by oral evidence. Secondary evidence: copies of instruments or oral evidence. Chain of custody: a log of evidence obtained and who had access to such evidence.

Hearsay (evidence) Rule 803 – Hearsay Exceptions; Availability of Declarant Immaterial Generally, hearsay is not admissible as evidence. Exceptions relating to expert testimony Business records such as memoranda, reports, records, or data compilations kept on a regular basis by a person with knowledge Public records; such as records, reports, statements, or data compilations kept by public offices or agencies Market reports and commercial publications; such as market quotations, lists, directories, etc. relied on by the public Learned treatises; such as almanacs of business information and technical literature Missing business records; reports normally prepared daily or the fact that they were not prepared is admissible Business records, such as computer printouts, may be entered into evidence without the testimony of the employee who actually prepared the records as long as the court considers the source of the information and the method of preparation trustworthy Experts are not required to prove that the information upon which they have relied is trustworthy May be grounds for a Daubert/Kumho challenge if confirmation is required or recommended by standards of practice.

Hearsay evidence: a statement made outside the court to prove the truth of the matter stated
You, Larry, try to state in the courtroom that Joe said “Paul is a crook.” Hearsay may be offered to prove a nonhearsay purpose. Trustworthiness. Unavailability of declarant. Practical considerations. Exemptions to Fed. Rules of Evidence. Major exceptions Excited utterances. Business records. Official records. Dying declarations. Learned treatises. Commercial publications.

Most trials boil down to one issue: Credibility
Expect the other side to present evidence that you are biased (to throw out your testimony). Prior Inconsistent Statements.

Entertainer As strange as it may be, an attorney wishes to present an expert who is “guaranteed to entertain and interest the jury - - the hallmarks of an expert who will be able to persuade.” Experts are now in the television and entertainment business. Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 93.

Six Ways to Discredit Testimony
If an expert, the witness is not qualified. The witness did not consider all the facts. The witness relied on erroneous facts. If an expert, the witness’s conclusions do not follow from a correct analysis of the facts. The witness’s testimony is inconsistent with prior testimony. The witness was biased or prejudiced and therefore shaded his or her perceptions or conclusions. A fact witness employed by the defrauded party generally will be grilled more than an expert witness about bias or prejudice. Source: D.R. Carmichael, et. al, Fraud Detection, 5th, Fort Worth: Practitioners Publishing, 2002, p. 8 – 39.

Avoid Conflicts of Interest
You must not have present or past relationships with individuals on either side of the dispute which will prevent or interfere with objective testimony. Checking your firm’s files and records for professional conflicts early is extremely important.

Result-Oriented Work Estate of Bessie I. Mueller v. Commissioner, T.C. Memo , Doc (57 pages), the issue was the valuation of stock of the Mueller Co. The IRS produced as its expert on the valuation questions Dr. Shannon Pratt, managing director of Willamette Management Associates and the acknowledged dean of business appraisers. Tax Court Judge Renato Beghe nevertheless concluded that “Willametie’s report was result-oriented and this was reflected in Dr. Pratt’s testimony.” The Judge noted that appraisers “have third-party responsibilities – just as certified public accountants do – to those who rely on their opinions, and their determinations must be independent and objective….” Dr. Pratt strayed from the standard of objectivity and cast aside his scholar’s mantle and became ‘a shill’ for respondent.” In Mueller, as a result, Judge Beghe rejected most of both the Willamette report and Dr. Pratt’s testimony, but did take account of Dr. Pratt’s criticism of the taxpayer’s expert’s reports and testimony. Source: B.J. Raby and W.L. Raby, “Reasonable Compensation, Expert Witnesses, and the Tax Practitioner,” Tax Notes, September 15, 2003 p

Alternative Dispute Resolution
Mediation: appointment of an agreed-upon third party to facilitate settlement negotiations. before or after suit is filed parties control the outcome and all resolutions are voluntary. Arbitration: parties submit the dispute for resolution to an agreed-upon arbitrator or panel. rules less formal faster and cheaper can be binding or non-binding. Example: Arthur Andersen and Andersen Consulting. When testifying, remember arbitrator more sophisticated than the average juror.

Written Agreement The written agreement should cover the following matters: The name of the attorney’s client. The litigants’ names and place for the legal proceeding. The nature of the litigation services to be performed. Whether the practitioner will be asked to testify as an expert witness. What restrictions will be imposed on use and disclosure of the practitioner’s work. Whether the practitioner has any conflicts of interest with the litigants and/or their attorneys. Whether the practitioner’s work will be protected by the attorney work product privilege. Circumstances under which the practitioner may terminate his or her engagement. Fee (including payment arrangements).

Qualifying as an Expert Witness
Under the Frye standard, the test for admitting expert testimony is: Whether the expert’s testimony will assist the trier of fact in understanding the evidence or in determining a fact in issue Whether the theories and/or techniques relied upon by the expert are generally accepted by the relevant professional community Whether the particular expert is qualified to present expert testimony on the subject at issue

Under the Federal Rules of Evidence, a judge will permit an accountant to testify as an expert witness only if the judge decides that: The accountant’s testimony will help the jurors or judge understand the evidence or determine a fact in issue The accountant is qualified as an exert by knowledge, skill, experience, training or education The accountant can show that his or her testimony (a) will be based on sufficient facts or data and (b) will be the product of reliable principles and methods that have been applied reliably to the facts of the case

In Daubert v. Merrill Dow Pharmaceuticals, Inc., the U.S. Supreme Court established the rule for federal courts that trial judges have a special responsibility to ensure that scientific testimony is not only relevant, but also reliable. In Kumho Tire Company, Ltd. V. Carmichael, the Supreme Court decided that a judge’s “gatekeeping” obligation applies not only to scientific testimony but to all expert testimony.

In Daubert, the U.S. Supreme Court suggested that judges consider the following factors: Whether the theory or technique in question can be (and has been) tested Whether the theory or technique in question has been subjected to peer review and publication The theory’s or technique’s known or potential error rate Whether the theory or technique has attracted widespread acceptance within the relevant community

Daubert’s Five Factors
Whether the theory or technique used by the expert can be, and has been, tested; Whether the theory or technique has been subjected to peer review and publication; The known or potential rate of error of the method used; and The degree of the method’s or conclusion’s acceptance within the relevant community. Did theory exist before litigation began. (on remand, CA-9 adds 5th factor)

Kumho Tire Co. Ltd. v. Carmichael, 119 S.Ct. 1167 (1999).
Daubert factors apply to nonscientific testimony as well as scientific expert testimony Court will probably not exclude testimony on the basis of one factor alone. Frye rule: general acceptance rule may still apply, especially in certain state courts. Daubert challenges generally occur after the deadline for naming experts. Thus, disaster if disqualified. Can open expert up to a malpractice claim.

Kumho Tire Supreme Court said:
“The objective of that requirement is [Daubert] to ensure the reliability and relevancy of expert testimony. It is to make certain that an expert, whether basing testimony upon professional studies or personal experience, employs in the courtroom the same level of intellectual rigor that characterizes the practice of an expert in the relevant field.”

Rejecting Experts In Frank J. Laureys, Jr., 92 T.C. 101 (1989), the IRS offered the testimony of Dr. Bradford Cornell, a professor of finance and economics at UCLA, to demonstrate that taxpayer was never “at risk” as to his option trading activities. About his proffered testimony, Tax Court Judge Mary Ann Cohen commented: We agree with petitioner that the factual premises of Dr. Cornell’s report are unreliable and that neither his testimony nor his qualifications assist in determining petitioner’s purpose in engaging in the transactions in issue….[W]e do not believe that the type of economic analysis set forth in Dr. Cornell’s report is relevant to the type of risk covered by section 465(b)…. Dr. Cornell’s testimony is tainted by his perception that, from an economic standpoint, wash sales are not legitimate. Source: B.J. Raby and W.L. Raby, “Reasonable Compensation, Expert Witnesses, and the Tax Practitioner,” Tax Notes, September 15, 2003, pp

Rejecting Experts Second, his isolation of data as to certain transactions, on certain dates, chosen from a few transactions selected by respondent among hundreds engaged in by petitioner, is not reasonably representative. It is also inconsistent with his own statement that his analysis must consider “the investor’s overall strategy.” Third, his assumption of predictability of stock prices is inconsistent with reality and with the existence of an active national options exchange in which differing views of the future create buyers and sellers at different prices. Source: B.J. Raby and W.L. Raby, “Reasonable Compensation, Expert Witnesses, and the Tax Practitioner,” Tax Notes, September 15, 2003, pp

Searchable Databases of Daubert Decisions
Daubert Tracker (launched August 2002) 93 accounting decisions (mid-February 2003). [46 accounting experts admitted, 38 denied, 9 admitted/denied in part] 4,000 trial and appellate opinions. Composed of five distinct services. The searchable database of all reported cases. Core documents – docket sheets, briefs and transcripts – for each case. An update of new cases from the previous week. A quarterly journal with articles by trial attorneys, law professors, judges and experts. A series of “Web lectures” delivered by authorities on Daubert and scientific evidence. A year subscription is $495.

Searchable Databases of Daubert Decisions (contd …)
“Daubert on the Web” Online free tracking service. In early July, 2003, 40 cases were under the field “Accountants and Economists” with an admissibility rate of .675. There are a total of 25 fields with various “admissibility rate,” such as Computer experts, Criminologists, Marketing experts, Polygraphers, Toxicologists,

Successful Daubert Challenges
Accountant failed to incorporate into his opinion (without explanation) some of his findings that contradicted his testimony [similar to Kumho Tire engineering expert’s testimony]. Target Marketing Pub., Inc. v. ADVD, Inc., 136 F.3d 1139 (CA-7, 1998). Accountant testified from unaudited financial reports, did not analyze data covering the entire period of time in question, did not compare revenue to budget projections of revenue, and allowed his opinion to be influenced by subjective statements of an interested party. SEC v. Lipson, 46 F.Supp.2d 758 (N.D. Ill.1998). In comparing hosiery made by different manufacturers, expert relied upon an inadequate sample and destroyed the records of his methodology. Lithuania Commerce Corp. v. Sara Lee Hosiery, 179 F.R.D. 450 (D.N.J. 1998)

Preparing to Testify as an Expert Witness
Maintaining independence from the client Evidence upon which experts may rely Use of confidential client information Expert reports Working papers Evaluation of other experts Exhibits and other demonstrative evidence Source: Crumbley, Heitger & Smith, Forensic and Investigative Accounting, 2003, p. 8-13

Testifying at a Deposition
Expert witnesses can expect to be asked about the following at a deposition: The scope of their assignment Their current employment (job title, duties) Their educational background Licenses Work experience Memberships in professional organizations Publication and lectures Fields in which they are qualified as an expert Other work they have performed as an expert or other litigation consultant What compensation they are receiving (and what percentage of their compensation is derived from testifying as an expert witness) What opinions they have formed The bases for their opinions Source: Crumbley, Heitger & Smith, Forensic and Investigative Accounting, 2003, p. 8-13

Differences Between Fact and Expert Witness
Purpose of testimony To provide the court with relevant facts relating to the case. To help the court or trier-of-fact understand technical issues. Training No specialized training is necessary, unless the witness undertakes a factual investigation. The witness must qualify as an expert. Therefore, he or she must have specialized knowledge, training, experience, or other qualifications (for example, writings) in a subject outside the average person’s understanding. What determines whether the witness will testify? The witness will be allowed to testify if he or she has information relevant to the case, and the testimony is not prejudicial or unnecessarily duplicative of evidence already presented. The judge must determine whether the witness has the qualifications needed to testify in the case. The testimony also must be relevant and must not be unnecessarily duplicative or prejudicial. Testimony Facts and observations based on the witness’s perceptions and everyday common information. Facts and opinions based on the witness’s knowledge, training, and experience and the fraud procedures performed by him or her. Evidence and exhibits All documents referred by the witness must already be in evidence. The witness can testify about documents that have not been entered into evidence if they are of the type normally relied on by experts in that field to form an opinion. Can the witness testify about hearsay evidence? No. Yes, as long as it is something that is normally relied upon by experts in the field. Payment of fees The witness is only entitled to the statutory daily fee (which is very small in most jurisdictions). The witness is entitled to a reasonable hourly rate. Source: D.R. Carmicael, et. al, Fraud Detection, 5th, Fort Worth: Practitioners Publishing, 2002, p. 8-3.

Types of Witnesses Percipient witness – one with direct personal knowledge of the facts, circumstances, and events surrounding the dispute (e.g., fraud, the robbed bank teller). Peripheral witness – may be able to provide background information. Hostile – normally unfriendly to the forensic accountant or to the lawyer. Friendly – friendly toward your position.

Four Conditions An expert witness can state an opinion or conclusion if four conditions are satisfied: The validity of the opinion or conclusion depends on special knowledge, experience, skill, or training not ordinarily found in lay jurors; The witness must be qualified as an expert in the pertinent field; She must possess a reasonable degree of certainty (probability) about her opinion or conclusion; and Generally, in common law jurisdictions an expert must first describe the data on which her conclusion is based, or she must testify in response to a hypothetical question that sets forth such data. Source: J.R. Waltz, Evidence, New York: Foundation Press, 1999, p. 15.

Three Approaches to Testifying
Express opinion based upon facts personally observed, or facts communicated to him by another expert. Be present in courtroom and express opinion on such evidence (that is not in dispute). Base an opinion on a hypothetical question embracing evidence in the record. Source: J.R. Waltz, Evidence, New York: Foundation Press, 1999, p. 15.

Written Reports An expert should never draft a written report of any kind unless he or she has been expressly directed to do so by hiring counsel. Federal Rules of Civil Procedure 26(a)(2)(B) requires a written report. Keep a diary of interview dates, etc. Do not destroy interview notes.

Written Report Contents (FRCP 26(a)(2)(B))
All opinions to be expressed and the bases for them. Data or other information considered in forming the opinions. Any exhibits to be used as a summary of or support for opinions. Witness qualifications, including a list of all publications authored within the last 10 years. Witness compensation. List of other disputes in which the witness has testified at deposition or trial during the last 4 years. Signature of the expert testifying. Note: Federal Rule of Civil Procedure 27(e)(1) indicates that an expert must update a written report or disposition.

Types of Expert Reports
Fact-oriented report – gathers and evaluates facts and uses them to prepare a report. Check and re-check the numbers and the facts. Opinion report (e.g., valuation report) – more subjective and rely more on the professional judgment of the expert. Combination of above types.

Ghost-Writing Reports
In a district court case in 2001, the plaintiff’s attorney argued that the government’s litigation consultants were ghost-writing expert reports, and the experts were destroying documents in order to prevent discovery. The court refused to allow the expert to participate in the dispute. “The more involvement the client’s attorney has with the expert’s report the more likely this involvement will be disclosed on cross-examination and result in the court discounting the expert’s testimony as lacking objectivity. Source: Jon Almeras, “Judges Offer Advice On Expert Testimony,” Tax Notes (March 18, 2002), p

Citators Commerce Clearing House Citator (taxation)
Research Institute of America PH Citator and Citator 2nd Series (taxation only) Shepard’s (for virtually every case reporter series and specialized areas, e.g., taxation) RIA and Shepard’s give a notation why the case was cited. CCH does not.

Citators (cont.) Shepard’s CCH Citator (2 volumes)
Oldest. Greater breadth. Must know court reporter citation (not just name). Go through LEXIS or Westlaw. Does not furnish name of cited case. Gives references to selective law review articles. Gives citations to Federal Statutes and Regulations. CCH Citator (2 volumes) lists cited cases for each court decision in reverse chronological order Missing most current cases (two or three months).

Things to do Only use theories or techniques that have been tested and passed. Use theories or techniques that are objective. Specify the known error rate or potential error rate for the method. Use methods with acceptable error rates. Produce peer-review literature (i.e., journal studies, reports, and treatises supporting the expert’s conclusions and opinions). Produce reliable scientific data to prove that her methods and conclusions are generally accepted in the scientific community. Demonstrate that her theories existed prior to the commencement of the litigation. Not develop novel theories to support conclusions for specific litigation. Demonstrate that she maintained standards and controls (for example, good laboratory practices and simultaneous blinded controls). Source: Babitsky et. al, The Comprehensive Forensic Manual, Seak, Inc.,

Things to do … Demonstrate that findings can and have been replicated by others. Demonstrate that her methodology followed the scientific method as it is practiced by at least a recognized minority of scientists in the expert’s field. Offer testimony that is sufficiently tied to the facts of the case to help the jury to resolve a factual dispute. Avoid relying on coincidence. Avoid extrapolating unjustifiably from an accepted premise to an unfounded conclusion. Adequately account for obvious alternative explanations. Demonstrate the same care and accuracy as in the regular professional work. Use the real-world methodology of her field. Use an appropriate methodology to ensure that her opinion derives from and constitutes a form of specialized knowledge. Source: Babitsky et. al, The Comprehensive Forensic Manual, Seak, Inc.,

Judges Can Be Mean Judges can hurt an expert witness’ reputation by making negative comments about the expert in open courtroom. A judge in Florida’s Fourth District Court of Appeal said the following about an expert when a defense attorney asked why he excluded the expert: “Dr. ____ is an insidious perjurer who wouldn’t know the truth if it leapt up and bit him on the ***.” The expert is a doctor since 1963 and has testified for 25 years. On appeal the appellate court upheld the judge’s ruling that the expert’s claim lacked merit.

