Strategies for Detecting & Preventing Fraud D. Larry Crumbley, CPA, Cr

Strategies for Detecting & Preventing Fraud D. Larry Crumbley, CPA, Cr
Strategies for Detecting & Preventing Fraud D. Larry Crumbley, CPA, Cr.FA, CFD, FCPA 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 Risk, Former chair of the Executive Board of Accounting Advisors of the American Board of Forensic Accountants, Member of the NACVA’s Fraud Deterrence Board, and On the AICPA’s Fraud Task Force ( ). A frequent contributor to the Forensic Examiner, Professor Crumbley is a co-author of CCH Master Auditing Guide, along with more than 50 other books and 350 articles. His latest book entitled Forensic and Investigative Accounting is published by Commerce Clearing House ( ). Some of his 12 educational novels have as the main character a forensic accountant. His goal is to create a television series based upon the exciting life of a forensic accountant and litigation consultant.

Forensic Report

TALLY STICKS

Puff Adder Australia annual fraud, 2003, $5.8 billion or 1.147% of GDP.

Glimpse Forward Overview of Forensic Accounting
Persuasiveness/ Costs of Fraud/ Abuse COSO’s Model After FRA: Detection and Investigation Misappropriation of Assets/ Cooking the Books Detection, Investigation, and Deterrence Types of Misappropriations Procurement Frauds Developing Fraud Interviewing Skills Best Fraud Auditing Techniques Now John at the bar is a friend of mine. He gets me my drinks for free. Sing us a song, you’re the piano man. “Piano Man” Billy Joel

Some Fraud Figures Australia’s annual fraud, 2003, $5.8 billion or 1.147% of GDP. Malaysia’s telecom operators lose 3% of revenue to fraud each year. A KPMG Malaysian survey found that more than a third of the polled companies lost over RM 1 million from fraud in 2 years. Fraud and abuse in U.S. is $652 billion to $1 trillion annually. The quantity of corruption crimes has continued to rise in China after the market liberalizations in 1978 (because so much more money involved). An employee at the Australian mint stole $100,145 over ten months by hiding bills and coins in his lunch box and boots. He carried away on an average 150 coins in each boot every day.

Fannie Mae Forensic Probe
BOD hired investigators who cleared the current management of Fannie Mae of knowingly participating in any wrongdoing. The report took 17 months; 616 pages plus 2,000 plus pages of supporting documents. Cost of $60 million to $70 million. The fraud was estimated to be $11 billion. Former N.H. Senator Warren Rudman used The Huron Consulting Group.

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

Definition of Forensic Accounting
Forensic accounting is the application of accounting, tax, auditing, finance, quantitative analysis, investigative and research skills, and an understanding of the legal process for the purpose of identifying, collecting, analyzing, and interpreting financial or other data or issues in connection with: Litigation services: providing assistance for actual, pending or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of disputes between parties, or Non-litigation services: performing analyses or investigations that may require the same skills used in 1, above, but may not involve the litigation process.

Definition of Forensic Accounting Litigation Service
Forensic accounting litigation services are the professional assistance accountants provide related to the litigation process. These services may involve accounting, financial, auditing, tax, quantitative analysis, and investigative and research skills, as well as an understanding of the legal process to provide assistance for actual, pending, or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between parties.

Definition of Forensic Accounting Non-Litigation Services
Forensic accounting non-litigation services are the professional assistance accountants provide not related to the litigation process. These services may involve accounting, financial, auditing, tax, quantitative analysis, and investigative and research skill as well as an understanding of the legal process to provide assistance in connection with matter or issues not involving the litigation process.

Short History Late 1800’s – Find fraud
1930’s- Puff Adder –encyclopedia independent audits 1950’s-Eighth edition Montgomery auditing reduced formal stress on fraud detection. January H.W. Bevis, AR, questioned the benefit of discovering minor employee thefts. 1960s-auditors claimed no responsibility. Financial audits: Consistency. Audit surveillance: test of details (disappeared). Stock market bubble Panel on Audit Effectiveness (2000) Enron/ WorldCom/ Parmalat/ HealthSouth Sarbanes-Oxley/ PCAOB SAS No. 99

Why Growth in Forensic Accounting
Increase in fraud. Less loyalty to organization. Employee mobility. Change in societal values. Break-up of family unit. Less religious. Less ethics. Computers replacing accounting functions. External accountants are looking for new jobs. Higher insurance premiums for auditing. Auditors became sales people. Grade inflation/coursework deflation. Enron/WorldCom/Xerox. SOX/ SAS No. 99.

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 Under-funded Moral & Ethical Leadership Source: Cynthia Cooper, L.S.U., November 24, 2003

The Bubble Deception There are 14,000 publicly traded companies in the United States. Expecting all of them to be honest is unrealistic. Like any town of 14,000, the market is bound to have its share of grifters and shoplifters. By January 2001, all manner of companies were abusing accounting rules to mislead their investors, seemingly without fear of being caught. A strange madness had gripped the market. Even its most solid citizens were running red lights and breaking windows. And the police were nowhere in sight. Alex Berenson, The Number, Random House, 2003, p. xxiii.

Enriching Insiders I know that sounds crazy, but the stock market has gone from a place where investors actually own part of a company and have a say in their management to a market designed to enrich insiders by allowing them to sell shares they buy cheaply through options. Companies continuously issue new shares to their managers without asking their existing shareholders. Those managers then leak that stock to the market a little at a time. It’s unlimited dilution of existing shareholders’ stakes, dilution by a thousand cuts. If that isn’t a scam, I don’t know what is. Individual shareholders have nothing but the chance to sell their shares to the next sucker . A mutual fund buys one million shares of a company with your and your coworkers’ money. You own 1 percent of the company. Six weeks later you own less, and that money went to insiders, not to the company. Alex Berenson, The Number, Random House, 2003, p. xviii.

Forensic Accounting Factors
Time: Forensic accounting focuses on the past, although it may do so in order to look forward (e.g., damages, valuations). Purpose: Forensic accounting is performed for a specific legal forum or in anticipation of appearing before a legal forum. Peremptory: Forensic accountants may be employed in a wide variety of risk management engagements within business enterprises as a matter of right, without the necessity of allegations (e.g., proactive). With a single clue a forensic accountant can solve a fraudulent mystery.

One Small Clue A former Scotland Yard scientist tried to create the world’s biggest fraud by authenticating $2.5 trillion worth of fake U.S. Treasury bonds. When two men tried to pass off $25 million worth of the bonds in Toronto in 2001, a Mountie noticed the bonds bore the word “dollar” rather “dollars.” Police later raided a London bank vault and discovered that the bonds had been printed with an ink jet printer that had not been invented when the bonds were allegedly produced. Zip codes were used even though they were not introduced until 1963. Sue Clough, “Bungling Scientist Is Jailed for Plotting World's Biggest Fraud,” News.telegraph.co.uk, January 11, 2003.

Forensic Accounting Defined
Forensic accounting is the action of identifying, recording, settling, extracting, sorting, reporting, and verifying past financial data or other accounting activities for settling current or prospective legal disputes or using such past financial data for projecting future financial data to settle legal disputes. Source: Forensic and Investigative Accounting (CCH) When the death of a company occurs under mysterious circumstances, forensic accountants are essential. Other accountants look at the charts but forensic accountants actually dig into the body. Douglas Carmichael

Forensic Accounting Areas
Investigative Auditing Litigation Support Forensic: Latin for “forum,” referring to a public place or court. Black’s Law Dictionary: Forensic, belonging to the courts of justice. Note: Corporate spooks are used to check on competitors.

Forensic Auditing Forensic auditing is a type of auditing that specifically looks for financial misconduct, and abusive or wasteful activity. It is most commonly associated with gathering evidence that will be presented in a court of law as part of a financial crime or a fraud investigation. Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of Government Financial Management, Winter, 2003, pp “ Forget the stuffed white shirt, forensic accountants are more parts Philip Marlowe than Casper Milquetoast. They open the books and crack the code, transforming a dull science of numbers into a suspenseful mystery with a logical, even riveting resolution.” Cory Johnson

Top Niche Services 1. Business Valuations 89% 2. SOX Compliance 77%
3. Litigation Support 69% 4. Attest Services 67% 5. Estate/Trust/Gift 66% 9. Forensic/Fraud 56% Source: Accounting Today.

Forensic Accounting vs. Fraud Auditing
Fraud Auditor: An accountant especially skilled in auditing who is generally engaged in auditing with a view toward fraud discovery, documentation, and prevention. “Economic crimes and fraud often do not involve obvious evidence like the smoking gun. Forensic accountants look behind the deals and handshakes and probe beyond the numbers to uncover the reality of financial situations.” Source: D.W. Squires, “Problems Solved with Forensic Accounting: A Legal Perspective,” Journal of Forensic Accounting., Vol. IV (2003),. P. 131.

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

AICPA’s Position Does not require auditors to carryout specific forensic procedures, but rather provide guidance on how to include forensic techniques within processes outlines in SAS 99. This combination will enhance the detection and prevention of fraudulent financial statement reporting and misappropriation of assets; thus protect investors and financial statement users. Public accounting firms could use forensic accountants to help revise their approach to planning and fieldwork on all audits, while requiring forensic accountants only on high risk audit clients to aid in the interpretation of forensic testing results and preventive control enhancements. The inclusion of audit procedures focused towards detecting misappropriation of corporate assets may lead to the identification of weaknesses within corporate governance or control weaknesses. Frauds that are identified which represent a material misappropriation of assets could significantly impact public perception.

AICPA’s Position (cont.)
Professional forensic accountants can best be used by ensuring such procedures are properly developed and executed in-line with internal audit and audit committee concerns. Forensic accountants could then be engaged in high-risk situations, or when a fraud is suspected. Companies should not use the forensic services of their outside audit firm, unless it pertains to the annual audit. Putting a price on a substantive test or forensic auditing procedure may be smart for business; however, the inherent risk is that short-cuts geared towards reducing audit costs may eventually cause investors to question the companies true financial position. AICPA – Discussion Memo Question Responses

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Forensic vs. Fraud Audit
Google result, June 6, 2006 Forensic Audit, 92,800 hits Fraud Audit, 27,600 hits Fraud Examination, 70,700 hits Fraud Accounting, 20,800 hits Forensic Accounting, 921,000 hits I don’t care what they say, but [forensic accounting] is here to stay. Danny & the Juniors I see skies of blue and clouds of white, and I think to myself, what a wonderful world. Louis Armstrong

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.

Asset Tracing Three Italian lawyers said in a filing to be presented to a bankruptcy court that they had traced $7.7 billion in missing Parmalat funds. “We are preparing a filing in which we are asking for the insolvency status to be revoked because the money was robbed and not lost,” lawyer Carlo Zauli told Reuters. But he said it would be an illusion to believe proof of electronic transfers of the funds could be found and the lawyers representing the Parmalat Creditors Committee did not say where the money was being held or if it was recoverable. An Italian website, TGfin ( said a company linked to Parmalat founder Tanzi was holding the funds in the form of U.S. bonds in an account with Bank of America. Source: Emilio Parodi and Stefano Bernabei, “Wrap-up 2: Paramalat Fraud Probe Widens to Auditors, Ex-Banker, “forbes.com, January 8, 2004.

Gross Profit Comparison
In a divorce situation, a business owner claimed only about $75,000 annual income. He claimed he had borrowed and not paid back huge sums. Wife said he was spending about $400,000 per year more than his salary. Four schedules for the courtroom: What was known and alleged about husband’s expenditures. Schedule comparing income with expenditures. Amounts husband claimed he had borrowed.

Gross Profit Comparison (cont.)
Company’s income statements side-by-side: New Gross Profit His Per Industry $75,000 $475,000 Husband had overstated COGS. Checks issued to vendors, into COGS. Some of the vendors cashed the checks and returned the money to husband. Mark Kohn, “Unreported Income and Hidden Assets,” Forensic Accounting in Matrimonial Divorce, Philadelphia: R. T. Edwards, 2005, pp Mark Kohn, “Unreported Income and Hidden Assets,” in Forensic Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards, 2005, pp

Unreported Beer Sales Business owner reports only $50,000 business income, but has expensive cars, private schools, buying significant real estate. Subpoenaed records of local beer distributors. Then went to the club and ordered some drinks, noting the pricing of the beer, etc. 1,000 cases of Miller’s 24 bottles 24,000 x $2 $48,000 per year Found that reported sales were underreported by $500,000. Mark Kohn, “Unreported Income and Hidden Assets,” Forensic Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards, 2005, pp

Home Improvements Massive improvements to personal home, not paid for by personal funds. Company showed many corporate payments to home remodeling contractors/landscapers. But the industrial park not owned by company. Only photocopies of invoices provided. FC demanded original documents. Finally, the original documents had white-outs of job locations and work descriptions. Could turn over the originals and read the real data from the back side. Mark Kohn, “Unreported Income and Hidden Assets,” Forensic Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards, 2005, pp

Finding Unreported Income/Hidden Assets
Look at the lifestyles. Look at the expenses. Look at the cash flow. Look at the business operations. Look at the industry ratios. Consider using private investigators. Use the net worth method. Mark Kohn, “Unreported Income and Hidden Assets,” Forensic Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards, 2005, pp

Fiction v. Reality The main difference between fiction and reality is that instead of using mask and gun, today’s villains use mouse and keyboard. Instead of hiding behind a lamppost in a trench coat and fedora, today’s forensic accountants are more likely to be hiding behind their own computers, searching for clues amid mountains of data. Source; “Book ‘EM! Forensic Accounting in History and Literature,” The Kessler Report, Vol.1, No. 2. “Every investigation I did as a prosecutor, you have a particular target, but it always branches off because something else gets your attention. And that’s what is going to happen with a forensic accountant.” Tom Carlucci: E-library Rueter Library September 20, 2002

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

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

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

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

Potpourri Deutsche Bank is being sued for $1.3 billion by Bruce Winston (one of the heirs of Harry Winston diamond dynasty) for priceless gems disappearing from a trust under their control. A Burlington, Kentucky city finance director is accused of embezzling more than $1.2 million to support his estranged wife and his girlfriend. Martin Frankel vanished with between $200 million in cash and diamonds one day. He accomplished this insurance fraud by buying poorly capitalized insurance companies, cooking the books to show increased premium value, and by including non-existing real estate and leases on the balance sheet. Bank of China’s Mr. Wu allegedly embezzling up to $18 million from a bank branch, using improper bills of exchange. BoC has a number of cases involving the embezzlement of $737 million from branches in the Southern Guangdong Province. A U.S. Lime officer embezzled nearly $2.2 million by forging signatures of other company officers on checks, and falsifying the company’s check register to create the impression that the amounts he received went to U.S. Lime creditors.

Potpourri (contd …) In December 2002, two Van Gogh paintings were stolen from the Van Gogh Museum in Amsterdam. Two weeks earlier there was a multimillion-dollar gem heist from a Dutch diamond exhibition at the Museum in the Hague. Spanish authorities shut down Afinsa’s Forum stamp-investing programs with several hundred thousand of small investors. Alleged investments in overvalued stamps and suspected pyramid scheme. Eight officials jailed. 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 (USA).

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

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

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

Find It, or I’ll Sue Accountants must be attuned to detecting fraud at every level of service, including standard accounting services, compilations, reviews, and bank reconciliations. If there is fraud and you don’t detect it, you are going to be sued, and you will likely lose, as the public perception is the accountant is the watchdog. Robert J. DiPasquale, Parsippany, N.J. Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp

Forensic Accounting Knowledge Base
LAW Investigative auditing Accounting Criminology Forensic Accountant Silk, Silk, Silk

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.

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.

Al Capone Caper “Perhaps the most celebrated case of an accountant nailing a famous criminal was the case of Al Capone. For all of Capone’s colorful history of violent crime, the FBI could never gather enough evidence to convict him until FBI agent Eliot Ness had an idea. He gathered special agents of the IRS to track the flow of cash from Capone’s illicit activities. When the mobster failed to pay taxes on those earnings, the IRS nailed him for tax evasion. Capone went to jail and was never a factor again. IRS recruitment posters boast till this day: ‘Only an accountant could catch Al Capone.’” Source: “Book ‘Em! Forensic Accounting History and Literature,” The Kessler Report, Vol. 1, No. 2.

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

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.

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[now $660], more or less annual problem nobody knows about.” Joseph W. Koletar, Fraud Exposed, John Wiley & Sons, Inc 2003, p. 228.

Be like

Fictional Hero “Forensic accounting is turning up more frequently in the world of fiction, too. The financial intrigue of fraud and the investigative process of forensic accounting are a natural fit with mystery of suspense novels. Add exotic locations, colorful characters and a murder or two, and you have all the elements of a classic thriller. There is a selection of books featuring forensic accountants as the heroes of their own stories, as well. Lenny Cramer, perhaps the most prominent of this fictional group, is the star of a series of novels written by I.W. Collett and various co-authors. In one of these novels, Cramer tracks forged receipts to uncover a plot to steal Burmese religion treasures. Another features Cramer, while conducting an audit at Coca-Coca, uncovering a scheme to steal the company’s secret formula. In yet another, Cramer uses his forensic accounting skills to solve a series of murders in the New York art world.” Source: “Book ‘em! Forensic Accounting in History and Literature,”The Kessler Report, Vol. 1, No. 2.

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. Did not believe a GAAS audit should become a fraud audit. In all audits the degree of audit effort in forensic- type steps should be more than inconsequential [p. 24].

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.

Fraud Strategies Differ
Forensic Accountants Internal Auditors External Auditors Fraud Examiners Certified Fraud Deterrence Analysts (CFD) or CFFAs Forensic CPA Society (FCPA)

Who Do You Call? Detection v. Deterrence Proactive v. Reactive

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 Auditing,” Journal of Forensic Accounting, Vol. 111, 2002, pp

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; ; Certified Insolvency and Reorganization Accountant (CIRAs). Accountants, lawyers, consultants included in insolvency and bankruptcy matters. 3-part exam. 4,000 hours AIRA, 221Stewart Avenue, Suite 207, Medford, Or Forensic CPA Society (FCPA); formed in July 2005, Spokane, WA. 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. About 20 firms. $1,825. 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.

