Transcript Forensic Accounting Update Exam II Copyrighted 2002 D

© D.L. Crumbley
Forensic Accounting Update
Copyrighted 2001
D. Larry Crumbley, CPA, Cr.FA
KPMG Endowed Professor
Department of Accounting
Louisiana State University
Baton Rouge, LA 70803
225-578-6231
225-578-6201 Fax
[email protected]
Dr. Crumbley is the editor of the Journal of
Forensic Accounting: Auditing, Fraud, and
Taxation, former chair of the Executive Board of
Accounting Advisors of the American Board of
Forensic Accountants, member of the Fraud
Deterrence Board, and on the AICPA’s Fraud
Task Force. A frequent contributor to the Forensic
Examiner, Professor Crumbley is a co-author of
CCH 2002 Master Auditing Guide, along with
more than 45 other books. His latest book entitled
Forensic and Investigative Accounting is published
by Commerce Clearing House (800-224-7477).
Some of his 12 educational novels have as the
main character a forensic accountant. His goal is
to create a television series based upon the
exciting life of a forensic accountant and litigation
consultant.
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Forensic Accounting Factors
• Time: Forensic accounting focuses
on the past, although it may do so in
order to look forward.
• Purpose: Forensic accounting is
performed for a specific legal forum
or in anticipation of presentation
before a legal forum.
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Definition of Forensic Auditor
Someone who can look behind the
facade--not accept the records at
their face value--someone who has a
suspicious mind that the documents
he or she is looking at may not be
what they purport to be and someone
who has the expertise to go out and
conduct very detailed interviews of
individuals to develop the truth,
especially if some are presumed to
be lying.
Robert G. Roche, a retired chief of the IRS Criminal Investigation
Division of the IRS
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Why Growth in Forensic Accounting
1.
2.
3.
4.
Increase in fraud.
Less loyalty to organization.
Employee mobility.
Change in societal values.
a. Break-up of family unit.
b. Less religious.
c. Less ethics.
5. Computers replacing accounting
functions. External accountants are
looking for new jobs.
6. Higher insurance premiums for
auditing.
7. Auditors became sales people.
8. Grade inflation/coursework deflation.
9. Enron/WorldCom/Xerox.
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Cynthia Cooper’s Reasons
Irrational Exuberance
Capital Influx
Market Bubble
Short-term Focus
Auditing vs.
Consulting
Passive Boards
Inadequate Balance of
Power
Excessive Executive
Compensation
Loans to Executives
Analysts and
Investment Bankers
Non-GAAP Financial
Measures
Rapid Growth through
Acquisitions
SEC Underfunded
Moral & Ethical
Leadership
Source: Cynthia Cooper, L.S.U., November 24, 2003
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Forensic Accounting
Defined
Forensic accounting is the action of
identifying, recording, settling,
extracting, sorting, reporting, and
verifying past financial data or other
accounting activities for settling
current or prospective legal disputes or
using such past financial data for
projecting future financial data to settle
legal disputes.
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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.
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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. 10-13
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Open Job Orders
© D.L. Crumbley
• Valuation Partner for NJ Forensic Firm - Roseland, NJ...up to
$250K base. Key words - Matrimonial, business valuation, expert
testimony, litigation support, forensic.
• Forensic Partner for NY firm - up to $300's base. Key words Bankruptcy, forensic, litigation support, expert
testimony,insolvency CPA a must and solid public acct.
experience.
• Audit Partner, Houston, Texas- up to $120k base first 12 months,
60% of collection between 12&17month, 70% of collection
between 17&36 month-client prefers a manager or director level
candidate with good business development skills. They rather
mold. No book of business required. SEC exp. a must. CPA a
must. The firm ranks among the top 10 nationally in "number of
public companies audited." Currently, they have 4 audit partners
and will be looking to add a 5th one this fall. Revenues last year
were $1.3 million and for 2003 they estimate $1.7 million.
• Litigation Support Manager - NY office up to $115K. One CPA
firm has 5 offices, 300+ staff. CPA a must and mid size firm
experience. Big 4 experience not a good fit. (Valuation, Audit and
Tax Senior/Managers from big 4 and CPA, always welcomed with
this client.)
• Forensic Senior for Southern NJ firm - up to $80K...Forensic
firm has three 3 office in NJ, 7 partners, 60+ staff. CPA a plus.
Audit professional from big 4 or top firm okay.