Risk Management There is an emerging trend of increased expert witness liability. General Rule: Immunity to a witness from civil liability from testimony / communication made in the course of litigation. Exceptions: Spoliation of evidence – losing or destroying evidence. Lying under oath. Defamation lawsuits against opponent's witnesses. Negligence (disappointed clients). $42M Mattco Forge decision (Acct. malpractice). Arthur Young [reversed on appeal on technicality] Court appointed expert can be liable for negligence. [e.g., Accountant in a divorce case: Levine v Wiss & Co, 478 F.2d 397 (N.J. 1984)]

You Can Be Sued Witness Immunity State: State of Washington
States Ignoring Immunity: Alaska California Connecticut Louisiana Missouri New Jersey [court appointed] Pennsylvania Texas West Virginia

Breach of Contract A client may win a breach of contract dispute by showing that the expert failed to perform a specific contracted service, perform the service in a timely fashion, perform in a satisfactory manner, or comply with professional standards. Examples of specific service performance would include engagements such as a review of a client’s internal control system or conducting a complete audit. Source: “Breach of Contract” (New York Practicing Law Institute, January 2000), Ch. 3.2[B].

Lack of Immunity There is no immunity for communication made outside the context of the lawsuit. Probably no immunity if the alleged misconduct results in a professional disciplinary proceeding. If you present false evidence, may be subject to criminal prosecution.

10 Guidelines to Meet Potential Legal Challenges
Know the relevant professional standards Apply the relevant professional standards Know the relevant professional literature Know the relevant professional organizations Use generally accepted analytical methods Use multiple analytical methods Summarize the conclusions of the multiple analytical methods Disclose all significant analytical assumptions and variables Subject the analysis to peer review Test the analysis – and the conclusion – for reasonableness Source: R.E. Figlewicz and Hans-Dieter Sprohge, “The CPA’s Expert Witness Role in Litigation Services: A Maze of Legal and Accounting Standards,” The Ohio CPA Journal, July-September, 2002, p. 35

Sufficient Relevant Data
A practioner needs to base his or her conclusions and judgments on sufficient relevant data. Ballentine’s Law Dictionary defines evidence as follows: The means by which any matter of fact, the truth of which is submitted to investigation, may be established or disproved. That which demonstrates, makes clear, or ascertains the truth of the very fact or point in issue, either on the one side or the other. The law of evidence embraces those rules which determine what testimony is to be admitted or rejected in the trial of a civil action, or a criminal prosecution, and what weight is given to evidence which is admitted. Source: Ballentine’s Law Dictionary

Sufficient Relevant Data (contd…)
Ballentine’s further defines sufficient evidence and relevant evidence as follows: Sufficient evidence—Abstractly, evidence of such probative value as to support the verdict of the jury or a finding of fact by the court. Practically, evidence such as will satisfy an unprejudiced mind of the truth of that which the court or jury has found to be the fact. [Emphasis added] Relevant evidence—Any matter of fact the effect, tendency, or design of which, when presented to the mind, is to produce a persuasion concerning the existence of some other matter of fact — a persuasion either affirmative or disaffirmative of its existence. Concisely, evidence of one fact rendering the existence of the fact in issue probable. A practitioner must advise the attorney of possible missing or questionable documents and the lack of sufficient relevant data upon which to reach an opinion. Source: Ballentine’s Law Dictionary

Eleven Guidelines for Evidence
Relevance Objectivity Documentation Externality Sample Size Sample Method Corroboration Timeliness Authoritativeness Directness Adequacy of Controls Source: R.L. Ratliff and I.R. Johnson, “Evidence,” Internal Auditor, August 1998, pp.56-61

Ten Commandments for Depositions
Always tell the truth, but answer only the question asked. Think before answering. Never answer a question you do not understand. Do not guess or speculate. Do not bring notes, diagrams, books, or other written material to the deposition unless a subpoena or your attorney requires you to do so. Listen carefully to each objection made by your lawyer. Do not argue or become angry or hostile with the examining attorney. Even if a question calls for a yes or no answer, ask to explain your response if you feel a qualification or explanation is required to complete your answer. Beware of questions which involve absolutes. Do not memorize your answers before the deposition. Source: B.P. Brinig, “The Art of Testifying,” in Handbook of Financial Planning for Divorce and Separation, John Wiley, 1990.

An Expert’s Advantages
They are experts. They are not intimidated by the process. They can hide behind their expertise. Trial work is more lucrative than office or classroom work. They are more highly educated than lawyers. They like to teach. Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 56.

Getting to Experts However, Malone and Zwier point out how to “get to” unintimidated experts; they “may lose sight of the deposing attorney’s goal, which is to find means to diminish the expert’s credibility or to challenge the bases for the expert’s opinions.” Call it arrogant. “Because they think they are safe within their own field, experts at deposition may be more willing to provide explanations and lengthy answers, to volunteer information, and to educate their ignorant but interested students.” They advise lawyers to smile, nod, lean forward, maintain eye contact, and ask open questions to “play” the expert. Encourage them to teach at the deposition. Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 57.

Seven Answers at Deposition
Yes. No. Green. I don’t know. I don’t remember. I don’t understand the question. I need a break. Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 81.

Weaknesses of Experts It is the lawyer’s arena.
They cannot resist teaching. Their time is finite and the universe is infinite. They must rely on assumptions. They are concerned about consistency. They worry about facts they do not know. You know how to use FRE 803(18). Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 73.

Federal Rule of Evidence 803(18)
Federal Rule of Evidence 803(18) permits the introduction of relevant material from written sources to get around the hearsay rule. The opposing attorney can get the expert to “concede the existence of reliable authorities in the field” that later may be used at trial to help their side. Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 73.

Jerry Lee Lewis Judges do say negative things about experts, and if an expert witness is denied, that side may lose. Most often the deadline for listing experts has passed. An old saying by Jerry Lee Lewis is appropriate: “You don’t miss your water until the well runs dry.” If the expert and report is not admissible, the lawsuit may be over. For example, a plaintiff lost a breach of contract and breach of fiduciary duty dispute by summary judgment because their accounting expert report was “pure speculation, based upon utterly implausible assumptions and unreliable methodology.” But Daubert challenges must be timely. Sources: Target Market Publishing Co. v. ADVO, Inc., 136 F.3d 1139 (CA-7, 1998). Questar Pipeline Co. v. Grynberg, 2001 F.3d 1277 (CA-10, 2000).

Cross Examination Tactics
No substitute exists for good preparation. Before your cross-examination, question your assumptions and explore alternative positions. Study the opposing expert’s analysis. If you can’t answer the question yes or no, say so and shift the burden back to the lawyer to frame a proper question, one that can be simply answered or permits a fair explanation. Answer only the question asked. Become familiar with the examining attorney’s background, skills, and tactics. Be yourself, but be sensitive to negative habits which may distract from the quality or credibility of your testimony, such as averting your eyes when asked a difficult question. Be polite. Avoid the appearance of bias or untrustworthiness. Do not hesitate to concede an error. But be careful: “So, you just picked a number?” “So, your study isn’t accurate, isn’t it?” “So, after this brief, informal interview, you decided....” Don’t overstate your opinion. Source: B.P. Brinig, “The Art of Testifying,” in Handbook of Financial Planning for Divorce and Separation, John Wiley, 1990.

Reply 1 (Novice/Direct): Yes, I am.
Question 3: Expert witness referral agency Question: You are represented by an expert witness referral agency that has agreed to work for you by advertising, spam s, sponsorship, and bulk mail solicitations, is that correct? Reply 1 (Novice/Direct): Yes, I am. Reply 2 (Aggressive/Defensive): It is not a referral agency, but an expert witness service which thousands of other experts subscribe to. I know they advertise and send out letters. I do not know anything about s or sponsorship. Reply 3 (Artful): I do list myself with a well-respected expert service. Lawyers contact the service to obtain consultations with qualified experts like me, who sometimes can be quite difficult to locate. Source: Babitsky and Mangraviti, Cross – Examination: A Comprehensive Guide for Experts, Seak, Inc., 2003.

Reply 2 (Evasive): What do you mean by “forensic income?”
Question 27: Forensic income Question: What was your forensic income last year Reply 1 (Evasive/Defensive): I don’t know. My spouse takes care of all the billings and collection. Reply 2 (Evasive): What do you mean by “forensic income?” Reply 3 (Humorous): Not nearly enough, I can tell you that. Reply 4 (Artful): Approximately $80,000 gross income. Source: Babitsky and Mangraviti, Cross – Examination: A Comprehensive Guide for Experts, Seak, Inc., 2003

Reply 1 (Novice): I didn’t make any notes.
Question 33: Missing records Question: Where are the notes you made when you discovered the fraud. Reply 1 (Novice): I didn’t make any notes. Reply 2 (Jail): I shredded them after I received our subpoena so I would not have to answer asinine questions like these. Reply 3 (Artful): I utilized the notes and incorporated them into my typewritten report. After I did this, I discarded the handwritten notes because they were no longer needed. This is the document retention practice I have followed for the past twelve years. Source: Babitsky and Mangraviti, Cross – Examination: A Comprehensive Guide for Experts, Seak, Inc., 2003

Question 47: Research Question: What research did you do before you formed your opinion in this case? Reply 1 (Novice): I reviewed the records, reports, and depositions in the case and also looked at my initial report. I did no additional research as this has been my area of specialty for many years. Reply 2 (Evasive): I have been researching this issue my entire twenty-one-year career. Reply 3 (Artful): I consulted the text Accountants’ Handbook as well as the following fourteen articles….. Source: Babitsky and Mangraviti, Cross – Examination: A Comprehensive Guide for Experts, Seak, Inc., 2003

Example 1: The opposing attorney wants to discredit the witness’s training. Opposing attorney: “I see from your curriculum vitae that you have not taken training in the highly regarded Forshay Fraud Detection Method. Is that correct?” Expert: “Well actually, the courses I took were superior to that course.” This question assumes facts that may or may not be true. First, there is no evidence that the course referenced in the question is, in fact, a real course. Second, there is no evidence the course is highly regarded. Source: D.R. Carmichael, Fraud Detection, Vol. 1, 2002, Practitioners Publishing Co., p

Example 2: The opposing attorney wants to discredit the witness’s experience. Opposing attorney: “Isn’t it true this is the first time you have investigated fraud in the shipping industry?” Expert: “While it is true I have never investigated fraud in the shipping industry, I have investigated cash frauds on several occasions. As such, I believe I have the necessary level of knowledge to pursue frauds of this type.” This question implies the witness is inexperienced because he or she has never before investigated fraud in a company exactly like the one in question. Secondly, it incorrectly implies that only someone with such direct experience could provide a useful opinion. Source: D.R. Carmichael, Fraud Detection, Vol. 1, 2002, Practitioners Publishing Co., p

Example 3 and 4: The opposing attorney tries to make the expert’s opinion look weak or wrong. Example 3: Opposing attorney: “When performing your fraud detection procedures on the company’s inventory system, did you also test the company’s controls over cash receipts to determine whether they were operating effectively ?” Expert: “No. I did not.” . The question implies, incorrectly, that the practitioner cannot provide an opinion as to the existence of fraud in the inventory system unless he or she has also performed procedures in the cash receipts area. The client’s attorney will have an opportunity to ask the expert to expand on his or her answer during re-direct. Example 4: Opposing attorney: “Is it possible your conclusion is wrong?” Expert: “I have done my analysis to the best of my ability, and I’ve made a conclusions accordingly. It’s always possible I’ve made a mistake, but based on everything I’m aware of, my testimony stands.” It is, of course, always possible the witness is wrong, but if the witness simply says “Yes,” the lawyer will argue to the jury that the witness conceded the possibility of error. Source: D.R. Carmichael, Fraud Detection, Vol. 1, 2002, Practitioners Publishing Co., p

Cross Examination Tactics (more)
Keep your hands on top of the table, not hidden. Be sure your attorney questions you in detail about your qualifications in order to impress the judge/jurors. Do not allow the other side to stipulate you as an expert. Dress neatly and conservatively. Arrive on time at the court house. When taking the oath as a witness, say loudly, “I do.” Be sincere and respectful. Talk directly to the jurors (or judge if no jurors). Look them in the eyes. Make contact with each of the jurors.

Judge’s Instructions to Jury:
“You have heard evidence in this case from witnesses who testified as experts. The law allows an expert to express opinions on subjects involving their special knowledge, training, skill, experience, or research. You shall determine what weight, if any, should be given such testimony, as with any other witness.” Jay W. Danker’s Four Rules: A relevant, coherent, understandable story. To keep their interest at all times. To be spoken to in clear, definite terms. Respect and sincerity.* * Jay W. Danker, Communicating with the Jury. Handout materials for the Fifth Annual National Expert Witness and Litigation Seminar, Hyannis, Massachusetts (June 20, 21, 1996) 2.

A Bulletproof Expert They give opposing counsel little or nothing
productive during cross-examination. This is dangerous to the other side because the jury expects counsel to make some good points during cross-examination. When few or no good Points are made during cross-examination, the expert’s stature is likely to grow significantly and opposing counsel’s stature is likely to diminish. Steven Babitsky and J.J. Mangrauiti, Cross-Examination, Seak, Inc. 2003, p.392

Three Communication Techniques
Central – focus on what you say. Peripheral – focus on how you say things. Amount of evidence presented. Number of points you make. Length of your testimony. Your qualifications. Trustworthiness. Likeability. Combination. Source: D.S. Scott and R. Laguzza, “Communication With The Jury,” Litigation Services Handbook, John Wiley, 2001, p

Ross Davis and Ross Laguzza Say
At least one of the jurors will not listen to you. Those that listen to you must understand you (e.g., Accounting/Taxation/Valuation issues are not easy). Jurors need to understand why you say what you say. You must persuade the jurors that what you say is correct, despite the cross-examination. Source: D.S. Scott and R. Laguzza, “Communication With The Jury,” Litigation Services Handbook, John Wiley, 2001, p

Why Financial Experts Fail
The financial expert does not know the case story (e.g., the strategic messages). Expert never develops home base messages, or develop the wrong ones (short simple messages). Inconsistencies between direct and cross-examination. Unnecessary use of jargon and terms or art. Insufficient meaningful practice. Source: D.S. Scott and R. Laguzza, “Communication With The Jury,” Litigation Services Handbook, John Wiley, 2001, pp and

Investigative Techniques and Evidence
Documentary evidence – written evidence on paper or computer medium. Testimonial evidence – testimony of individuals. Observational evidence – evidence, actions, or observations seen by an investigator. Physical examination of evidence (e.g., counts or inspections). Fixed point observations of activities (e.g., watching a scene and recording). Moving observations. Invigilation – strict temporary controls are imposed so that fraud virtually impossible. Keep detailed records. Covert observations. Forensic document examination. Source: D.R. Carmichael et.al., Fraud Detection, Vol. I, Practitioners Publishing Co., 2002, pp. 3-1 to 3-4

Evidence Best evidence rule: Demonstrative evidence (the chalks)
original documents to be produced rather than secondary evidence (including oral testimony) Many exceptions: Computer print-out – now admissible if a foundation of accuracy is laid. Copies admitted if lost. Generally can get around the best evidence rule. Demonstrative evidence (the chalks) objects – the gun. models. photographs. videos. charts. exhibits Do they have the tendency to “assist the trier of the facts”?

Authentication Requirement
To be admissible as evidence in a legal proceeding, a document or other material usually must be authenticated or identified as to what its proponent claims it to be.

Authentication Concept
Authentication Concept: The writing or object must be proven to be what it purports to be direct testimony / chain of custody. content. other circumstances. e.g., computer records may be used in the courtroom by showing that they were prepared by an accurate process.

Criminal Proceedings No plaintiff, but a prosecutor.
A criminal defendant. Due process is stronger. Burden of proof beyond a reasonable doubt. 4th Amendment, search and seizures. 5th Amendment, right against self-incrimination. Obtaining information from defendant more difficult. Case dismissed if prosecutorial misconduct. Double jeopardy applies. Fewer depositions. Original documentation and chain of custody important. Normally jury must be unanimous.

Criminal Investigations Differ
Different mentality – look for the financial evidence to support or refute an allegation. Different skill set (an investigative competency) – inquiring, observant, professional skepticism, and attention to detail . Your job is not to determine guilt or innocence. Strategy – team approach – requires obtaining witnesses, collecting evidence, and proving fraudulent intent. Source: Laura J. East, “The Role of the Forensic Accountants In a Criminal Investigation.” Journal of Forensic Accounting.

Common Problems In Criminal Investigation
Identifying the criminal activity and the violation. Locating witnesses who have moved. Gaining the cooperation of witnesses. Establishing fraudulent intent. Organizing and maintaining documents and other evidence. Responding to defense motions and anticipating defenses. Completing investigations within the statute of limitations. Investigators and prosecutors being reassigned over the life of the case. Criminals adapting their schemes to new technology. Competing for a prosecutor’s time. Source: Laura J. East, “The Role of the Forensic Accountants In a Criminal Investigations.” Journal of Forensic Accounting.

Criminal Grand Jury (e.g. Fraud)
Arrest or grand jury. 16 – 23 sworn jurors; meet bi-weekly or monthly. Indictment if at least 12 votes (without prosecutor present). Accused has no right to be informed. Have power to accuse, not to convict. Can subpoena witnesses and documents. If accused attends, no right to an attorney. A witness may be compelled to testify under a grant of immunity. If immunized witness refuses, can be found in contempt, jailed. Arraignment: reading of the indictment in open court. Burden of proof much higher: beyond a reasonable doubt. Innocent until proven guilty (U.S. constitution).