Some accountants believe that ethics is a place in England.
Fraud Some accountants believe that ethics is a place in England. Essex, U.K. A statement made by Mark Twain about New England weather applies to fraud and corruption: “It’s hard to predict, but everyone agrees there’s plenty of it.” As Sherlock Holmes said, “the game is afoot.” Read My Lips; It’s The Fraud, Stupid.

Termites, Rust, and Fraud
Just as termites never sleep, fraud never sleeps. Just like termites, fraud can destroy the foundation of an entity. Like rust, fraud never sleeps.

Joseph W. Koletar’s Opinions
“In my private-sector forensic career, I have seen few organizations that have a firm grasp on the size and components of their fraud problems. Usually they rely on incidental reports and, in turn generate incremental responses.” p. 99. Business failures and financial statement fraud “occur because existing controls were not operating, not because they were improperly designed and installed. Often internal auditors are not permitted to do their jobs. Serious audit results impact executives, and many executives are resistant to change or feel threatened. Consequently, those who make a difference are stifled.” Barry Lipton’s letter, p. 104. “Far too many organizations are penny wise and pound foolish in their approach to internal controls staffing and monitoring….” p. 117. Michael J. Comer: “The Cow grows fat under the eyes of the owner.” p. 8. Source: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003.

Fraud is Possible The motto of a fraudster:
Anything is possible. The impossibility simply takes longer. Biggleman’s Safe – a safe builder wrote blueprints of a unbreakable safe and locked the blueprints inside the safe. Internal controls can be broken, often by top executives. Just as a pitcher tries to fool batters, financial statements may be misleading or wrong (baseball or cricket).

White-Collar Crime: Rich People Steal
Edwin Sutherland coined the term “white-collar crime.” [Indiana University sociology professor.] Sutherland believed that white-collar crime is a learned behavior, a consequence of corporate culture where regulations are regarded as harassment, and profit is the measure of the man. “White-collar crime violates trust and thus creates distrust, and this lowers social morale and produces social disorganization on a large scale. Cynthia Crossen, “A Thirties Revelation: Rich People Who Steal are Criminals, Too,” Wall Street Journal, October 15, 2003, p. B-1.

Tyco Prosecutor’s Closing Argument
“Remember, these are two very, very smart men; they are not charged with being stupid men,” she said of Mr. Kozlowski and Mr. Swartz. “These crimes have an element of sophistication so you can be sure that when they were committing them they built in an element of deniability.” She added: “Every good scheme has it. That is how white-collar criminals work.” Mistrial on April 2, 2004. Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,” N.Y. Times, March 17, 2004, p. C-1.

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

How Corruption Occurs Category % Conflicts of Interest 61.6% Bribery
42.7% Illegal Gratuities 29.8% Extortion 16.9% Source: 2006 Wells Report, ACFE.

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.

Starwoods Hotels Poll of Executives
Starwoods Hotels interviewed 401 top executives who golf. The results are surprising. Consider themselves to be honest in business 99% Played with someone who cheats at golf 87% Cheated themselves at golf 82% Hated others who cheated at golf Believe that business and golf behaviors are parallel 72% Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA Today, June 26, 2002, p. A-1.

The Cost of Fraud Organizations lose 5 percent of annual revenue to fraud and abuse. Fraud and abuse costs U.S. organizations more than $652 billion annually (about $4,500 per employee). The average organization loses more than $12 a day per employee due to fraud and abuse. Source: 2006 Wells Report

The Trillion Dollar Gorilla
(in Billions) U.S. Business $256.32 Federal Government State Government Tax-exempts Local Government Annual Fraud (trillion) $ 1.053 2002 Statistics of Income, $1,281.6 trillion time 20%. $ trillion budget times 10% $3,542.1 million times 10% $897 billion in revenue times 15%. $684.6 billion times 10%.

Fraud Multiplier Employee Fraud = $ for $ reduction in net income
Suppose $100,000 bottom line reduction. Suppose 20% profit margin How much new revenue needed to offset the lost income? $100,000 = $500,000 20% So ACFE says $652 billion lost per year (2006). $652 billion = $3.26 trillion needed revenue 20%. This amount lost to fraud and abuses is twice the size of the U.S. military budget.

The Cost of Fraud (cont.)
Over 90% of occupational frauds involve asset misappropriations. Average length of a fraud scheme is 15 to 24 months. Most common way of detecting occupational fraud is by tips from employees, customers, vendors, or anonymous sources. Second way, by accident. Third most common detection: internal audit (2nd in 2004). The most targeted asset is cash. Source: 2006 Wells Report

Ernst & Young Study (2000) Leading companies and public bodies in 15 (82) countries More than 82% (50%) have been victims of fraud in the past year. 82% (84%) of total losses can be attributed to staff. 33% (50%) of the most serious frauds were committed by the organization’s own management. Most with company more than 5 years (25% more than 10 years). Theft of cash and purchasing schemes (i.e., employee kickbacks) constituted the majority of frauds. Reasons: Poor internal controls and finance directors had a limited knowledge of internal controls.

Ernst & Young 2002 Survey More than 20 percent of the respondents were aware of fraud in their workplace. Nearly 80 percent would be willing to turn in a colleague thought to be committing a fraudulent act. Employers lose a staggering 20 percent of every dollar earned to some type of workplace fraud. More frequently committed frauds are theft of office items, claiming extra hours worked, inflating expense accounts, and taking kickbacks from suppliers. Women are more likely than men to report fraudulent activities. Older employees were more likely to report fraudulent activities than younger employees. Ernst & Young. “American Works: Employers Lose 20 Percent of Every Dollar to Work Place Fraud.” (2002) Available at

Put Fraud In Perspective
The Iraq War may cost as much as $200 billion. Since fraud and abuse reduce the bottom lines of businesses as much as $660 billion per year (assuming a tax rate of 30%), the federal government loses in taxes each year $198 billion. So in less than 13 months, stopping fraud and abuse would pay for the Iraqi war.

Advantage of Compliance Spending
General Counsel Roundtable says that each $1 of compliance spending saves organizations, on the average, $5.21 in heightened avoidance of legal liabilities, harm to the organization’s reputation, and lost productivity. Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April 2004, p. 47.

2003 PricewaterhouseCooper Survey
Survey to several hundred of the largest companies (with 91 responses). Half of the detected economic crimes at responding companies were found by auditors, but it did not distinguish between internal audits. Another 36 percent of the frauds were reported by whistle-blowers Although 76 percent of the United States respondents were covered by insurance, fewer than half were able to recover from their insurers. And less than a third of insured companies affected by fraud collected more than 20 percent of the amount lost. The average amount lost was $2.2 million, and the highest levels of economic crime were reported in Africa and North America (including Canada and the United States). Source: J.D. Glater, “Survey Finds Fraud’s Reach in Big Business”

Scienter Necessary To prove any type of fraud, prosecutors must show that scienter was present. That is, the fraudster must have known that his or her actions were intended to deceive. The allure of numbers to most of us, is like the excitement of settling sand--a narcoleptic surety. Crafty criminals prey on this boredom. They pile on the numbers, spewing meaningless records in the false books. Cory Johnson

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.

How Fraud Occurs Source: KPMG Fraud Study

Types of Fraud Source: KPMG Fraud Study

Certain Fraud is Increasing
Source: KPMG Fraud Study

Occupational Fraud Re Industry
Banking/ Financial Services 14.3% Government/ Public Administration 11.5% Manufacturing 9.7% HealthCare 8.6% Insurance 7.5% Retail 7.2% Education 7.0% Service (General) 5.8% Service (Professional, etc.) 5.6% Construction 3.4% Utilities 3.3% Oil/ Gas 3.1% Real Estate 2.9% Wholesale trade Source: 2006 Wells Report, ACFE.

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

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

COSO Survey (1999) Financial pressures were important contributory factors for the commitment of financial statement fraud (FSF). Top executives (e.g., CEOs, CFOs) were commonly involved in FSF. The majority of alleged FSF were committed by small companies. Board of directors and audit committees of the fraud companies were weak and ineffective. Adverse consequences for fraud companies were bankruptcy, significant changes in ownership, and delisting by national stock exchanges. Cumulative amounts of FSF were relatively significant and large. More than half of the alleged FSF involved overstatement of revenues. Most FSF were not isolated to a single fiscal period. Fifty-five percent of the audit reports issued in the last year of the fraud period contained unqualified opinions. The majority of the sample fraud companies (56 percent) were audited by Big Eight/Big Five auditing firms.

Business Fraud Survey (1999)
Nearly 15 percent reported management misappropriation as the greatest fraud risk to their organization. Sixty percent of the respondent reported their department’s fraud risk analysis process as being reactive in nature. The majority of respondents (72 percent) reported that their organization did not have fraud detection and deterrence programs in place. The majority of respondents (68 percent) reported that they never felt pressured to compromise the adherence to their organization’s standard of ethical conduct. The majority of the respondents reported their organization’s external auditors as being ineffective in preventing and detecting fraud. The majority of the respondents believed that more budgets should be devoted to fraud-related activities and training in department. The Institute of Management and Administration (IOMA) and the Institute of Internal Auditors(IIA). “Business Fraud Survey.” (1999). Available at

One Piece at a Time Johnny Cash (1976)

One Piece At A Time Well, I left Kentucky back in '49 An' went to Detroit workin' on a 'sembly line The first year they had me puttin' wheels on cadillacs Every day I'd watch them beauties roll by And sometimes I'd hang my head and cry 'Cause I always wanted me one that was long and black. One day I devised myself a plan That should be the envy of most any man I'd sneak it out of there in a lunchbox in my hand Now gettin' caught meant gettin' fired But I figured I'd have it all by the time I retired I'd have me a car worth at least a hundred grand. CHORUS I'd get it one piece at a time And it wouldn't cost me a dime You'll know it's me when I come through your town I'm gonna ride around in style I'm gonna drive everybody wild 'Cause I'll have the only one there is a round. So the very next day when I punched in With my big lunchbox and with help from my friends I left that day with a lunch box full of gears Now, I never considered myself a thief GM wouldn't miss just one little piece Especially if I strung it out over several years.

One Piece At A Time The first day I got me a fuel pump And the next day I got me an engine and a trunk Then I got me a transmission and all of the chrome The little things I could get in my big lunchbox Like nuts, an' bolts, and all four shocks But the big stuff we snuck out in my buddy's mobile home. Now, up to now my plan went all right 'Til we tried to put it all together one night And that's when we noticed that something was definitely wrong. The transmission was a '53 And the motor turned out to be a '73 And when we tried to put in the bolts all the holes were gone. So we drilled it out so that it would fit And with a little bit of help with an A-daptor kit We had that engine runnin' just like a song Now the headlight' was another sight We had two on the left and one on the right But when we pulled out the switch all three of 'em come on. The back end looked kinda funny too But we put it together and when we got thru Well, that's when we noticed that we only had one tail-fin About that time my wife walked out And I could see in her eyes that she had her doubts But she opened the door and said "Honey, take me for a spin." .

One Piece At A Time So we drove up town just to get the tags And I headed her right on down main drag I could hear everybody laughin' for blocks around But up there at the court house they didn't laugh 'Cause to type it up it took the whole staff And when they got through the title weighed sixty pounds CHORUS I got it one piece at a time And it didn't cost me a dime You'll know it's me when I come through your town I'm gonna ride around in style I'm gonna drive everybody wild 'Cause I'll have the only one there is around. (Spoken) Ugh! Yow, RED RYDER This is the COTTON MOUTH In the PSYCHO-BILLY CADILLAC Come on Huh, This is the COTTON MOUTH And negatory on the cost of this mow-chine there RED RYDER You might say I went right up to the factory And picked it up, it's cheaper that way Ugh!, what model is it? Well, It's a '49, '50, '51, '52, '53, '54, '55, '56 '57, '58' 59' automobile It's a '60, '61, '62, '63, '64, '65, '66, '67 '68, '69, '70 automobile.

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Missing Fraud Auditors will continue to miss fraud because much of their work is predicted on the assumption that separation of duties prevents fraud (i.e., one person hold the money and another person keeps track of it). The Equity Funding case shakes the foundations of auditing in that so much is based on the assumption that people don’t collude very long. These people work together as an efficient team for a very long time [9 years]. Lee Seidler “When the sun goes down, then the sneaks will play at night.” From Porter Wagoner “Sneaks Crawl at Night.”

The Perpetrators First-time offenders.
Losses from fraud caused by managers and executives were 3.5 times greater than those caused by non-managerial employees. Losses caused by men were 3 times those caused by women. [53% males; 47% females] Losses caused by perpetrators 60 and older were 27 times those caused by perpetrators 25 or younger. Losses caused by perpetrators with post-graduate degrees were more than 3.5 times greater than those caused by high school graduates. Source: 2002 ACFE Report

White-collar criminals have these characteristics:
Likely to be married. Member of a church. Educated beyond high school. No arrest record. Age range from teens to over 60. Socially conforming. Employment tenure from 1 to 20 years. Acts alone 70% of the time. Source: Jack Robertson, Fraud Examination for Managers and Auditors (1997).

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

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

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

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

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

How Fraud Is Detected 2006 2004 Tips 34.2% 39.6% By accident 25.4%
21.3% Internal audit 20.2% 23.8% Internal controls 19.2% 18.4% External audits 12.0% 10.9% Notification by police 3.8% 0.9% Source: 2006/ 2004 Wells Reports, ACFE.

Sources of Tips Employees 64.1% Anonymous 18.1% Customers 10.7%
Vendors 7.1% Source: 2006 Wells Report, ACFE.

Tips Are Important Some of the biggest recent accounting scandals (e.g., HealthSouth, Xerox, Waste Management) involve situations where the auditors were tipped off or otherwise alerted to possible frauds but they failed to investigate them deeply enough. In her book Power Failure, Sherron Watkins says she talked to Jim Hecker, at Arthur Andersen, on the phone about the dangers of the Raptors and Fastow’s inherent conflict. Hecker wrote a memo to the files and forwarded copies to David Duncan and Enron’s audit partner, Debra Cash. His note: “Here is my draft memo, for your review, for ‘smoking guns’ that you can not extinguish.” p. 285.

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

Quotes You should attack fraud problems the way the fictional Sherlock Holmes approached murder cases D. Larry Crumbley To be a good fraud auditor, you have to be a good detective. Source: Robert J. Lindquist Many lap-dog internal and external auditors need to be replaced with junkyard dogs.

Difficult Task More forensic techniques should become a part of both external and internal auditing. But Stephen Seliskar says that “in terms of the sheer labor, the magnitude of effort, time and expense required to do a single, very focused [forensic] investigation -- as contrasted to auditing a set of the financial statements -- the difference is incredible.” It is physically impossible to conduct a generic fraud investigation of an entire business. Source: Eric Krell, “Will Forensic Accounting Go Mainstream?” Business Finance Journal, October 2002, pp

Stealth Once a forensic accountant [e.g., Cr.FA, CFE, CFFA] is engaged, Michael Kessler says that they should not be disruptive. Most employees are not aware that an investigation is taking place. We go in as just another set of auditors, favoring a Columbo-esque investigative style. “We don’t wear special windbreakers that say ‘forensic accountant.’” Source: Eric Krell, “Will Forensic Accounting Go Mainstream?” Business Finance Journal, October 2002, pp

Kessler Survey (2001) About 13% of employees are fundamentally dishonest. Employees out-steal shoplifters. About 21% of employees are honest. But 66% are encouraged to steal if they see others doing it without repercussion. Source: “Studies Show 13% of employees are fundamentally dishonest,” KesslerNews, November 1, 2001, 30% of people in U.S. are dishonest. 30% situational dishonest. 40% are honest all of the time. Source: R.C. Hollinger, Dishonesty in the Workplace, Park Rider, N.Y.: London House Press, 1989, pp. 1-5.

Little Has Changed: CFO Survey
Nearly half of CFOs – 47 percent – report they still feel pressure from their superiors to use aggressive accounting to make results look better. What is worrisome is that the pressure to make the numbers hasn’t abated much. Of these who have felt pressure in the past, only 38 percent think there is less pressure today than there was three years ago, and 20 percent say there is more. Few finance executives have much confidence in the numbers their colleagues are reporting. Only 27 percent say that if they were investing their own money, they would feel “very confident” about the quality and completeness of information available about public companies. Source: Don Durfee, “It’s Better (and Worse) Than You Think,” CFO Magazine, May 3, 2004.

D.R. Cressey’s Fraud Pyramid
Don’t think you’re the only ones Who bend it, break it, stretch it some. We learn from you. Girls lie, too Terri Clark

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

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

Greed “I don’t see many ways to eliminate greed; it is an inherent part of the human character. So antifraud measures must be aimed at educating people on the risks and the type of technical controls that they can implement.” Alan Oliphant Source: David G. Banks, “The Fight Against Fraud,” Internal Auditor, April 2004, pp “It was definitely the perfect fraud…….. unfortunately they hired the perfect investigator.” Cartoon in M.J. Comer’s book

Example of Greed (or Incentive)
Three Duke Energy employees were charged in April 2004 for allegedly ginning up “phony electricity and material-gas trades to boost trading volumes” and inflating “profits in a trading book that was the basis of their annual profits.” “The trading schemes are alleged to have inflated their bonuses by at least $7 million” between March 2001 and May There were 400 rigged trades that produced a $50 million profit in the trade books. Duke used mark-to-market accounting to record profit and loss contracts that might not be settled for years. So called “round-trips trades (or wash sales) were used to jack up reported trading volumes. Source: Rebecca Smith, “Former Employees of Duke Charged Over Wash Trades,” WSJ, April 22, 2004, p. A-15.

KPMG’s Causes or Indicators of Fraud (1998)
Personal financial pressure. Substance abuse. Gambling. Real or imagined grievances. Ongoing transactions with related parties. Increased stress. Internal pressures to meet deadlines/budgets. Short vacations. Unusual hours. Source: KPMG’s 1998 Fraud Survey

How Fraud is Discovered-Singapore 2002
Management investigation (41%). Anonymous letter/informant (35%). Internal controls (33%). By chance (26%). Internal auditor review (12%). Source: KPMG Fraud Survey Report, 2002.

