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© D.L. Crumbley 1 Forensic Accounting Update Copyrighted 2001 D. Larry Crumbley, CPA, Cr.FA KPMG Endowed Professor Department of Accounting Louisiana State.

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Presentation on theme: "© D.L. Crumbley 1 Forensic Accounting Update Copyrighted 2001 D. Larry Crumbley, CPA, Cr.FA KPMG Endowed Professor Department of Accounting Louisiana State."— Presentation transcript:

1 © D.L. Crumbley 1 Forensic Accounting Update Copyrighted 2001 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.

2 © D.L. Crumbley 2 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.

3 © D.L. Crumbley 3 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

4 © D.L. Crumbley 4 Why Growth in Forensic Accounting 1.Increase in fraud. 2.Less loyalty to organization. 3.Employee mobility. 4.Change in societal values. a.Break-up of family unit. b.Less religious. c.Less ethics. 5.Computers replacing accounting functions. External accountants are looking for new jobs. 6.Higher insurance premiums for auditing. 7.Auditors became sales people. 8.Grade inflation/coursework deflation. 9.Enron/WorldCom/Xerox.

5 © D.L. Crumbley 5 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

6 © D.L. Crumbley 6 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.

7 © D.L. Crumbley 7 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.

8 © D.L. Crumbley 8 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

9 © D.L. Crumbley 9 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:

10 © D.L. Crumbley 10 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

11 © D.L. Crumbley 11 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.

12 © D.L. Crumbley 12 Top Niche Services Source: J.M. Covaleski, “Many Top 100 Growth Areas Revolve Around Synergy of CPA/Attorney Relationship,” Accounting Today, March 18-April 7, 2003, p Business Valuations78% 2. Estate Planning77% 3. Litigation Support73% 4. Mergers & Acquisitions61% 5. Business Mgt. Wealthy clients56% 6. Forensics/fraud55% 7. Employee benefits55% 8. Computer systems/consulting53%

13 © D.L. Crumbley 13 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.

14 © D.L. Crumbley 14 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.

15 © D.L. Crumbley 15 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.

16 © D.L. Crumbley 16 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),

17 © D.L. Crumbley 17 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.

18 © D.L. Crumbley 18 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.

19 © D.L. Crumbley 19 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.

20 © D.L. Crumbley 20 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

21 © D.L. Crumbley 21 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].

22 © D.L. Crumbley 22 “Rather than combing torn clothing,” forensic accountants “comb through corporate books, looking for oddities that could signal swindles,” says Bruce Dubinsky. Investigations can be extremely complex, with crates and crates of documents and thousands of computer files. Investigators look for flags or patterns that would not normally occur. Source: Mark Maremont, “Tyco Is Likely to Report New Woes,” Wall Street Journal, April 30, 2003, p. C-1. Forensic Accountants

23 © D.L. Crumbley 23 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.

24 © D.L. Crumbley 24 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.

25 © D.L. Crumbley 25 Six Areas of Litigation Services 4)Valuation *Business and professional practices *Pension *Intangibles *Property 5)General Consulting *Actuarial analyses *Statistical analyses *Projections *Industrial engineering *Market analyses *Computer consulting 6)Analyses *Tax bases *Cost allocations *Tax treatment of specific transactions 1)Damages *Lost profits *Lost value *Lost cash flow *Lost revenue *Extra cost 2)Antitrust Analysis *Price-fixing *Market share, market definition *Pricing below cost *Dumping and other price distribution *Anti-competition actions *Monopolization 3)Accounting *Bankruptcy *Tracing *Contract cost and claims *Regulated industries *Frauds (civil and criminal) *Historical analyses *Family law Source: Management Advisory Services Technical Consulting Practice Aid 7: Litigation Services, (AICPA, 1986)

26 © D.L. Crumbley 26 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 Definition

27 © D.L. Crumbley 27 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: Deep Pockets

28 © D.L. Crumbley 28 As part of the securitization agreement, UC agreed to pay the principal and interest on defaulted loans. Creditors contend that UC failed to account for the interest it was paying, and D&T should have caught the mistake earlier. After UC wrote off $605 million in debt, the company filed for bankruptcy. Confidential mid-court settlement. Source: Adrian Angelette, “United Companies Settlement Reached,” Baton Rouge Advocate, October 31, 2003, pp. A-1 and A-12 Auditors Blamed (cont.)

29 © D.L. Crumbley 29 Forensic Accounting Knowledge Base LAW Investigative auditing Accounting Criminology Forensic Accountant

30 © D.L. Crumbley 30 Forensic Accountant Criminology Accounting Computer Science Law Investigative Auditing © Hugh M. Christensen Forensic Accountant’s Knowledge Base

31 © D.L. Crumbley 31 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.

32 © D.L. Crumbley 32 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.

33 © D.L. Crumbley 33 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.

34 © D.L. Crumbley 34 Investigative Techniques “You know how it goes,” I said. “You get a case. You just keep poking around, see what scurries out.” p “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 – Source: R.B. Parker, Widow’s Walk, Berkley Books, 2002.

35 © D.L. Crumbley 35 Government Created FA Generally, forensic accounting was created by government agencies, and Government agencies have caused the growth in forensic accounting.

36 © D.L. Crumbley 36 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.

37 © D.L. Crumbley 37 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

38 © D.L. Crumbley 38 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: 1. academic institutions, 2. students, and 3. 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 Universities (cont.)

39 © D.L. Crumbley 39 ProfessorsPractitioners RankMeanCurriculum ContentRankMean 14.56Fundamentals of Fraud Financial statement fraud Types of fraud (employees,management) Cooking the books and problems in accounting Three Elements of fraud Anti-fraud controls Internal control evaluation Theory and methodology of fraud examination Principles of ethics and corporate code of conduct Fraud detection and deterrence Analytical Review procedures Effective report writing Techniques in locating hidden assets Shareholder litigation Expert testimony and expert witness techniques Litigation consulting techniques Curriculum Content

40 © D.L. Crumbley 40 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.