Criminal Expert’s Report
After a suspect has been indicted but before the trail, an expert testifying in a criminal trial may be asked to prepare a written summary of the testimony expected to be given. Under Federal Rule of Criminal Procedures 16(a)(1)(E), a defendant has a right to request that the government provide a written summary of the testimony expected to be given by the government’s expert if prepared, the government’s summary report should include the information listed above. Once the government provides the defendant with this summary information, the government is entitled under Rule of Criminal Procedures 16(b)(1)( C ) to reciprocal discovery of the same information from the defendant’s expert.

Rule 26 Ramification Dear Dr.
If, hypothetically, I was engaged as an expert witness by an attorney in connection with “undesirables” let’s say, for example, drug dealers and I gave expert testimony. Would the fact that I was associated with such people be a reason the opposing counsel or trier of fact might use to have me dismissed as an expert witness in future cases? I believe that under Rule 26 I must indicate the cases I have served on as an expert witness. If there are negative ramifications, that is certainly something I wish to avoid. Will the court or anyone else hold the above hypothetical example against me in any way? Thank you for your attention in this important matter.

Administrative Proceedings
May have own particular procedures. Broad standard of procedural due process. Technical rules of evidence may not apply. Procedural formality may be missing. Prosecution and judicial function may be the same. But be prepared to document and support your opinion. Often no formal appeal from an administrative decision. Therefore, must file a separate pleading to obtain a judicial review (e.g., writ of mandamus or writ of review).

AICPA Consulting Aids AICPA Consulting Services Report 93-1 (superseded by AICPA Consulting Services Special Report 03-1, March 2003) AICPA Consulting Services Special Report 93-2 CPA serving as an expert witness for a client is not an advocate. Trier of fact. AICPA Consulting Services Practice Aid 95-2 If a CPA acts as an expert witness, engagement letter discoverable. Detailed engagement letter can be a roadmap for opposing attorney. May wish to restrict services to a broad statement. CPA work product not protected.

AICPA Consulting Aids AICPA Consulting Services Report Practice Aid 96-3 Minimum elements to be included in your report. Table of contents, executive summary,introduction and background, objectives of the engagement, assumptions, and references. Does not require a report. Sampling less useful for off-the-book fraud. AICPA Consulting Services Report Practice Aid 97-1 List of selected badges of fraud. Description of fraud schemes. Legal references. Illustrative engagement letter scope paragraph. A short letter or memorandum. Statement of prediction, list of interviews conducted, and summary of interview information. Avoid stating any conclusions about the presence and absence of fraud. Avoid editorial content or judgments. Opinion on guilt or innocence left to judge or jury. (CFE has similar directive).

AICPA Consulting Aids Statement on Standards for Consulting Services No.1 – Consulting Services Definitions and Standards. These standards apply. Professional competence. Due professional care. Planning and supervision. Sufficient relevant data. Client interest. Understanding with client. Communication with the client.

EXPOSURE DRAFT STATEMENT ON RESPONSIBILITIES FOR LITIGATION SERVICES NO. 1 December 1, Prepared by Litigation and Dispute Resolution Subcommittee Statement on Responsibilities Task Force Comments should be received by January 31, 2002, and addressed to Anat Kendal, Director, Member Innovation—Financial Planning, Harborside Financial Center, 201 Plaza Three, Jersey City, NJ or via the Internet to

Litigation Services Roles of Litigation Services Practitioner
Consulting services that involve pending or potential formal legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between two or more parties. A trier of fact is a court, regulatory body, or government authority; their agents; a grand jury; or an arbitrator or mediator of a dispute. Roles of Litigation Services Practitioner Expert witness Consultant Other

Litigation Services Practitioner
Products and Services Computation Consulting Business valuations Proactive and reactive fraud investigation Pre- and post-bankruptcy restructuring, solvency analysis, and liquidation consulting Special accountings, tracings, reconstructions, and cash flow analysis Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Litigation Services Practitioner
Products and Services (contd …) Tax issues assessment and analysis Marital dissolution’s assessment and analysis Contract costs and claims assessment and analysis Historical results assessment and analysis Antitrust and other business combinations assessment and analysis Construction and environmental disputes assessment and analysis Business interruption and other insurance claims assessment and analysis Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Tasks of the Litigation Services Practitioner
Issue identification Locating other experts Fact-finding Analysis Discovery assistance Document management Settlement assistance Expert testimony Trial and deposition assistance Post-trial support (for example, accounting services, and funds administration) Negotiations Arbitration Mediation Training Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Three guidelines for admissibility of expert testimony
The testimony should assist the trier of fact to understand the evidence or to determine a fact in issue. The expert should have some minimum qualifications, which would include one or more of the following: Special knowledge Special skills Special experience Special training Special education In addition, before providing testimony, the expert would have to show that the testimony (a) is based upon sufficient reliable facts or data, (b) is the product of reliable principles and methods, and (c) is the result of the application of established principles and methods to the facts in the case. The reliability standards set for expert testimony are based on three pillars: (a) reliable data, (b) a reliable methodology, and (c) the reliable application of the methodology. Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Pyramid of Standards and Responsibilities
Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Testimony Pyramid Expert testimony must be based upon sufficient facts or data, be the product of reliable principles and methods, and the principles and methods must be reliably applied to the facts of the case. Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Professional Responsibility
AICPA Standards Code of Professional Conduct Rule 102: Objectivity and integrity Conflict of interests expert accepts work against the interest of an existing client. make conflict search of names before receiving confidential information. Objectivity and subordinating judgment make sure your opinion is your opinion. expected to defend your position avoid allowing opposing attorney to put words in your mouth. Rule 201 – General Standards professional competence due professional care. adequate planning/supervision of services sufficient relevant data. Rule 202 – Technical Standards. Rule 203 – Accounting principles Rule 301 – Confidential client communication Rule 302 – Contingent fees if contingent, can not be objective.

Understanding With The Attorney
Identification of the attorney’s client The title of the litigation, including the litigants’ names, the court, and docket number A description of the nature of the litigation services to be provided or a statement that the services will be as the attorney may direct An identification of the expert witness or the willingness of the person who will be the expert witness if necessary Reference to the absence or existence of conflicts of interest The absence or existence of the attorney’s work product privilege Restrictions of the use or exposure of the CPA’s work The CPA’s right to withdraw from and terminate the engagement in certain circumstances Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

Some Pertinent Laws Securities Act of 1933: gives full and complete disclosure to investors about new securities being offered for sale. Sections 11, 12, and 15 may impact auditors who prepare or certify the accuracy of a portion of a registration statement. Securities Exchange Act of 1934: involves previously issued securities. Imposes implied liability on auditors. Foreign Corrupt Practices Act (1977): crime for U.S. companies to bribe foreign official; must maintain and monitor adequate internal control system. Civil RICO statute: prevent and prosecute criminal activities under the guise of a legitimate business (3 times damages and attorney fees). Fair Credit Reporting Act of 1971: regulates activities of credit, insurance, and employment investigations. Private Securities Litigation Reform Act of 1995: reform to decrease frivolous lawsuits. Requires three fraud requirements for an audit: Design procedures to detect illegal acts. Procedures to identify related-party transactions. Evaluate the entity as a going concern. Securities Litigation Uniform Standards Act of 1998: Securities class actions are permitted only in federal courts.

Federal Sentencing Guidelines (Chapter 8)
Three Pronged Approach Restitution Probation Fines Combats fraud and abuse against government and to eradicate all federal crimes committed in an organization. Note: An organization is liable for the criminal conduct of its executives, employees, and agents. See

Some Coverage of Guidelines
Bid rigging. Bribes. Collusion. Conspiracy. Data security. Discrimination. False records. Fraud. Harassment. Kickbacks. Price fixing. Software piracy. Vendor relationship. Whistleblower protection.

Table 1: Base Fine Offense Level Amount 6 or less $5,000 7 7,500 8
10,000 9 15,000 10 20,000 11 30,000 12 40,000 13 60,000 14 85,000 15 125,000 16 175,000 17 250,000 37 $57.5 million 38 72.5 million Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61.

Table 2: Culpability Level
Activity Penalty Conviction +5 Tolerating, condoning, and willfully ignoring +4 Prior history +1 or +2 Violating judicial order Obscuring justice +3 Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61.

Table 3: Multiplier Culpability Score Minimum Multiplier
Maximum Multiplier 10 or more 2.00 4.00 9 1.80 3.60 8 1.60 3.20 7 1.40 2.80 6 1.20 2.40 5 1.00 4 0.80 3 0.60 2 0.40 1 0.20 0 or less 0.05 Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61.

(whichever of the three above is higher)
Good News Table Activity Score* Self-reporting to authorities minus 5, or Cooperating with authorities minus 2 or Accepting responsibility Minus 1 (whichever of the three above is higher) Effective compliance program minus 3 * Subtract the higher of the first three and then subtract for effective compliance program. Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61.

Some Accountants believe that ethics is a place in England.
Fraud Some Accountants believe that ethics is a place in England. Essex, U.K. 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.”

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

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.

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.

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.

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.

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. 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.

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. 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.

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. 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.

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. 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.

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.

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

SEC’s Proposed Rules (12-5-2002)
Auditor may not Audit own work. Perform management function. 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 – 1266.

Sarbanes-Oxley Act Creates Need For Forensic Accounting
To assist corporations in their quest to ensure compliance with the mandates of S-O. Public accounting firms must introduce forensic techniques into audits, and they may request help from forensic experts.

Assistance of Forensic Accountants
S-O requires principal executives and financial officer to certify annual and quarterly reports. 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. Officers and directors are prohibited from influencing, coercing, manipulating, or misleading the accountant performing the independent audit. Civil and criminal penalties against officers for violations of S-O. Auditors workpaper retentions for five years. PCAOB shall adopt auditing standards. SEC may censure auditors.

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.

Michael Comer’s Types of Fraud
Corruptions (e.g., kickbacks). Conflicts of interest (e.g., drug/alcohol abuse, part-time work). Theft of assets. False reporting or falsifying performance (e.g., false accounts, manipulating financial results). 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.

Starwoods Hotels Poll of Executives
Starwoods Hotels interviewed 401 top executives who golf. The results are surprising. 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 Believe that business and golf behaviors are parallel 72% Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA Today, June 26, 2002, p. A-1.

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

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

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.

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”

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.

Fraud Legally, 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. 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.

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

Foreign Corrupt Practices Act of 1977
Public companies shall maintain adequate internal controls: 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 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; 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

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).

Superseded SAS No. 53 Accounting 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.

Superseded SAS No. 82 Accounting 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): Known history of securities law violations (14.6%) Significant compensation tied to aggressive accounting practices (12.9%) 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

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.

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.

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.

COSO’s Most Common Fraud Methods
Overstatement of earnings. Fictitious earnings Understatement of expenses. Overstatement of assets. Understatement of allowances for accounts receivables. Overstatements of the value of inventories by not writing down the value of obsolete goods. Overstatement of property values and creation of fictitious assets.

COSO’s Major Motives for Fraud
Cover up assets misappropriated for personal gain. Increase the stock price to increase the benefits of insider traders and to receive higher cash proceeds when issuing new securities. Obtain national stock exchange listing status or maintain minimum exchange listing requirements to avoid delisiting. Avoiding a pretax loss and bolstering other financial results.

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.

Joseph 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.

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. Source: 2002 Wells Report

Restatements of Financial Statements
2002 - 330 2001 - 270 2000 - 233 1999 - 216 1998 - 158 Reasons for 2002 restatements: Accounting rules. Human and system errors. 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 In 2002, they had 40, with 26 after new auditors were retained. Source: “An Analysis of Restatement Matters,” Huron Consulting Group,

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.

Triple Fraud Sting A Michigan woman received an 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, Reviewed June 15, 2003.

Rite 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.

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

White-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).

Other Characteristics of Occupational Fraudsters:
Egotistical Risk taker Hard Worker Greedy Disgruntled or a complainer Overwhelming desire for personal gain Pressured to perform Inquisitive Rule breaker Under stress Financial need Big spender Close relationship with vendors / suppliers Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff,

Insights on cheaters and deceivers:
People who have experienced failure are more likely to cheat. People who are disliked and who dislike themselves tend to be more deceitful. People who are impulsive, distractible, and unable to postpone gratification are more likely to engage in deceitful crimes. People who have a conscience (fear, apprehension, and punishment) are more resistant to the temptation to deceive. Intelligent people tend to be more honest than ignorant people. Middle- and upper-class people tend to be more honest than lower-class people. The easier it is to cheat and steal, the more people will do so. Individuals have different needs and therefore different levels at which they will be moved to lie, cheat or steal. Lying, cheating, and stealing increase when people have great pressure to achieve important objectives. The struggle to survive generates deceit. Source: Gwynn Nettler, Lying, Cheating, and Stealing, Cincinnati, Ohio: Anderson, 1982.

Quotes Source: Robert J. Lindquist
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

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

Fraud Catching D. Larry Crumbley
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.

Forensic Audit of a Forensic audit
Harris Tories (Canada) tarred by Andersen Consulting and Accenture deals - - $200 million blown to save $16 million in welfare funds. Firms found $58.2 million in so-called welfare fraud, saving up to $16 million. James Clancy calls for forensic audit of Ontario’s payments to the two companies. The union leader said, “instead of wasting $200 million in this manner, the money could have been used to improve education, healthcare, and all the other social services.”

How Fraud Is Detected Tips from employees (26.3%).
By accident (18.8%). Internal audit (18.6%). Internal controls (15.4%). External audits (11.5%). Tips from customers (8.6%). Anonymous tips (6.2%). Tips from vendors (5.1%). Therefore, 46.2% from tips. Source: 2002 Wells Report.

Tips Are Important Some of the biggest recent accounting scandals (e.g., 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.

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 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.

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.

Quotes 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

Difficult Task 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

Stealth 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

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

Kessler Survey (2001) 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,

SAS No. 99 Characteristics of Fraud
Incentives / pressures Attitude / Rationalization Opportunity

Fraud Pyramid Motive Opportunity Rationalization
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.”)

Financial Statements Fraud Formula-CRIME
Cook + Recipes + Incentives + Monitoring (lack of) + End Results = CRIME Source: Zab Rezaee “Cooking The Books Is a Crime, Journal of Forensic Accounting Vol. IV (2003), pp

Rite Aid’s Bag of Tricks
Rite Aid overstated its income in every quarter from May 1997 to May 1999, by massive amounts. Restated its pre-tax income by $2.3 billion and net income by $1.6 billion, the largest restatement ever. Source: SEC Announces Fraud Charges Against Former Rite Aid Senior Management.

Rite Aid’s Bag of Tricks
Wayne M. Carlin, Regional Director of the Commission's Northeast Regional Office, stated: "The charges announced today reveal a disturbing picture of dishonesty and misconduct at the highest level of a major corporation. Rite Aid's former senior management employed an extensive bag of tricks to manipulate the company's reported earnings and defraud its investors. At the same time, former CEO Martin Grass concealed his use of company assets to line his own pockets. When the house of cards teetered on the edge of collapse, Grass fabricated corporate records in a vain effort to forestall the inevitable. The Commission's enforcement action, and the related criminal prosecutions announced today, demonstrate that there will be no refuge for corporate executives who commit this kind of wrongdoing." Source:

Rite Aid’s (Cont.) Upcharges — Rite Aid systematically inflated the deductions it took against amounts owed to vendors for damaged and outdated products. For vendors who did not require the unusable products to be returned to them, Rite Aid applied an arbitrary multiplier to the proper deduction amount, which resulted in overcharging its vendors by amounts that ranged from 35% to 50%. These practices, which Rite Aid did not disclose to the vendors, resulted in overstatements of Rite Aid's reported pre-tax income of $8 million in FY 1998 and $28 million in FY 1999. Source:

Rite Aid’s (Cont.) Stock Appreciation Rights (SARs) — Rite Aid failed to record an accrued expense for stock appreciation rights it had granted to employees, in a program that gave the recipients the right to receive cash or stock in amounts tied to increases in the market price of Rite Aid stock. Rite Aid should have accrued an expense of $22 million in FY 1998 and $33 million in FY 1999 for these obligations. When questioned by Rite Aid's independent auditors about the existence of any SARs, Bergonzi falsely denied that any had been issued. Source:

Rite Aid’s (Cont.) Reversals of Actual Expenses — In certain quarters, Bergonzi directed that Rite Aid's accounting staff to reverse amounts that had been recorded for various expenses incurred and already paid. These reversals were completely unjustified and, in each instance, were put back on the books in the subsequent quarter, thus moving the expenses to a period other than that in which they had actually been paid. The effect was to overstate Rite Aid's income during the period in which the expenses were actually incurred. For example, Bergonzi directed entries of this nature which caused Rite Aid's pre-tax income for the second quarter of FY 1998 to be overstated by $9 million. Source:

Rite Aid’s (Cont.) "Gross Profit" Entries — Bergonzi directed Rite Aid's accounting staff to make improper adjusting entries to reduce cost of goods sold and accounts payable in every quarter from the first quarter of FY 1997 through the first quarter of FY 2000 (but not at year end, when the financial statements would be audited). These entries had no substantiation, and were intended purely to manipulate Rite Aid's reported earnings. For example, as a result of these entries alone, Rite Aid overstated pre-tax income by $100 million in the second quarter of FY 1999. Source:

Rite Aid’s (Cont.) Undisclosed Markdowns — Rite Aid overstated its FY 1999 net income by overcharging vendors for undisclosed markdowns on those vendors' products. The vendors did not agree to share in the cost of markdowns at the retail level, and Rite Aid misled the vendors into believing that these deductions — taken in February 1999 — were for damaged and outdated products. As a result, Rite Aid overstated its FY 1999 pre-tax income by $30 million. Source:

Rite Aid’s (Cont.) Vendor Rebates — On the last day of FY 1999, Bergonzi directed that Rite Aid record entries to reduce accounts payable and cost of goods sold by $42 million, to reflect rebates purportedly due from two vendors. On March 11, 1999 — nearly two weeks after the close of the fiscal year — Bergonzi directed that the books be reopened to record an additional $33 million in credits. All of these entries were improper, as Rite Aid had not earned the credits at the time they were recorded and had no legal right to receive them. Moreover, due to Rite Aid's pass-through obligations in agreements with its own customers, Rite Aid would have been obligated to pass $42 million out of the $75 million through to third parties. The $75 million in inflated income resulting from these false entries represented 37% of Rite Aid's reported pre-tax income for FY 1999. Source:

Rite Aid’s (Cont.) Litigation Settlement — In the fourth quarter of FY 1999, Grass, Bergonzi and Brown caused Rite Aid to recognize $17 million from a litigation settlement. Recognition was improper, as the settlement was not in fact consummated in legally binding form during the relevant period. Source:

Rite Aid’s (Cont.) "Dead Deal" Expense — Rite Aid routinely incurred expenses for legal services, title searches, architectural drawings and other items relating to sites considered but later rejected for new stores. Rite Aid capitalized these costs at the time they were incurred. Rite Aid subsequently determined not to construct new stores at certain of these sites. Under Generally Accepted Accounting Principles, Rite Aid should have written off the pertinent "dead deal" expenses at the time that it decided not to build on each specific site. Such writeoffs would have reduced reported income in the relevant periods. Instead, Rite Aid continued to carry these items on its balance sheet as assets. By the end of FY 1999, the accumulated dead deal expenses totaled $10.6 million. Source:

Rite Aid’s (Cont.) "Will-Call" Payables — Rite Aid often received payment from insurance carriers for prescription orders that were phoned in by customers but never picked up from the store. Rite Aid recorded a "will-call" payable that represented the total amount of these payments received from insurance carriers, that Rite Aid would be obligated to return to the carriers. In the fourth quarter of FY 1999, Rite Aid improperly reversed this $6.6 million payable. When Rite Aid's general counsel learned of this reversal, he directed that the payable be reinstated. Bergonzi acquiesced in the reinstatement, but then secretly directed that other improper offsetting entries be made which had the same effect as reversing the payable. Source:

Rite Aid’s (Cont.) Inventory Shrink — When the physical inventory count was less than the inventory carried on Rite Aid's books, Rite Aid wrote down its book inventory to reflect this "shrink" (i.e., reduction presumed due to physical loss or theft). In FY 1999, Rite Aid failed to record $8.8 million in shrink. In addition, also in FY 1999, Rite Aid improperly reduced its accrued shrink expense (for stores where a physical inventory was not conducted), producing an improper increase to income of $5 million. Source:

Rite Aid’s (Cont.) Related-Party Transactions with Grass
Grass caused Rite Aid to fail to disclose his personal interest in three properties that Rite Aid leased as store locations. Rite Aid was obligated to disclose these interests as related party transactions. Even after press reports in early 1999 prompted Rite Aid to issue corrective disclosure regarding these matters, Grass continued to conceal and misrepresent the facts, which caused Rite Aid's corrective disclosures to be false. Source:

Rite Aid’s (Cont.) Grass never disclosed an additional series of transactions, in which he funneled $2.6 million from Rite Aid to a partnership controlled by Grass and a relative. The partnership used $1.8 million of these funds to purchase an 83-acre site intended for a new headquarters for Rite Aid. Rite Aid subsequently paid over $1 million in costs related to this site even though it was owned by the partnership, and not by Rite Aid. After press reports raised questions about this site, Grass transferred $2.9 million back to Rite Aid from a personal bank account, but continued to conceal the series of transactions from Rite Aid's Board. Source:

Rite Aid’s (Cont.) Fabrication of Minutes by Grass
In September 1999, when Rite Aid was in perilous financial condition, and in order to obtain a bank line of credit to keep the company afloat, Grass caused minutes to be prepared for a meeting of Rite Aid's Finance Committee, stating that the Committee had authorized the pledge of Rite Aid's stock in PCS Health Systems Inc. as collateral. Grass signed these minutes even though he knew that no such meeting occurred and the pledge was not authorized. Source:

Which of these statements are false?
A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting. Personal guarantees of debt of a company that are significant to one’s personal net worth is an example of a pressure/incentive for fraudulent financial reporting. A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting. An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting. Anticipated future layoff would be an example of an incentive to misappropriate assets. A large amount of cash on hand would be an example of a rationalization to misappropriate assets. Inadequate internal controls is an example of an opportunity to misappropriate assets.

Which of these statements are false?
A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting. F (I/P) Personal guarantees of debt of a company that are significant to one’s personal net worth is an example of a pressure/incentive for fraudulent financial reporting. T A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting. F (I/P) An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting. T Anticipated future layoff would be an example of an incentive to misappropriate assets. T A large amount of cash on hand would be an example of a rationalization to misappropriate assets. F (O) Inadequate internal controls is an example of an opportunity to misappropriate assets. T

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

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.

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 years and has an annual income between $15,000 to $30, % of fraudsters have tertiary educational qualifications.

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.

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.

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.

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

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

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

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.

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: Property, Plant & Equipment $647,000,000 Operating Expenses $647,000,000 The support for this entry was a yellow post-it note. Now, a number of companies are trying to obtain IRS refunds for inflated incomes.

WorldCom Fraud Massive
At 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. Company officials decided what tax rates they wanted and then used the reserves to arrive at the tax rates. Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,” Wall Street J., June 10, 2003, p. 3.

WorldCom Fraud Massive (contd.)
David Schneedan, CFO at a division, refused to release reserves twice. 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.

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

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.

SAS No. 99 Ways to Overcome the Risk of Management Override of Controls
Examining journal entries and other adjustments. Reviewing accounting estimates for bias, including a retrospective review of significant management estimates. Evaluating the business rationale for significant unusual transactions.

Examples 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.

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,” p. 1.

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.

Comparison of Auditing and Forensic Examination
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. Source: Apostolou, B, “Course : Fundamentals of Fraud Detection and Prevention,”

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

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

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

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

Auditing Internal Controls
The audit of internal controls includes these steps: Planning the audit. Evaluating the process management used to perform its assessment of internal control effectiveness. Obtaining an understanding of the internal controls. 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. Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.

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

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

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

Traditional Audit Traditional Investigation Pre SAS 99 Auditing Standards Consulting Standards SAS 99 Traditional Investigation Forensic Procedures in the Audit Environment Post SAS 99 Auditing Standards Consulting Standards Source: Ronald L. Durkin et.al, Litigation and Dispute Resolution Services Subcommittee, Incorporating Forensic Procedures in an Audit Environment, AICPA, 2003, Fraud Task Force.

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).

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.”

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.

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

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.]

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

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.

How Fraud Occurs Source: KPMG Fraud Study

Measures Helpful in Preventing Fraud
Strong Internal Controls (1.62) Background checks of new employees (3.70) Regular fraud audit (3.97) Established fraud policies (4.08) Willingness of companies to prosecute (4.47) Ethical training for employees (4.86) Anonymous fraud reporting mechanisms (5.02) Workplace surveillance (6.07) 1 = Most effective 8 = Least effective Source: 2002 Wells Report

Auditors Must be Alert for:
Concealment Collusion Evidence Confirmations Forgery Analytical relationships Source: Gary Zeune, “The Pros and Cons.” “Things are not what you think they are.” Al Pacino, “The Recruit.”

SAS No. 99 Recommendations
Brainstorming. Increased emphasis on professional skepticism. Discussions with management. Unpredictable audit tests. Responding to management override of controls.

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. to get free subscription to PCAOB Update.

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.

When Fraud Is Discovered
Notify management or the board when the incidence of significant fraud has been established to a reasonable certainty. 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. A written report should include all findings, conclusions, recommendations, and corrective actions taken. A draft of the written report should be submitted to legal counsel for review, especially where the internal auditor chooses to invoke client privilege.

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.

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.

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”

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.”

SKEPTICISM Ronald Reagan said with respect to Russia, “Trust, but verify.” FA’s motto should be “Trust no one; question everything; verify.”

Example of Management Override/Skepticism
“And second, I want to tell you that you and your people did nothing short of uncovering a quarter-of-a-million –dollar embezzling scheme that Loomis [the controller of the entity who had a gambling problem] was involved in.” Looking around the room, he explained to the other partners how Pat [an auditor] investigated the mysterious check made out to Richard Loomis and how he used the bank and Nationwide Express to get the statement back to the unsuspecting controller. He told them that Pat had talked privately to Gordon Banks [Executive Director], explaining to him how Loomis had switched the checks before giving the statement back to Pat. “After Pat left Banks’ office, Gordon called me personally and told me that he needed my help. He wanted a fresh pair of eyes to look over what Pat showed him. “So Russell and I drove down there the same day to meet Gordon. He showed us the check made payable to the post office, and it appeared to have cleared the bank. And sure enough, it was for the same amount and had the same check number as the check that did, in fact, clear the bank with Loomis as the payee. Fortunately, Pat made a copy of the check before Loomis had a chance to destroy it.” “What did you do next?” Bob Ramsey asked. He and the others were mesmerized. “I asked Gordon to get a few old bank statements for us, and Russell and I pulled out every check payable to the post office, and the three of us went to the bank.” “And?” “We asked the bank to pull their photocopy of each check that we had payable to the U.S. Postal Service. There was the proof. The bank’s copies of several of the checks had the same number and were for the same amount, but had Loomis as the payee.”

Example of Management Override/Skepticism
“But you said that the checks had the same check numbers, and appeared to have cleared the bank. How did he manage to do that?” Ramsey asked again, astonished. “Actually, it was very simple once it was uncovered. As it turned out, Loomis ordered two sets of identically numbered checks from two different check-printing companies. They looked exactly the same.” “And?” “He ran checks routinely on his office computer. Every week or so, he would make one check out to the U.S. Postal Service and, of course not mail it because the post office had nothing to do with it. He’d go home with a copy of the diskette he used to make out the checks in the office. There he used his name as the payee on that particular check, printed the check on his printer, forged a signature, and cashed the check at a different bank, of course. Because he got the bank statements, he only had to pull out the check he cashed, destroy it, and replace it with the original check from the bank statement, payable to the post office.” “But you said that it looked like the check had been cashed and it had a receipt. How did he manage that?” one of the other partners asked. “Simple. He had a friend who worked at the post office in on the scheme. His friend endorsed the check with the post office’s actual endorsement stamp and then gave him a real post office receipt.” “But how about the bank’s encoding information on the bottom right front of the check and their clearinghouse stamps on the back. How did he fake that?” Bob Ramsey asked, incredulous. “That wasn’t hard,” Autry continued, “He had duplicates of clearinghouse stamps made at a rubber stamp company. They’ll make just about anything you need. He stamped them himself, and they looked authentic enough to fool anyone.” Source: E.J. McMillan, The Audit, Churchton, MD: Harwood Publishing, 2000, pp

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.

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.

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.

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?

See Things Differently
Can’t see a way out? Take the time to see things differently. See the two white swans instead of the one black one. See the slice of pie instead of the pie with the slice missing.Flip the Necker cube outward instead of inward. Master the gestalt. It will make you free. (p.327). “Must always look for butterfly. In the middle of nothing, thing that does not belong. In cascade of digital transfer codes, you ask: is there butterfly? Yes. Always butterfly. Flap, flap, flap. So. You must know how to look.” (pp ) Robert Ludlum, The Janson Directive, New York: St. Martin’s Paperback, 2002.

Thinking as a Forensic Auditor
The Iceberg Theory of Fraud Overt Aspects Hierarchy Financial Resources Goals of the Organization Skills and Abilities of Personnel Technological State Performance Measurement Structural Considerations Water line Covert Aspects Attitudes Feelings (Fear, Anger, etc.) Values Norms Interaction Supportiveness Satisfaction Behavioral Considerations Source: G.J. Bologna and R.J. Lindquist, Fraud Auditing and Forensic Accounting, 2nd Edition, New York: John Wiley, 1995, pp

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

“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.

Three Major Phases of Fraud
The Act itself. The concealment of the fraud (in financial statements). 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

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.

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. 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,

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

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

Fate of Recent Whistle-Blowers
Whistle-Blowing It 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-Blowers Name Company Allegations Personal Outcome Company 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

RED FLAGS AICPA’s Statement on Auditing Standards No. 82 provides many red flags for external auditors in the detection of financial statement fraud. Replaced by SAS No. 99

Daryl Zero Daryl Zero, the world’s greatest detective in the movie Zero Effect, has the appropriate mottos for FAs: Precise Observation and Careful Intervention. Passion is the enemy of Precision.

Roadmap For An Embezzler: 14 Ways
Sam diverted payroll taxes meant for the IRS to himself through a dummy account. He switched the IRS correspondence address to his home, hiding the default letters. He carried on an extensive letter-writing campaign with the IRS to confuse and delay action. He made back payments, disguising them to us as current payments. He set up dummy bank accounts to skim funds before they made their way into legitimate accounts. Sam got one employee fired for doing “sloppy management,” which “lost” some deposits. Of course, Sam gave me the “proof” that this employee was incompetent. He refocused attention by pointing fingers at “slow payers” on our accounts receivable. He claimed that some people had never paid (they had) and that he had sent them to collections (he hadn’t). Of course, his records showed that their payments had never made it into our account (they went into a dummy account.) Source: Bev Harris, “How to Embezzle a Fortune,”

Roadmap For An Embezzler: 14 Ways (contd …)
He stole postage and then “reported” it, to alert me that he was honest; if anything was amiss, I would then blame others (and he offered his opinions on the least trustworthy employees). He diverted bank statements to his home and altered them before filing them at the office. Sam volunteered to run daily deposits to the bank, skimming off the cash and changing the deposit tickets. He made reimbursements to himself and his wife for “business expenses” that didn’t exist. Sam set up his landlord, once or twice a year, as an accounts payable. A fax machine was stolen from the office. Also a TV and VCR. He was supposedly the first to arrive; he hastened to point out the broken window. He personally handled the police report. (I doubt that anyone broke in; the window was high up and fairly small.) Source: Bev Harris, “How to Embezzle a Fortune,”

He put his wife on the payroll (a sweet woman who divorced him when she found what he really was). He “miscalculated” withholding to overpay her, and adjusted her W-2s downward to match. She was hourly, so he also padded her hours by $20 to $50 per pay period, and altered the time log sheets. We figured that over the course of four years, he overpaid her by at least $3,000. Of course, he was in charge of their family finances, and he deposited all her checks. Sam double-reimbursed himself for legitimate expenses. Here’s how: He would list perhaps four expenditures on one voucher, three on another. So the first would say “Office Depot, $21.64; Kinkos, $18.92; Office Depot, $39.12; Office Depot, $16.10.” A month or two later, one would show up like this: “Kinkos, $11.30; Office Depot, $39.12; Shay Office equipment, $26.20.” Source: Bev Harris, “How to Embezzle a Fortune,”

Yes, receipts were stapled to the voucher, and all the vouchers/receipts added up. Here’s how he handled that: for some vendors he copied receipts by running them through an old fax machine that used thermal paper. He made two copies for double submissions. Many cash registers use thermal paper, so the receipts looked real. This technique survived an outside audit. Increasingly arrogant, he began making “phone-authorized” wire transfers out of company accounts into his personal checking account. Sam did an amazing job of doctoring the financial statements. (If this man spent half the effort on legitimate pursuits that he did on embezzling, he’d be a millionaire instead of an ex-con). Source: Bev Harris, “How to Embezzle a Fortune,”

Some Hints 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.

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 Honest and ethical conduct. Full, fair, accurate, timely and understandable disclosure in SEC filings. Compliance with government laws, rules, and regulations. Prompt internal reporting code violations; Accountability for adherence to the code.

More Hints … 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

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

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.

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.

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 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.

$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.

To Find Compensation Data

Internal and External Fraud
Internal Fraud External Employee Management Check Forgery Stock theft Misappropriation of cash/assets Lapping Check forgery Expense account Petty cash Kickbacks Loans/investments Expense accounts False financial statements Unnecessary purchase Kickbacks Ghost vendors Diversion of sales 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

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.

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.

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.

Earnings Management 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.

Earnings Management 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 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 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

Professor Ketz’s Shoddy Accounting Practices
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. Contrast the income with the firm’s operating cash flow. Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003

Hiding Debt Companies hide debt by these techniques:
Using the equity method (rather than Trading Security and Available for Sale methods). Nets the assets and liabilities of the investee. Lease accounting (arguing that leases are operating leases). Understates 10 to 15% . Pension accounting – netting of the projected benefit obligation and the pension assets. Must unnet them. 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

Components of Internal Controls
Control environment Risk assessment Control activities or control procedures Information and communication systems support Monitoring Source: COSA

The COSO Model Control environment – management’s attitude toward controls, or the “tone at the top.” Risk assessment – management’s assessment of the factors that could prevent the organization from meeting its objectives. 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. Information and communication – system that allows management to evaluate progress toward meeting the organization’s objectives. Monitoring – continuous monitoring of the internal control process with appropriate modification made as deemed necessary.