Singapore Fraud Survey, 2002
Management investigation, informant notification, and good internal controls rank highly as methods of fraud detection. 76% of the frauds were perpetrated internally [management (41%) and non-management employees (35%)] Poor internal controls, override of internal controls, and collusion between employees and third parties were the top three reasons cited as to why frauds were allowed to take place “Red flags,” which should have alerted respondents to the fraud, were present and ignored in 29% of cases. The main reason for not reporting fraud was lack of evidence The typical fraudster is predominantly male within the age group of years and has an annual income between $15,000 to $30, % of fraudsters have tertiary educational qualifications.

Rationalization Sherron Watkins provides an excellent comment about rationalization with respect to Enron’s Jeff Skilling and Andy Fastow. At what point did they turn crooked? “But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a slow erosion of values over time.” Source: Pamela Colloff, “The Whistle-Blower,” Texas Monthly, April 2003, p. 141.

Fraud’s Fatal Failings
85% of fraud victims never get their money or property back. Most investigations flounder, leaving the victims to defend for themselves against counter-attacks by hostile parties. 30% of companies that fail do so because of fraud. Source: Michael J. Comer, Investigating Corporate Fraud, Burlington, VT: Gower Publishing, 2003, p. 9.

Importing Sarbanes-Oxley?
One-size-fits-all approach. Resulted in a loss of foreign listings on U.S. exchanges. U.S. exchanges seek to acquire foreign exchanges. Market consolidations may impose U.S. regulatory standards across national boundaries. Foreign companies listed on U.S. exchanges are subject to SOX. Once 500 Americans hold shares in a foreign-listed company, if separate platforms not maintained, subject to U.S. laws and rules (including SOX). Harvey Pitt, “Sarbanes-Oxley Is An Unhealthy Export,” Financial Times, June 21, 2006, p.15.

Sarbanes-Oxley Act (7-30-2002)
Most significant change since 1934 Securities Exchange Act New five-member Public Company Accounting Oversight Board (PCAOB) Authority to set and enforce auditing, attestation, quality control and ethics (including independencies) standards for auditors of public companies. Empowered to inspect the auditing operations of public accounting firms that audit public companies as well as impose disciplinary and remedial sanctions for violations of the board’s rules, securities laws and professional auditing and accounting standards. Rotation of lead and concurring audit partners every five years (5 year time-out period).

Sarbanes-Oxley Act (7-30-2002)
Eight types of services outlawed: +Bookkeeping. +Information systems design and implementation +Appraisals or valuation services, fairness opinions, or contribution-in-kind-reports. +Actuarial services +Internal audit outsourcing Management and human resources services Broker/dealer, investment adviser, and investment banking services Legal or expert services related to audit services Applies to foreign accounting firms filing with SEC after July 15, 2006. to get free subscription to PCAOB Update.

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 service commences). Auditor must report to the audit committee on a timely basis. Cooling off period of one year before a member of the audit engagement team can begin working for the registrant in certain positions. There is no requirement to rotate the auditors. There is discussion of requiring a forensic audit irregularly. Harvey Pitt suggested this proposal.

Sarbanes-Oxley (contd.)
Many of the Sarbanes-Oxley’s provisions became effective July 30, 2002. Thus, the SEC will control the auditing 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.

Sarbanes-Oxley Act Creates Need For Forensic Accounting
To assist corporations in their quest to ensure compliance with the mandates of S-O. Public accounting firms must introduce forensic techniques into audits, and they may request help from forensic experts. Robbers do not need guns. Pencil and paper will do. Opportunity and greed are thievery’s driving forces. Put enough zeroes behind a number, and it’s amazing how flexible morals become. How many years in prison would you do to accumulate a half a billion dollars in your bank account? John H. Bolt

Section 404-Sarbanes-Oxley
Beginning June 2004, large companies must have in place tight internal controls, assess the effectiveness of these controls annually (and issue a report of their effectiveness), and pay for an independent assessment by external auditors. Need an internal control framework (e.g., COSO or similar). Companies are paying steep fees to fund the PCAOB. Audit fees have increased by as much as 30% since S/O.

FEI’s Costs of Compliance
Source: Financial Executive Institute FEI’s Costs of Compliance Revenue First-Year Costs First-Year Hours Less than $25 million $.28 million 1,996 $25 to $99 million $.74 million 3,080 $100 to $499 million $.78 million 5,118 $500 to $999 million $1.04 million 6,950 $1 to $4.9 billion $1.83 million 13,355 Over 5 billion $4.67 million 41,201 Source: Financial Executive Institute Audit fees have increased about 50%. First year spending around $10 billion. Steve Watkins, “For Some, SOX Is No Hassle at All,” IBD, January 14, 2005, p. A6. About $100,000 each year for insuring Board members.

Six-Legged Table of Financial Statements
External Auditors Audit Committee Top Management Board of Directors Internal Auditors External Auditor PCAOB and SEC In a baseball analogy, think of the pitcher as the auditee, the catcher as the internal auditor, the manager as top management, the scorekeeper as the external auditor, and the umpire would be PCAOB (SEC). The scoreboard could be the general ledger. The Big “R”

Parallel Universe: Two Opinions
External auditors must do a regular audit of a company (e.g., financial statements are fairly stated) and must also audit the internal controls that are to ensure that the financial statements are accurate (e.g., issue two opinions). Prior to the external auditors’ arrival, the company itself must review its internal controls and issue a report on the effectiveness of these controls. There will be two external opinions: on management’s assessment of the internal controls over financial reporting and another one on the effectiveness of the internal controls themselves (e.g., statements are fairly stated). PCAOB Release

The company’s stance on fraud and other breaches of the ethical code.
Anti-Fraud Strategy The company’s stance on fraud and other breaches of the ethical code. What will be done and by whom in the case that frauds or other breaches are suspected. The key initiatives which the company proposes; Who will lead these initiatives. Clear deadlines and measures for monitoring effectiveness of implementation. Source: David Davies, Fraud Watch, 2nd Edition., London, ABG Professional Information, 2000, p. 77.

PCAOB endorses the COSO Cube [pp. 24-26 and A-25 and A-26]
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 ‘principal evidence’ about the effectiveness of internal controls.” PCAOB endorses the COSO Cube [pp and A-25 and A-26] Source: PCAOB Release

Several Strategies Establishment of responsible corporate governance, a vigilant board of directors and audit committees, diligent management, and adequate and effective internal audit functions. Utilization of an alert, skeptical external audit function, responsible legal counsel, adequate and effective internal control structure, and external regulatory procedures. Implementation of appropriate corporate strategies for correction of the committed financial statement fraud, elimination of the probability of its future occurrences, and restoration of confidence in the financial reporting process Financial statement fraud occurs when one or a combination of these strategies are relaxed due to self-interest, lack of due diligence, pressure, over-reliance, or lack of dedication. Source: Crumbley, Razaee, Ziegenfuss, U.S. Master Auditing Guide, Chicago, CCH, pp

Frameworks Being Used by CFOs
COSO 82% Auditing Standard No % COBIT (Control/ Objectives for Inf./ Related Technology) 33% SAS 55/78 (AICPA) 13% Others 2% Source: Helen Shaw, “The Trouble with COSO,” CFO, March 2006, p.75.

COSO CUBE (5 components of internal controls)

HIERARCHY OF INTERNAL CONTROL NEEDS

The COSO Model Control environment – management’s attitude toward controls, or the “tone at the top.” Risk assessment – management’s assessment of the factors that could prevent the organization from meeting its objectives. Control activities – specific policies and procedures that provide a reasonable assurance that the organization will meet its objectives. The control activities should address the risks identified by management in its risk assessment. Information and communication – system that allows management to evaluate progress toward meeting the organization’s objectives. Monitoring – continuous monitoring of the internal control process with appropriate modification made as deemed necessary.

COSO New Cube: Enterprise Risk Management
Source: erm.coso.org. See Apostolou and Crumbley, “ Sarbanes-Oxley Fall-out Leads to Auditing Standards No. 2: Importance of Internal Controls,” The Value Examiner, November/December 2004, pp

Management Control Philosophy
Fraudulent Financial Reporting more likely to occur if Firm has a poor management control philosophy. Weak control structures. Strong motive for engaging in financial statement fraud. Poor management philosophy: Large numbers of related party transactions. Continuing presence of the firm’s founder. Absence of a long-term institutional investor. Source: Paul Dunn “Aspect of Management Control Philosophy that contributes to fraudulent Financial Reporting,” Journal of Forensic Accounting, Vol. IV (2003), pp

CONTROL ACTIVITIES Segregation of Accounting Duties
Effective segregation of accounting duties is achieved when the following functions are separated: Authorization—approving transactions and decisions. Recording—Preparing source documents; maintaining journals, ledgers, or other files; preparing reconciliations; and preparing performance reports. Custody—Handling cash, maintaining an inventory storeroom, receiving incoming customer checks, writing checks on the organization’s bank account. If any two of the preceding functions are the responsibility of one person, then problems can arise. Source: Accounting Information Systems, 10e Romney/Steinbart, PH

AUTHORIZATION FUNCTIONS
CONTROL ACTIVITIES CUSTODIAL FUNCTIONS Handling cash Handling inventories, tools, or fixed assets Writing checks Receiving checks in mail RECORDING FUNCTIONS Preparing source documents Maintaining journals, ledgers, or other files Preparing reconciliations Preparing performance reports EXAMPLE OF PROBLEM: A person who has custody of cash receipts and the recording for those receipts can steal some of the cash and falsify accounts to conceal the theft. SOLUTION: The pink fence (segregation of custody and recording) prevents employees from falsifying records to conceal theft of assets entrusted to them. AUTHORIZATION FUNCTIONS Authorization of transactions Source: Accounting Information Systems, 10e Romney/Steinbart, PH

EXAMPLE OF PROBLEM: A person who has custody of checks for transactions that he has authorized can authorize fictitious transactions and then steal the payments. SOLUTION: The green fence (segregation of custody and authorization) prevents employees from authorizing fictitious or inaccurate transactions as a means of concealing a theft. CONTROL ACTIVITIES CUSTODIAL FUNCTIONS Handling cash Handling inventories, tools, or fixed assets Writing checks Receiving checks in mail RECORDING FUNCTIONS Preparing source documents Maintaining journals, ledgers, or other files Preparing reconciliations Preparing performance reports AUTHORIZATION FUNCTIONS Authorization of transactions Source: Accounting Information Systems, 10e Romney/ Steinbart, PH

EXAMPLE OF PROBLEM: A person who can authorize a transaction and keep records related to the transactions can authorize and record fictitious payments that might, for example, be sent to the employee’s home address or the address of a shell company he creates. SOLUTION: The purple fence (segregation of recording and authorization) prevents employees from falsifying records to cover up inaccurate or false transactions that were inappropriately authorized. CONTROL ACTIVITIES CUSTODIAL FUNCTIONS Handling cash Handling inventories, tools, or fixed assets Writing checks Receiving checks in mail RECORDING FUNCTIONS Preparing source documents Maintaining journals, ledgers, or other files Preparing reconciliations Preparing performance reports AUTHORIZATION FUNCTIONS Authorization of transactions Source: Accounting Information Systems, 10e Romney/Steinbart, PH

Risk Assessment Benefits
A major step in a forensic audit is to conduct a risk assessment, which entails a comprehensive review and analysis of program operations in order to determine where risks exists and what those risks are. Any operation developed during the risk assessment process provides the foundation or basis upon which management can determine the nature and type of corrective actions needed. A risk assessment helps an auditor to target high-risk areas where the greatest vulnerabilities exist and develop recommendations to strength internal controls Source: B.l. Derby, “Data Mining for Improper Payments,” Journal of Government Management, Winter 2003, Vol.52, No. 4, pp

Fraud Risk Assessment Ernst & Young report found that organizations that had not performed fraud vulnerability reviews were almost two-thirds more likely to have suffered a fraud within the past 12 months. J.W. Koletar, p. 167. A company should have a fraud risk assessment performed of their controls, procedures, systems, and operations. J.W. Koletar, p. 166. Sources: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003

Fraud Risk-Assessment Process
1. Organize the assessment – integrate into organization’s existing business cycle or establish a separate cycle. 2. Determine areas to assess – conduct at company wide, business-unit, and significant-account levels. 3. Identify potential schemes and scenarios – typically affecting the industry or locations. Fraudulent financial reporting. Misappropriation of assets. Expenditures and liabilities for an improper purpose (cash kickbacks and corruption). Organization commits a fraud against employees or third parties. Tax fraud. Financial misconduct by senior management.

Fraud Risk-Assessment Process
4. Assess likelihood of fraud Remote Reasonably possible Probable 5. Assess significance of risk Inconsequential More than inconsequential Material 6. Link antifraud controls – identify the control activities for fraud risks that are both more than likely to occur and more than inconsequential in amount. 7. Apply assessment results to the audit plan – consider and document the results of the fraud assessment when developing the audit plan. Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April, 2004, pp

Swimming Lanes X Mary Larry Jane Sam Controls Cash Entries in Books
Deposits Checks Does Reconciliation Controls Account Receivable

Sophisticated Approaches
The Quad Method The Staggered Box Method The Chessboard Method

COSO Guidance Risk Assessment Matrix
See COSO, “Guidance for Smaller Public Companies,”

PCAOB’s AS2 Report: Hindrances
Failure to coordinate or integrate the AS2 audit of internal controls with the financial audit. Doing detail testing before the top down audit looking for the high risk areas (e.g., fishing). Inadequate consideration of the unique risk factors of the company (e.g., avoid the checklist mentality). Do not audit the low risk areas. Inefficient walkthroughs of transaction controls. Too little reliance on others. Insufficient evaluation of compensating controls when there is a discovery of control deficiencies. Inadequate testing of controls over financial statement presentation and disclosures.

GAP Analysis Actual Internal Controls
Organization’s Stated Internal Controls Best Practice Internal Controls

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.

Fraudulent financial reporting may occur by the following:
Manipulation, falsification, or alteration of accounting records, or supporting documents from which financial statements are prepared. Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information. Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure. Source: SAS No. 99, “Consideration of Fraud in a Financial Statement Audit,” New York: AICPA

Falsification Enron’s crude oil trading operation based in Valhalla, New York was fictitious, according to one auditor. “It was pretend. It was a playhouse. There were a lot of expensive people working there, and it was impressive looking, but it wasn’t legitimate work. The traders were keeping two sets of books, one for legitimate purposes – to show Enron and auditors from Arthur Andersen – one other set in which to record their ill-gotten gains. Source: Mimi Swartz and Sherron Watkins, Power Failure, New York: Doubleday, 2003, p.31.

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

Parmalat Deceptions Parmalat, an Italian diary company, had a nonexistence Bank of America bank account worth $4.83 billion. A SEC lawsuit asserts that Parmalat “engaged in one of the largest and most brazen corporate financial frauds in history.” Apparently, the auditors Grant Thornton relied on a fake Bank of America confirmation prepared by the company. SAS No. 99 does not prohibit clients from preparing confirmations. The fraud continued for more than a decade. At least $9 billion unaccounted for. Therefore, the audited company should not be in control of the confirmation process. The owner treated the public company as if it was his own bank account. An unaware phone operator was the fake chief executive of more than 25 affiliated companies. Some $3.6 billion in bonds claimed to be repurchased had not really been bought.

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.

Journal Entries at Year End: Those Magic Changes
Apparently, Arthur Andersen was given limited access to the general ledger at WorldCom, which had a $11 billion fraud (largest accounting fraud in history). Most of the original entries for online costs were properly placed into expense accounts. However, near the end of the period these entries were reversed. One such entry was as follows: Other Long-term Assets $629,000,000 Construction in Progress $142,000,000 Operating Line Costs $771,000,000 The support for this entry was a yellow post-it note. WorldCom’s outside auditors refused to respond to some of Cynthia Cooper’s questions and told her that the firm had approved of some of the accounting methods she questioned.

Those Magic Changes: Yellow Peril
Fourth Quarter of 1999: "The $239 million [international line cost accrual release] was entered in WorldCom's general ledger ... The only support recorded for the entry was '$239,000,000,' written on a Post-it Note and attached to a printout of the entry." Third Quarter of 2001: "Myers gave Sethi a Post-it Note that said 'Assume $742 million.' Later, Myers and Sethi had a conversation confirming that $742 million identified on the Post-it Note was the line cost capitalization entry for the quarter.” Those Magic Changes “Oh my heart arranges, oh those magic changes, oooh yeah.” Grease

Yellow Peril First Quarter of 2002: "In Capital Reporting, Myers told Sethi to go see Vinson, who would have the amount to be capitalized. When Sethi did so, Vinson handed him a Post-it Note that had the $818 million adjustment on it. Brian Higgins once again refused to make the necessary allocation for the first-quarter 2002 capitalization entry. Despite his growing concerns, Sethi made the allocation because he was concerned that his immigration status would be jeopardized if he lost his job." First Quarter 2002: "$109.4 million was taken from the general accrual account that Vinson set up and reclassified to several SG&A balance sheet accounts in five large, round-dollar amounts. The only supporting documentation that we were able to locate for these entries was a Post-it Note listing the various SG&A accounts and the amounts that should be taken from the Vinson account."

WorldCom Fraud Massive
At least 40 people knew about the fraud. They were afraid to talk. Scott Sullivan handed out $10,000 checks to 7 involved individuals. Altered key documents and denied Andersen access to the database where most of the sensitive numbers were stored. Andersen did not complain about denied access. Company officials decided what tax rates they wanted and then used the reserves to arrive at the tax rates. Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,” Wall Street J., June 10, 2003, p. 3.

WorldCom Fraud Massive (contd.)
David Schneedan, CFO at a division, refused to release reserves twice. from David Myers, WorldCom comptroller, to Schneedan: “I guess the only way I am going to get this booked is to fly to DC and book it myself. Book it right now; I can not wait another minute.” Buddy Gates [director of general accounting] said to an employee complaining about a large accounting discrepancy: “Show those numbers to the damn auditors, and I’ll throw you out the f_____ window.” Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,” Wall Street J., June 10, 2003, p. 3.