41 © D.L. Crumbley 41 Phrase “Forensic Accounting” Is Born Maurice E. Peloubet coined the phrase in print in 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

42 © D.L. Crumbley 42 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.

43 © D.L. Crumbley 43 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

44 © D.L. Crumbley 44 Be like

45 © D.L. Crumbley 45 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.

46 © D.L. Crumbley 46 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.

47 © D.L. Crumbley 47 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.

48 © D.L. Crumbley 48 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.

49 © D.L. Crumbley 49 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 (www.nifa.co.uk/services.htm). English group of 16 specialist accounting practices.www.nifa.co.uk/services.htm 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.

50 © D.L. Crumbley 50 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.

51 © D.L. Crumbley 51 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

52 © D.L. Crumbley 52 “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 Quotes

53 © D.L. Crumbley 53 “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) Foreign Language

54 © D.L. Crumbley 54 Three Branches of Government  Executive (regulations)  Legislative law [takes precedence]  Judicial law [a referee]

55 © D.L. Crumbley 55 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 Civil Procedure

56 © D.L. Crumbley 56 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 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

57 © D.L. Crumbley 57 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, Hard To Convict

58 © D.L. Crumbley 58 “Well you do what you do, and you pay for your sins.” Tim McGraw’s “Red Ragtop” Tim McGraw’s Position

59 © D.L. Crumbley 59 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 Knowledge of Legal Concepts Necessary

60 © D.L. Crumbley 60 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 (3 rd Cir. 1962).

61 © D.L. Crumbley 61  Our purpose: Assist the trier of the facts.  Question of Facts v. Question of Law [not always clear].  Negligence may be either. Expert Witnessing

62 © D.L. Crumbley 62 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.

63 © D.L. Crumbley 63 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).

64 © D.L. Crumbley 64 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.

65 © D.L. Crumbley 65 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

66 © D.L. Crumbley 66 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

67 © D.L. Crumbley 67

68 © D.L. Crumbley 68 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.

69 © D.L. Crumbley 69 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.

70 © D.L. Crumbley 70 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, 5 th 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).

71 © D.L. Crumbley 71 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.

72 © D.L. Crumbley 72 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.) ADMINISTRATIVE AGENCIES (In some cases, appeals to a U.S. District Court, instead of the circuit courts.) U.S. DISTRICT COURTS 50 States Washington, D.C., Puerto Rico, Virgin Islands, Guam U.S. COURT OF INTERNATIONALT RADE (Created in 1980, formerly the 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. MAGISTRATES U.S. BANKRUPTCY COURTS U.S. Tax Court 19 judges, with 1 judge hearing most tax cases

73 © D.L. Crumbley 73 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). Facts Determination

74 © D.L. Crumbley 74 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 ). Helpfulness

75 © D.L. Crumbley 75 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.”

76 © D.L. Crumbley 76 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

77 © D.L. Crumbley 77 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. The Judge Controls

78 © D.L. Crumbley 78 Motions Motion: Requests a rule or order in favor of the applicant Source: Babitsky et. al, The Comprehensive Forensic Manual, Seak, Inc., 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.

79 © D.L. Crumbley 79 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.

80 © D.L. Crumbley 80 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]

81 © D.L. Crumbley 81 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)

82 © D.L. Crumbley 82 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.

83 © D.L. Crumbley 83 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.

84 © D.L. Crumbley 84 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)

85 © D.L. Crumbley 85 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

86 © D.L. Crumbley 86 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).

87 © D.L. Crumbley 87 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).

88 © D.L. Crumbley 88 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.

89 © D.L. Crumbley 89 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 e- mail 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.

90 © D.L. Crumbley 90 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.

91 © D.L. Crumbley 91 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).

92 © D.L. Crumbley 92 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.

93 © D.L. Crumbley 93 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.

94 © D.L. Crumbley 94 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.

95 © D.L. Crumbley 95 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?

96 © D.L. Crumbley 96 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. Getting Paid

97 © D.L. Crumbley 97 Incentive Test 1.A(n) ______ is a device used by courts to have disputing parties to agree in advance of a trial to facts, evidence, etc. 2.A(n) _____ _____ brief is filed by a party not directly related to a lawsuit. 3.The _____ _____ doctrine states that a case once decided will control. 4.The appropriate court to bring a dispute is called _____. 5.______ is opinions of a judge which goes beyond the facts before the court and are not binding on future courts as precedent. 6.A higher court ______ a lower court decision and sends it back for further consideration. 7.You file a writ of ______ to ask the Supreme Court to hear your dispute. 8._____ _____ refers to a decision of the full court. 9.A ________ is a written statement of a witness under oath, often in a question/answer format.

98 © D.L. Crumbley 98 Incentive Test 10.The ____ _____ is preliminary questioning by the court (or lawyer) of jurors to determine competency. 11.A motion in _____ is a request before trial that evidence (or expert) of opposing side is inadmissible. 12.The complaint and answer would be called the _____. 13.The _____ is the person sued. 14.A subpoena _____ _____ is a command to produce documents to a court that become evidence. 15.A subpoena _____ _____ is a command to appear and testify as a witness. 16.A(n) _____ _____ is appointed by a court or judge to decide certain facts, etc. 17.Models, forms, and exhibits would be considered ______ evidence. 18.______ ______ means a party is representing himself.

99 © D.L. Crumbley 99 Incentive Test 1.A(n) stipulation is a device used by courts to have disputing parties to agree in advance of a trial to facts, evidence, etc. 2.A(n) amicus curiae brief is filed by a party not directly related to a lawsuit. 3.The stare decisis doctrine states that a case once decided will control. 4.The appropriate court to bring a dispute is called venue. 5.Dicta is opinions of a judge which goes beyond the facts before the court and are not binding on future courts as precedent. 6.A higher court remands a lower court decision and sends it back for further consideration. 7.You file a writ of certiorari to ask the Supreme Court to hear your dispute. 8.En banc refers to a decision of the full court. 9.A deposition is a written statement of a witness under oath, often in a question/answer format.