Risk 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

Management Control Philosophy
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

Corporate Fraud Task Force
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

Corporate Fraud Task Force…
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 Investigation Michael Chertoff, Assistant Attorney General for the DOJ’s Criminal Division Eileen O’Connor, Assistant Attorney General for the DOJ’s Tax Division James Comey, U.S Attorney for the Southern District of New York Roslynn Mauskopf, U.S. Attorney for the Eastern District of New York Patrick Fitzgerald, U.S. Attorney for the Northern District of Illinois Michael Shelby, U.S. Attorney for the Southern District of Texas Kevin Ryan, U.S. Attorney for the Northern District of California Debra Yang, U.S. Attorney for the Central District of California John Snow, Secretary of the Treasury Elaine Chao, Secretary of Labor William Donaldson, Chairman of the Securities and Exchange Commission James Newsome, Chairman of the Commodity Futures Trading Commission Patrick Wood III, Chairman of the Federal Energy Regulatory Commission Michael Powell, Chairman of the Federal Communications Commission Lee Heath, Chief Postal Inspector of the U.S. Postal Inspection Service

Indictments Adaptec 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

Indictments eConnect 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

Just Say No 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.” Source: Susan Pulliam, “A Staffer Ordered to Commit Fraud Balked, Then Caved,” Wall Street Journal, June 23, 2003, p. A-1.

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

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,

Audit Procedures Audit evidence is gathered in two fieldwork stages:
internal control testing phase account balance testing phase

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.

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.

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.

Types of Financial Statement Fraud Schemes
Three professors have broken financial statement fraud schemes into these ten types: 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. Premature Revenue Recognition (e.g., holding books open). 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

Types of Financial Statement Fraud Schemes (contd …)
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. Overvalued Assets or Undervalued Expenses/Liabilities (e.g., insufficient allowance for bad debts). Omitted or Undervalued Liabilities (e.g., understated pension expenses). Omitted or Improper Disclosures (e.g., stock option expense estimates).

Types of Financial Statement Fraud Schemes (contd …)
Equity fraud (e.g., recording nonrecurring and unusual income or expense in equity). Related-Party Transactions (e.g., fictitious sales to related parties). Enron had many related-party transactions. Financial Fraud Going the Wrong Way (e.g., for tax purposes reducing income or increasing expenses).

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.

Tax Issues 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.

AICPA Indicia of Fraud Lack of written corporate policies and standard operating procedures Lack of interest in or compliance with internal control policies, especially division of duties Disorganized operations in such areas as bookkeeping, purchasing, receiving, and warehousing Unrecorded transactions or missing records Bank accounts not reconciled on a timely basis Continuous out of balance subsidiary ledgers Continuous unexplained differences between physical inventory counts and perpetual inventory records

AICPA Indicia of Fraud (contd …)
Bank checks written to cash in large amounts Handwritten checks in a computer environment Continual or unusual fund transfers among company bank accounts Fund transfers to offshore banks (Enron had more than 880 offshore accounts) Transactions not consistent with the entity’s business Deficient screening procedures for new employees Reluctance by management to report criminal wrongdoing Unusual transfers of personal assets Employees living beyond their means

Vacations not taken Frequent or unusual related-party transactions (e.g., the Enron special purpose entities) Employees in close association with suppliers Expense account abuse Business assets dissipating without explanation Inadequate explanations to investors about losses A few other indicia of fraud are: Heavy selling of stock by insiders (e.g., Enron) Sudden resigning of an officer (e.g., Jeffrey Shilling at Enron)

Unconsolidated special purpose entities (Enron had more than 3,500 subsidiary companies, some hiding billion-dollars of debts and others used as tax shelters). Greater than 5% of “other revenue” Large loans to executives (Baptist Foundation of Arizona loaned companies controlled by one director and two former directors almost $140 million which they invested in real estate) Negative cash flow from operations Recurring nonrecurring charges Off-balance sheet financing Related Parties – SFAS 57 says a related party is any party that controls or can significantly influence the management or operating policies of the company to the extent that the company may be prevented from fully pursuing its own interests. Source:

Seven Investigative Techniques
Public document review and background investigation (non-financial documents). Interviews of knowledgeable persons. Confidential sources. Laboratory analysis of physical and electronic evidence. Physical and electronic surveillance. Undercover operations. Analysis of financial transactions. Source: R.A. Nossen, The Detection, Investigation and Prosecution of Financial Crimes, Thoth Books, 1993.

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

Investigative 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.

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.

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.

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.

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 Dollar Amount $180,000 $140,000 $120,000 $100,000 Horizontal Comparison 180% 140% 120% 100%

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. 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).

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] Index for manipulators = 1.2 to 1 Source: M.D. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, September/October, t-1 = prior year.

Asset Quality Index = 1- (Current Assets t + Net Fixed Assets t ) Total Assets t (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, t-1 = prior year.

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, LTD = Long-term debt.

A Charles Lundelius Example
Comparison to peer group benchmarks: Characteristic MPS Peer group % over peers DSRI % GMI % AQI % SGI % TATA % Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p. 129.

Problems The following information is taken from the accounting records of Donald Company: Average receivables $700,000 Cost of goods sold ,900,000 Sales ,000,000 Average inventory ,100,000 Net credit sales 1,200,000 Operating income ,000 The inventory turnover is 1.81 2.2 2.64 2.92 None of the above. Using the facts above, the operating margin is .1125 .32 1.1 1.6

Problems Solution: Inventory Turnover = C of GS Average Inventory
= $2.9 million = 2.64% 1.1 million Operating Margin = Operating Income Sales = $900,000 = $8 million

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.

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. Explain the purpose of interview- need to assess risk and comply with audit responsibilities 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? Has the CEO or CFO ever approved an accounting treatment for transactions that were not appropriate? Have there been any instances where someone has attempted to inflate assets or revenue or deliberately understate liabilities and expenses? Is there any member of management that has a direct interest or indirect interest in any customer, vendor, competitor, supplier or lender? Is any member of management related to any other member of management? Does anyone in the company have any personal, financial or other problems that might affect their job performance? If there was an area within the company that might be vulnerable to fraud, what would that be? Has anyone within the accounting department been let go or resigned within the past year? Is there anyone in management that appears to be living a lifestyle beyond their means? – expensive cars, trips, jewelry, vices Has anyone been involved in civil or criminal proceedings or filed bankruptcy Does the company have a strong ethics policy? 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.

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.

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.

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.

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 truth interviewees cross their legs. Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”

Posture Language Truthful Deceptive 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.

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,”

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

Some Financial Outlaws
Andrew S. Fastow (Enron) Dennis Kozlowski (Tyco) Crazy Eddie Antar (Electronics) Robert E. Brennan (New Era Philanthropy) Barry Minkow (ZZZZ Best) Robert Vesco (Investors Overseas) Charles K. Ponzi John Bennett Michael Milken (junk bonds) Scott Sullivan (WorldCom) John D. Apfelbaum (stamps) John Rigas (Adelphia) Frank W. Abagnale (great imposter) Richard Scrushy (HealthSouth) Narcissistic personality disorder: a pervasive pattern of grandiosity (in fantasy or behavior), need for admiration, and lack of empathy.

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. 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. Source: John Helyar, “The Insatiable King Richard,” Fortune, July 7, 2003, p. 84.

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. Source: John Helyar, “The Insatiable King Richard,” Fortune, July 7, 2003, p. 82.

Look For Fraud Symptoms
Source Documents. Journal Entries. Accounting Ledgers.

Source Documents Checks. Employee time cards. Sales invoices.
Shipping documents. Expense invoices. Purchase documents. Credit card receipts. Register tapes.

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. Source: John Helyar, “The Insatiable King Richard,” Fortune, July 7, 2003, p. 82.

Journal Entries Fraud Symptoms
Out-of-balance. Lacking supporting documents. Unexplained adjustments. Unusual/numerous entries at end of period. Written entries in computer environment.

Ledger Fraud Symptoms Underlying assets disagree.
Subsidiary ledger different than general ledger.

AICPA Top Technologies Task Force
The task force found the following top ten technologies for 2002 in descending order of importance: Business and financial reporting applications Training and technology competency Information security and controls Quality of service Disaster recovery (includes business continuation and contingency planning) Communication technologies bandwidth Remote connectivity tools Web-based and web-enabled applications (Internet) Qualified IT personnel Messaging applications ( , faxing, voic , instant messaging)

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

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

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.

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.”

Preventive 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.

Some Employee Schemes (contd …)
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].

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.

Cash Schemes 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.

Kickback Example 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.

Refund Schemes 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.

Accounts Receivables Schemes
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.

Lapping 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 (cont.) 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.

Inventory 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.

Stealing Diamond Inventory
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.

Payroll 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.

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.

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.

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.

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.

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

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.

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: The Official Government Auction Guide.

Forensic Auditing Steps
Count the Petty Cash Twice in a Day Investigate Suppliers (Vendors) Investigate Customers 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

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

Anti-fraud Checklist Business policy
Is there a published ethics policy with definitions of fraud? Is fraud included in the company’s overall business risk assessment? Is there a plan in place to respond to risk and to limit damage to the business? Staff Does the company check job applicants’ references and get certificates for qualifications for appointments at all levels? Are staff trained to notice signs of all types of fraud? Are whistle blowers encouraged to come forward? Source: Adapted from Moody, M., “Fraud – enemies within” in Director (April 2000), p. 16.

Anti-fraud Checklist (contd …)
Commercial activities Does the company follow strict credit-management practice and enforce credit limits? Does the company follow good practices on credit cards and counterfeit money? Are goods received and their prices checked against delivery notes and invoices? Is ownership checked on product-refund requests? Security Have physical security arrangements been reviewed recently? Are visitors identified (e.g., name tags) and accompanied? Source: Adapted from Moody, M., “Fraud – enemies within” in Director (April 2000), p. 16.

Red 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.

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.

Red Flags or Fraud Identifiers (contd…)
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.

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.

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.

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

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.

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.

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

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.

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.

Cash T A 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.

Preliminary Cash-T Gross Receipts: Business Expenses: Schedule C
$120,000 $95,000 Preliminary Understatement Personal Living Expenses $60,000 $155,000 $35,000

Preliminary Cash-T (contd …)
The cash hoard defense is illustrated in the Edwin Edwards’ gambling corruption trial in 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. Source: C. Baughman, “Prosecution Concludes Case In Edwards’ Trial,” The Advocate Online, April 4, 2000.

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.

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, He said it was primarily to prepare for a gambling election in Bossier City, where DeBartolo was applying to put in a casino boat.

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.

But Small said the cash shortfall that Semesky found - - about $872, 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.

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.

Source/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 Net unreported funds $3,600 49,500 7,000 3,000 $63,100 $12,200 $1,700 53,000 13,000 $77,700 $46,000

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: Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of a period Add nondeductible living expenses to the increase in net worth 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).

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

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 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.

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).

Formula for Bank Deposit Method
Total deposits to all accounts Less: Transfers and re-deposits = Net deposits plus: Cash Expenditures = All total receipts less: Funds from known sources = Funds from unknown sources $195,000 21,000 174,000 68,000 242,000 119,000 123,000

Formula for Expenditure Method
Expenditures less: Known sources of income = Unknown sources of income $210,000 115,000 $95,000

Percentage of Markup Method Gross Profit on Sales Formula
Sales per books Gross profit percentage Gross profit as recomputed $100, % $25,000 Sales on Cost of Sales Formula Cost of Sales-Percentage of Sales Price Cost of Product A Cost of Product B $10,000 $20,000 Cost of Sales – Percent of Selling Price Product A Product B 25% 50% Recompiled Sales of products A and B Sales as recomputed $40,000 $80,000 (10,000/.25) (20,000/.5) Ratio Analysis Formula Restaurant Sales Number of waiters Average sales per waiter Customer’s tip percentage Waitress tip income as recomputed $90,000 3 30,000 10% $3,000

Unit and Volume of Sales Method
Average sales price per machine Number of machines manufactured Total sales as recomputed Total sales per return Unreported sales: Suppose: Beginning inventory Ending inventory $900 1,100 $990,000 720,000 $270,000 $220,000 $250,000

Some Exercises Given the following facts about Sammie Bright, calculate his preliminary understatement using the Cash-T method. Schedule C expenses $102,000 Personal living expenses ,000 Schedule C receipts ,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) $520,000 Calculated 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%

Some Exercises

Other Techniques A 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

Witness and Attorneys Have Testy Session
On cross examination, Edwards’ defense attorney, Dan Small, attacked Ms. East’s testimony. Below is the exchange between Laura East and Dan Small, taken from a reporter’s version: Laura East was on the stand eight hours Wednesday. Dan Small used much of that time to attack the numbers she came up with for prosecutors. East had testified Edwards had about $98,000 in cash at the beginning of 1994 that was not deposited in banks. She used a financial statement from January 1994 that said Edwards had $200,000 in cash. East said she subtracted about $102,000 Edwards had in a bank to come up with the $98,000 cash on hand. Source: B. Barrouquere, “Appeal Questions Edwards Case Money Trail,” The Advocate Online, April 10, 2002.

But East agreed with Small that cash on hand in financial statements can “be all screwed up.” Using the $98,000 as a starting point, East concluded that Edwards had a total of $855,652 in undeposited cash from 1994 to 1996. She said he spent $1,597,853. East concluded that Edwards had another, unreported source of income totaling $742,301. But Small suggested that East had underestimated Edwards’ cash on hand by starting at $98,000. Small focused attention on financial disclosure forms public officials must file with the state. Officials report their holdings in ranges.

Except for 1993, Edwards had consistently reported having $200,000 or more in cash, Small said. In 1993, Edwards checked the $150,000-$199,999 range for cash. And Small used tax returns to show Edwards won $1,104,000 gambling between 1987 and 1993. Although some of the winnings came in the form of checks, East agreed most probably was cash. But East said she only looked at Edwards’ finances between 1994 and 1996. “I didn’t review his tax returns from 1987,” said East, a former FBI financial analyst. “It was beyond the scope of my assignment.” Small also attacked other calculations East made, pointing out the vast differences between some numbers in her draft report on the ranch and those in her final version.

A draft report East prepared in December showed Edwards had spent $231,000 in cash on improvements on his Double E ranch in Mississippi. East based some of her report on a handwritten list FBI agents seized from Edwards during a 1997 raid. But Small contended the list did not denote cash spent. It was a tally of improvements Edwards made in anticipation of selling the ranch, such as siding and roofing, he said. East said that in her final report, she revised the cash expenditures for the ranch down to $70,560, using what she could confirm as cash spent from 1994 to 1996. And she defended her calculations of what Edwards spent building a home in the Country Club of Louisiana.

East calculated the home cost about $1.3 million. Of that, Edwards had spent $733,567 in cash, she said. Small said East had overestimated by almost $200,000 how much Edwards actually spent in cash. For example, Small said, East figured Edwards spent about $76,000 in cash buying lumber and supplies from his mother-in-law, Pat Picou, who owns Picou Builders’ Supply. Picou testified Edwards had given her about $47,000 in cash. East said she found a lot of Edwards’ transactions to be “suspicious,” and had made some assumptions based on those suspicions. “So the jury needs to believe your assumptions, and not the testimony in front of it?” Small asked. Source: C. Baughman and A. Angelette, “Witness and Attorneys Have Testy Session,” The Advocate Online, March 2, 2000, pp. 3 and 4.

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).

Bradford v. Commissioner provides other badges of fraud:
Tax Fraud 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).

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

Venue for Tax Fraud Criminal Tax Fraud: Federal District Court Civil Tax Fraud: Federal District Court. U.S. Tax Court. Federal Claims.

Caltex (Indonesian companies)
Fraud vs. Avoidance Chevron Texaco 50% 50% Caltex (Indonesian companies) 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

Financial Statement Fraud May Serve Many Purposes:
Obtaining credit, long-term financing, or additional capital investment based on misleading financial statements; Maintaining or creating favorable stock value; Concealing deficiencies in performance; Hiding improper business transactions (e.g., fictitious sales or misrepresented assets); and 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.

Increasing compensation through higher reported earnings;
Management may also engage in financial statement fraud to obtain personal benefits of: Increasing compensation through higher reported earnings; Enhancing value of personal holding of company stock such as stock-based compensation; Converting the company’s assets for personal use; and Obtaining a promotion or maintaining the current position within the company. Source: Zab Rezaee, Financial Statement Fraud, New York: John Wiley & Sons, 2002.

KPMG provides 10 steps to follow when an organization finds or suspects fraud:
Shut the door! Keep assets secure until you can provide appropriate long-term security. Safeguard the evidence. Ensure that all records and documents necessary for an investigation remain intact and are not altered by you or anyone else. Notify your insurer. Failure to notify may negate your coverage. Call a professional. Do not confront or terminate the employment of a suspected perpetrator without first consulting your legal advisor. Prioritize your objectives. What’s most important: punishment, loss recovery, prevention, detection of future occurrences?

KPMG’s 10 steps to follow contd..
Consider prosecution. Before you make the call, weigh the plusses and minuses and determine if your insurance company requires prosecution. Terminate business relations. If the fraud is external, business relations with the suspect individual or organization should be terminated. Seek advice and assistance. An important consideration is whether you have the knowledge and resources necessary to effectively manage the process. Prepare a witness list. It is important that statements be taken before a “party line” can develop. Consider the message. Whatever you do will affect future situations. Now may be the time to change the way your business operates.

Catch Me If You Can 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.

Fraudsters Should Be Prosecuted
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.

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.

Governmental Frauds 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 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,” 2002 Wells Report: 25% of fraud incidents occurred in government agencies, with a $48,000 median loss (.25 times $600 billion = $150 billion).

New Zealand Government Fraud
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

Government Quiz 101 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. Source: Deborah Soloman, “SEC’s Own Accounting Requires Tightening, Internal Audit Says,” Wall Street J., July 3, 2003, A-2.