Differences Between Auditing/Forensic Accounting
Auditing Forensic Investigation 1. Recurring 1. Non-recurring 2. Express an 2. Resolve an opinion allegation or deterrence review 3. Follow GAAS 3. Follow consulting and SAS standards 4. Materiality 4. Materiality not important important 5. Sampling activity 5. Detailed financial analysis 6. Use professional 6. Establish scienter skepticism 7. Audit program 7. No set of rules

Financial Audit v. Forensic Audit
The typical financial audit is a sampling activity that doesn’t look at every transaction and can therefore be exploited by someone who knows how to rig the books. Forensic accounting focuses on a specific aspect of the books and examines every digit. While the average accountant is trying to make everything add up, a forensic accountant is performing a detailed financial analysis to find out why everything doesn’t or shouldn’t add up. It’s a far more time-consuming enterprise and can be significantly more expensive than regular auditing work. Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,

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:AICPA, “Forensic Services, Audits, and Corporate Governance: Bridging the Gap,” Discussion Memorandum, 2004.

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

Inexperienced Forensic Auditors
Find out who did it. Do not worry about all the endless details. Be creative, think like the fraudster, and do not be predictable. Lower the auditing threshold without notice. Take into consideration that fraud often involves conspiracy. Internal control lapses often occur during vacations, sick outages, days off, and rest breaks, especially when temporary personnel replace normal employees. H. R. Davia, Fraud 101, New York: John Wiley & Sons, 2000, pp

AICPA Audit Committee Toolkit
“In some situations, it may be necessary for an organization to look beyond the independent audit team for expertise in the fraud area. In such cases, CPA forensic accounting consultants can provide additional assurance or advanced expertise, since they have special training and experience in fraud prevention, deterrence, investigation, and detection. Forensic accounting consultants may also provide fresh insights into the organization’s operation, control systems, and risks. The work of forensic accounting consultants may also provide comfort for the organization’s CEO and CFO, who are required to file certifications under Sarbanes-Oxley.”

Types of Forensic Engagements
Determine if fraud is occurring. Support criminal or civil action against dishonest individuals. Form a basis for terminating a dishonest employee. Support an insurance claim. Support defense of an accused employee. Determine whether assets or income were hidden by a party to a legal proceeding (such as a bankruptcy or divorce). Identify internal controls to prevent it from happening again. Source: D.R. Carmichael, et. al, Fraud Detection, 5th, Fort Worth: Practitioners Publishing, 2002, p. 2 – 4.

Engagement Letters Are Important
For claims to Continental Casualty Company the national provider of CPA malpractice insurance, in : Tax, 48% Compilation and bookkeeping, 15% Consulting, 11% Audit, 10% Fiduciary, 6% All Others, 5% Most accounting malpractices claims involve inadequate documentation. In claims re business tax, 54% of the time no engagement letter. For individual tax claims, no engagement letters 78% of the time. Estate-related tax services, none, 63%. The most costly malpractice claims area is audit practice. Almost 40% of all audit claims allege that an auditor either failed to detect fraud or failed to inform the client of internal control weakness to reduce the risk of fraud. Source: Joseph Wolfe, “Accounting for Malpractice,” AICPA,

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 Auditing,” Journal of Forensic Accounting, Vol. 111, 2002, pp

Proactive vs. Reactive Approaches
Proactive approaches include Effective internal controls, Financial and operational audits, Intelligence gathering, Logging of exceptions, and Reviewing variances. Reactive detection techniques include Investigating complaints and allegations, Intuition, and Suspicion. Jack Bologna and Robert Lindquist, Fraud Auditing and Forensic Accounting, 2d Edition, New York: John Wiley, 1995, p. 137.

Proactive Is Best When the IRS began requiring banks to issue Form 1099s reporting interest, the reported interest income increased by $8 billion (even though for 3 years the IRS did not have computer matching capacity). When the IRS began to require taxpayers to list a social security number for dependents, the next year the number of reported dependents dropped by seven million. More than 11,000 of these taxpayers claimed seven or more dependents in 1986, but they claimed none in 1987. When the IRS began to require taxpayers to list a name, address, and social security number for babysitters, two years later 2.6 million babysitters disappeared.

Fraud Deterrence Better Than Fraud Investigation
Fraud deterrence less expensive. Deterrence is more comprehensive. Fraud deterrence produces greater savings. Deterrence is faster. Fraud deterrence promotes better customer relations. Daniel Finnegan, “Deterring Fraud,” Quality Planning Corporation, 1991.

Insurance Fraud Equations
1st Law of Fraud Control: An illusion of effective investigation deters fraud, in turn making possible the reality of effective investigation, thereby perpetuating deterrence. Evil Twin Corollary: When deterrence fails, fraud grows to levels that overwhelm enforcement capacities, in turn undermining deterrence. 2nd Law of Fraud Control: Fraud happens when anticipated income is greater than expected costs. Anticipated income = Award x Opportunity x Racketeering 2nd Corollary: Fraud is eliminated when potential perpetrators believe the costs of fraud are greater than income. Daniel Finnegan, “Deterring Fraud,” Quality Planning Corporation, 1991.

Is Company Proactive? Fraud hotline (reduce fraud losses by 50% re Wells 2002 Report). Suggestion boxes. Make everyone take vacations. People at top must set ethical tone. Widely known code of conduct. Check those employee references. Reconcile all bank statements. Count the cash twice in the same day. Unannounced inventory counts. Fraud risk assessment (CFD).

Some Hints Need to really understand the business unit. What they really do. Have a mandatory vacation policy. Rotation of assignments. Have a written/signed ethics policy. Do things differently each time you audit a unit. Do not tell client what you are doing. Hard to find fraud in the books. Look/listen. Look for life style changes. Do not rely on internal controls to deter fraud. Auditors must have control of the confirmation process. Careful of related parties. Careful of “trusted” employees.

Stamp Mates Afinsa, a Spanish stamp company, controls 72% of Escala, a U.S. company (formerly Greg Manning Auctions). Escala says all sales to Afinsa takes place at independent established prices. But Escala’s reported gross margin on stamp sales to Afinsa exceeds 44% [like land flipping]. Compared to less than 14% on those to other clients. Therefore, Escala was manipulating the value of stamps sold to Afinsa to artificially boost its own bottom line. Escala’s stock fell from $32 to $5 in five days after the May 8, 2006 arrests of seven executives. Police found $12.6 million behind one dealer’s freshly plastered walls in his home (e.g., unreported profits?). Escala owns A-Mark Precious Metals, which buys and distributed more than one-half of the gold coins handed each year by the U.S. mint.

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.]

Fraud Detection Process
Discuss facts and objectives with client/attorney (e.g., conflict of interests). Evaluation whether to accept the engagement. Prepare a work program. Develop time and fee schedule. Obtain approval of work program, staff assignments, and fee estimates. Obtain an engagement letter. 7/ Identify fraud exposures and symptoms. 9/ Evaluate evidence obtained and determine if more evidence is needed. 11/12. Search for and evaluate additional evidence. Discuss preliminary findings with client/attorney. Draft a final report. Review the report and work papers. Resolve professional disputes. Clear review points and open items. Communicate report or findings. Help attorney prepare court case/testify. Perform follow-up procedure. File work papers/report. Source: Carmichael et. al, PPC Fraud Detection, Vol.1, Ch. 2 (2002).

Financial Audit v. Forensic Audit
“ During one investigation, we found in the auditing working papers written in the margin of the internal audit working papers by the internal audit manager: ‘Conceal from bankers,’ says Nicholas L. Feakins, CPA, partner at San Mataeo, Calif based forensic accounting firm Feakins & Feakins. “ It sounds amazing, but the [third-party] auditors has put B-level staff on the project who simply didn’t read the documents and missed it.” MiniScribe, one of the world’s largest disk-drive makers, which in the late 1980s was surreptitiously shipping bricks instead of disk drives to the Far East and receiving credit from the bank for the amount of the shipments. “After all,” he says “it’s going to be 90 days until they ship the brick back to you. “MiniScribe’s public accounting firm, Coopers & Lybrand, didn’t catch the false-revenue scam during its regular audits-but a forensic accountant did.” Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,

Materiality Unimportant
“Auditing is governed by materiality. In investigative accounting, it is the opposite. I am looking for one transaction that will be the key. The one transaction that is a little different, no matter how small the difference, and that will open the door.” Lorraine Horton, owner of L. Horton & Associates in Kingston, R.I. “Fraud usually starts small. It begins with little amounts, because the perpetrator is going to test the system. If they get away with it, then they keep on increasing and increasing it.” Robert J. DiPasquale Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp

Forensic Accounting v. Auditing
“Forensic accounting is very different from auditing in that there is no template to use. There are no set rules. You don’t know when you go into a job how it is going to be.” Lorraine Horton, Kingston, R.I “Forensic accounting “is a very competitive field. What is interesting is that you may be a good accountant, but not a good forensic accountant. The training and the way you look at transactions are different.” Robert J. DiPasquale, Parsippany, N.J. “Unlike auditing, lower-level staff often can’t be used for an engagement. They normally will not spot anything out of the ordinary, and an experienced person should be the one testifying as well as doing the investigative work.” Lorraine Horton, Kingston, R.I. Source; H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp

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

SAS No. 99: SKEPTICISM An attitude that includes a questioning mind and a critical assessment of audit evidence. An auditor is instructed to conduct an audit “with a questioning mind that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity.”

SKEPTICISM Ronald Reagan said with respect to Russia, “Trust, but verify.” FA’s motto should be “Trust no one; question everything; verify.” This ain’t my first rodeo I didn’t make it all the way through school. But my mama didn’t raise no fool. I may not be the Einstein of our time. But honey, I’m not dumb and I’m not blind. Vern Gosdin

SAS No. 99: Questions for Management
Whether management has knowledge of any fraud that has been perpetrated or any alleged or suspected fraud. Whether management is aware of allegations of fraud, for example, because of communications from employees, former employees, analysts, short sellers, or other investors. Management’s understanding about the risks of fraud in the entity, including any specific fraud risks the entity has identified or account balances or classes of transactions for which a risk of fraud may be likely to exist. Programs and controls the entity has established to mitigate specific fraud risks the entity has identified, or that otherwise help prevent, deter, and detect fraud, and how management monitors those programs and controls. For an entity with multiple locations, (a) the nature and extent of monitoring of operating locations or business segments, and (b) whether there are particular operating locations or business segments for which a risk of fraud may be more likely to exist. Whether and how management communicates to employees its views on business practices and ethical behavior.

BE SKEPTICAL Assume there may be wrong doing.
The person may not be truthful. The document may be altered. The document may be a forgery. Officers may override internal controls. Try to think like a crook. Think outside the box.

SAS No. 99: Brainstorming Aims to make the auditor’s consideration of fraud seamlessly blended into the audit process and continually updated until the audit’s completion. Brainstorming is now a required procedure to generate ideas about how fraud might be committed and concealed in the entity. No ideas or questions are dumb. No one owns ideas. There is no hierarchy. Excessive note-taking is not allowed. Source: Michael Ramos, “Auditors’ Responsibility for Fraud Detection,” J. of Accountancy, January, 2003, pp. 28 – 36.

More Brainstorming Best to write ideas down, rather than say them out loud. Take plenty of breaks. Best ideas come at the end of session. Important to not define the problem too narrow or too broad. Goal should be quantity, not quality. Geniuses develop their most innovative ideas when they are generating the greatest number of ideas. No such things as bad ideas. Many companies are great at coming up with good ideas, but lousy at evaluating an implementing them. Source: A.S. Wellner, “Strategies: A Perfect Brainstorm,” Inc. Magazine, October 2003, pp

Potential Pitfalls Group domination: one or two participants dominating the process can quickly squelch the creative energies of the groups as a whole, reducing the likelihood the team will identify any actual fraud risks. Social loafing: participants disengage from the process, expecting other team members to pick up the slack. Groupthink: team members become so concerned with reaching consensus that they fail to realistically evaluate all ideas or suggestions. Group shift: avoid allowing the team to take an extreme position on fraud risk. Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,” Journal of Accountancy, December 2003, pp

Three Types of Brainstorming
Open brainstorming: unstructured; few rules; free-for-all; someone should record ideas. Round-robin brainstorming: start with no talking, silent period; assigned homework ahead; each individual presents own ideas; each member has a turn. Electronic brainstorming: shortens meetings, increases ideas, and reduces personalizing ideas because an idea’s author remains anonymous. Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,” Journal of Accountancy, December 2003, pp

How Management Overrides Controls (SAS No. 99)
Recording fictitious journal entries (especially near end of quarter or year). Intentionally biasing assumptions and judgments used to estimate accounts (e.g., pension plan assumptions or bad debt allowances). Altering records and terms related to important and unusual transactions.

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

Bias Assumptions There are almost as many oil/gas reserve definitions as there are countries. During the first week of January 2004, Royal Dutch/Shell Group slashed its estimates of oil reserves by 20% or about 3.9 billion barrels of oil. Stock fell 9%. Shell, Exxon/Mobil, and Chevron/Texaco make the estimates themselves. By the end of 2002, a total of 4.47 billion barrels cut; another 1.4 billion barrel cut in 2003. Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves Prove Unrefined,” Wall Street Journal, January 14, 2004, p. C-4. Chip Cummins, “Shell Slashes Oil Reserves Again, News Overshadows Profit Surge,” WSJ, February 4, 2005, p. A-3

Shell Board Kept In the Dark
One memo drafted on February 11, 2002, warned that about one billion barrels of oil-equivalent reserves appeared not to be in compliance with SEC guidelines. Board learned of information only in early January 2004. Chairman Sir Philip was ousted in early March 2004. Most of the misstated reserves were recorded from 1997 to 2000, when Sir Philip was in change of exploration and production. Oil/gas reserves were increased (not by discovery) by changing its accounting. Source: Stephen Labaton and Jeff Gerth, “At Shell, New Accounting and Rosier Oil Outlook,” New York Times, March 12, 2004, pp. A-1 and C-4.

Wildcatting The SEC has recently adopted the proactive strategy of “wildcatting” where investigations into entire industries and business sectors are begun after evidence emerges from only one company in the group regarding financial reporting problems. Over time, the PCAOB will probably be able to identify peculiarities within existing or evolving industries that require either standard setting or regulatory attention, or both. Source: Berton, L., “U.S. Accounting Watchdogs Try to Shut Barn Door,” Bloomberg.com, April 2, 2004; J.H. Edwards, “Audit Committees: The Last Best Hope,” Journal of Forensic Accounting, Vol. IV (2004), pp

Walkthroughs An auditor must perform a walkthrough of a company’s significant processes (each major class of transactions). Can not be achieved secondhand. 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.

Slot Machine Example

Revenue Flows

Wandering Around Informal observations while in the business.
Especially valuable when assessing the internal controls. Observe employees while entering and leaving work and while on lunch break. Observe posted material, instructions, job postings. Observe information security and confidentiality. Observe the compliance with procedures.

New Terms in Financial Reports: Deficiencies Have No Bright Lines
Control deficiency – one that might allow a bad number to get into the financial reports (e.g., the likelihood that a company misstates reports is remote– 1 out of 20) Example: company does not check changes made by a salesman in a minor contract. Significant deficiency – more serious flaw or a number of flaws that increase the chances that wrong numbers will significantly distort financial statements (e.g., more than remote). Example: company not checking for changes to terms of several key contracts. Need only to report to BOD, but some companies are making them public.

Deficiencies Have No Bright Lines
Material weakness – deficiencies are so bad that there is more than a remote change of a material misstatement in financial statements. Example: a bank does not regularly check for errors in estimating loan-loss expenses (i.e., Fannie Mae reported a $1.3 billion error from its computer model, many in an uncontrolled environment). They must be reported. David Henry, “How Clean Are the Books?” Business Week, March 7, 2005, pp Firms that reported material weaknesses in tax accounting lost an average of 5.8% of their stock value 60 days after the announcement. As of , 695 companies have disclosed material weaknesses in their annual report.

Material Weakness Areas
AREAS OF FAILURE 2005 2004 Tax accruals/ deferrals 34.5% 32.0% Revenue recognition 28.4 31.3 Inventory/ vendor cost of sales 23.7 27.4 Fixed/ Intangible assets 16.0 18.6 Leases or contingencies 9.3 16.8 Cash flow (FAS 95 error) 8.8 -- Consolidation (Fin 46 issues) 6.7 9.0 * 10% of corporate filers in 2005 and 16% in 2004. Source: AuditAnalytics.com

Law Suits Few So Far Companies reporting problems with internal controls have not seen a big increase in class-action lawsuits, according to a study by Deloitte & Touche between November 2003 and August 2004. Deloitte said only 6% of the 290 companies reporting internal-control flaws were sued. 52% of the firms had material weakness in their internal controls. These internal control announcements did not seem to send prices downward. Highest incidence of internal controls: -computer-software firms -manufacturers -health-care and pharmaceutical companies. - financial-services firms -telecommunication companies. Source: Judith Burns, “Few Firms Are Sued Over Flaws in Internal Controls, Study Finds, WSJ, December 29, 2004, p. B-5.

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. FAs must learn the tricks of the trade as well as the trade.

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?

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

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

Fraud Hypothesis Testing Approach
Here a forensic accountant attempts to pro-actively detect fraud that is still undiscovered by formulating and testing null hypotheses. This proactive technique requires an forensic investigator to Identify the frauds that may exist in a particular situation. Formulate null hypotheses stating that the frauds do not exist. Identify the red flags that each of the frauds would create. Design customized queries to search for the specific red flags or combination of red flags. In a refinery, three authors report that after a formalized pro-active search for red flags, some unknown frauds were discovered. But applying generic data mining programs to the company’s database to detect fraud resulted in a number of Type II errors. So in order to be useful the red flags had to be fraud and company specific. C.C. Albercht, W.S. Albercht, and J.G. Dunn, “Conducting a Pro-Active Fraud Audit: A Case Study,” Journal of Forensic Accounting, Vol. 11, 2000, pp

The Methods Asset misappropriation accounted for more than four out of five offenses or 91.5% in (92.7% in 2004). $150,000 Bribery and corruption constituted about 30.8% in 2006 (30.1% in 2004) of offenses. ($538,000) Fraudulent statements were the smallest category of offense 10.6% in 2006 (7.9% in 2004) (most costly). $2 million per scheme. Source: 2006 Wells Report, ACFE.