100 © D.L. Crumbley 100 Incentive Test 10.The voir dire is preliminary questioning by the court (or lawyer) of jurors to determine competency. 11.A motion in limine is a request before trial that evidence (or expert) of opposing side is inadmissible. 12.The complaint and answer would be called the pleadings. 13.The respondent is the person sued (defendant). 14.A subpoena duces tecum is a command to produce documents to a court that become evidence. 15.A subpoena ad testificandum is a command to appear and testify as a witness. 16.A(n) special master is appointed by a court or judge to decide certain facts, etc. 17.Models, forms, and exhibits would be considered demonstrative evidence. 18.Pro se means a party is representing himself.

101 © D.L. Crumbley 101

102 © D.L. Crumbley 102 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.

103 © D.L. Crumbley 103 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.

104 © D.L. Crumbley 104 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.

105 © D.L. Crumbley 105 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).

106 © D.L. Crumbley 106 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.

107 © D.L. Crumbley 107 Deductive vs. Inductive Source: W.S. Albrecht and C.C. Albrecht, “Root Out Financial Deception,” Journal of Accountancy (April 2002), p. 33. Deductive ApproachInductive Approach Generic data miningCustom data mining Digital analysisAnalysis of all data Discovery sampling Generic softwareCustom software For smaller organizationsFor larger organizations Basic featuresSophisticated features Easy to learnRequires advanced skills Relatively inexpensiveMore expensive  Deductive: one goes from general to specific; fairly simple and economical.  Inductive: one starts with specific experiences and then draws inferences.

108 © D.L. Crumbley 108 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,

109 © D.L. Crumbley 109 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.

110 © D.L. Crumbley 110 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%

111 © D.L. Crumbley 111 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.

112 © D.L. Crumbley 112 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: 1.Accounting-forensic units of big CPA firms. 2.Data-recovery and computer-repair specialists, 3.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, byron.html

113 © D.L. Crumbley 113 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.

114 © D.L. Crumbley 114 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.

115 © D.L. Crumbley 115 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.

116 © D.L. Crumbley 116 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.

117 © D.L. Crumbley 117 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.

118 © D.L. Crumbley 118 Federal Rules of Evidence 702 – 705 (deal with expert witnesses) Rule Testimony by Experts a)"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) b)Fed.R.Evid. Rule 702 requires the Trial Court to perform the gatekeeper role described in Daubert regarding all expert testimony 1)Proffered expert testimony must be both relevant and reliable to be admissible

119 © D.L. Crumbley 119 Federal Rules of Evidence Section 702 Comparative Analysis Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, Generally, if you meet the applicable AICPA professional standards, you probably meet Rule 702.

120 © D.L. Crumbley 120 a)“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.” b)Sources of information an expert may use include: 1)Firsthand knowledge 2)Information admitted into evidence during the trial 3)Information made known to the expert before the trial 4)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 Basis of Opinion Testimony by Experts

121 © D.L. Crumbley 121 Rule Opinion on Ultimate Issue a)"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." 1)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 a)"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.” 1)Experts are, generally, allowed to testify about their opinions or give reasons for their opinions without first testifying about the underlying facts or data. 2)The court may require the expert to disclose the underlying facts or data during cross- examination.

122 © D.L. Crumbley 122 Rule 706 – Court-Appointed Experts a)The Court has the authority to appoint an expert whom all parties may cross-examine when: 1)The Court believes the experts for the litigants are “hired guns,” and their testimony is unreliable or prejudicial. 2)The proffered expert opinions have failed to adequately explain the complex issues upon which the Court must decide. b)The Court has ultimate discretion regarding the admissibility of all expert testimony

123 © D.L. Crumbley 123 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.

124 © D.L. Crumbley 124 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.

125 © D.L. Crumbley 125 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).

126 © D.L. Crumbley 126 a) Rule 401 – Definition of “Relevant Evidence” a)Evidence is relevant if it tends to prove or disprove an alleged fact. b) Rule 402 – Relevant Evidence Generally Admissible; Irrelevant Evidence Inadmissible 1)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 1)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. Relevancy and its limits (evidence)

127 © D.L. Crumbley 127 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.

128 © D.L. Crumbley 128 Hearsay (evidence) Rule 803 – Hearsay Exceptions; Availability of Declarant Immaterial a)Generally, hearsay is not admissible as evidence. b)Exceptions relating to expert testimony 1.Business records such as memoranda, reports, records, or data compilations kept on a regular basis by a person with knowledge 2.Public records; such as records, reports, statements, or data compilations kept by public offices or agencies 3.Market reports and commercial publications; such as market quotations, lists, directories, etc. relied on by the public 4.Learned treatises; such as almanacs of business information and technical literature 5.Missing business records; reports normally prepared daily or the fact that they were not prepared is admissible c)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 d)Experts are not required to prove that the information upon which they have relied is trustworthy a)May be grounds for a Daubert/Kumho challenge if confirmation is required or recommended by standards of practice.

129 © D.L. Crumbley 129 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.

130 © D.L. Crumbley 130  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.

131 © D.L. Crumbley 131 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.

132 © D.L. Crumbley 132 Six Ways to Discredit Testimony 1.If an expert, the witness is not qualified. 2.The witness did not consider all the facts. 3.The witness relied on erroneous facts. 4.If an expert, the witness’s conclusions do not follow from a correct analysis of the facts. 5.The witness’s testimony is inconsistent with prior testimony. 6.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, 5 th, Fort Worth: Practitioners Publishing, 2002, p. 8 – 39.

133 © D.L. Crumbley 133 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.