GASB Statement No. 34 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

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.

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).

Assess Financial Health
Ratio Purpose Negative Indicator Financial Position: Unrestricted Net Assets Expenses Measures a government’s ability to provide basic government services Decreasing Financial Performance: Change in Net Assets Total 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. Liquidity: (Cash + Current Investments + Receivables) / Current Liabilities Measures the extent to which current liabilities are covered by the more liquid current assets. 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 Source: B.A. Chaney, D.M. Mead, and K.R. Schermann, “The New Governmental Reporting Model,” Journal of Governmental Management, Spring 2002, p. 29.

Early Warning Signals of Possible Trouble for Municipal Entities
Current year operating deficit Two consecutive years of Operating Fund deficit Current year operating deficit that is larger than the previous year’s deficit A General Fund deficit in the current year – balance sheet – current position A current General Fund deficit (two or more years in the last five) Short-term debt outstanding at the end of the fiscal year, greater than five percent of main Operating Fund Revenues A two-year trend of increasing short-term debt outstanding at fiscal year end Short-term interest and current year-end service greater than 20 percent of total revenues Property taxes greater than 90 percent of the tax limit Debt outstanding greater than 90 percent of the debt limit Total property tax collections less than 92 percent of total levy A trend of decreasing tax collections – two consecutive years in a three-year trend Declining market valuations – two consecutive years – three-year trend 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 to

Assess 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 5% or consecutive Elastic revenue (sales, utilities, other elastic taxes)/total revenue Varies State and federal aid / total revenue Increasing Current liabilities/total revenue 5% Uncollected property taxes/ current tax levy Greater than 8% Fixed costs/ total expenditures Debt service/total revenue Greater than 20% Tax levy/tax limit Greater than 90% Debt outstanding/debt limit Source: S.M. Winckler and Dewey Ward, “Can City Hall Go Broke? The Going Concern Issue,” Journal of Accountancy, May 1984.

Office of New York State Comptroller
Indicator 1: Revenue and Expenditures Per Capita Recurring Revenues Per Capita Gross Revenues Population Gross Expenditures Recurring Revenues (Gross Revenues – One-Time Revenues) 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 Salaries and Fringe Benefits Debt Service Expenditures Salaries and Fringe Benefits + Debt Service 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.

Indicator 4: Operating Surplus/Deficit Gross Revenues – Gross Expenditures Gross Expenditures Gross Revenues – Gross Expenditures – One-Time Revenues Negative Trend: Percentages decreasing over time. Indicator 5: Unreserved Fund Balance and Appropriated Fund Balance Unreserved Fund Balance Appropriated Fund Balance 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.

Indicator 6: Liquidity Cash and Investment as a Percentage of Current Liabilities Cash and Investments as a Percentage of Gross Monthly Expenditures Cash and Investments Current Liabilities Gross Expenditures/12 Negative 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 Debt Long-Term Debt Population Negative Trend: Percentage increase over time Note: An increase in #7 would likely trigger a future increase in #3 formula as well as a decrease in #8. Indicator 8: Capital Outlay Capital Outlay Gross Expenditures Negative Trend: Percentage decreasing over time Note: This eighth indicator is an early warning sign of financial stress. * Razek and Hosch, ibid., p.411.

Indicator 9: Current Liabilities Current Liabilities Gross Revenues Negative Trend: Percentage increasing over time Indicator 10: Intergovernmental Revenues Intergovernmental Revenues Negative Trend: Percentage increasing over time. Indicator 11: Economic Assistance Costs Economic Assistance Cost Gross Expenditures

Indicator 12: Public Safety Public Safety Cost Gross Expenditures Negative Trend: Percentage increasing over time 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.

Some Exercises 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 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 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 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 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?

6. Determine if the following situations are negative indicators of the financial health of a government unit. Cash and investments divided by current liabilities ratio is decreasing over several years. Current liabilities divided by total revenues ratio is decreasing. Fixed costs divided by total expenditures ratio is increasing. Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time. Debt Service expenditures as a percentage of revenues is greater than 25%. Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time. Gross Revenues – Gross Expenditures : Decreasing over time. Gross Expenditures The debt service expenditures as a percentage of revenues is 25% or larger. A fund balance is greater than 10% of revenues. Unreserved fund balance divided by gross expenditures ratio is decreasing over time. The quick ratio of a large state government is 2.2 to 1. Long-Term Debt divided by population ratio is decreasing over time. Current Liabilities divided by Gross Revenues ratio is increasing over time. Tax Levy divided by Tax Limit ratio is decreasing over time.

Favorable

6. Determine if the following situations are negative indicators of the financial health of a government unit. Cash and investments divided by current liabilities ratio is decreasing over several years. Negative Current liabilities divided by total revenues ratio is decreasing. Positive Fixed costs divided by total expenditures ratio is increasing. Negative Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time. Negative Debt Service expenditures as a percentage of revenues is greater than 25%. Negative Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time. Positive Gross Revenues – Gross Expenditures : Decreasing over time. Gross Expenditures Negative The debt service expenditures as a percentage of revenues is 25% or larger. Negative A fund balance is greater than 10% of revenues. Favorable Unreserved fund balance divided by gross expenditures ratio is decreasing over time. Negative The quick ratio of a large state government is 2.2 to 1. Favorable Long-Term Debt divided by population ratio is decreasing over time. Favorable Current Liabilities divided by Gross Revenues ratio is increasing over time. Negative Tax Levy divided by Tax Limit ratio is decreasing over time. Favorable

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 ( 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.

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.

Don’t Volunteer For Trouble
Dos and Don’ts If 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.

Elements of a Damage Claim
Violation of an entity’s rights (e.g., breach of contract infringement, or a tort claim) Defendant’s action or non-action harmed plaintiff (causation) Proximately related to defendant’s action (but-for rule) – but for the actions of defendant, the plaintiff would have ….

Legal Framework of Damages
In order to win an award for damages, the injured party must generally prove two points: That the other party was liable for the damage That the injured party suffered damages as the results of the actions or lack of actions of the offending party

Legal Framework of Damages
Proximate (direct) cause—The damages caused were a direct result of the offending party’s actions or lack of actions Reasonable certainty—That it is “reasonably certain” that the injured party would have earned the claimed amount of damages “but-for” the actions of the other party Forseeability—That a prudent person could look into the future and see that the actions of the offending party would damage the other party to the litigation

Obtaining Damages A New York District Court explains what a plaintiff must do to obtain damages: First, it must be demonstrated with certainty that such damages have been caused by the breach and, second, the alleged loss must be capable of proof with reasonable certainty. In other words, the damages may not be merely speculative, possible or imaginary, but must be reasonably certain and directly traceable to the breach, not remote or the result of other intervening causes…. In addition, there must be a showing that the particular damages were fairly within the contemplation of the parties to the contract at the time it was made. Thus, in New York a plaintiff may be awarded only out-of-pocket damages rather than expectation damages. Source: Telewide System, Inc., 794 F.2d 766 (CA-2, 1986).

Huge Settlements Here are some disputes with the award or settlement:
Honeywell v. Litton $1.2 billion Polaroid v. Eastman Kodak $873.2 million Smith v. Hughes $204.8 million DCS Communication v. General Instruments $140 million Fonar v. G.E. $128 million Honeywell v. Minolta $128 million 3M v. Johnson & Johnson $107.3 million

Recovery Rules Types of Claims Recovery Buyer of goods
Difference between purchase price and market value + incidental damages, - expenses saved. Sellers of goods Difference between resale price and contract price, plus incidental expenses, less expenses saved. Breach of warranty Difference between value of goods accepted and value if had been warranted. Agency contracts Lost profits. Covenants not to compete/unfair compensation Difficult. Maybe defendant’s gain. Fraud Out-of-pocket or benefit-of-the bargain theory. Source: Brining et al, Guide to Litigation Support Services, 7th, Fort Worth: Practitioners Publishing Co., 2002, pp. 3.5 and 3.6.

Two Types of Harm Tort—The occurrence of the harmful act itself is wrongful Breach of contract—A failure without excuse or justification to fulfill one’s obligations under a contract

Some Contract Breaches
Employment contract. Insurance contract. Failure to pay/provide services. Broken covenant not to compete. Stock sales. Sale of a business. A construction contract. Sale of inventory. Real estate contract.

Some Tort Lost Profits Theft/conversion of funds.
Trademark/patent infringement. Professional malpractice. Fraud (e.g., kickbacks). Defamation. Simple/gross negligence. Slander/Libel. Tort: Wrongful damage, injury, or act, other than a breach of contract, for which there is a civil remedy Good read: John Grisham, The King of Torts (2003).

1986 AICPA’s Possible Types of Damages
Two Types of Damages Restitution: harmful act has unjustly enriched the defendant at the expense of the plaintiff. Reliance: the harmful act is fraudulent and the intent of damages is to restore the plaintiff to the position as if no promises were made. 1986 AICPA’s Possible Types of Damages Lost profits. Lost value. Lost cash flows. Lost revenue. Extra costs. Notice: Can not find these accounts in the general ledger.

Types of Damages Compensation damages-
Economic (lost earnings) and noneconomic damages (pain and suffering). Special (receipts) and general damages. Hedonic damages (loss of quality of life). Avoid. Punitive damages (punish the person). Nominal damages (e.g., $10).

Two Different Jurisdictions For Fraud
Out-of-pocket costs: puts plaintiff in the same position as before plus out-of-pocket costs (maybe attorney fees). Benefit-of-the Bargain: can sue for investment put into the transaction plus any profits he or she would have made. Debra (defendant) sells Paula (plaintiff) an asset with an alleged value of $2 million for $1.8 million. However, the asset really had a market value of only $1.6 million. Calculate fraud damage. Out-of-Pocket loss rule: $1.8 million - $1.6 million = $200,000 Benefit-of-the Bargain rule (majority): $2 million - $1.6 million = $400,000

Benefit-of-Bargain Rule Example
S agrees to buy a house from P for $205,000 6 months later P says no sale House is now worth $325,000 Judge gave S $120,000

Alternatives Some Benefit-of-Bargain states allow the plaintiff to use the out-of-pocket approach (e.g., plaintiff’s option). Some states have a “flexible rule” which is really a combination of both rules (e.g., plaintiff’s option). Example: Plaintiff pays $2,250 for a stamp collection. Court found the collection only worth $1,500. Defendant said worth was $5,500. Benefit-of-the-bargain ($5,500 - $1,500 = $4,000). Out-of-pocket states ($2,250 - $1,500 = $750). Excellent book: R.L. Dunn, Recovery of Damages For Fraud, 2nd Edition, Westport, CT: Lawpress, 1995.

Benefit-of-Bargain Rule
In benefit-of-bargain jurisdictions expert can include money invested plus any lost profits and extra costs. Computation requires at least five factors: Method. Damage period. Definition of profit. Growth rate. Discount rate.

Methods Direct method – contract may explain how.
Before-and-after method – compare sales or sales growth before wrongful act with comparable figures afterward. Fails to consider increases in sales. May not be good for a growing business. Yardstick (benchmark) method – compare the particular entity to other entities or industry averages. Useful if no historical patterns. But-for (market model) method (simulation or mathematical method) – incorporate inputs from internal and external sources. Not necessarily historical. Example, Polaroid v. Kodak. May use combination of methods.

Format For Calculating Damages
Earnings before trial, had the harmful event not occurred – Actual earnings before trial Prejudgment interest Damages before trial = Projected earnings after trial, had the harmful event not occurred Projected earnings after trial Discounting Damages after trial + – Source: V.A. Lazear, “Estimating Lost Profits and Economic Losses,” in R.L. Weil et. al. Litigation Services Handbook, New York: John Wiley, 2001, Chapter 5.2.

Net Profits Damages for lost profits are based on net profits rather than gross receipts. Thus, a plaintiff may not recover its fixed overhead costs, such as administrative salaries, real estate taxes and insurance, and other types of costs. A plaintiff must present evidence of its expenses in order to establish its net loss. If a plaintiff presents only evidence of gross receipts or fails to prove expenses with some specificity, there may not be any recoverable damages. Plaintiff must submit evidence of costs and other expenditures related to the gross sales revenue. Sources: Thomasville Furniture Indus., Inc. v. The Elder-Beerman Stores, Corp., 250 B.R. 624 (S.D. Ohio 1998), appeal dismissed 201 F.3d 1440 (CA-6, 1999). Omura v. American River Investors, 894 P.2d 115 (Haw. App. Ct. 1995); Clayton v. Howard Johnson Franchise Systems, Inc., 954 F.2d 652 (CA-11, 1992).

Defendant’s Damages Estimate
The defendant’s expert report would include his or her damages estimate along with support for the numbers presented. In order to arrive at a “zero” damages estimate, a defendant must demonstrate to the court that the plaintiff suffered no financial damages.

Plaintiff’s Damages Estimate
Much of the support for the damages estimate for the plaintiff come from various accounting records, but the use of those supporting data also shows that damages estimates are both an art and a science. The scientific part is primarily the understanding and appropriate use of accounting information. The art part of the process is in knowing how the accounting information is used in creating components of the damages estimate. In addition, expert witnesses frequently use many other kinds of information other than traditional accounting records in arriving at and defending damages calculations.

Expert’s Journey Through the Legal System
Testimony early in case Pretrial summary judgments Decision to try the case Defending the expert report Deposition testimony Preparation for trial testimony Trial testimony Questioning by client’s attorney Questioning by opposing attorney Rebuttal testimony

Discounting After-trial Damages
There are two major approaches to discount amounts to present values. One approach is to project a plaintiff’s hoped-for income stream by modifying losses to a realistic expectation by factoring in future losses to a present value at a risk-reduced relatively low discount rate. Another approach is to project the hoped-for-but-lost amounts and then apply a higher discount rate that already includes risk or uncertainty in order to determine the present value.

Discounting Future Losses (5%)
Years in Future Loss Discount Factor Discounted Loss $1,000 1.0 1 1,200 1,088 2 1,300 1,179 3 1,500 1,296

Consider Incremental Costs
A plaintiff’s sales were $1 million before a wrongful act, and expenses were $600,000. After the harmful event, sales decreased to $800,000 and expenses fell to $520,000. Calculate any lost profits, considering the incremental costs. Lost profits = Lost sales less avoidable costs. $1 million - $800,000 = $200,000 $600,000 - $520,000 = ($80,000) $120,000

Cost Behavior Cost behavior: The way that costs change with respect to changes in the volume of activity. Relevant range: Area where there is a specific relationship between the level of activity (volume) and the cost in question. Fixed costs: those not driven by the changes in the volume of activity (e.g., lease payment, mortgage, depreciation, property taxes, plant fire insurance, supervisory salaries). FCs remain unchanged over the relevant range, but become smaller and smaller per unit as quantity increases. Variable costs: change directly and proportionately with the volume of activity (e.g., direct materials, direct labor, sales commissions).

Cost Behavior (contd…)
Mixed costs: contain both a fixed and a variable component (e.g., store labor costs, utility costs, maintenance costs, overhead costs, marketing costs). Semi-variable costs: change with the volume of activity, but not in proportion with activity change (called learning curve costs, e.g., introduction of a new product or service). Or shipping supplies may increase 6% with a 10% increase in sales. Step-fixed costs: increase in steps or jumps (e.g., depreciation costs of a finished goods warehouse) Cost Driver: some variable or factor that causally effects costs over the relevant range (e.g., level of activity or volume). Time Horizon: The longer the time period, the more likely the cost will approach variable.

Mitigation, etc. A plaintiff must take whatever steps or actions necessary to overcome or mitigate any damages. Law does not necessarily allow interest. Consequential damages may be allowed. Pre-tax or after-tax basis?

Damage Future Period The damage future period is always a difficult issue in lost profits disputes. In an alleged appropriation of trade secrets by a defendant, Ensign-Bickford Company, the plaintiff’s expert assumed that technological innovation would have a shelf life of twenty years. The court said that the expert’s lack of factual support for his assumptions was staggering. The court rejected the expert’s testimony with the following statement:

Damage Future Period … Perhaps most astonishing is Mr. Schachter’s assumption that not only would the technological innovation achieve worldwide acceptance and profitability, but that this profitability would last twenty years. Mr. S confesses that the sole basis for this assumption is that the technological innovation would mirror the life of the original technology: “I projected royalties out to 2020 because the original technology, the hot wire technology or hard wire technology in the airbags of current automobiles, came into existence in the early 1980s and has had a life in excess of twenty years.” Yet Mr. S made no inquiry into the historical performance of the current hot wire technology and admits that “it is possible that the SCB could be displaced during the next twenty years or earlier.” Source: K & V Science Company v. Ensign-Bickford Company, 2002 Conn. Super. LEXIS 3606.

Back Door Attempt In Schonfeld v. Russ Hilliard, the Second Circuit disagreed with a District Court that a CPA’s lost profits analysis was a back door attempt to recover lost profits. The plaintiff could not prove, with reasonable certainty, the existence or amount of damages for lost profits. “The damages may not be merely speculative, possible or imaginary.” The District Court said that the CPA’s technique probably would not survive a Daubert inquiry. This trial court declined to exclude the evidence under Daubert because it had already held that the plaintiff failed to establish a foundation for the existence of damages from lost profits. On appeal the Second Circuit held that the district court improperly excluded the accountant’s testimony. Source: Schonfeld v. Russ Hilliard,218 F.3d 164 (CA-2, 2000).