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.

Restatements of Financial Statements
2005 2004 1,195 (8.5%) 616 2003 514 2002 330 2001 270 1999 216 1998 158 Reasons for 2004 restatements: Revenue recognition. Equity accounting. Revenues, accruals, contingencies. 15% were repeat filers. Arthur Andersen had averaged 11 restatements before In 2002, they had 40, with 26 after new auditors were retained. Source: Greg Farrell, “Restatements of Earnings in 2005 to Break Record,” USA Today 12/29/2005; Stephen Taub, CFO.com, March 3, 2006.

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.”

Measures Helpful in Preventing Fraud
Strong Internal Controls (3.66) Willingness of companies to prosecute (3.44) Regular fraud audit (3.40) Fraud training for auditors (3.33) Anonymous fraud reporting mechanisms (3.27) Background checks of new employees (3.25) Established fraud policies (3.12) Ethical training for employees (2.96) Workplace surveillance (2.89) Source: 2004 Wells Report

Anti-Fraud Measures – Months to Detect – Median Loss
YES NO Hotlines $100,000 (15) $200,000 (24) Internal audits $120,000 (18) $218,000 (24) External audits $181,000 (23) $125,000 (18) Surprise audits Fraud awareness/ Ethics Training Source: 2006 Wells Report, ACFE.

Executions for Fraud? In September 2004, Wang Liming, a onetime accounting officer at China Construction, and two other bank employees were executed for defrauding the bank of $2.4 million. In an unrelated corruption case, an officer at the Zhuhai branch of the Bank of China was put to death. John Goff, “Bank Fraud Brings Executions,” CFO, November 2004, p.20.

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

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

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

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

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

Code of Ethics Required by Sarbanes-Oxley
Section 406: Public issuer has to adopt a code of ethics for senior financial officers to deter wrong –doing and to promote Honest and ethical conduct. Full, fair, accurate, timely and understandable disclosure in SEC filings. Compliance with government laws, rules, and regulations. Prompt internal reporting code violations; Accountability for adherence to the code.

More Hints … Check employee references/resume.
Stop giving the employee/client the answer when you ask a question. Zero tolerance for allowing employee/executive to get away with anything. Always reconcile the bank statements. Try to think like a criminal. Get inside the criminal’s mind. Be a detective. Do not assume you have honest employees. Bond employees. Uni-ball gel pens. Source: Gary Zeune

Auditing Hints SAS No. 99 does not require auditors to make inquiries of “others,” as opposed to management. Auditors must talk to and interview others below management level. If asked, employees may be willing to report suspicious activities. Use independent sources for evaluating management (e.g., financial analysts). Surf the internet. Auditors need to follow the performance history of managers and directors. If a company has an anonymous reporting system, obtain information about the incidents reported and consider them when assessing fraud risk. Be sure to perform analytical procedures, and the work should be reviewed by senior members of the audit team. Auditors should select sample items below their normal testing scope (e.g., HealthSouth). Fraud procedures should be more than checklists. Audits should focus on finding and detecting fraud.

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

Integrity Testing Pre-employment drug testing.
Post-employment drug testing more sensitive. Pre-employment polygraph tests prohibited by 1988 Act (Federal, State, Local Governments and Federal Contractors exempted from the Act). Written integrity tests.

Lavish Executive Pay Many of the companies indicted by the SEC after Enron had one thing in common: CEOs were making about 75% above their peers. The common thread among the companies with the worst corporate governance is richly compensated top executives, as per the Corporate Library, Portland, Maine governance-research firm. Hefty pay checks and perks to current or former chief executives. Poor BODs have in common: an inability to say no to current or former chief executives. Source: Monica Langley, “Big Companies Get Low Marks for Lavish Executive Pay,” Wall Street J., June 9, 2003, p. C-1.

Compensation Facts CEOs compensation components have increased dramatically in the 1990 [mean of $1.68 million in 1992 to 43.2 million in 2000] even after the passage of IRC Section 162 (m) in 1993 [$1 million limit]. Balsam, S An Introduction to Executive Compensation. San Diego, CA: The Academic Press. Compensation increases when the CEO has influence over the outside directors, as measured by the percentage of outside directors appointed by the CEO. Core, J.E, Holthausen, R and Larcker, D Corporate governance, chief executive officer compensation, and firm performance, Journal of Financial Economic 51: CEO compensation is higher when the CEO’s tenure is greater than the chair of the compensation committee. Main, B., O’Reilly, C, and Wade, J The CEO, the board of directors and executive compensation: economic and psychological perspectives, Industrial and Corporate Change 4: The relation between the change in CEO cash compensation and stock returns weaken with tenure. Hill, C. and Phan, P CEO tenure as a determinant of CEO pay. Academy of Management Journal 34: The greater the percentage of outside board members appointed after the CEO, the more likely the CEO will have a golden parachute. Wade, J., O’Reilly, C, and Chandratat, I Golden parachutes: CEOs and the exercise of social influence. Administrative Science Quarterly 35:

External Fraud-Shoplifting
It’s not just stars (e.g., Bess Myerson, Hedy Lamarr, and may be Winona Ryder). Why, each year, ordinary people shoplift $13 billion of lipstick, batteries, and bikinis from stores (last year $26 to $33 billion). May account for one-third of total inventory shrinkage. 800,000 times a day the thrills and temptations win over fear – a product of the late 19th century with the larger stores. Source: Jerry Adler, “The Thrill of Theft,” Newsweek, February, 2002.

Earnings Management Earnings management may be defined as the “purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.” – Katharine Schipper, “Commentary on Earnings Management,” Accounting Horizon, December 1989, p. 92.

Earnings Management The difference between earnings management and financial statement fraud is the thickness of a prison wall. D. Larry Crumbley The difference between earnings management and financial statement fraud is like the difference between lightning and a lightning bug.

Financial Statement Fraud Schemes
Category % Concealed Liabilities 45.0% Fictitious Revenues 43.3% Improper Asset Valuations 40.0% Improper Disclosures 37.5% Timing Differences 28.3% Source: 2006 Wells Report, ACFE.

Good Earnings Management
Careful timing of capital gains and losses; Use of conferencing technology to reduce travel costs; and Postponement of repair and maintenance activities when faces with unexpected cash flow declines. L. G. Weld et. al, “Anatomy of a Financial Fraud,” The CPA Journal, October 2004.

Abusive Earnings Management
Improper revenue recognition; Improper expense recognition; and Using reserves to inflate earnings in years with falling revenues (cookie jar accounting). SEC § 704 Report

Early Warning Signs of Earnings Management
Cash flows that are not correlated with earnings; Receivables that are not correlated with revenues; Allowances for uncollectible accounts that are not correlated with receivables; Reserves that are not correlated with balance sheet items; Acquisitions with no apparent business purpose; and Earnings that consistently and precisely meet analysts’ expectations. Magrath and Weld, “Abusive Earnings Management and Early Warning Signs,” The CPA Journal, August 2002.

Some Red Flags of Earnings Management
CEO is also Chairperson of BOD (e.g., Parmalat). Insiders have majority control of BOD. Weak system of internal controls. Performance emphasis on short-term goals. Weak or non-existent Code of Ethics (e.g., Parmalat). Questionable business strategies with opaque disclosures (e.g., special purpose entities). CEO is uncomfortable with criticism (Enron’s Jeff Skilling). CEO or other senior management turnover (Qwest’s CFO). Insiders selling stock (Enron’s Ken Lay). Independence problem from large non-audit fees paid to external auditors (e.g., HealthSouth). Company’s investment banker has independence problems (e.g., Parmalat, Enron).

Earnings Management Companies that consist solely of independent directors and meet at least four times a year are likely to have lower non-audit service fees. L.J. Abbott et.al, “An Empirical Investigation of Audit Fees, Non-Audit Fees, and Audit Committees,” Contemporary Accounting Research, Summer, 2003, p. 230. An auditor who is also an industry specialist further enhances the credibility of accounting information (e.g., less earnings management). G.V. Krishnan, “Does Big 6 Auditor Industry Expertise Constrain Earnings Management?” Accounting Horizons, Vol. 17, Supplement 2003, p. 15.

Earnings Management Lower perceptions of earnings quality lead investors to more thoroughly examine a firm’s audited financial statements. A more thorough analysis of a firm’s financial statements lead investors to lower their assessment of the firm’s earnings quality. F.D. Dodge, “Investors perceptions of Earnings Quality, Auditor Independence, and the Usefulness of Audited Financial Information,” p. 46. Found no evidence that short sellers trade on the basis of information contained in accruals. Scott Richardson, “Earnings Quality and Short Sellers,” p. 49.

Earnings Management Small companies tend to more frequently manage earnings to avoid losses than large companies. Auditors type appears insignificant. Brain Lee and Ben Choi, “Company Size, Auditor Type, and Earnings Management.” Journal of Forensic Accounting, Vol. 3 (2002), pp

Professor Ketz’s Shoddy Accounting Practices
Pro forma means “as if,” so pro forma earnings means earnings that would have been reported had the corporation been using alternative methods (e.g., everything but the bad stuff). “Today, however, pro forma numbers are seldom published for the purpose of informing investors and creditors in a better manner. Instead, these disclosures have become a way of under-minding orthodox accounting by not recognizing a variety of items as expenses.” Examples: Goodwill never declines. Moving expenses and losses from operating items to so-called nonrecurring items. Contrast the income with the firm’s operating cash flow. Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003

Hiding Debt Companies hide debt by these techniques:
Using the equity method (rather than Trading Security and Available for Sale methods). Nets the assets and liabilities of the investee. Lease accounting (arguing that leases are operating leases). Understates 10 to 15% . Pension accounting – netting of the projected benefit obligation and the pension assets. Must un-net them. Hiding debt inside Special – Purpose Entities – trillions of dollars of SPE debt is off the books (e.g., securitization, SPE borrowings, synthetic leases). Readers can make analytical adjustments by searching footnotes for 1,2, and 3. But no disclosures for asset securitization, SPE borrowings, and synthetic leases. Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003

Types of Financial Statement Fraud Schemes
Three professors have broken financial statement fraud schemes into these ten types: Fictitious and/or overstated revenues and assets (e.g., nonordered or cancelled goods). Sunbeam created revenues by contingent sales, a bill-and-hold strategy, and accelerated sales. Digital Lightware, Inc. recognized fraudulent billings. Premature Revenue Recognition (e.g., holding books open). Misclassified Revenues and Assets (e.g., combining restricted cash accounts with unrestricted cash accounts). School districts and universities may engage in this strategy with dedicated funds. Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud Types and Auditor Litigation,” The Accounting Review, October 1998, pp

Types of Financial Statement Fraud Schemes (contd …)
Fictitious Assets and/or Reductions of Expenses/Liabilities (e.g., recording consigned inventory as inventory). Cendant Corporation created fictitious revenues, and Knowledge Ware inflated revenues with phony software sales. Overvalued Assets or Undervalued Expenses/Liabilities (e.g., insufficient allowance for bad debts). Omitted or Undervalued Liabilities (e.g., understated pension expenses). Omitted or Improper Disclosures (e.g., stock option expense estimates).

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

Wrong Way Earnings Management
Freddie Mac understated past earnings as much as $5 billion. Certain transactions and accounting policies were “implemented with a view to their effect on earnings” (e.g., to smooth earnings). Restatements will result in higher earnings in prior periods but lower earnings in future periods. Employees appeared to knowingly violate accounting rules in an effort to manipulate earnings. Source: Patrick Barta and J.D. McKinnon, “Freddie Mac Profits May Have Been Low By Up to $4.5 Billion,” Wall Street J., June 26, 2003, pp. C-1 and C-11. Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005, pp

Fannie Mae’s Problem Fannie Mae was ordered by the SEC [2004] to a restatement of earnings of $ 9 billion (reducing earnings since 2001). Misuse of hedge-accounting transactions and improper accounting for loans. CFO J. Timothy Howard resigned with an annual pension of $400,000 and lifetime access to Fannie Mae’s Medical benefits. Plus $ 4 million of stock options. CEO Franklin Raines was paid more than $60 million over a 6 year period. On Dec. 21, 2004, Raines took early retirement. $ 1 million annually for life. The Board replaced KPMG as Fannie’s auditor. Source: Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005, pp Mike McNamee, “Franklin Raines Lost Gamble,” Business Online, December 22, 2004.

Lessons From Enron Enron’s management figured an ingenious method of overriding the double-entry of accounting. They simply ignored it. It remains the simplest, most elegant financial fraud. Enron created special-purpose entities (SPEs) and pledged Enron stock – just pieces of paper. If the SPE was successful, they recognized income. When the SPE had huge losses they issued more paper. Debts were filed off-balance sheet in the partnerships. Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p

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

Financial Fraud Detection Tools
Interviewing the executives Analytics Percentage analysis Horizontal analysis Vertical analysis Ratio analysis Using checklists to help detect fraud SAS checklist Attitudes/Rationalizations checklist Audit test activities checklist Miscellaneous fraud indicator checklist

Public Document Review Real and personal property records. Corporate and partnership records. Civil and criminal records. Stock trading activities. Check vendors. Laboratory Analysis Analyzing fingerprints. Forged signatures. Fictitious or altered documents. Mirror imaging or copying hard drives/company servers. Use clear cellophane bags for paper documents.

Analytical Procedures
Analytical procedures involve the study or comparison of the relationship between two or more measures for the purpose of establishing the reasonableness of each one compared. Five types of analytical procedures help find unusual trends or relationships, errors, or fraud: Horizontal or Percentage Analysis Vertical Analysis Variance Analysis Ratio Analysis or Benchmarking Comparison with other operating information Source: D.L. Crumbley, J.J. O’Shaughnessy, and D.E. Ziegenfuss, 2002 U.S. Master Auditing Guide, Chicago: Commerce Clearing House, 2002, p. 592.

Sales v. Net Income Forensic accountants should compare the trend in sales with the trend in net income. For example, from 1999 to 2001, HealthSouth’s net income increased nearly 500%, but revenues grew only 5%. On March 19, 2003, the SEC said that HealthSouth faked at least $1.4 billion in profits since 1999 under the auditing eyes of Ernst & Young. The SEC said that HealthSouth started cooking its numbers in 1986, which Ernst & Young failed to find over 17 years. HealthSouth also inflated its cash balances.

Beware Intercompany Entries
HealthSouth used PeopleSoft, with at least 2,000 different ledgers. Suspense Account xx Revenue xx Accounts Receivable xx Inventory xx Property xx Suspense Account xxx Most of the entries were intercompany entries. During 2005, 2004, and 2003, professional fees associated with the reconstruction of HealthSouth’s financial records and restatement of 2001 and 2002 consolidated financial statements approximated $206.2 million and $70.6 million, respectively.

Financial Statement Fraud Audit
Obtain current year’s financial statements. Obtain prior 3 years’ financial statements. Perform vertical/ horizontal analysis of the 4 years, plus all current quarters. Pay attention to footnotes. Analysis of %s and footnotes by senior auditors. Nonsense %s and footnotes inquire explanations from financial management. Interview lower level financial employees who approved questionable journal vouchers. Combine explanations with visits to accounting records/ source documents.

Horizontal Analysis Suppose advertising in the base year was $100,000 and advertising in the next three years was $120,000, $140,000, and $180,000. A horizontal comparison expressed as a percentage of the base year amount of $100,000 would appear as follows: Year 4 Year 3 Year 2 Year 1 Dollar Amount $180,000 $140,000 $120,000 $100,000 Horizontal Comparison 180% 140% 120% 100%

Red Flags with Horizontal Analysis
When deferred revenues (on the balance sheet) rise sharply, a company may be having trouble delivering its products as promised. If either accounts receivable or inventory is rising faster than revenue, the company may not be selling its goods as fast as needed or may be having trouble collecting money from customers. For example, in 1997 Sunbeam’s revenue grew less than 1% but accounts receivable jumped 23 percent and inventory grew by 40 percent. Six months later in 1998 the company shocked investors by reporting a $43 million loss. If cash from operations is increasing or decreasing at a different rate than net income, the company may be being manipulated. Falling reserves for bad debts in relation to account receivables falsely boosts income (cookie jar accounting).

More Red Flags Look for aggressive revenue recognition policies (Qwest Communication, $1.1 billion in ). Beware of hockey stick pattern. Beware of the ever-present nonrecurring charges (e.g., Kodak for past 12 years). Check for regular changes to reserves, depreciation, amortization, or comprehensive income policy. Related-party transactions (e.g., Enron). Complex financial products (e.g., derivatives). Unsupported top-side entries (e.g., WorldCom). Under-funded defined pension plans. Unreasonable management compensation. Source: Scott Green, “Fighting Financial Reporting Fraud,” Internal Auditor, December 2003, pp

Five Statistically Significant Ratios
Use the ratios for two successive fiscal years. Convert into indexes for benchmarking. Day’s Sales in Receivable Index: (Accounts Receivable t / Sales t ) (Accounts Receivable t-1 / Sales t-1) Index for manipulators: 1.5 to 1 Gross Margin Index: [(Sales t - Cost of Sales t ) / Sales t] [(Sales t-1 - Cost of Sales t-1 ) / Sales t-1] Index for manipulators = 1.2 to 1 Source: M.D. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, September/October, t-1 = prior year.

Asset Quality Index = 1- (Current Assets t + Net Fixed Assets t ) Total Assets t (Current Assets t-1 + Net Fixed Assets t-1) Total Assets t-1 Index for manipulators = 1.25 to 1 Sales Growth Index : Sales t / Sales t-1 Manipulators: 60% Non manipulators 10% Source: M.D. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, September/October, t-1 = prior year.