134 © D.L. Crumbley 134 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

135 © D.L. Crumbley 135 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.

136 © D.L. Crumbley 136 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).

137 © D.L. Crumbley 137 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

138 © D.L. Crumbley 138 Qualifying as an Expert Witness 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

139 © D.L. Crumbley 139 Qualifying as an Expert Witness 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.

140 © D.L. Crumbley 140 Qualifying as an Expert Witness 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

141 © D.L. Crumbley 141 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 5 th factor)

142 © D.L. Crumbley 142 Kumho Tire Co. Ltd. v. Carmichael, 119 S.Ct (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.

143 © D.L. Crumbley 143 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.” Kumho Tire

144 © D.L. Crumbley 144 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

145 © D.L. Crumbley 145 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 Rejecting Experts

146 © D.L. Crumbley 146 Searchable Databases of Daubert Decisions 1.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.www.mdexonline.com

147 © D.L. Crumbley 147 Searchable Databases of Daubert Decisions (contd …) 2.“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,0.838 Marketing experts,0.500 Polygraphers,0.148 Toxicologists,0.375

148 © D.L. Crumbley 148 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)

149 © D.L. Crumbley 149 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

150 © D.L. Crumbley 150 Testifying 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 Expert witnesses can expect to be asked about the following at a deposition: Source: Crumbley, Heitger & Smith, Forensic and Investigative Accounting, 2003, p. 8-13

151 © D.L. Crumbley 151 Differences Between Fact and Expert Witness Source: D.R. Carmicael, et. al, Fraud Detection, 5 th, Fort Worth: Practitioners Publishing, 2002, p FACTEXPERT 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. TrainingNo 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. TestimonyFacts 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 feesThe 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.

152 © D.L. Crumbley 152 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.

153 © D.L. Crumbley 153 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.

154 © D.L. Crumbley 154 Three Approaches to Testifying 1.Express opinion based upon facts personally observed, or facts communicated to him by another expert. 2.Be present in courtroom and express opinion on such evidence (that is not in dispute). 3.Base an opinion on a hypothetical question embracing evidence in the record. Source: J.R. Waltz, Evidence, New York: Foundation Press, 1999, p. 15.

155 © D.L. Crumbley 155 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.

156 © D.L. Crumbley 156 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.

157 © D.L. Crumbley 157 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.

158 © D.L. Crumbley 158 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

159 © D.L. Crumbley 159 Citators  Commerce Clearing House Citator (taxation)  Research Institute of America PH Citator and Citator 2 nd 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.

160 © D.L. Crumbley 160

161 © D.L. Crumbley 161  Shepard’s  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). Citators (cont.)

162 © D.L. Crumbley 162 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.,

163 © D.L. Crumbley 163 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.,

164 © D.L. Crumbley 164 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.

165 © D.L. Crumbley 165 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)] Risk Management

166 © D.L. Crumbley 166 Witness Immunity State: State of Washington States Ignoring Immunity: Alaska California Connecticut Louisiana Missouri New Jersey [court appointed] Pennsylvania Texas West Virginia You Can Be Sued

167 © D.L. Crumbley 167 A client may win a breach of contract dispute by showing that the expert failed to (a) perform a specific contracted service, (b) perform the service in a timely fashion, (c) perform in a satisfactory manner, or (d) 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. Breach of Contract Source: “Breach of Contract” (New York Practicing Law Institute, January 2000), Ch. 3.2[B].

168 © D.L. Crumbley 168 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. Lack of Immunity

169 © D.L. Crumbley Guidelines to Meet Potential Legal Challenges 1.Know the relevant professional standards 2.Apply the relevant professional standards 3.Know the relevant professional literature 4.Know the relevant professional organizations 5.Use generally accepted analytical methods 6.Use multiple analytical methods 7.Summarize the conclusions of the multiple analytical methods 8.Disclose all significant analytical assumptions and variables 9.Subject the analysis to peer review 10.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

170 © D.L. Crumbley 170 Source: Ballentine’s Law Dictionary 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.

171 © D.L. Crumbley 171 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.

172 © D.L. Crumbley 172 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

173 © D.L. Crumbley 173  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, Ten Commandments for Depositions

174 © D.L. Crumbley 174 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.

175 © D.L. Crumbley 175 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. Getting to Experts Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 57.

176 © D.L. Crumbley 176 Seven Answers at Deposition 1.Yes. 2.No. 3.Green. 4.I don’t know. 5.I don’t remember. 6.I don’t understand the question. 7.I need a break. Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 81.

177 © D.L. Crumbley 177 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.

178 © D.L. Crumbley 178 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. Federal Rule of Evidence 803(18) Source: D.M. Malone and P.J. Zwier, Effective Expert Testimony, Notre Dame, IN: NITA, 2000, p. 73.

179 © D.L. Crumbley 179 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. Jerry Lee Lewis 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).

180 © D.L. Crumbley 180

181 © D.L. Crumbley 181  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, Cross Examination Tactics

182 © D.L. Crumbley 182 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.

183 © D.L. Crumbley 183 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

184 © D.L. Crumbley 184 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

185 © D.L. Crumbley 185 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

186 © D.L. Crumbley 186 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

187 © D.L. Crumbley 187 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

188 © D.L. Crumbley 188 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.”. 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.” 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. 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

189 © D.L. Crumbley 189 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.

190 © D.L. Crumbley 190 “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. Judge’s Instructions to Jury:

191 © D.L. Crumbley 191 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

192 © D.L. Crumbley 192 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

193 © D.L. Crumbley 193 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

194 © D.L. Crumbley 194 Why Financial Experts Fail 1.The financial expert does not know the case story (e.g., the strategic messages). 2.Expert never develops home base messages, or develop the wrong ones (short simple messages). 3.Inconsistencies between direct and cross- examination. 4.Unnecessary use of jargon and terms or art. 5.Insufficient meaningful practice. Source: D.S. Scott and R. Laguzza, “Communication With The Jury,” Litigation Services Handbook, John Wiley, 2001, pp and

195 © D.L. Crumbley 195 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

196 © D.L. Crumbley 196 Evidence  Best evidence rule: 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”?