• Litigation Support Senior - up to $70K plus bonus...Woodbury
NY (LI).The firm has 24 Partners, 230 staff, 4 offices....Forensic
and litigation support and CPA firm experience a must. CPA a
plus.
• Jessica Cardona, Executive Recruiter
218 North Wood Ave. Suite # 3Linden, NJ 07036main: 908-4869500direct: 908-486-9023
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Income Expectations for
Forensic Accountants
• Salaries start around $30,000
• Senior-level government employees
can earn between $75,000 to
$90,000
• In the private sector, one can earn
between $125,000 to $150,000
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Consulting Fees
• Forensic accountants work with
attorneys, private investigators, law
enforcement officers, corporate
security specialists, the IRS, and the
FBI.
• In 1999, Kessler International stated
that the firm charges about $300 per
hour for forensic consultations.
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Top Niche Services
1. Business Valuations
2. Estate Planning
3. Litigation Support
4. Mergers & Acquisitions
5. Business Mgt. Wealthy clients
6. Forensics/fraud
7. Employee benefits
8. Computer systems/consulting
78%
77%
73%
61%
56%
55%
55%
53%
Source: J.M. Covaleski, “Many Top 100 Growth Areas Revolve
Around Synergy of CPA/Attorney Relationship,” Accounting Today,
March 18-April 7, 2003, p.1.
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Forensic Accounting vs.
Fraud Auditing
Fraud Auditor: An accountant especially
skilled in auditing who is generally engaged
in auditing with a view toward fraud
discovery, documentation, and prevention.
-----------------------------------------------------“Economic crimes and fraud often do not
involve obvious evidence like the smoking
gun. Forensic accountants look behind the
deals and handshakes and probe beyond the
numbers to uncover the reality of financial
situations.”
Source: D.W. Squires, “Problems Solved with Forensic Accounting: A
Legal Perspective,” Journal of Forensic Accounting., Vol. IV (2003),.
P. 131.
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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.
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Forensic vs. Fraud Audit
Google result, October 7, 2002
•
•
•
•
•
•
•
•
•
•
•
– Forensic Audit, 6,490 hits
– Fraud Audit, 1,800 hits
Czech TV to Undergo Forensic Audit.
National Forensic Audit of SA Post Office.
OPSEU Calls for Forensic Audit of
Accenture.
Forensic Audit Saved Ghanair $434,000.
McGuinty Wants Forensic Audit of all
Hydro contracts.
Action Taken on Forensic Audit by Boise
City Council.
Harris Tories Spends $200 million to save
$16 million.
Pitt Wants Special Audits to Find Fraud.
Mayor Orders Forensic Audit of Parks.
Audit Ordered for ATSI Companies.
Financial Audit Details Tobin’s Dealings.
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Historical Roots of
Accounting
10,000 years ago—temple priests took inventory of
village livestock
3,000 B.C.—scribes recorded ruler’s wealth
1887—American Association of Public
Accountants (later becoming the AICPA)
was formed
1896—New York State legislated the first CPA law
1900—School of Commerce, Accounts, and
Finance at New York University opens
1902—Congress calls for audit reports for large
corporations
1913—Federal Reserve Board created
1913—Federal income tax law was passed
1914—Federal Trade Commission created
By 1921—All states had passed laws requiring
exam for CPA certificate.
Source: Crumbley, Heitger, and Smith, Forensic and Investigative
Accounting, CCH, (2003),
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History of Financial
Reports and Legal
Challenges
• Financial reports were created by
accountants long before independent
audits were mandated.
• Current system of accounting checks
and balances is relatively recent.
• Before financials were audited by
outside experts, the courts often
handled challenges and brought in
experts to give testimony.
• Practice of forensic accounting was
common even before independent
accountants were asked to certify
financial statements in auditing
engagements.
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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.
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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.
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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
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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].
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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.
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Potpourri
• Deutsche Bank is being sued for $1.3 billion by Bruce
Winston (one of the heirs of Harry Winston diamond
dynasty) for priceless gems disappearing from a
trust under their control.
• A Burlington, Kentucky city finance director is
accused of embezzling more than $1.2 million to
support his estranged wife and his girlfriend.
• Martin Frankel vanished with between $200 million in
cash and diamonds one day. He accomplished this
insurance fraud by buying poorly capitalized insurance
companies, cooking the books to show increased
premium value, and by including non-existing real
estate and leases on the balance sheet.
• After the terrorists’ attack in New York city, about
4,500 people manipulated the broken ATM machines
of a municipal employees credit union, stealing as
much as $15 million.