Total Accruals to Total Assets = Δ Working Capital t - Δ Cash t - Δ Current Taxes Payable t - Δ Current Portion of LTD t - Δ Accumulated depreciation and amortization t Total Assets t TATA for manipulators: .031 TATA for non manipulators: .018 Source: M.D. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, September/October, LTD = Long-term debt.

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

Exercises In order to determine how risky a particular company is that you are auditing, you prepare these five ratios along with the same ratios of this company’s peers: Company Peers Day’s Sales in Receivable Index 1.51 1.05 Gross Margin Index 1.98 1.11 Asset Quality Index 1.21 1.01 Sales Growth Index 1.53 1.19 Total Accruals to Total Assets 0.11 0.06 What are your thoughts about the risk potential of this company? 2. You are provided the following information about a company for two years (in millions): 2005 2006 Sales $23,000 32,000 Cost of Sales 11,960 17,600 Accounts Receivable 4,830 10,560 Calculate: a. Days Sales in receivable index. b. Gross margin index. c. Sales growth index. Any thoughts about this company?

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

Excel Spreadsheet Sherron Watkins discovered the Enron fraud in 2001 when she was again working under Andy Fastow, CFO. She took a simple inventory, using an Excel spreadsheet to calculate which of the division’s assets were profitable and which were unprofitable. She discovered the special purpose entities called Raptors, off-the-books partnerships. Enron had hidden hundreds of millions of losses by borrowing money from Raptors and promising to pay the loans back with Enron stock. Enron was hedging risks in its left pocket with money from its right pocket. As the value of Enron stock fell and the losses in the Raptors mounted, Enron had to add more and more stock because Enron had risked 97% of the losses, and Arthur Andersen had agreed to the accounting. Source: Mimi Swartz and Sherron Watkins, Power Failure, New York: Doubleday, 2003, p. 269.

Fraud Awareness Auditing: Unrefined Oil

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

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

Behavioral Concepts Important
“Not all fraud schemes can effectively be detected using data-driven approaches. Instances of corruption-bribery, kickbacks, and the like – and collusion consistently involve circumvention of controls. Searching relevant transaction data for patterns and unexplained relationships often fails to yield results because the information may not be recorded, per se,by the system. Behavioral concepts and qualitative factors frequently allow the auditor to look beyond the data, both with respect to data that is there and the data that isn’t.” Source: S. Ramamoorti and S. Curtis, “Procurement Fraud & Data Analytics, “Journal of Government Financial Management, Winter 2003, Vol. 52, No. 4, pp

Life Styles Important For someone who earned a salary of just $1,000 a month, Rana Koleilat managed to live a pretty nice life. She traveled by private jet, took along her servant and hairdresser, and stayed at luxurious locality in London and Paris. Back home in Beirut, Lebanon, she lived in a three-story penthouse. To anyone who asked how she lived so well, she replied that she had a “rich uncle.” Actually, Koleilat helped manage a private bank in Beirut, and thereby hangs a tale. The chairman of the bank said he lost $1.2 billion, and depositors lost another several hundred million dollars. E.T. Pound, “Following the Old Money Trail,” U.S. News & World Report, April 4, 2005, p. 30

Fraud Identifiers to Spot Fraudsters
Large ego Substance abuse problems or gambling addiction Living beyond apparent means Self-absorption Hardworking/taking few vacations Under financial pressure (e.g., heavy borrowings) Sudden mood changes. Source: G.E. Moulton, “Profile of a Fraudster,” Deloitte Touche Tohatsu,

Red Flags or Fraud Identifiers
Earnings problem: downward trend in earnings Reduced cash flow: If net income is moving up while cash flow from operations is drifting downward, something may be wrong. Excessive debt: the amount of stockholders' or owners' equity should significantly exceed the amount of debt. Overstated inventories (California Micro) and receivables (BDO Seidman): If accounts receivables exceeds 15 percent of annual sales and inventory exceeds 25 percent of cost of goods sold, be careful. Inventory plugging: Record sales to other chains as if they were retail sales rather than wholesale chains (e.g., Crazy Eddie). Balancing Act: Inventory, sales, and receivables usually move in tandem because customers do not pay up front if they can avoid it. CPA Switching: Firms in the midst of financial distress switch auditors more frequently than healthy companies.

Red Flags or Fraud Identifiers (contd…)
Hyped Sales: hyped sales by using his ample personal fortune to fund purchases. Reducing Expenses: Rent-Way reduced the company’s expenses—a reduction of $127 million. Ebitda: Earnings before interest, taxes, depreciation, and amortization is a popular valuation method for capital-intensive industries. Off-Balance Sheet Items: Enron had more than 2,500 offshore accounts and around 850 special purpose entities. Unconsolidated Entities: Enron did not tell Arthur Andersen that certain limited partnerships did not have enough outside equity and more than $700 million in debt should have been included on Enron’s statements.

Red Flags or Fraud Identifiers (contd…)
Creative or Strange Accounts: For their 1997 fiscal year, America Online, Inc. showed $385 million in assets on its balance sheet called deferred subscriber acquisition costs. Pension Plans Reserve Estimates Personal Piggy Bank: Family member owners may use a corporation as a personal piggy bank at the expense of public investors and creditors. Barter deals: A number of Internet companies used barter transactions (or non-cash transactions) to increase their revenues.

Barter Deals AOL created ad revenues out of thin air. With an obsession to get advertising revenue in the door, “nobody there appears to have paid much attention to whether the business deals at issue were really producing ad ‘revenues’ by any acceptable definition….” At least $90 million of revenues were expunged by mid-2003, with another $400 million contested. Source: C.J. Loomis, “Why AOL’s Accounting Problems Keep Popping Up,” Fortune, April 28, 2003, p. 86.

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. In March 2005, the SEC said that executives are gatekeepers. Thus, an executive can be in trouble if in a position to detect wrongdoing below them and do not move forcefully to prevent the fraud. It does not matter if the executive has been lied to. An executive has the responsibility to cut through the lies and try to root out the truth. Carol. J. Loomis, “The SEC Turns the Screws on Gatekeepers,” Fortune, April 18, 2005, p. 38.

Pressures On All Sides CEOs are now being squeezed as a result of SOX by BODs, auditors, and lawyers because these watchdogs are finally facing genuine liability for their failures. These watchdogs are trying to protect their hides. Arthur Andersen is out of business, and directors at WorldCom and Enron are paying off fraud claims out of their own pockets. Hank Greenberg, former Chairman and CEO of AIG said that the balance of power in corporate America has shifted. Diane Brady and Joseph Weber, “The Boss on the Sidelines,” Business Week, April 25, 2005, p. 88.

Significant Variables of Fraudulent Companies
Percentage of total Board of Directors holdings held by insiders. Insiders having greater than 50% control of the BOD. CEO also being chairman of the BOD. CEO being the company’s founder. Lack of an audit committee. SEC Accounting and Auditing Enforcement Releases ( ).

CEO Duality Eight of the ten recent scandals had board chairs who were also CEO: Enron 5. HealthSouth Adelphia 6. Quest Tyco 7. Homestore Waste Management 8. Sunbeam WorldCom and Global Crossing had different Chairman and CEO. Aging Board of Directors. “Easier for Management to get away with misdeeds.” Enron’s Audit Committee chairman was 72. “They can be hard of hearing.” Nearly 10% of directors in the S & P’s 500 stock index are 70 or over. Source: Louis Lavelle, “Directors: Know When to Fold Them, “Business Week, May 24, 2004, p.14.

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”

Internal Auditors and Fraud Detection
The Institute of Internal Auditors’ Due Professional Care Standard (Section 280) assigns the internal auditor the task of assisting in the control of fraud by examining and evaluating the adequacy and effectiveness of the internal control system. However, Section 280 says that management has the primary responsibility for the deterrence of fraud, and management is responsible for establishing and maintaining the control systems. In general, internal auditors are more concerned with employee fraud than with management and other external fraud.

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

Audit Committee The audit committee is the subcommittee of an organization’s board of director’s charged with overseeing the organization’s financial reporting and internal control processes. The audit committee’s biggest responsibility is monitoring the component parts of the audit process. The board of directors and its representative audit committee should oversee (1) the integrity, quality, transparency, and reliability of the financial reporting process; (2) the adequacy and effectiveness of the internal control structure in preventing, detecting, and correcting material misstatements in the financial statements; and (3) the effectiveness, efficacy, and objectivity of audit functions.

Audit Committee Red Flags
Independence of audit committee from management. The clarity with which the audit committee’s responsibilities are articulated, such as in the charter, and how well the audit committee and management understand those responsibilities; The audit committee’s interactions and involvement with the independent and internal auditor; and Whether the audit committee raises and pursues with management and the independent auditor the appropriate questions, including questions that indicate an understanding of the critical accounting policies and judgmental accounting estimates.

Computer Forensics “ Today’s Sergeant Joe Friday does not write in a small notebook in the course of solving crimes; he now reconstructs the data from imaging hard drives.” Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003. “Corporate criminals don’t always tell the truth. Their computers usually do.” Thomas Talleur, KPMG

Data Mining Found WorldCom Mess
Auditors should perform all of the analytics themselves, and they must be educated in fraud detection and introduced to data mining techniques. When the concept of data mining is brought up, audit managers cringe and argue that they cannot afford to employ statisticians. However, while there is data mining software that requires a statistician’s level of expertise (such as IBM’s Intelligent Miner), there also are products, such as WizSoft Inc., that can be employed by most auditors who are acquainted with the fundamentals of Microsoft Office and who are curious as to why they obtained their audit results. Source: Bob Denker, “Data Mining and the Auditor’s Responsibility,” Information Systems Audit and Control Association InfoBytes.

Technology Commits Fraud
“Technology was used to commit fraud in selling pools of credit card debt. A cooked formula was embedded in software by the seller of the debt to analyze the quality of debt for the purchaser, so no matter what debt came out, it had a good collection ratio, and the purchaser was willing to pay more. Only by analyzing the software coding was the fraud discovered,” Cal Klausner, Bethesda Md. The trend toward paperless systems hinders a CPA’s ability to find fraud. For example, many banks are no longer sending out checks Roberts J. DiPasquale H.W. Wolosky, “Forensic Accounting to the Forefront, “ Practical Accountant, February 2004, pp

Using Technology to Gather Evidence
Drill-down functionality Electronic imaging Benford’s law Digital Analysis Tests and Statistics (DATAS) Data warehousing/mining Inductive vs. deductive method

Technology is Here “Extensive knowledge and use of technology is an absolute necessity. The ability to go into an electronic image and download information, and to get information from systems that don’t talk to each other. All the accumulated information can then be reviewed for financial improprieties.” Bert Lacativo, Southlake, Texas “We use off-the-shelf software (IDEA) to import large databases, read different data files, set up queries, and compare database files such as addresses, telephone numbers, and Social Security numbers. This process will tell us, for example, if a purchase order was done on Saturday or Sunday when the company isn’t open.” Cal Klausner, Bethesda, Md. H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp

Data Analysis vs. Data Mining Software
ACL, IDEA, and SAS are data analysis (DA) software used to ensure the integrity of data, to program continuous monitoring, and to detect fraudulent transactions. DA requires a program to be set up and run against the data. The program is written by auditors (i. e., humans) who may be prejudice in the routines that are executed. Data Mining finds patterns and subtle relationships in data. Wiz Rule (from WizSoft, Inc.) and IBM’s Intelligent Miner are data mining software. Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.

Wiz Rule Data Auditing Tool
Based upon data mining. Performs complex analysis of data, finding errors, inconsistencies, and situations that require further investigation. WizRule reveals all the if-then rules, mathematical formula rules, and spelling irregularities. Divides situations deviating from the rules into data entry errors and suspicious errors. Can be used in auditing, fraud detection, data scrubbing, and due diligence reviews. Learning curve is short. Cost license is $1,395 and yearly maintenance fee is $279. Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.

Who Uses IDEA? External and Internal Auditors
Forensic Accountants/ Fraud Investigators Financial managers General and systems consultants Educators Statisticians Information systems professionals

IDEA Benefits Sort Compare Manipulate Sample Extract data
Mathematical testing Exception reports Aging Statistics Find missing data Analytics Convert test files to data base Create summary reports

Using Data Mining Match employee addresses against vendor addresses.
Sort vendor list by size to determine the most highly paid suppliers. Review the structure of vendor names. Uncover indications of ghost employees (e.g., N.O. Police dept.). Fraudulent expense reports (even amounts, $6). Repeated withdrawals of even amounts from petty cash.

Ink Analysis Martha Stewart was 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). Xerox laser printers now encode the serial number of each machine in tiny yellow dots in every printout, nestled within the printed words and margins. It tracks back to you like a license plate. Advice for fraudsters: use pencils. Source: Mark Maremont, “In Corporate Crimes, Paper Trail Often Leads to Ink Analysts’ Door,” Wall Street J., July 1, 2003, p. A-1.

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

Benford’s Law 0= ----- 1= 30.1% 2= 17.6% 3= 12.5% 4= 9.7% 5= 7.9%
Distribution of initial digits in natural numbers is not random Predictable patterns: There is software to detect potentially invented numbers in many situations. Compare actual frequency with Benford’s frequency. 0= ----- 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% 12% % 11.4% % 10.9% % 10.4% % 10% % 9.7% % 9.3% % 9% % 8.8% % 8.5% %

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.

Spreadsheet Fraud Spreadsheets can be excellent tools for committing fraud. There is little or no security in controlling changes within the worksheets. Aside from fraud, they are ripe grounds for errors because of their open nature for change. For examples, see European Spreadsheet Risks Interest Group: Source: R. B. Lanza, “The Spreadsheet: The Easiest Place for Committing Financial Statement Fraud,” Fraud Magazine, July/August 2005, p. 15.

Some Spreadsheet Frauds
AIB/Allfirst Trading Fraud – The fraudster substituted links to his private manipulated spreadsheet which exaggerated bonuses by more than half a million dollars. HealthSouth – Two ex-HealthSouth executives admitted that they prepared a false spreadsheet for auditors that inflated HealthSouth’s assets and made the company appear to be worth more than it was. CFX – The Internal Audit Department noted in its investigation that management created spreadsheets showing desired results first and then adjustments were made to the accounting system to match the spreadsheet. Source: R. B. Lanza, “The Spreadsheet: The Easiest Place for Committing Financial Statement Fraud,” Fraud Magazine, July/August 2005, p. 15.

Combating Spreadsheet Fraud
Use techniques native in Microsoft Excel [enormous resources, time, money, manpower] EXChecker™ (does not allow any editing to the Excel spreadsheet) Source: R. B. Lanza, “The Spreadsheet: The Easiest Place for Committing Financial Statement Fraud,” Fraud Magazine, July/August 2005, p. 15.

When Benford Analysis Is or Is Not Likely Useful
When Benford Analysis is Likely Useful Examples Sets of numbers that result from mathematical combination of numbers-Result comes from two distributions. Accounts receivable (number sold times price). Accounts payable (number bought times price). Transaction-level data – No need to sample. Disbursements, sales, expenses. On large data sets – The more observations, the better. Full year’s transactions. Accounts that appear to conform – When the mean of a set of numbers is greater than the median and the skewness is positive. Most sets of accounting numbers. When Benford Analysis Is Not Likely Useful Data set is comprised of assigned numbers Check numbers, invoice numbers, zip codes. Numbers that are influenced by human thought. Prices set at psychological thresholds ($1.99), ATM withdrawals. Accounts with a large number of firm-specific numbers. An account specifically set up to record $100 refunds. Accounts with a built in minimum or maximum. Set of assets that must meet a threshold to be recorded. Where no transaction is recorded. Thefts, kickbacks, contract rigging. Source: Durtschi, Hillison, and Pacini, p. 24.

Fraudulent Tax Returns

IRS’s Forensic Analysis
IRS Commissioner Mark W. Everson said that the role of the IRS in the HealthSouth matter was to trace the flow of money. “IRS agents in this case used the same comprehensive financial analysis that we use in criminal tax investigations to document million of dollars in transactions through dozens of financial institutions, including banks and brokerage firms,” Everson said. “The IRS will use its financial expertise to help the government hold accountable those executives who engage in fraud,” Everson said. “Our investigation supports the money-laundering charges as well as the forfeiture counts against Mr. Scrushy involving a staggering sum of money – over a quarter of a billion dollars – which he accumulated during a seven-year period,” “This money went to support a lavish lifestyle, one few Americans could possibly imagine,” the Commissioner continued. “With his ill-gotten gains, Mr. Scrushy purchased multiple estates, racing and leisure boats, fine art by such artists as Picasso, Miro, and Renoir, cars including a Lamborghini and a Rolls-Royce, and extravagant jewelry, such as a 22-carat diamond ring.” Source: Amy Hamilton, “Everson Publicizes Criminal Charges Against HealthSouth CEO,” Tax Notes, November 10, 2003, p. 671.

Lifestyle Probes The lifestyle of a taxpayer or employee may give clues as to the possibilities of unreported income. Obvious lifestyle changes may indicate fraud and unreported income: Lavish residence Expensive cars and boats Vacation home Private schools for children Exotic vacations

IRS Financial Status Audits
If someone is spending beyond his or her apparent means, there should be concern. If a forensic accountant suspects fraud or unreported income, a form of financial audit may be appropriate that will enable the investigator to check the lifestyles of the possible perpetrators.

Forensic Audit Approaches Used by the IRS
Direct methods involve probing missing income by pointing to specific items of income that do not appear on the tax return. In direct methods, the agents use conventional auditing techniques such as looking for canceled checks of customers, deed records of real estate transactions, public records and other direct evidence of unreported income. Indirect methods use economic reality and financial status techniques in which the taxpayer’s finances are reconstructed through circumstantial evidence.

Indirect Methods An indirect method should be used when:
The taxpayer has inadequate books and records The books do not clearly reflect taxable income There is a reason to believe that the taxpayer has omitted taxable income There is a significant increase in year-to-year net worth Gross profit percentages change significantly for that particular business The taxpayer’s expenses (both business and personal) exceed reported income and there is no obvious cause for the difference

Market Segment Specialization Program
The Market Segment Specialization Program focuses on developing highly trained examiners for a particular market segment. An integral part of the approach used is the development and publication of Audit Technique Guides. These Guides contain examination techniques, common and unique industry issues, business practices, industry terminology, and other information to assist examiners in performing examinations. A forensic accountant can use this resource to learn about a particular industry.