197 © D.L. Crumbley 197 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.

198 © D.L. Crumbley 198 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.

199 © D.L. Crumbley 199 Criminal Proceedings  No plaintiff, but a prosecutor.  A criminal defendant.  Due process is stronger.  Burden of proof beyond a reasonable doubt.  4 th Amendment, search and seizures.  5 th 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.

200 © D.L. Crumbley 200 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.

201 © D.L. Crumbley 201 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.

202 © D.L. Crumbley 202 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).

203 © D.L. Crumbley 203 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.

204 © D.L. Crumbley 204 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.

205 © D.L. Crumbley 205 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).

206 © D.L. Crumbley 206 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.

207 © D.L. Crumbley 207 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).

208 © D.L. Crumbley 208 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.

209 © D.L. Crumbley 209 EXPOSURE DRAFT STATEMENT ON RESPONSIBILITIES FOR LITIGATION SERVICES NO. 1 December 1, 2001 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

210 © D.L. Crumbley 210 Litigation Services  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

211 © D.L. Crumbley 211 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.

212 © D.L. Crumbley 212 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.

213 © D.L. Crumbley 213 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.

214 © D.L. Crumbley 214 Three guidelines for admissibility of expert testimony a.The testimony should assist the trier of fact to understand the evidence or to determine a fact in issue. b.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 c.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.

215 © D.L. Crumbley 215 Pyramid of Standards and Responsibilities Source: AICPA Proposed Statement on Responsibilities for Litigation Services No. 1, December 1, 2001.

216 © D.L. Crumbley 216 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.

217 © D.L. Crumbley 217 Professional Responsibility AICPA Standards Code of Professional Conduct Rule 102: Objectivity and integrity 1.Conflict of interests  expert accepts work against the interest of an existing client.  make conflict search of names before receiving confidential information. 2.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.

218 © D.L. Crumbley 218 Understanding With The Attorney a.Identification of the attorney’s client b.The title of the litigation, including the litigants’ names, the court, and docket number c.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 d.An identification of the expert witness or the willingness of the person who will be the expert witness if necessary e.Reference to the absence or existence of conflicts of interest f.The absence or existence of the attorney’s work product privilege g.Restrictions of the use or exposure of the CPA’s work h.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.

219 © D.L. Crumbley 219 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.

220 © D.L. Crumbley 220 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

221 © D.L. Crumbley 221 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.

222 © D.L. Crumbley 222 Table 1: Base Fine Offense LevelAmount 6 or less$5,000 77, , , , , , , , , , ,000 37$57.5 million million Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61.

223 © D.L. Crumbley 223 Table 2: Culpability Level Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61. ActivityPenalty Conviction+5 Tolerating, condoning, and willfully ignoring +4 Prior history+1 or +2 Violating judicial order+1 or +2 Obscuring justice+3

224 © D.L. Crumbley 224 Table 3: Multiplier Source: Itamar Sittenfeld, “Federal Sentencing Guidelines,” Internal Auditor, April 1996, p. 61. Culpability Score Minimum Multiplier Maximum Multiplier 10 or more or less

225 © D.L. Crumbley 225 Good News Table * 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. ActivityScore* Self-reporting to authoritiesminus 5, or Cooperating with authoritiesminus 2 or Accepting responsibilityMinus 1 (whichever of the three above is higher) Effective compliance programminus 3

226 © D.L. Crumbley 226 Some Accountants believe that ethics is a place in England. Essex, U.K Fraud A statement made by Mark Twain about New England weather applies to fraud and corruption: “It’s hard to predict, but everyone agrees there’s plenty of it.” As Sherlock Holmes said, “the game is afoot.”

227 © D.L. Crumbley 227 Sarbanes-Oxley Act ( ) 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

228 © D.L. Crumbley 228 Sarbanes-Oxley Act ( ) 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.

229 © D.L. Crumbley 229 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.

230 © D.L. Crumbley 230 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.

231 © D.L. Crumbley 231 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.

232 © D.L. Crumbley 232 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.

233 © D.L. Crumbley 233 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.

234 © D.L. Crumbley 234 Acceptable Non-audit Services (cont.) 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.

235 © D.L. Crumbley 235 Acceptable Non-audit Services (cont.) 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.

236 © D.L. Crumbley 236 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.

237 © D.L. Crumbley 237 Sarbanes-Oxley (contd.) Many of the Sarbanes-Oxley’s provisions became effective July 30, Networkwww.tnwinc.com 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.

238 © D.L. Crumbley 238 SEC’s Proposed Rules ( ) Auditor may not 1.Audit own work. 2.Perform management function. 3.Act as an advocate of a client.  Traditional tax preparation service okay: preparation of tax returns. tax compliance. tax planning. tax recovery. other tax-related services.  Reviewing tax accruals is audit service.  Tax Court representation would impair an auditor’s independence.  Formation of tax strategies (e.g., tax shelters) is not okay.  Unknown: Tax opinions for tax shelters.  The audit committee must weigh the risk associated with using the company auditor for tax services versus the cost savings of using the company auditor. Source: Sheryl Stratton, “SEC Seeks Input on Defining Scope of Tax Service,” Tax Notes, December 9, 2002, pp – 1266.

239 © D.L. Crumbley 239 Sarbanes-Oxley Act Creates Need For Forensic Accounting 1.To assist corporations in their quest to ensure compliance with the mandates of S-O. 2.Public accounting firms must introduce forensic techniques into audits, and they may request help from forensic experts.