Assumptions AICPA Guideline 6.31 states that the appropriateness of a particular assumption should be commensurate with the likely relative impact of that assumption on the prospective results. Assumptions with greater impact should receive more attention than those with less impact. The Supreme Court explains making inferences from existing data: Trained experts commonly extrapolate from existing data. But nothing in either Daubert or the Federal Rules of Evidence requires a district court to admit opinion evidence which is connected to existing data only by the mere opinion of the expert. A court may conclude that there is simply too great an analytical gap between the data and the opinion offered. Source: General Electric Co. v. Joiner, 522 U.S. 136 (1997).

Knowledge of The Client
A bankrupt oil brokerage business and its owners sued a secured creditor for fraud, breach of duty of good faith and fair dealing, negligence, breach of fiduciary duty, and tortuous interference with business relations. The court said the following about the plaintiff’s expert, a CPA with eighteen years of experience in general accounting, advisory services, computer consulting and litigation support, who estimated the future profitability of an oil company (Pointer Oil) for 1990 to 1996: The problem with Mr. [Gary L.] Atnip’s affidavit is that it is not based upon a review of the actual transactions of POC. Mr. A admitted in his deposition that he was not familiar with the actual operating results of POC for 1990, that he had not reviewed cash flow or performed a cash flow analysis of POC. Additionally, Mr. A assumed a gross profit margin of 3% but throughout its entire existence POC never attained a gross profit margin of 3%.

“A” Is For Rejection Mr. A’s opinion also fails to take into account possible loss of customers in spite of the fact that customers, such as the State of Tennessee, the company’s single largest account, were lost in Mr. A acknowledges in his deposition that he was unaware that the State of Tennessee had terminated POC’s contract due to nonperformance and admitted that the loss of this contract would drastically alter his projections for future revenues. Mr. A opined that POC experienced approximately $500, in annual contract revenue growth per month during the last six months POC operated out of the offices of TECC. Mr. A, however, could not remember how he arrived at this number. Mr. Smith’s review of the actual cash revenue of the company does not bear out this assumption. Moreover, Mr. A admitted he had not analyzed Mr. Smith’s [defendant’s expert] analysis and had no idea whether it was accurate or not. Mr. A based his opinions on projected expenses and on projected revenue. Mr. Smith, however, based his analysis on actual aggregate cash expenditures of the company. Source: Pointer v. Tenn. Equity Capital Corp., 2001 Tenn. App. LEXIS 918.

Replication Is Important
Moral: Unless your work can be replicated, it is not evidence.

Industry-specific Experience
An expert does not necessarily have to have industry-specific experience. As one court said, “we are not persuaded to abandon this principle in favor of a bright line rule that expert witnesses must possess prior industry-specific experience. Industries may be segmented infinitesimally. Some economists’ and accounting professionals’ skills may be transferred between industries.” Source: Beverly Hills Concepts v. Schatz & Schatz, 247 Conn. 48, 63, 717 A.2d 724 (1998).

Industry Specific Investigations: IRS’s Audit Technique Guides (ATGs)
Market Segment Specialization Program produces ATGs. At least 74 different ATGs. Length: 13 to 237 pages. 58 ATGs on IRS website. See CCH Internet Tax Research Network. 60 more under study. Usually contain: Common and unique practices. Industry terminology. Examination techniques (e.g. interview questions). Other information.

Some ATGs Attorneys. Auto Dealerships. Bars and Restaurants.
Child Care Providers. Construction Industry. Oil and Gas Industry Pizza Restaurants. Retail Gift Shops. Scrap Metal. Taxicabs. Trucking Industry. Wine Industry.

Inconsistent Judges In one dispute a district court was unkind to a number of experts. The trial court held that a manager of an accounting firm’s “fairly simple pass” opinion was not acceptable merely because he was an expert in accounting. This expert conceded that he did not employ the methodology that experts in valuation find essential. The accounting expert used a discounted cash flow analysis, assigning a value of zero to a number of projects that had low or negative net cash flow. Thus, his method implied that raw land and a large office building had no value even though it was fully leased. The judge also would not allow a report of a University of Chicago accounting professor (testifying for the defendant) because the witness had not disclosed his opinion sufficiently far in advance of trial. However, the same judge allowed three other witnesses for the plaintiffs to give extensive testimony that had not been disclosed until the last minute. Source: Frymire-Brinati v. KPMG Peat Marwick, 2 F.3d 183 (CA-7, 1993).

Weaving a Story In a Michigan District Court dispute a CPA spent 2,000 hours assisting in the prosecution of a claim for damages because of alleged wrongdoings of defendants. The judge said that an expert may not opine on the ultimate liability of defendants even though an expert may give the jury all of the information from which the jury can draw inferences as to the ultimate issues. Further, expert testimony is not needed to determine if someone is telling the truth. After listening to the expert’s testimony, the judge said the expert was trying to “weave a story.” He “selected those portions of the available material which support his client’s position, and has deliberately ignored other portions that do not support his client’s claim.” Source: DeJager Construction v. Schleininger, 938 F.Supp. 446 (D.Ct. Mi, 1996).

Valuation Societies/Certifications
American Society of Appraisers (ASA) oldest, 555 Herndon, Suite 125, Herndon, VA years of appraisal experience and 1 ½ years of BV experience. Institute of Business Appraisers (CBA and BVAL) P.O. Box 17410, Plantation, FL National Assoc. of Certified Valuation Analysts (NACVA) 1111 Brickyard Road, Suite 200, Salt Lake City, Utah (AVA and CVA) AICPA’s Accredited Business Valuation (ABV). Recently calling it Business Valuation/Forensic & Litigation Services. October 15, BV engagements . About 1,500.

Internal Revenue Service Position: FMV
No general formula, but the price at which property will change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, and both parties have reasonable knowledge of relevant facts. Rev. Rul , C.B. 237; amplified by Rev. Ruls , , and

AICPA’s Position of Valuation
The valuation process is an art and not a science, and the results may vary depending on the methods used. A practitioner may use various methods to value a business, although circumstances generally dictate which method to use. Source: AICPA, Valuation of Closely Held Business, Management Advisory Service Practice Aid No. 8, 1987, p. 10.

Valuations are needed for various purposes:
Needed Valuations Valuations are needed for various purposes: Tax purposes (estate tax, gift tax, charitable contributions, casualty loss, sale of securities, state tax, etc.) Divorce distributions. Liquidations (partnerships, sole proprietorships, corporations) Employee share ownership plans. Lost profit analysis. Mergers and acquisitions. Minority shareholder disputes.

Several Valuation Standards:
Fair market value (gift, estate, divorce). Intrinsic value (theoretical value at which an analyst thinks a stock should be selling). Book value (assets – liabilities). Historical cost (original cost paid). Replacement cost (cost to replace). Ad valorem value. Net present value. Fair value (defined statutorily and often used in shareholder disputes). Investment value (strategic value to a specific buyer).

Valuation premise: Going concern value. Forced sale value.
Liquidation value. Good Resource: AICPA, Valuation of a Closely Held Business, Small Business Consulting Practice Aid No. 8 (1987).

Major Valuation Methods
Income Approach Discounted future earnings. Discounted net cash earnings. Capitalization of earnings. Capitalization of net cash flow (or gross) Excess earnings. 2. Market Approach Using guideline companies (calculate multiples and ratios). Comparative sales method. Past transaction method. Rules of thumb. 3. Cost Approach [Balance Sheet] Book value. Adjusted book value.

Guideline Company Data
Price/earnings. Price/gross cash flow. Price/dividends. Price/book value. Price/revenues. Price/net asset value Source: J.E. Fishman, PPC’s Guide to Business Valuation, 13th edition, Practitioners Publishing Co., January 2003, p. 2-7.

Valuation Methods Agreed or legal value – a contract, buy-sell agreement, or other agreement may state how to value. Fair Market Value (e.g., securities closing prices at end of year). Market comparison (compare company with companies in the same industry) Net Asset Approach (value of company’s assets less liabilities). Prior Transactions (prior transactions in the stock or asset) or a Comparative sale. Capitalization of earnings or cash flow (actual earnings of a business is divided by a factor to obtain an overall valuation). Example: average earnings for past 5 years, with a capitalization rate of 10% Thus, $10, = $100,000 value 10%

Valuation Methods Capitalization of excess earnings: earnings in excess of the reasonable return on tangible assets is capitalized to arrive at a valuation). IRS uses 15% to 20%, if no better rate (or multiply by 5), for capitalizing excess earnings and a 8% to 10% after-tax return for net tangible assets. Cash Flow Capitalization: future earnings are projected and discounted to present value. The sum of the present value represents the value of the business. Enterprise discounted cash flow – value of the company’s operations less, the value of debt and other investor claims. Good for a multi-business company. Value of operations equals the discounted value of expected future free cash flow. Free cash flow = after-tax operating earnings + noncash charges – investments in operating working capital, property, plant, equipment and other assets.1 Most widely used. Economic profit model2 EP = Invested Capital X [Return on Invested Capital – Opportunity Cost of Capital] Highlights whether a company is earning its cost of capital. 1 T. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd, New York: John Wiley, 2000, Chapter 8. 2 Ibid., p. 37

Valuation Methods Adjusted Present value (good for leveraged buyout targets)3 Equity DCF – good for financial institutions4 Price to Earnings Method – earnings are multiplied by a factor to determine the value of a business. Weighted average net income times P/E ratio $88,000 x 15 = $1,320,0005 Dividend capitalization method6 Weighted Average Earnings $88,000 Weighted Average Industry Payout ratio Dividend capacity $33,440 Weighted Average Industry Dividend Yield Value of company $539,355 3 Ibid., p. 131 4 Ibid., p. 150 5 J.H. Lipman, Valuation of Closely-held Business, Handbook of Financial Planning for Divorce and Separation, New York: John Wiley, 1990, p. 305. 6 Ibid., p. 303

Valuation Methods Industry Methods
Rules of thumb are applied to value a business based upon the industry within it operates. G. Desmond, The Handbook of Small Business Valuation Formulas, Los Angeles: Valuation Press, 1987. e.g., Manufacturer’s representative organization: 50% to 150% of commission income payable. Book Value and Economic Net Worth Methods. Use historical cost of business asset to determine a business’ value. Adjust these historical amounts to current values of the tangible and intangible assets. Weighted Average of several methods: Valuation Method Valuation Amount Weighting Value A $3,500, $2,100,000 B 3,200, ,000 C 4,500, ,000 Weighted average valuation $3,640,000

Valuation of An S Corporation
Actual Tax-Adjusted S Earnings $1,000,000 650,000 Capitalization 25% Valuation $4,000,000 $2,600,000 Which is the proper valuation?

S Corporations (continued)
Walter L. Gross, Jr., T.C. Memo , aff’d (CA-6, 2001). In a gift tax situation, courts would not accept a reduction for a hypothetical corporate tax. John E. Wall, T.C. Memo In a gift tax situation, tax-affecting “is likely to result in an undervaluation.” Experts had tax-affected by 34% and 40%. Estate of Heck, T.C. Memo In an estate situation, neither expert tax-affected the estate, except for 1.5% California state income tax. One expert included a 10% discount for “additional risk associated with S corporation,” e.g., loss of election. Estate of William G. Adams, T.C. Memo Tax Court said “it is appropriate to use a zero corporate tax rate to estimate net cash flow when the stock being valued is stock of an S corporation. Estate of Natalie M. Leichter, T.C. Memo No tax-affecting by experts. Note: Two-thirds of the $10 billion tax valuations are in dispute (Howard A. Lewis, June 2003)

Capitalized Returns Method Discounted Future Returns Method
Comparison of the Capitalized Returns and Discounted Future Returns Method Capitalized Returns Method Discounted Future Returns Method Used when – Future operations are expected to be similar to current operations. Future operations are expected to be “significantly different” from current operations. Information used – Cash flows or earnings from a single period. A forecast of cash flows or earnings for several future periods and an estimated value of the business in the final year of the forecast. How is value calculated – A capitalization rate is applied to the single period amount A discount rate is used to determine present value factors, which are applied to the period amounts and to the final year value. How the rate is determined – The capitalization rate is determined by taking the discount rate and subtracting out the estimated growth rate for the company. The discount rate can be determined in several ways, including the build-up approach. Source: B.P. Brinig, Guide to Litigation Support Services, FortWorth: Practitioner Publishing Co., 2002, p

Miscellaneous Many people believe that the income statement provides the most useful information in valuing profitable operating businesses. Valuation approaches may be broken into asset-based, market, and income approaches. Asset-based: what the equipment and real estate are worth. Income approach: How much money a buyer can make from the business. Market approach: what others have paid for similar items. The most common method is using price-earnings ratios. Discounting income (or cash flow) is probably a better approach. The dividend yield approach may be appropriate for minority shareholders. IRS believes that intangible assets are worth from 5 to 6.67 times excess earnings (Rev. Rul ). This is the reciprocals of the 15 to 20% capitalization rates. Rev. Rul , the courts, and ESOP Association have discredited valuation formulas, such as the excess earnings formula [value = book value + capitalized excess earnings] The IRS Valuation Policy Council will issue valuation guidelines shortly. Look for these.

Some Basics Discount rate: Amount expressed in a percentage that a buyer will pay to receive some estimated level of cash in the future, given the level of risk of not receiving the future cash flows. The higher the risk, the higher the discount rate, which results in lower current values. E.g., 5% Next year 1/1.05 = Next year 1.05 x 1.05 = = 1/ = 10% Next year 1/1.10 = Next 1.10 x 1.10 = 1.21 = 1/1.21 = Discount rate is the inverse of price earnings ratio. Say 6 firms have P/E ratio ranging from 6 to 8, with 7 average. If average earnings are $293,000, valuation is $2,051,000 [$293,000 x 7] Or capitalization rate of 1/7 = So, $293,000 / = $2,051,000

Some Basics (contd …) Capitalization factor:
Worth $1 million = 10 factor or 10% Current earnings $100,000 Capital Asset Pricing Model (CAPM): complex way of obtaining discount rate. Built-up Method: way of calculating the discount rate. B.P. Brinig, et al says Capitalization rate is derived from company’s discount rate: subtract the company’s expected average compound growth rate from its discount rate. Discount rate – Long-term growth rate = capitalization rate. Since a company’s cash flow is often less than its earnings (because of working capital and fixed assets investments), a company’s discount rate for net cash flow is usually less than discount rate of net earnings. Source: B.P. Brinig, et. al, Guide to Litigation Support Services, Vol. 3, Fort Worth: Practitioners Publishing, 2002, Chapter 10

Eleven Valuation Tips Understand your appraisal assignment.
Comply with competency and independence standards. Watch the market. Know the difference between fair market [IRS] and investment value [to a particular person]. Know when to use the invested capital and equity model. Do not let rates of return distort values. Beware of earnings measures - - cash is king. Verify all rates of return. Always challenge long-term growth rates. Challenge premiums or discounts. Have pride in your report. Source: F.C. Evans, “Tips For The Valuator,” J. of Accountancy, March 2000, pp. 35 – 41.

Fixed Costs Variable Costs Total Costs = FC + VC Total Costs = FC + Q (Variable Cost per unit) Total Revenue = Price X Q B.E. = Break Even Point = Loss zone Q $ Total Costs Total Revenue ---Relevant Range--- BE

Cost Behavior Defined In its simplest form, cost behavior is the way that cost(s) change with respect to changes in the volume of activity.

Ways of Estimating Cost Behavior
Account Analysis Method: classify the cost accounts in the subsidiary ledger as fixed, variable, etc. based upon experience and judgement. Cheap, but is subjective. High-low method (simplest quantitative analysis) Basic formula: y = a + b x, Where b = unit variable cost per measure of activity b = Cost at High Activity Level – Cost at Low Activity Level High Activity Level – Low Activity Level b = Change in Total Cost Change in Activity Level b = Unit variable cost per measure of activity. Source: Barfield et. al, Cost Accounting, 5th, Mason, Ohio: South-Western, 2003, p. 89.

Ways of Estimating Cost Behavior
Independent Dependent Machine hours Associated total cost High activity 9,000 $350 Low activity 4,600 $218 Change 4,400 $132 b = $132 / 4,400 = 0.03 per machine hours High level: Total variable costs = 0.03 (9,000) = $270 Low level: Total variable costs = 0.03 (4,600) = $138 High level: a = $350 - $270 = $80 fixed High level: a = $218 - $138 = $80 fixed 3. Regression Analysis (more accurate) Computer programs may be used to find relationships between the cost driver or volume (independent variable) and a cost (dependent variable). 4 Engineering or work-measurement method This industrial engineering approach can be expensive.

General Observations Valuation analysts must ignore their client preferences and provide independent, unbiased opinions of value. Valuation analysts must possess: Strong written and verbal communication skills. Attention to detail. Ability to interpret financial statements. Understanding of relevant economic forces. Knowledge of, and the ability to research and learn about relevant industry forces. Organizational skills. Thorough conceptual understanding of valuation concepts and methodologies. Source: G.S. Gaffen, “Guidance for The CPA Entering the Business Valuation Profession,” The Ohio CPA Journal, July – September 2002, pp. 22 – 28.