Minimum Income Probes For non-business returns, an agent question the taxpayer or representative about possible sources of income other than reported on the return. If there is no other information in the file indicating potential unreported income, the minimum income probe is met. For taxpayers who are self-employed and file a Schedule C or F, an analysis is made of tax return information to determine if reported income is sufficient to support the taxpayer’s financial activities.

Cash T A cash T is an analysis of all of the cash received by the taxpayer and all of the cash spent by the taxpayer over a period of time. The theory of the cash T is that if a taxpayer’s expenditures during a given year exceed reported income, and the source of the funds for such expenditures is unexplained, such excess amount represent unreported income or possible fraud.

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

Source and Application of Funds Method (Expenditure Approach)
This technique is a variation of the net worth method that shows increases and decreases in a taxpayer’s accounts at the end of the year. The format of this method is to list the applications of funds first and then subtract the sources. If the taxpayer’s applications exceed his or her known cash receipts (including cash on hand at the beginning of the year), any difference may be unreported income.

Source/Application of Funds
2005 2006 Bank balance increase Down payment on home Closing costs on home Purchase of SUV Rent payment (4 months) Mortgage payment Down payment on boat Credit card payments Miscellaneous (living) Balance $7,300 15,000 3,700 17,600 2,000 4,200 - 14,000 11,500 75,300 $29,500 8,400 10,000 38,800 37,000 $123,700 Known sources of funds: Cash on hand Salary Consulting Dividends and interest Loan proceeds Net unreported funds $3,600 49,500 7,000 3,000 $63,100 $12,200 $1,700 53,000 13,000 $77,700 $46,000

Net Worth Method The net worth method is a common indirect balance sheet approach to estimating income. To use the net worth method, an IRS agent or forensic accountant must: Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of a period Add nondeductible living expenses to the increase in net worth Account for any difference between reported income and the increase in net worth during the year as (a) nontaxable income and (b) unidentified differences Hollard v. U.S., 348 U.S. 121 (1954).

Net Worth Example Total assets (at cost) Less: Total liabilities
Net worth, end of the year Net worth at beginning of year Increase or decrease in net worth Add: living expenditures Estimated Income Less: Known sources of income Unexplained income $1,200,000 (550,000) 650,000 530,000 120,000 145,000 265,000 (130,000) $135,000

Net Worth Application 2003 2004 2005 Calculated Net Worth1
Computed Net Worth2 Net Asset increase Unexplained net worth increase Income Expenses Net asset increase $225,000 225,000 11,000 ____0 $62,000 51,000 $11,000 $421,000 310,000 $111,000 21,000 $90,000 $81,000 60,000 $21,000 $610,000 420,000 $190,000 23,000 $167,000 $87,000 64,000 $23,000 1 Actual Net Worth recalculated based upon actual assets less liabilities. 2 Net Worth based upon reported income less expenses.

Bank Deposit Method The bank deposit method looks at the funds deposited during the year. This method attempts to reconstruct gross taxable receipts rather than adjusted. Gleckman v. U.S., 80 F.2d 394(CA-8, 1935).

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

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

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

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

Some Exercises Given the following facts about Sammie Bright, calculate his preliminary understatement using the Cash-T method. Schedule C expenses $102,000 Personal living expenses ,000 Schedule C receipts ,000 31) Based upon the following facts about Phil Tizzard, in Sour Lakes, Texas, calculate any unexplained net worth increase (if any): Computed Net worth (reported income less expenses) $520,000 Calculated Net worth (actual net worth recalculated upon actual assets less liabilities) $618,000 Income $93,000 Expenses $67,000 32) Ben Lautenberg is a waiter in Las Vegas, and reports tip income of $4,200 for the year. The restaurant sales where he works were $360,000 and there were 5 waiters. Assume that the waiters have about the same amount of sales. Compute Ben’s tip income recomputed if customers’ tip percentage is approximately 11%

Other Techniques A check spread deals with disbursements and may be used when a target uses checking accounts. George A. Manning says the following information is needed to perform a check spread: date, payee, check number, amount, bank from, bank to, first endorsement, second endorsement, and second signatory. Check spreads show patterns of activities and can gather data for the net worth method. A deposit spread deals with the receipts into a checking account, and shows patterns of activities and gathers data for the net worth and expenditures methods. Credit card spreads may be used for legal and stolen credit cards to show where a target has been geographically over time. Source: G.A. Manning, Financial Investigation and Forensic Accounting, Boca Raton, FL: CRC Press, 1999, pp

Financial Statement Fraud May Serve Many Purposes:
Obtaining credit, long-term financing, or additional capital investment based on misleading financial statements; Maintaining or creating favorable stock value; Concealing deficiencies in performance; Hiding improper business transactions (e.g., fictitious sales or misrepresented assets); and Resolving temporary financial difficulties (e.g., insufficient cash flow, unfavorable business decisions, defense control in maintaining prestige). Source: Zab Rezaee, Financial Statement Fraud, New York: John Wiley & Sons, 2002.

Fraudsters Should Be Prosecuted
Rest Of The Story: Fraudsters Should Be Prosecuted Although large frauds may be reported to law enforcement agencies, smaller frauds are often not reported. This failure to report fraud incidents and the reluctance of police to aggressively tackle the issue only empowers the perps and diminishes the victims. Ultimately, these unreported incidents are precursors to larger and larger acts of violence. If we do not deal with simple crimes, we will eventually have to deal with homicide. Source: Stephen Doherty, “How Can Workplace Violence Be Deterred,” Security Management, April 2002, p. 134.

Use IRS Form 1099 Threat For fraudsters and embezzlers, use the threat of filling a Form 1099 for amounts stolen. Ask for an installment payback. If they stop payment, report them to the IRS on a Form 1099.

Some Exercises

Computer Forensics “I need you to step away from your computer please,” Lee Altschuler said. Morgan Fay’s chief financial officer glanced up from her computer screen. She regarded the man standing at her office doorway for a moment. “Excuse me?” Cindy Shalott asked. “We’d like you to please conclude your business for the day.” Lee Altschuler said. “I’d appreciate it if you could complete whatever you’re doing as quickly as you can. Please leave your computer in the way that it is now. Don’t turn it off.” The chief financial officer swung her desk chair around. “Just move away from your computer please,” Altschuler repeated. “Who are you?” Cindy Shalott asked. Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91

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

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

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

Catch Me If You Can Punishment for fraud and recovery of stolen funds are so rare, prevention is the only viable course of action. Frank W. Abagnale 30 years ago Abagnale cashed $2.5 million in fraudulent checks in every state and 26 foreign countries. Was later associated with the FBI for 25 years.

Over-all Fraud Plan Background checks Avoid Nepotism
Signed Conditions of Employment Agreement Noncompete Agreement Confidentiality of Information Agreement Bonding Two-signatures on checks/ wire transfers/ lines of credit Lockbox Positive pay Check security and restrictive endorsements Check stock (can not be scanned and it smears easily) Close out cash registers at unpredictable times Back up computer files Accounting personnel can not cancel debt Have an internal audit CEO signs numbered check request form E.J. McMillan, Policies and Procedures to Prevent Fraud & Embezzlement, 2006, John Wiley.

Types of Misappropriations
Embezzlement Cash and check schemes Larceny of cash Skimming Swapping checks for cash Check tampering Kiting Credit card refund and cancellation schemes Accounts receivable fraud Lapping Fictitious receivables Borrowing against accounts receivable Inventory fraud Stealing inventory Short shipments with full prices Fictitious disbursements Doctored sales figures Sham payments Price manipulations: land flipping, pump and dump, and cybersmearing Money laundering Bid rigging

How Cash Is Misappropriated
% Median Loss Inflow: Skimming 18.9% $76,000 Cash larceny 14.2% 73,000 Disbursements: Billings 28.3% 130,000 Expense Reimbursements 19.5% 25,000 Check Tampering 17.1% 120,000 Payroll 13.2% 50,000 Wire transfers 6.5% 500,000 Register Disbursements 1.7% 26,000 Source: 2006 Wells Report, ACFE.

Cash Wheel Accruals Cash Accounts Receivable Adjusting Entries
Accounts Payable Depreciation Accruals Cash Source: Fraud Auditing Small Businesses With The Wheel , James A. Goldstine

Some Employee Schemes Embezzlement/skimming involves converting business receipts to one’s personal use and benefit, by such techniques as cash register thefts, understated/unrecorded sales, theft of incoming checks etc.

Some Skimming Schemes (off-book)
Unrecorded sales. Theft of incoming checks. Swapping checks for cash. Auditing Suggestions Compare receipts with deposits. Surprise cash count. Investigate customers complaints. Gross profit analysis (also for money laundering). Check for reversing transactions, altered cash counts, and register tapes that are “lost.”

Preventive Measures Segregation of duties, mandatory vacations, and rotation of duties help prevent cash larceny. Review and analyze each journal entry to the cash account. Two windows at drive-through restaurants. Signs: Free meal if no receipt. Blank checks and the automatic check signing machine should be kept in a safe place from employees. Pre-numbered checks should be logged and restricted to one responsible employee. Require two signatures on cashier checks.

Processing Checks Best Procedure
Step 1. The invoice is approved for payment. Step 2. A check request form is completed. Step 3. The CEO approves the check request. Step 4. The check request is forwarded to accounting. Step 5. Accounting processes the check. Step 6. The CEO signs the check. Step 7. A second designated employee (who does not approve the payment and is not in the accounting department) should cosign the check. Therefore, 4 people involved. E.J. McMillan, Policies & Procedures to Prevent Fraud & Embezzlement, John Wiley, 2006, p.44.

Processing Checks Best Procedure
Invoice is approved for payment. Check request form is prepared. The CEO approves/ signs the numbered check request form. Check request form is forwarded to accounting. Accounting processes the check. The check is signed by two authorized individuals. The check is mailed. The bank statements are sent to the CEO’s home (or P.O. box) for review. The CEO forwards the reviewed bank statements to accounting for reconciliation. E.J. McMillan, Policies & Procedures to Prevent Fraud & Embezzlement, John Wiley, 2006, p.45.

Some Employee Schemes (contd …)
Kiting: building up balances in bank accounts based upon floating checks drawn against similar accounts in other banks. Wire transferring makes kiting easier. Auditing Suggestions Look for frequent deposits and checks in the same amount. Large deposits on Fridays. Short time lag between deposits/withdrawals. Bank reconciliation audit [cut-off bank statement].

Cut-off Bank Statement Shorter period of time (10-20 days). Bank statement sent directly to fraud auditors. Compare the cancelled checks, etc. with the cut-off bank statement. Helpful for finding kiting and lapping.

Cash Schemes Other Cash Schemes
Theft of checks (bottom or middle of checks). Checks may be intercepted or payee altered (washing checks). Forged endorsements (disappearing ink). Stolen credit cards. Refund schemes. Kickback schemes.

Kickback Example Paul J. Silvester, former state treasurer for Connecticut, admitted accepting cash kickbacks in return for placing millions of dollars in state pension investments with certain equity funds. Mr. Silvester was sentenced to 51 months in prison for taking bribes in return for investing $527.5 million from the state pension fund in five investment funds. Source: Marc Santora, “After Help in Corruption Cases, Central Figure Gets 51 Months,” N.Y. Times, November 21, 2003, p. C-12.

Parmalat Kickback Scheme
Former Bank of America executive Luca Sala told investigators that over 7 years he took $27 million in a kickback scheme involving Parmalat. He obtained the monies by a kickback arrangement with an outside broker who helped organize bond issues from Parmalat. Mr. Sala (corporate finance head) helped organize several bond placements for Parmalat for which the bank regularly received fees. Source: A. Galloni and C. Mollenkamp, “Ex-Parmalat Banker Admits Stealing $27 Million,” WSJ, February 27, 2004, p. A-3.

Refund Schemes A television station’s former accounting director pleaded guilty to stealing more $1.8 million from her employees and spending it on jewelry, paintings, and fur coats. She would overpay the station’s travel bills and divert the refunds to her own credit card bills and personal accounts. She was sentenced to 7 ½ years in prison on a single count of theft from CBS affiliate WBBM – TV Source: AP, “Ex-Accountant at CBS Affiliate Sentenced,” Las Vegas Sun, November 5, 2003.

Accounts Receivable’s Schemes
Lapping. Fictitious receivables [for a fictitious sale], which is later written off. Borrowing against receivables (use receivable as collateral). Improper posting of credits against receivables.

Lapping Lapping Recording of payment on a customer’s account some time after receipt of payment. Later covered with receipt from another customer (robbing Peter to pay Paul). Lapping is more successful where one employee has both custody of cash and record keeping responsibility.

Lapping (cont.) Warning Signs of Lapping Increase in complaints.
Excessive billing errors. Delays in posting customer payments. Trend of decreasing accounts receivable payments. Accounts receivable details do not agree with the general ledger.

Independently verifying customers who do not pay.
Lapping (cont.) Audit Steps Independently verifying customers who do not pay. Reviewing write-offs. Reviewing customers’ complaints. Compare the checks on a sample of deposit slips to the details of the customers’ credits that are listed on the day’s posting to the customer’s account receivables. Closely monitor aging accounts.

How Non-Cash Assets are Misappropriated – 2006
Category % Median Loss Inventory 16.6% $55,000 Information 3.6% 78,000 Securities 1.5% 1,850,000 Source: 2006 Wells Report, ACFE.

Inventory Inventory Fraud
Stealing inventory/supplies for personal use or for sale at flea markets/garage sales. Kickback schemes (vendor/supplier and an employee). Sale of unreported inventory at inflated prices. Audit Steps for Inventory Fraud Use renumbered inventory tags matched to count sheets; use count procedures for work-in-progress items; separate duties between purchasing and logging receipts of shipments Check for same vendors. Prices higher than other vendors. Purchasing agent does not take vacation. Only photocopies of invoices are available. Aging of inventory. Inventory turnover There is data-mining software.

Stealing Diamond Inventory
Farrah Daly was charged with stealing at least 39 diamonds (1 to 3 carats), one at a time over several years from a diamond sorting area. She and her husband allegedly had friends and others sell the approximately $500,000 worth of diamonds at pawn shops and jewelry stores. Source: AP, “Ohio Woman Accused of Stealing Diamonds,” Las Vegas Sun, November 10, 2003.

Reducing Bad Debts Before MCI was acquired by WorldCom, Walter Paulo a billing manager, had to reduce a $180 million bad debt expense down to $15 million. Eventually MCI had to write-off $650 million in bad debt. His schemes: Allow a customer to sign a promissory note to turn the receivable into a short-term asset. Redacting invoices. Developing interpretations to explain why some items are aged so long. Using questionable codes. Used unapplied cash to cover. Arthur Andersen did not audit the smaller bad debt accounts where the questionable accounts occurred (e.g., the third tier). Paulo said that the AA auditors were young, inexperienced, and fresh out of college. Source: J.M. Jacka, “An Environment for Fraud,” Internal Auditor, April 2004, pp

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

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

Source Documents Fraud Symptoms
Photocopies of missing documents. Counterfeit/false documents. Excessive voids/credits. Second endorsements. Duplicate payments. Large numbers of reconciling items. Older items on bank reconciliations. Ghost employees. Lost register tapes. Number of round numbers. Too many beginning 9’s.

Journal Entries Fraud Symptoms
Out-of-balance. Lacking supporting documents. Unexplained adjustments. Unusual/numerous entries at end of period. Written entries in computer environment. Number of round numbers. Too many 9’s.

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

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. Martin L. Glass was sentenced to 8 years, and his CFO was sentenced to 2 years and 4 months. 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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some Contract/ Procurement Frauds
Multiple payments to same payee. Multiple payees for the same product/ service. Shell payments: documented purchase for a fictitious product, service, or project (phantom vendor). Defective delivery. Rigged advertised contracts. Defective pricing (product substitution). Collusion. Pseudo-collusion. Kickbacks Unilateral kickbacks Bilateral kickbacks Unbalanced contracts or purchase orders (contracting rigging fraud), Conflict of interest (e.g., Jeff Skilling). Unnecessary purchases. Bribes. Personal Use or Resale. H.R. Davia et. al, Accountant’s Guide to Fraud Detection and Control, John Wiley, 2000, p.62.

Payroll Payroll Schemes
Ghost Employee: A person on the payroll who does not work for that company. False Workers’ Compensation claims: Fake injury to collect disability payments. Commission schemes: Falsify amount of sales or the commission rate. Falsify hours and salary: Exaggerate the time one works or adjusts own salary.

Fictitious Disbursements Multiple payments to same payee. Multiple payees for the same product or service. Ghosts on the payroll. Inflated invoices. Shell companies and/or fictitious persons. Bogus claims (e.g., health care fraud and insurance claims). Overstate refunds or bogus refunds at cash register. Many fictitious expense schemes (e.g., meals, mileage, sharing taxi, claiming business expenses never taken). Duplicate reimbursements. Overpayment of wages.

Other Fraud Schemes Stealing inventory/scrap. Stealing property. Theft of proprietary assets. Personal use of assets. Shoplifting. False down grading of products. A land flip involves a situation where a company decides to purchase land for a project. A person or group will find the land and buy it under a front name or company. The fraudster then increases the price of the land before selling it to the company. Money laundering is the use of techniques to take money that comes from one source, hide that source, and make the funds available in another setting so that the funds can be used without incurring legal restrictions or penalties.

Other Fraud Schemes (contd …) A ponzi scheme is a pyramid-type technique where early investors are paid with new money collected from future investors, who lose their investments. Bid rigging occurs when a vendor is given an unfair advantage in an open competition for a certain contract.

Ponzi Scheme Example Women Helping Women group hosted invitation – only “birthday parties” that promised $40,000 in the future to each woman who invested $5,000. Some of the women received the pay-off, but most lost out. $12 million pyramid schemes. Cheryl Bean, the leader, given 3 years probation, ordered to pay $15,000 in restitution, and $10,000 to a charity fund. Source: AP, “Pyramid Scheme Leader Pleads No Contest,” Las Vegas Sun, November 8, 2003.