• A U.S. Lime officer embezzled nearly $2.2 million by
forging signatures of other company officers on
checks, and falsifying the company’s check register to
create the impression that the amounts he received
went to U.S. Lime creditors.
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Potpourri (contd …)
© D.L. Crumbley
• In December 2002, two Van Gogh paintings were
stolen from the Van Gogh Museum in
Amsterdam. Two weeks earlier there was a
multimillion-dollar gem heist from a Dutch
diamond exhibition at the Museum in the Hague.
• During 2002, as many as 2,000 churches and
other groups put as much as $18,000 each into a
church fraud scam ran by a Georgia minister.
• In 2000, Rent Way’s CAO artificially reduced
the company’s expenses by $127 million.
• WorldCom’s external auditors missed about $11
billion improperly booked items.
• Ahold NV, a Dutch company, said a U.S. unit had
overstated revenues by $880 million by booking
more discounts from suppliers than actually
received.
• Average big city resident caught on videotape
about 75 times a day. Common in workplace and
stores.
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Six Areas of Litigation Services
1)
Damages
*
*
*
*
*
2)
Lost profits
Lost value
Lost cash flow
Lost revenue
Extra cost
Antitrust Analysis
*
*
*
*
*
*
3)
Price-fixing
Market share, market
definition
Pricing below cost
Dumping and other
price distribution
Anti-competition actions
Monopolization
Accounting
*
*
*
*
*
*
*
4)
Bankruptcy
Tracing
Contract cost and claims
Regulated industries
Frauds (civil and
criminal)
Historical analyses
Family law
Valuation
* Business and professional
practices
* Pension
* Intangibles
* Property
5)
General Consulting
*
*
*
*
*
*
6)
Actuarial analyses
Statistical analyses
Projections
Industrial engineering
Market analyses
Computer consulting
Analyses
* Tax bases
* Cost allocations
* Tax treatment of specific
transactions
Source: Management Advisory Services Technical Consulting
Practice Aid 7: Litigation Services, (AICPA, 1986)
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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
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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
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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
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Forensic Accounting Knowledge Base
LAW
Criminology
Investigative
auditing
Accounting
Forensic Accountant
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Forensic Accountant’s
Knowledge Base
Law
Criminology
Investigative
Forensic
Auditing
Accountant
© Hugh M. Christensen
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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.
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Forensic Accounting in
Print
• Articles on arbitration, fraud,
investigation, and expert witnesses
began appearing in the late 1800s.
• After a comment in 1925 by the
Chairman of the U.S. Board of Tax
Appeal, The Journal of Accountancy
proposed that educational
institutions should start including in
their curricula the study of the law of
evidence.
• The first forensic accounting book
appeared in 1982.
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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.
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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.
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Government Created FA
Generally, forensic accounting
was created by government
agencies, and
Government agencies have
caused the growth in forensic
accounting.
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FBI and Forensics
• During WWII, the FBI employed
approximately 500 agents who were
accountants.
• In 1960, about 700 FBI agents were
Special Agent Accountants.
• Today, there are more than 600 FBI
agents with accounting backgrounds.
The FBI has a Financial Crimes
Section that investigates money
laundering, Internet crimes, financial
institutions fraud, and any other
economic crime.
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Universities
Max Lourie, stated that colleges and
universities should begin to teach forensic
accounting:
The colleges and schools of accountancy
should begin to teach forensic accounting.
No doubt, and this is as it should be, it will
first be taught at a graduate level. In those
colleges and universities where there is both a
school of accountancy and a school of law,
joint classes in forensic accounting and
accounting jurisprudence could be held, just as
in one university, where the school of
medicine had joint classes with the school of
law, and the future doctors appeared as expert
witnesses at trials conducted by the law
students.
Source: Max Lourie, (1953) “Forensic Accounting,” New
York CPA, November, pp. 696-705.
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Universities (cont.)
Accounting departments clearly have
been slow to follow this old advice.
Buckhoff and Schrader’s study
found “that adding a forensic
accounting course to the accounting
curriculum can greatly benefit the
three major stakeholders in
accounting education:
1. academic institutions,
2. students, and
3. employers of accounting
graduates.”
Source: T.A. Buckhoff and R.W. Schrader (2000), “The
Teaching of Forensic Accounting,” Journal of Forensic
Accounting, Vol. 1, No. 1, p. 135.