240 © D.L. Crumbley 240 Assistance of Forensic Accountants 1.S-O requires principal executives and financial officer to certify annual and quarterly reports. 2.Certification must cover internal controls, disclosure controls, and fraud. Need for a Chief Forensic Officer? The SEC suggests the entity assign the duties of monitoring internal controls to a specific individual. SEC suggests a disclosure committee, also. 3.Officers and directors are prohibited from influencing, coercing, manipulating, or misleading the accountant performing the independent audit. 4.Civil and criminal penalties against officers for violations of S-O. 5.Auditors workpaper retentions for five years. 6.PCAOB shall adopt auditing standards. 7.SEC may censure auditors.

241 © D.L. Crumbley 241 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.

242 © D.L. Crumbley 242 Michael Comer’s Types of Fraud 1.Corruptions (e.g., kickbacks). 2.Conflicts of interest (e.g., drug/alcohol abuse, part-time work). 3.Theft of assets. 4.False reporting or falsifying performance (e.g., false accounts, manipulating financial results). 5.Technological abuse (e.g., computer related fraud, unauthorized Internet browsing). Comer’s Rule: Fraud can happen to anyone at anytime. Source: M.J. Comer, Investigating Corporate Fraud, Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5.

243 © D.L. Crumbley 243 Starwoods Hotels Poll of Executives Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA Today, June 26, 2002, p. A-1. Consider themselves to be honest in business 99% Played with someone who cheats at golf87% Cheated themselves at golf82% Hated others who cheated at golf82% Believe that business and golf behaviors are parallel 72% Starwoods Hotels interviewed 401 top executives who golf. The results are surprising.

244 © D.L. Crumbley 244 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

245 © D.L. Crumbley 245 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

246 © D.L. Crumbley 246 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.

247 © D.L. Crumbley 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”

248 © D.L. Crumbley 248 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.

249 © D.L. Crumbley 249 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.

250 © D.L. Crumbley 250 SEC’s Definition of Fraud It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or the mails, or of any facility of any national securities exchange, a)To employ any device, scheme, or artifice to defraud, b)To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or c)To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. SEC Rule 106-5

251 © D.L. Crumbley 251 Foreign Corrupt Practices Act of 1977 Public companies shall maintain adequate internal controls: A)Make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of issuer; and B)Devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that- 1) transactions are executed in accordance with management’s general or specific authorization; 2)transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements…. FCPA Section 102

252 © D.L. Crumbley 252 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).

253 © D.L. Crumbley 253 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.

254 © D.L. Crumbley 254 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): 1)Known history of securities law violations (14.6%) 2)Significant compensation tied to aggressive accounting practices (12.9%) 3)Management’s failure to display appropriate attitude about internal controls (12.6%) Source: B.A Apostolou et.al, “The Relative Importance of Management Risk Factors,” Behavioral Research in Accounting, January 1, 2001, pp

255 © D.L. Crumbley 255 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 Something is material if there is a substantial likelihood that a reasonable person would consider it important.

256 © D.L. Crumbley 256 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.

257 © D.L. Crumbley 257 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.

258 © D.L. Crumbley 258 COSO’s Most Common Fraud Methods 1.Overstatement of earnings. 2.Fictitious earnings 3.Understatement of expenses. 4.Overstatement of assets. 5.Understatement of allowances for accounts receivables. 6.Overstatements of the value of inventories by not writing down the value of obsolete goods. 7.Overstatement of property values and creation of fictitious assets.

259 © D.L. Crumbley 259 COSO’s Major Motives for Fraud 1.Cover up assets misappropriated for personal gain. 2.Increase the stock price to increase the benefits of insider traders and to receive higher cash proceeds when issuing new securities. 3.Obtain national stock exchange listing status or maintain minimum exchange listing requirements to avoid delisiting. 4.Avoiding a pretax loss and bolstering other financial results.

260 © D.L. Crumbley 260 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.

261 © D.L. Crumbley 261 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 “Far too many organizations are penny wise and pound foolish in their approach to internal controls staffing and monitoring….” p 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.

262 © D.L. Crumbley 262 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

263 © D.L. Crumbley 263 Restatements of Financial Statements Source: “An Analysis of Restatement Matters,” Huron Consulting Group, Reasons for 2002 restatements: 1.Accounting rules. 2.Human and system errors. 3.Fraudulent behavior. Although the number of public registrants have decreased by 14% since 1999, restatements have risen by 53%. Revenue recognition was the cause of 85 of the restatements (22%) in Arthur Andersen had averaged 11 restatements before In 2002, they had 40, with 26 after new auditors were retained.

264 © D.L. Crumbley 264 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.

265 © D.L. Crumbley 265 Triple Fraud Sting  A Michigan woman received an e- mail from a Nigerian asking her to set up a bank account in the U.S. in order to help him steal $18 million.  She set up the bank account (to help pay the so-called bribes and fees) by allegedly embezzling $2 million from her employer during seven months in  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,

266 © D.L. Crumbley 266 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.

267 © D.L. Crumbley 267 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

268 © D.L. Crumbley 268 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).

269 © D.L. Crumbley 269 Other Characteristics of Occupational Fraudsters:  Inquisitive  Rule breaker  Under stress  Financial need  Big spender  Close relationship with vendors / suppliers  Egotistical  Risk taker  Hard Worker  Greedy  Disgruntled or a complainer  Overwhelming desire for personal gain  Pressured to perform Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff,

270 © D.L. Crumbley 270 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.

271 © D.L. Crumbley 271 To be a forensic auditor, you have to have a knowledge of fraud, what fraud looks like, how it works, and how and why people steal. Source: Robert J. Lindquist "Finding fraud is like using a metal detector at a city dump to find rare coins. You're going to have a lot of false hits." - D. Larry Crumbley “Fraud can be best prevented by good people asking the right questions at the right time.” - Michael J. Comer Quotes

272 © D.L. Crumbley 272 “Finding fraud is like trying to load frogs on to a wheelbarrow.” Larry Crumbley

273 © D.L. Crumbley 273 Finding fraud is like trying to herd cats and chickens. There is a chicken catching machine (150 chickens per minute),* but there is no perfect fraud catching machine. D. Larry Crumbley * PH2000 mechanical chicken harvester. Scott Kilman, “Poultry in Motion: Chicken Catching Goes High Tech,” Wall Street Journal, June 4, 2003, p. A-1. Human can catch about 1,000 an hour. $200,000 cost. Fraud Catching

274 © D.L. Crumbley 274 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.”