Hammersmith Trust Ponzi Scheme
Hundreds of sophisticated investors put $100 million in this prime banking scheme that promised as much as 1,600% annual return. The scheme revolved around the so-called international prime banking instruments (e.g., high-yield commercial paper or secret bank debenture programs). There is no market for prime bank instruments. “Not a single dime is invested in anything – save the fraudulent pyramid itself, with some money going from one investor to the other in the form of purported “interest” and “return of principal “payments – while most of it sticks to the pyramid or rather, to the people running the pyramid.” Source: John Anderson, “Take The Money & Run,” Smart Money, December 2003, pp

Bid Rigging or Bid Pooling
Sherman Antitrust Act – illegal restraint of trade. Felony. Substantial fines and up to three years. Group of dealers choose one dealer to bid on items. Later the dealers themselves bid on the items bought and they, therefore, share the profits.

Bid Rigging Red Flags Low turnout of auction attendees.
Winking, hand signals or other similar signs among dealers after the bidding is opened. A uniformity to the bidding. For example, Dealer One bids on a particular lot and buys it with little or no activity, and then Dealer Two buys another lot, again with little or no competition. Difficulty getting things going. A lot of handshaking and other signs of recognition among several dealers before or after the auction takes place. An air of silence throughout the auction since auctions are generally noisy – or conversely, a lot of conversation among bidders during the sale of lots they normally should be bidding on. Low competition among known dealers who normally bid strongly against one another. Source: The Official Government Auction Guide.

Forensic Auditing Steps
Count the Petty Cash Twice in a Day Investigate Suppliers (Vendors) Investigate Customers’ Complaints Examine Endorsements on Canceled Checks Add Up the Accounts Receivable Subsidiary Audit General Journal Entries Match Payroll to Life and Medical Insurance Deductions Source: Jack C. Robertson, Fraud Examination for Managers and Auditors, Austin, TX: Viesca Books, 2000, pp

Forensic Auditing Steps (contd …)
Match Payroll to Social Security Numbers Match Payroll with Addresses Retrieve Customer’s Checks Use Marked Coins and Currency Measure Deposit Lag Time Document Examination Inquiry, Ask Questions Covert Surveillance Source: Jack C. Robertson, Fraud Examination for Managers and Auditors, Austin, TX: Viesca Books, 2000, pp

Vendor Allowances In exchange for better shelf space or advertisement mentioning its products, a merchandise vendor will pay stores an extra fee--an allowance often based upon the amount of products sold. Employees at OfficeMax “fabricated supporting documents for approximately 3.3 million in claims billed to a vendor to its retail business.” Six employees were fired, and CEO Christopher Milliken resigned. The SEC sued three former executives in December 2004 at Kmart Holding Corp. for their role in a $24 million accounting fraud that booked these allowances early. The SEC settled a case in October 2004 with Ahold NV involving allegations of fraudulent inflation of promotional allowances at U.S. Foodservice, Inc. unit. Source: David Armstrong, “OfficeMax Results To Be Restated; CEO Steps Down,” WSJ, February 15, 2005, p. A-3.

Interviewing Executives
One way to detect fraud is to interview company personnel. The AICPA Fraud Task Force provides an interviewing template of 13 questions for CEOs, CFOs, and Controllers. Explain the purpose of interview- need to assess risk and comply with audit responsibilities Inquire whether they are aware of any instances of fraud within their organization- Do they have reason to believe that fraud may have occurred or is occurring? Has the CEO or CFO ever approved an accounting treatment for transactions that were not appropriate? Have there been any instances where someone has attempted to inflate assets or revenue or deliberately understate liabilities and expenses? Is there any member of management that has a direct interest or indirect interest in any customer, vendor, competitor, supplier or lender? Is any member of management related to any other member of management? Does anyone in the company have any personal, financial or other problems that might affect their job performance? If there was an area within the company that might be vulnerable to fraud, what would that be? Has anyone within the accounting department been let go or resigned within the past year? Is there anyone in management that appears to be living a lifestyle beyond their means? – expensive cars, trips, jewelry, vices Has anyone been involved in civil or criminal proceedings or filed bankruptcy Does the company have a strong ethics policy? Has anyone ever been fired for committing fraud against the company? Source: Ronald L. Durkin et. al, “Incorporating Forensic Procedures in an Audit Environment,” Litigation and Dispute Resolution Services Subcommittee, New York: AICPA, 2003.

Selecting the Right Interviewees
“Someone knows what is going on. If you tune in, you will get a feel for it.” Lorraine Horton, Kingston, R.I. “It is important that you select the right person to interview, and be conversant in interviewing techniques. For instances, pick someone from customer complaints or an employee who didn’t get a raise for two years, as they would be likely to provide the needed information.” R.J. DiPasquale, Parsippany, N.J. Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp Listen to rouges and whistle-blowers who complain.

Interview vs. Interrogation
Interview-non-accusatory process where person asks questions to develop factual information (e.g., who, what, when, where, how). Interrogation-accusatory interview to obtain an admission of guilt.

Advantage and Disadvantages
Advantages of an interview (non-accusatory) Facilitates the development of cooperation. Easier to develop rapport. More effective way of developing usable information. Disadvantages of interrogation Interviewee may be alienated and refuse to speak to anyone later. If interviewee will not speak to anyone, ability to obtain information or admission is diminished. Source: John E.Reed Associates, Inc.

Verbal and Nonverbal Behavior
Verbal behavior includes not only words, but timing, pitch, rate, and clarity of the responses. Nonverbal behavior includes body movement, position changes gestures, eye contact, and facial expressions. See “Interviewing & Interrogation,” The Reid Technique, John E.Reid Associates, Inc., L.E.R.C Law Enforcements.

Nonverbal Language 60% of communication is nonverbal.
Previous contact with person helpful. During President Bill Clinton’s testimony he touched his nose several times when he was lying, but did not touch his nose during truthful testimony. Two-thirds of truth interviewees cross their legs. Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”

Posture Language Truthful Deceptive Frontally aligned.
Upright or forward. Open (perhaps crossed legs). Dynamic, comfortable changes. Deceptive Non-frontally aligned. Slouched, retracted or leaning. Barriers (crossed arms, purse in lap). Frozen and rigid. Source: John E. Reid Associates, Inc.

Some Lying Signs Covering mouth with hand. Rubbing nose.
Frequent blinking. Biting lip. Moving or tapping foot. Crossing arms. Leaning forward. Handling objects (e.g., pencil, pen). Avoiding eye contact or averting eyes. Clearing the throat. Closing and opening coat. Picking at lint on clothing. Playing with collar. Moving away. Shrug gestures. Slow response. Higher pitch. Long answer. Gap between words becomes longer. Non-words such as uh. Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”

Lying: James R. Brown Style
“I lied in person to investors when I met them. I lied in company’s filings. I lied in the company’s press releases.” Adelphia Communications vice-president of finance. He had no formal training in accounting and finance. Adelphia began manipulating its financial reports soon after the company went public in 1986. We regularly fabricated statistics on the number of subscribers, cash flow, cable-system upgrades, and other closely followed metrics.

Lying: James R. Brown Style (cont.)
Top executives would meet on Saturdays to determine if we were meeting loan agreements. If not, we would make other types of manipulations of either arbitrarily moving expenses between companies or adding invented affiliate income or interest income from one internal company to another. For more than 10 years we kept two sets of books. Source: Chad Bray, “Adelphia Witness Lays Out Lies,” WSJ, May 19, 2004, pp. C-1 and C-2.

Voice – Analysis Software
Developed in Israel; can be used over the phone. Nemesysco system. Measures stress levels and displays them on a screen. U.K. insurers are using it, connected between the telephone and computer. Screen flashes “High Stress.” 70% O.K. Of 30% high risk, 12% prove O.K., but 18% rejected as fraudulent. Source: Charles Fleming, “Insurers Employ Voice-Analysis Software to Detect Fraud,” WSJ, May 17, 2004, pp. B-1 and B-4.

Fewer People Lie in E-mail
People tell fewer lies in s than in phone calls and face-to-face conversations. Possible reason: Most people know that s leave a record. J. T. Hancock, Corporate Human Interaction I got one thing to tell you, I…oooo, I ain’t tryin’ to sell ya’, No lies. Grand Funk Railroad

Interviewing Techniques
“Bosch didn’t say anything. He knew that sometimes when he was quiet, the person he needed information from would eventually fill the silence.” (pp. 5-6). “Just listen. You are a detective. Detectives are supposed to listen. You once told me that solving murders are getting people to talk and just listening to them.” (pp ). Source: Michael Connelly, The Black Ice, St. Martin’s Paperback, 1993.

Progression of Interpersonal Communication
Investigative Communication Type Investigative Conversation Structured Investigative Interviewing Basic Forensic Interrogation Advanced Forensic Interrogation Time Requirements Flexible Thirty minutes to one hour Three to six hours Required Environment Private setting Intimate setting

Skill/ Training Requirements Minimal training required. Preferable to have training in active listening skills, question formulation and basic behavior analysis as well as psychology of investigative discourse. Minimum fifteen hours training in structured interview formats and behavior analysis. Minimum fifteen hours interviewing training plus thirty hours of training in Reid Nine Steps.* Minimum standards for structured formats and basic interrogation as well as minimum ten hours of advanced training. *Inbau, F.E., Reid, J. E. & Budkley, J.P. (1986) Criminal Interrogation and Confessions, third edition (Baltimore, Williams and Wilkins). Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I

Appro- priate Use and Restrictions When you are looking for direction in an investigation. Result is a gamble rather than a predictable outcome When you have established the need for a formal investigation and are interacting with witnesses, victims, complainants or suspects. Must accept information as it is presented without confrontation. When you are interacting with an uncooperative suspect and require a truthful account of that person’s guilt. Make use of perception manipulation and as such requires comprehensive quality control. Most desirous form for uncooperative suspects of severe offences or suspects who may be emotionally unstable. Does not use perception manipulation and therefore beneficial when you need to identify true motivation for the offense. Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I A Thousand Lies What is a man that stays true to the game But has to cheat a little to get by Well that is a person that I know too well What if a man doesn’t stay true to the game Don’t care for no one, only cares for his greed. Machine Head

Chance of Confession John Baldwin found in 600 investigative interviews that 35.7 percent of suspects confessed from the outset and an additional 16.2 percent confessed initially to part of the allegation. “Police Interviewing Techniques,” British Journal of Criminology, Vol. 33, 1993. William Morrisette believes that “an investigator who properly identifies and implements the appropriate investigative communication type should be able to achieve an 85 percent confession rate through basic interrogation and a 95 percent rate by way of advanced interrogation.”

Fraud Detection Questions
Reason Why? Do you know why you are here today? Principle: Innocent subjects will acknowledge the reason for the interview, while the guilty subject will generally avoid indicating knowledge of the issue. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

Know/Suspect: Who do you think may have taken that $5,000 from the safe? Principle: Innocent subjects are more likely to volunteer a name or offer a suspicion. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

Vouch: Is there anyone that you work with that you feel would not have taken that $5,000 from the safe? Principle: Innocent subjects will vouch for others, while the guilty will vouch for themselves or no one. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

Think: Do you think that the $5,000 was actually stolen? Principle: Innocent subjects will generally agree that the money was actually stolen. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

Opportunity: Who do you think would have the best opportunity to take that $5,000 from the safe? Principle: Innocent subjects will usually offer a name of an individual or named position who would have had the best opportunity. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

Happen: What do you think should happen to the person who stole that missing $5,000? Principle: Innocent subjects will generally offer harsher punishment than the guilty. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

2nd Chance: Would you be inclined to give someone a second chance? Principle: Innocent subjects generally continue to offer harsh punishment, while the guilty are more likely to offer a second chance. Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.

Acquisition/Payment Cycle
From 62 standard audit procedures, external and internal auditors judged these 20 procedures to be more efficient is detecting fraud in the acquisition and payment cycle (in descending order). Examine bank reconciliation and observe whether they are prepared monthly by an employee who is independent of recording cash disbursement or custody of cash. Examine the supporting documentation such as vendor’s invoices, purchase orders, and receiving reports before signing of checks by an authorized persons. Examine the purchase requisitions, purchase orders, receiving reports, and vendors’ invoices which are attached to the vouchers for existence, propriety, reasonableness and authenticity. Examine internal controls to verify the cash disbursement are recorded for goods actually rendered to the company. Discuss with personnel and observe the segregation of duties between accounts payable and custody of signed checks for adequacy. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p

Acquisition/Payment Cycle (Contd.)
Confirm inventories in public warehouse and on consignment. Examine internal controls to insure the vendor’s invoices, purchase orders, and receiving reports are matched and approved for payment. Examine internal controls for the following documents: vendor’s invoices, receiving reports, purchase orders, and receiving reports. Trace a sample of acquisitions transactions by comparing the recorded transactions in the purchase journal with the vendor’s invoices, purchase requisitions, purchase orders, and receiving reports. Establish whether any unrecorded vendors’ invoices or unrecorded checks exist. Examine the internal control to verify the proper approvals of purchase requisitions and purchase orders. Reconciled recorded cash disbursement with disbursements on bank statements. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p

Acquisition/Payment Cycle (Contd.)
Discover related party transactions. Examine the internal control to verify the approvals of payments on supporting documents at the time that checks are signed. Discuss with personnel and observe the procedures of examining the supporting documentation before the signing of checks by an authorized person. Examine canceled checks for authorized signatures, proper endorsements, and cancellation by the bank. Account for the numerical sequence of prenumbered documents (purchase orders, checks, receiving reports, and vouchers). Trace a sample of cash payment transactions. Trace resolution of major discrepancy reports. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p

Sales/Collection Cycle
These 10 audit procedures were judged as being more effective for detecting fraud in the sales and collection cycle (in descending order) Observe the proper and appropriate segregation of duties. Review monthly bank reconciliation and observe independent reconciliation of bank accounts. Investigate the difference between accounts receivable confirmation and customer account receivable balances in the subsidiary ledger and describe all these exceptions, errors, irregularities, and disputes. Review sales journal, general ledger, cash receipts journal, accounts receivable subsidiary ledger, and accounts receivable trial balance for large or unusual amounts. Verify accounts receivable balance by mailing positive confirmations. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 209

Sales/Collection Cycle (Contd.)
Examine internal controls to verify that each cash receipts and credit sales transactions are properly recorded in the accounts receivable subsidiary ledger. Examine subsequent cash receipts and the credit file on all accounts over 120 days and evaluate whether the receivable are collectible. Compare dates of deposits with dates in the cash receipts journal and the prelisting cash receipts. Examine copies of invoices for supporting the bills of lading and customers’ orders. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 209

Inventory/Warehouse Cycle
These 14 standard audit procedures were judged by external and internal auditors as being more effective for detecting fraud in the inventory and warehousing cycle 9in descending order): Discover related party transactions. Follow up exceptions to make sure they are resolved. Review major adjustments for propriety. Review inventory count procedures: a. Accounting for items in transit (in and out); b. Comparison of counts with inventory records; and c. Reconciliation of difference between counts and inventory records. Review adequacy of physical security for the entire inventory. Confirm inventories in public warehouse. Review procedures for receiving, inspecting, and storing incoming items and for shipments out of the warehouses. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p

Inventory/Warehouse Cycle (Contd.)
Trace shipments to sales records, inventory records, and bill of lading (shipping documents). Determine if access to inventory area is limited to approval personnel. Observe the physical count of all location. Recount a sample of client’s counts to make sure the recorded counts are accurate on the tags (also check descriptions and unit of count, such as dozen or gross) Trace inventory listed in the schedule to inventory tags and the auditor’s recorded counts for existence, descriptions, and quantity. Trace shipments to sales journal. Perform compilation tests to insure that inventory listing schedules agrees with the physical inventory counts. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p

Payroll/Personnel Cycle
These 12 audit procedures were judged the more effective for detecting fraud in the payroll and personnel cycle (in descending order): Sample terminated employees and confirm that they are not included on subsequent payrolls and confirm propriety of termination payments. Observe the actual distribution of payroll checks to the employees. Observe the duties of employees being performed to insure that separation of duties between personnel, timekeeping, journalizing payroll transactions, posting payroll transactions, and payroll disbursement exists. Examine internal controls to verify that hiring, pay rates, payroll deductions, and terminations are authorized by the personnel department. Sample personnel files and physically observe the presence of personnel in the work place. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 208.

Payroll/Personnel Cycle (Contd.)
Examine internal control over payroll records to verify that payroll transactions are properly authorized. Discover related party transactions. Review the files of new hires for appropriate approvals, pay rates, and dates of accession. Review the payroll journal, general ledger, and employee individual pay records for large or unusual amounts. Examine internal controls to verify that unclaimed payroll checks are secured in a vault or safe with restricted access. Examine internal controls to verify that employee time cards and job order work tickets are reconciled. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 208.

Class Discussion -------------------------------------------
How can you defraud your own organization, working either from the inside or outside? “Fraudsters … identify and exploit weaknesses specific to the organization.” Herling, D.J., and J. Turner, “Fraud: Effective Use of Legal Remedies for Corruption,” 9th International Anti-Corruption Conference, October 13, PowerPoint presentation slide

Exercises You receive a tip on the company’s hot line that there has been some fraud in the collections area. What five audit steps would you suggest using in order to find the fraud? During a brainstorming session, a suggestion is made that the most likelihood of fraud in a particular division is in the area of acquisition and payment cycle. Outline five audit steps to help find any potential fraud. While auditing a company you notice an employee in payroll who is living beyond his means (e.g., clothes, automobiles, housing). His wife does not work. Suggest six audit steps to help satisfy you there is no fraud in the payroll and personnel cycle. An anonymous is sent to an internal auditor that there is fraud in the inventory/ warehousing cycle. Suggest some appropriate audit steps. What is meant by the hockey stick pattern?

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Strategies for Detecting & Preventing Fraud D. Larry Crumbley, CPA, Cr

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