Tax Court Valuation Fair market value is a factual determination considering all relevant evidence. Fair market value is as of a specific date. The taxpayer generally has the burden of proving that the IRS valuation is wrong. The taxpayer’s standard of proof is by a preponderance of the evidence. If taxpayers fail to carry the burden of proof, the IRS will prevail. An arm’s-length transaction near the valuation date is a strong indicator of FMV. If arm’s-length data is not available, a hypothetical willing seller and willing buyer must be considered. Both the willing seller and the willing buyer must receive equal consideration. Source: Estate of Kaufman, TCM

Tax Court Valuation The willing seller and willing buyer both seek to maximize profit. In the absence of arm’s-length data, a two-step process will be used: (1) estimate the value of the stock as if it were publicly traded, and (2) determine a marketability discount for the value so determined. In this case, Judge Bighe, in rejecting the IRS experts opinion, stated that the use of the capital asset pricing model and the weighted average cost of capital method are not “the proper analytical tools to value a small, closely held corporation with little possibility of going public.” The judge also found that the IRS expert’s computation of earnings before interest, taxes, depreciation, and amortization was faulty. Source: Estate of Furman, TCM ; W.E. Bradley, “Tax Court Valuation Standards,” Valuation Strategies, November/December 1999, pp

Gathering Initial Information
Goals of pre-engagement phone contact include: Develop trust and rapport Gain a brief understanding of the business Determine who will be responsible for gathering information Explain the valuation process and timing Determine methods of corresponding with the client

Discerning What Data Is Required
Request forecasts of future financial results Review articles on industry-related valuation issues Request client information prior to company interviews

Spreading Financial Statements
Financial spreadsheet reports include: Actual and common-sized income statements Actual and common-sized balance sheets Financial statement ratios Trend statements

Analyzing Financial Statements for Trends and Risks
The purpose of analyzing a company’s historic financial statements is to provide information about these factors that are crucial in the preparation of a valid valuation: Trends and what they say about the possible future How well or how poorly a company performs compared to industry peers Key elements of company strategy

Income Statement Profitability Analysis
Income statement profitability analysis helps valuators determine the following: Judgments about the historic performance of the company and the variability of results. Results against which to assess management’s strengths and weaknesses, and how this would impact an investor’s perception of the shares as an investment, and their associated risk. An objective basis for comparing a company’s performance relative to its industry peers. Insight into a company’s economics and how the business achieves its net profit on a given level of revenues. Clues concerning the internal and external forces that affect the business, and what this suggests about risk, future threats, and opportunities.

Income Statement Analysis
Revenues Past trends Growth rates Variability in individual annual results Overall observed results Identification of the appropriate questions Gross profits Components of goods sold Calculation of goods sold Operating expenses Operating profits Other income and expense Pretax profitability

Business Valuation Standards
Uniform Standards or Professional Appraisal Practice (USPAP) from The Appraisal Foundation Code of Professional Conduct from the American Institute of Certified Public Accountants (AICPA)

Features of the Standards
Independence Fee not contingent on appraised value Limiting conditions Professionals participating in the assignment Information sources used Report content Data collection and analysis Methodology Reconciliation of findings of value Adjustments to valuation findings Conclusion of value

Report Content Purpose and scope of the assignment
Standard of value used Identification of the specific interest being valued Specific valuation date used Relevant state law governing the entity Scope of the valuation report

Organization of the Report
Front pages Cover sheet (with company name and valuation date) Transmittal letter Table of contents Introduction Company information Financial condition Valuation methodology Valuation conclusion Exhibits Limiting conditions Definitions of valuation terms Qualifications of the valuation professionals who worked on the report Common size balance sheets of the company Common size income statements of the company Ratio analysis of the company

Definition A definition of money laundering that covers both legal and illegal contexts is 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.

Steps in Money Laundering
The traditional money laundering process can be divided into three steps: Money is deposited in a bank or financial institution. A set of complex transfers is made to disguise the original source for the money and to hide the audit trail. (This step is called layering the transactions.) The money is integrated back into the legitimate money supply.

Cybercash Creates New Laundering Opportunities
Using the Internet, it will be possible for anyone to transfer large sums of money from one location to another without using a bank and with the transfers being totally anonymous. Today, cybercash transactions are beginning to take place without the need for third parties and the consequential scrutiny that might otherwise exist. Furthermore, cybercash transfers can be structured so that they originate in a jurisdiction where such activities are not considered illegal.

Who Uses Money Laundering Practices?
Grant recipients Criminals Political asylum seekers

Did You Know That Money Launderers (Don Temple)
1. Often exchange small denomination bills for one hundred dollar bills. This techniques reduces the bulk of the currency several fold and makes it easier to conceal and transport. 2. Purchase monetary instruments such as money order, travelers checks, bank drafts, cashiers checks, treasurers checks, and official bank checks with currency in amounts below the $3,000 record-keeping requirement, thereby reducing the bulk of currency.

3. Purchase the monetary instruments mentioned above in increments just below the $10,000 Currency Transaction Report threshold. This will result in the financial institution identifying the purchaser and maintaining a log of these transactions; however, money launderers recognize that the log is not filed with the government. 4. Bulk ship currency to a jurisdiction with bank secrecy laws. Although a Currency and Monetary Instrument Report must be filed with the U. S. Customs Service anytime currency and/or monetary instruments are exported from the U. S. or imported into the U. S. money launderers do not file the report. Section 371 of the USA PATRIOT Act makes bulk shipping cash into or out of the United States a crime.

5. Recognize that financial institutions report repeated deposits of just under $10,000. Therefore many money launderers will open several accounts in the names of family members and possibly friends at several financial institutions and deposit small amounts of currency in each account. The deposited amount in these situations may be less than $1,000 on a daily basis or $2,000 to $3,000 twice or possibly three times a week. These deposited amounts remain below the thresholds of any known internally developed monitoring system and would probably only be detected using comprehensive technology along with a compliance team.

6. May purchase a currency generating business to launder funds. Money launderers have used businesses such as restaurants and service/gasoline stations. These businesses serve as both a method to place and layer dirty money simultaneously. 7. Use electronic transfers to move dirty money. A money launderer may fund an electronic transfer with up to $3,000 in currency without providing identification. These funds can be rapidly transferred anyplace in the world. In many cases the money launderer may request that a representative of a money service business (MSB) execute several wire transfers during the course of a day all below the $3,000 record-keeping threshold. The money launderer will normally offer the MSB employee a bribe for the accommodation.

8. May elect to execute electronic transfers below the $3,000 record-keeping threshold at several financial institutions. Doing this will keep these transfers under the radar screen since they are small increments and they are being distributed to multiple places. 9. Purchase a big-ticket item such as a car and use currency to pay down loans at an accelerated rate. The dealership is required to file a currency report if the money launderer uses currency and/or monetary instruments with a face value of $10,000 or less and the total value of the currency and the monetary instruments aggregates to over $10,000. Financing the automobile and making accelerated payments on the loan will evade the filing of a currency report.

10. Attempt to disassociate themselves from the proceeds of a fraud quickly. Money launders may deposit the fraudulent proceeds into an account and almost immediately withdraw those funds in the form of currency at various branches of an institution or via ATMs. Source: Don Temple, “Money Laundering 101: Ten Ways to Place Dirty Money,” July 26, 2002,

Extent of Money Laundering
You know how much dirty money moves in and out of America every year? Maybe three hundred billion. Bigger than the GDP of most countries. Banks wire transactions, yes? And how do you find this? Know how much moves in and out of American banks every day?” “I expect you’ll tell me.” “Two trillion dollars. Pretty soon you’re talking real money!” Berman slapped the table in merriment. “All bank wire transactions. Where you hide grain of sand so nobody find? On beach. “Phony companies, Grigori. You invented companies that existed only on paper.” “Nowadays, these people move beyond that. Buy real companies. Insurance companies in Austria, banks in Russia, trucking companies in Chile. Cash goes in, cash comes out, who can say where and when? Who stops them? Source: Robert Ludlum, The Janson Directive, New York: St. Martin’s Paperback, 2002, p. 241.

Correspondent Banking
Correspondent banking takes place when one bank provides services to another bank to move funds, exchange currencies, and access investment services such as money market accounts, overnight investment accounts, CDs, trading accounts, and computer software for making wire transfers and instant updates on account balances. A payable-through account enables the respondent bank’s clients within the country where the bank is registered to write checks that are drawn directly on the respondent bank’s correspondent account in the United States.

Tools Banks Use to Identify Money Launderers
Monitoring software Currency Transaction Reports (CTRs) $ 10,000 or above. Suspicious Activity Reports (SARs) See: Don Temple, “Money Laundering 101,” July 26, 2002,

Due Diligence Laws for Banks
Laws and regulations require that a bank perform due diligence in its relationships with other banks and important clients as well as continually monitor account transactions. Within banks, due diligence must co-exist with the client’s need for privacy and the secrecy laws existing in many foreign jurisdictions that prevent access to bank documents.

Shell and Offshore Banks
Shell banks are generally high-risk banks that exist without any physical presence in any legal jurisdiction. These banks have a banking license in a specific country, but they are not likely to have a staff and may be operated as part of another business or operated out of an individual’s personal residence. An offshore banking license prevents the organization from transacting banking activities with any citizens of the licensing jurisdiction or transacting business with the currency of the licensing jurisdiction. These bank operations solely exist within international financial transactions.

Warehouse Bank John stood up and went to an easel. He took a felt marking pen and began drawing a chart. “What we’ve done is set up something called a warehouse bank,” he said, pointing to the first block. “We take deposits into numbered accounts, and that’s very important. Once we establish an account and give you a number, we destroy any record that would show who owns the account. This drives the IRS crazy. I saw a quote from one official who said that investigating a warehouse bank is like looking for a needle in a stack of needles.” This got a good laugh. “Now, let’s say you open your account with ten thousand dollars. We then transfer these funds to certain western banks. When you want to pay a bill, you send an to the warehouse with your instructions and your account number; that is transmitted to the partner bank, which sends a banker’s draft to our creditor. So the bill is paid without your name being mentioned, only your account number with the creditor. If you want some cash, you request that by , too, and the money is sent by certified mail or an overnight delivery service.

Warehouse Bank (cont.) “At no point in this process are you identified by anything other than an account number, so the IRS can’t examine your records to find out how much money you’re depositing or how much you’re spending. This effectively puts a stop to the enforcement of the income tax laws.” A man raised his hand. “How much can we save in taxes this way?” “Depends on how much you earn,” John said. “Recently, one of our warehouse bank customers became the first of us to save one million dollars in taxes. I can tell you that we’ve saved our members, collectively, a quarter of a billion dollars in income taxes.” Source: Stuart Woods, Orchid Blues, Signet Book 2002, pp

Attacks Against Warehouse Banks
A Federal jury convicted six defendants of conspiracy to defraud the IRS in association with the Christian Patriot Association, a warehouse bank located in Boring, Oregan Christian Patriot Association (CPA) members would send deposits of checks, cash, money orders, and cashiers checks to CPA. The deposits of all members were commingled into commercial bank accounts held in the name of CPA Services in Oregan and Arizona. CPA would then pay bills for and mail cash to CPA members. As a result, the banking transactions of CPA members were virtually untraceable. Source: “News from U.S. Department of Justice, June 7, 2002.

Cash-Oriented Businesses
Currency exchanges Online auctions Casinos Purchasing departments

Audit Trail Churning Laundering cycles Illegal cash
Deposited into bank Purchase asset Sell asset Documented legal cash

Finding Money Laundering Schemes
Web logs Tracing IP addresses HTTP common logfile format Wire transfers Bank reports

Guarding Against Money Laundering
Individual due diligence Business associations Employment Company due diligence in verification procedures Corporate ownership and governance Bearer shares Trust due diligence Trust deeds Beneficiaries

Accountant’s Role as Gateway Keeper
AICPA Auditing Standards Governing Money Laundering SAS No. 54, Illegal Acts by Clients SAS No. 82, Consideration of Fraud in a Financial Statement Audit (now replaced by SAS No. 99) Lack of Reporting Requirement

USA Patriot Act of 2001 International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (MLAA) Payable-through accounts Enhancements and restrictions under MLAA Reporting requirements under MLAA

Patriot Act Ineffective
Two years later, some 3,200 banks, 6,000 brokerage firms and 4,400 insurance companies have yet to implement basic watch lists to screen new customers, according to Celent. In many cases, small outfits would rather pay a fine than install costly new technology Even companies spending big bucks to comply with the law seem to be fighting a losing battle. No institution has figured out a way, for example, to install a centralized customer-identification system for the entire company. Source: M.D. Hovanesian and D. Fairlamb, “Still Drowning in Dirty Money,” Business Week, December 1, 2003, pp

Antitrust Laws Antitrust laws are an outgrowth of the early years of the Industrial Age in the United States when a small number of powerful businessmen used any tactic at their disposal to force competitors out of business. Because such business practices were not in the best interest of the country, federal legislation was passed that prohibits the formation and continuation of monopolies, except when in the best interest of the public.

Role of Accountants in Antitrust Litigation
Accountants may be called upon to determine whether there is liability under the antitrust laws. The primary issue that forensic accountants address is whether the defendant has engaged in predatory pricing.

Predatory Pricing Predatory pricing is the act of pricing a product so low that the only logical explanation is that the pricing is designed to drive competitors out of business. The operational definition is whether a company prices its products or services below “average variable cost” and, if so, predatory pricing is present.

Estimating Cost Behavior Patterns
Graphic analysis and high-low method Regression/correlation analysis Simple linear regression Variables Least squares regression line Standard error of the estimate Correlation analysis Coefficient of correlation Coefficient of determination Coefficient of nondetermination Association vs. causation Movements in the independent variable Reasons for the unexpected

Federal False Claims Act
The Federal False Claims Act was passed to protect the government from the unscrupulous acts of a few government contractors that intentionally or carelessly overcharge the government for goods or services.

Federal False Claims Act Litigation
Fraud allegations Whistleblower allegations Qui tam suits Reasons for bringing action

Accountant’s Role in Federal False Claims Act Litigation
Accountants may act as an expert witness for the defense, the government, or a whistleblower litigating the qui tam parts of the case.

Typical questions that accountants help courts to answer are: What costs should be included in the contract? How should costs be measured under the contract? What is the correct timing of the costs and/or revenues under the contract? What accounting concepts, rules, etc., apply under this contract? What is the magnitude of the damages that occurred because of the fraud that took place?

Under the Federal False Claims Act, a person acts knowingly with respect to information if the person has: Actual knowledge of information Acts in deliberate ignorance of the truth or falsity of the information Acts in reckless disregard of the truth or falsity of the information

Hacker Defined A hacker is generally defined as an individual or group whose intent is to gain access to a computer network for malicious purposes.

Collecting Clues and Evidence
A forensic investigator needs to be familiar with the protocols used on the Internet to be able to collect clues about either internal or external attackers. In addition, when law enforcement officials send requests or subpoenas for information about a company’s logs, the forensic analyst must understand the type of information being sought.

Protocols Internet protocols are those rules allowing different operating systems and machines to communicate with one another over the Internet.

Transmission Control Protocol (TCP) and Internet Protocol (IP)
TCP/IP protocols are the communication guidelines used and widely supported over the Internet. Almost every packet of information sent over the Internet uses the datagrams contained within a TCP/IP envelope. The datagrams consist of layers of information needed to verify the packet and get the information from the sender’s to the receiver’s location following traffic control guidelines.

Message encapsulation is used in sending the packets. In message encapsulation, each layer of information in the sent packet is interpreted by the same layer at the receiving end of the transmission. Additionally, each layer can only communicate with the one directly above or below it.

Layered Operating System Interconnection (OSI) Model Application Layer Transportation Layer Network Layer Data Link Layer Hardware Layer Electronic Impulse

The application layer issues the commands that define the operations. The transportation layer functions to provide reliable message delivery. The network layer controls the route the data takes to get to its destination. The data link layer transfers the datagram from one network node to another. The hardware layer (or physical layer) provides the means of sending and receiving data on a network by converting bits into voltages for transmission to a coax cable.

IP Address Defined An IP address is a 32-bit number (four bytes) that identifies the sender and recipient who is sending or receiving a packet of information over the Internet.

Web Log Entries One important method for finding the web trail of an attacker is in examining web logs. Recorded network logs provide information needed to trace all website usage. Information provided in a log includes the visitor’s IP address, geographical location, the actions the visitor performs on the site, browser type, time on page, and the site the visitor used before arriving. Logs should be stored on a separate computer from the web server hosting the site so they cannot be easily altered.

TCPDUMP TCPDUMP is a form of network sniffer that can disclose most of the information contained in a TCP/IP packet. A sniffer is a program used to secretly capture datagrams moving across a network and disclose the information contained in the datagram’s network protocols.

Decoding Simple Mail Transfer Protocol (SMTP)
SMTP is the protocol used to send over the Internet. SMTP server logs can be used to check the path of the from the sending host to the receiving host. Most of the important information about the origin of an message is in the long form of the header. The most important data for tracing purposes is the IP addresses and the message ID.

Tracing and Decoding IP Addresses
Traceroute Whois Ping Finger searches

Narrowing the Search Preliminary Incident Response Form
John Doe subpoena

Informational Searches
Internet databases General searches Name, telephone number, and address search engines Internet relay chat (IRC), FTP, and Listserv searches Usenet postings search Legal records Instant messaging (IM) Web page searches Government data searches Miscellaneous searches

Cash Receipts Statement?
The receiver, Thomas F. Lennon, hired a CPA, William Ling, from San Diego. The receiver’s November 6, 1997 “cash receipt statement” prepared by Mr. Ling appeared as follows: Beginning Balance $268,439 Money Distributed to Investors $2,281,255 Money Raised From Investors 6,704,320 Employees / Principals / Overhead $2,332,066 Oil and Gas Production 394,575 Oil Field Operations $1,616,000 Other 194,575 Attorney’s Fees 1,027,984 158,626 $145,978

The End Is Here

Forensic Accounting Update Copyrighted 2001 D. Larry Crumbley, CPA, Cr

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