275 © D.L. Crumbley 275 How Fraud Is Detected 1.Tips from employees (26.3%). 2.By accident (18.8%). 3.Internal audit (18.6%). 4.Internal controls (15.4%). 5.External audits (11.5%). 6.Tips from customers (8.6%). 7.Anonymous tips (6.2%). 8.Tips from vendors (5.1%). Therefore, 46.2% from tips. Source: 2002 Wells Report.

276 © D.L. Crumbley 276 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.

277 © D.L. Crumbley 277 Finding Fraud In The Midst of a Conspiracy When speaking about the fraud of HealthSouth, a spokesman for Ernst & Young emphasized the difficulty of detecting accounting fraud in the midst of a conspiracy of senior executives and false documentation. An accountant testified that HealthSouth employees would move expenses of $500 to $4,999 from the income statement to the balance sheet throughout the year. Overall the SEC said about $1 billion in fixed assets were falsely entered. The employees moved only those expenses less than $5,000, because Ernst & Young automatically looked at those expenses over $5,000. An ex-bookkeeper even sent Ernst & Young an e- mail flagging one area of the fraud, but E & Y still did not catch it. Employees actually produced false invoices when the accounting firm asked for back-up. Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1 and A-13.

278 © D.L. Crumbley 278 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.

279 © D.L. Crumbley 279 You should attack fraud problems the way the fictional Sherlock Holmes approached murder cases D. Larry Crumbley To be a good fraud auditor, you have to be a good detective. Source: Robert J. Lindquist Quotes

280 © D.L. Crumbley 280 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 Difficult Task

281 © D.L. Crumbley 281 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 Stealth

282 © D.L. Crumbley 282 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

283 © D.L. Crumbley 283 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, Kessler Survey (2001)

284 © D.L. Crumbley 284 SAS No. 99 Characteristics of Fraud Incentives / pressures Attitude / Rationalization Opportunity

285 © D.L. Crumbley 285  Motive  Excessive spending to keep up appearances of wealth.  Other, outside business financial strains.  An illicit romantic relationship.  Alcohol, drug or gambling abuse problems.  Opportunity  Lack of internal controls.  Perception of detection = proactive preventative measure.  Rationalization  “Borrowing” money temporarily.  Justifying the theft out of a sense of being underpaid.(“I was only taking what was mine”)  Depersonalizing the victim of the theft. (I wasn’t stealing from my boss; I was stealing from the company.”) Fraud Pyramid

286 © D.L. Crumbley 286 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 Financial Statements Fraud Formula- CRIME

287 © D.L. Crumbley 287 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

288 © D.L. Crumbley 288 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:

289 © D.L. Crumbley 289 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 Source:

290 © D.L. Crumbley 290 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:

291 © D.L. Crumbley 291 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:

292 © D.L. Crumbley 292 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 Source:

293 © D.L. Crumbley 293 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:

294 © D.L. Crumbley 294 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 Source:

295 © D.L. Crumbley 295 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:

296 © D.L. Crumbley 296 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:

297 © D.L. Crumbley 297 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:

298 © D.L. Crumbley 298 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:

299 © D.L. Crumbley 299 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:

300 © D.L. Crumbley 300 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:

301 © D.L. Crumbley 301 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:

302 © D.L. Crumbley 302 Which of these statements are false? a.A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting. b.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. c.A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting. d.An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting. e.Anticipated future layoff would be an example of an incentive to misappropriate assets. f.A large amount of cash on hand would be an example of a rationalization to misappropriate assets. g.Inadequate internal controls is an example of an opportunity to misappropriate assets.

303 © D.L. Crumbley 303 Which of these statements are false? a.A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting. F (I/P) b.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 c.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) d.An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting. T e.Anticipated future layoff would be an example of an incentive to misappropriate assets. T f.A large amount of cash on hand would be an example of a rationalization to misappropriate assets. F (O) g.Inadequate internal controls is an example of an opportunity to misappropriate assets. T

304 © D.L. Crumbley 304 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

305 © D.L. Crumbley 305 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.

306 © D.L. Crumbley 306 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.

307 © D.L. Crumbley 307 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.

308 © D.L. Crumbley 308 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.

309 © D.L. Crumbley 309 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.

310 © D.L. Crumbley 310 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

311 © D.L. Crumbley 311 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

312 © D.L. Crumbley 312 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

313 © D.L. Crumbley 313 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.

314 © D.L. Crumbley 314 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.

315 © D.L. Crumbley 315 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.

316 © D.L. Crumbley 316 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.

317 © D.L. Crumbley 317 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

318 © D.L. Crumbley 318 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.

319 © D.L. Crumbley 319 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.

320 © D.L. Crumbley 320 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.

321 © D.L. Crumbley 321 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.www.talion.com/embezzle.htm

322 © D.L. Crumbley 322 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.

323 © D.L. Crumbley 323 Comparison of Auditing and Forensic Examination Source: Apostolou, B, “Course : Fundamentals of Fraud Detection and Prevention,” www.education.smartpros.com IssueAuditForensic Examination TimingRecurring: audits are conducted on a regular basis Nonrecurring: fraud examinations are nonrecurring. They are conducted only with sufficient predication. ScopeGeneral: collection of sufficient, competent data to support the opinion rendered. Specific: the fraud examination is conducted to resolve specific allegations. ObjectiveOpinion: express opinion on financial statements Affix blame: determine if fraud occurred and who is responsible. Adversarial in nature. MethodologyAudit techniques applied primarily to financial data. Fraud examination techniques include document examination, public record searches, and interviews. PresumptionProfessional skepticismProof to support or refute an allegation of fraud.

324 © D.L. Crumbley 324 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.

325 © D.L. Crumbley 325 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.

326 © D.L. Crumbley 326 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.

327 © D.L. Crumbley 327 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.

328 © D.L. Crumbley 328 Auditing Internal Controls The audit of internal controls includes these steps: 1.Planning the audit. 2.Evaluating the process management used to perform its assessment of internal control effectiveness. 3.Obtaining an understanding of the internal controls. 4.Evaluating the effectiveness of both the design and operation of the internal controls. 5. Forming an opinion about whether internal controls over financial reporting is effective. Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.

329 © D.L. Crumbley 329 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.

330 © D.L. Crumbley 330 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.

331 © D.L. Crumbley 331 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.

332 © D.L. Crumbley 332 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.

333 © D.L. Crumbley 333 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).

334 © D.L. Crumbley 334 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.”

335 © D.L. Crumbley 335 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, 5 th, Fort Worth: Practitioners Publishing, 2002, p. 2 – 4.

336 © D.L. Crumbley 336 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

337 © D.L. Crumbley 337 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.]

338 © D.L. Crumbley 338 Source: Michael Kurland, How to Solve A Murder: Macmillan, 1995, pp. 7-8 Guilt Pyramid

339 © D.L. Crumbley 339 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.

340 © D.L. Crumbley 340 Source: KPMG Fraud Study How Fraud Occurs

341 © D.L. Crumbley 341 Measures Helpful in Preventing Fraud 1.Strong Internal Controls (1.62) 2.Background checks of new employees (3.70) 3.Regular fraud audit (3.97) 4.Established fraud policies (4.08) 5.Willingness of companies to prosecute (4.47) 6.Ethical training for employees (4.86) 7.Anonymous fraud reporting mechanisms (5.02) 8.Workplace surveillance (6.07) 1 = Most effective 8 = Least effective Source: 2002 Wells Report

342 © D.L. Crumbley 342 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.”

343 © D.L. Crumbley 343 SAS No. 99 Recommendations Brainstorming. Increased emphasis on professional skepticism. Discussions with management. Unpredictable audit tests. Responding to management override of controls.

344 © D.L. Crumbley 344 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.http://www.pcaob.us

345 © D.L. Crumbley 345 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.

346 © D.L. Crumbley 346 When Fraud Is Discovered 1.Notify management or the board when the incidence of significant fraud has been established to a reasonable certainty. 2.If the results of a fraud investigation indicate that previously undiscovered fraud materially adversely affected previous financial statements, for one or more years, the internal auditor should inform appropriate management and the audit committee of the board of directors of the discovery. 3.A written report should include all findings, conclusions, recommendations, and corrective actions taken. 4.A draft of the written report should be submitted to legal counsel for review, especially where the internal auditor chooses to invoke client privilege.

347 © D.L. Crumbley 347 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.

348 © D.L. Crumbley 348 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.

349 © D.L. Crumbley 349 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”

350 © D.L. Crumbley 350 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.”

351 © D.L. Crumbley 351 SKEPTICISM Ronald Reagan said with respect to Russia, “Trust, but verify.” FA’s motto should be “Trust no one; question everything; verify.”

352 © D.L. Crumbley 352 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.”

353 © D.L. Crumbley 353 “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 Example of Management Override/Skepticism

354 © D.L. Crumbley 354 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.

355 © D.L. Crumbley 355 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.

356 © D.L. Crumbley 356 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.

357 © D.L. Crumbley 357 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?

358 © D.L. Crumbley 358 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.

359 © D.L. Crumbley 359 Covert Aspects Attitudes Feelings (Fear, Anger, etc.) Values Norms Interaction Supportiveness Satisfaction Overt Aspects Hierarchy Financial Resources Goals of the Organization Skills and Abilities of Personnel Technological State Performance Measurement Behavioral Considerations Water line Thinking as a Forensic Auditor Structural Considerations The Iceberg Theory of Fraud Source: G.J. Bologna and R.J. Lindquist, Fraud Auditing and Forensic Accounting, 2 nd Edition, New York: John Wiley, 1995, pp

360 © D.L. Crumbley 360 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

361 © D.L. Crumbley 361 Investigative Techniques “Facts weren’t the most important part of an investigation, the glue was. He said the glue was made of instinct, imagination, sometimes guesswork and most times just plain luck.” (p. 163) “In his job, he [Bosch] learned a lot about people from their rooms, the way they lived. Often the people could no longer tell him themselves. So he learned from his observations and believed that he was good at it.” (p. 31) Michael Connelly, The Black Ice, St. Martin’s Paperbacks, 1993.

362 © D.L. Crumbley 362 Three Major Phases of Fraud 1.The Act itself. 2.The concealment of the fraud (in financial statements). 3.Conversion of stolen assets to personal use. One can study any one of these phases. Examples: Things being stolen: conduct surveillance and catch perp. If liabilities being hidden, look at financial statements for concealment. If perp has unexpected change in financial status, look for source of wealth. Source: Cindy Durtschi, “The Tallahassee Bean Counters: A Problem-Based Learning Case in Forensic Audit,” Issues in Accounting Education, Vol. 18, No. 2, May 2003, pp

363 © D.L. Crumbley 363 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.

364 © D.L. Crumbley 364 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,

365 © D.L. Crumbley 365 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 “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 Sources: Burns, “Combating Corruption,” Internal Auditor, June 1997, p. 56; J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003

366 © D.L. Crumbley 366 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 A company should have a fraud risk assessment performed of their controls, procedures, systems, and operations. J.W. Koletar, p Sources: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003

367 © D.L. Crumbley 367 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 care