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Curriculum Content
Professors
Rank
Mean
1
4.56
2
Practitioners
Curriculum Content
Rank
Mean
Fundamentals of Fraud
1
4.36
4.48
Financial statement fraud
3
4.22
3
4.35
Types of fraud (employees,management)
8
4.06
4
4.29
Cooking the books and problems in
accounting
6
4.10
5
4.27
Three Elements of fraud
16
3.94
6
4.26
Anti-fraud controls
7
4.08
7
4.25
Internal control evaluation
5
4.13
8
4.21
Theory and methodology of fraud
examination
4
4.15
9
4.16
Principles of ethics and corporate code of 8
conduct
4.06
10
4.15
Fraud detection and deterrence
12
4.00
12
4.05
Analytical Review procedures
9
4.03
21
3.79
Effective report writing
2
4.23
25
3.62
Techniques in locating hidden assets
17
3.95
40
3.17
Shareholder litigation
3
4.22
45
2.90
Expert testimony and expert witness
techniques
32
3.50
46
2.85
Litigation consulting techniques
29
3.56
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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.
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Phrase “Forensic
Accounting” Is Born
• Maurice E. Peloubet coined the phrase
in print in 1946.
• Max Lourie wrote an article and also
claimed to coin the phrase, seven years
after Peloubet (1953). Lourie’s article
voiced three important positions:
– An accountant should not have to
attend law school to learn the art of
expert testimony
– Colleges and universities should
deliver forensic accounting training
– Forensic accounting reference books
and textbooks should be developed
for students
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The Essence of Forensic Accounting
by Maurice Peloubet (1946):
“The preparation of data for and the
appearance before government agencies as a
witness to facts, to accounting principles, or
to the application of accounting principles is
essentially forensic accounting practice
rather than advocacy.”
Modern Version
“Let’s face it, we in the forensic profession
labor in an obscure corner of the vineyard.
We are the carefully selected, trusted, highly
trained guardians of one of the last great
secrets remaining on the face of the earth - the $600 billion, more or less annual
problem nobody knows about.”
Joseph W. Koletar, Fraud Exposed, John Wiley &
Sons, Inc 2003, p. 228.
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Knowledge, Skills and
Abilities Needed by
Forensic Accountant
• Law, legal system, courts, and courtroom
procedure
• Financial statement fraud
• Corporate governance, shareholder rights and
litigation, securities laws, and protections
• Report writing and communication
• Criminal law and procedure
• Computer fraud and cybercrime
• Human factors involved in intelligence
gathering, interview techniques and
understanding the motivations for fraud and
other criminal activities
• Ethical issues in business
• Business valuation
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Be like
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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.
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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.
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Accountant’s Role in
Fraud Detection
• In the early 1980s, companies began to
use computers to perform their record
keeping
• Intense competition caused auditing fees
to fall as much as 50% from the mid1980s to the mid-1990s.
• Auditors cut costs by reducing the
process of reviewing hundreds of
corporate accounts. They grew more
reliant on internal controls.
• Top executives were able to circumvent
internal controls and manipulate the
records.
• This lead to situations such as Enron,
WorldCom, Xerox, Adelphia
Communication, and the fall of Arthur
Andersen in the early 2000s.
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Accountant’s Role in
Fraud Detection
• Due to the financial disaster of
companies such as Enron and
WorldCom, there will be an increase
of forensic techniques in audits and
an increase in fees.
• Some accounting experts believe
that every audit engagement should
include much more skepticism and
detailed review of transactions.
• Other accounting experts suggest
that only special engagements
specifically targeting fraud can
adequately and effectively root out
the problem.
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Forensic-Type Organizations
• American College of Forensic Examiners (2750 E.
Sunshine, Springfield, MO 65804; 800-423-9737;
www.acfi.com. DABFA and Cr.FA; 2000)
• Certified Fraud Examiners (Association of CFEs, The
Gregor Bldg., 716 West Avenue Austin, TX 78701; 800245-3321; www.cfenet.com).
• Forensic Accounting Society Of North America (FASNA,
8712 W. Dodge Road, Suite 200, Omaha, NE, 68114; 402397-9433).
• Certified Forensic Financial Analyst (NACVA, Salt Lake
City, Utah 84106; 801-486-0600). Also, Certified Fraud
Deterrence (CFD) analyst.
• National Litigation Support Services Association
(NLSSA, III East Wacker Drive, Suite 990, Chicago, IL
60601; 800-869-0491). Not-for-profit.
• Network of Independent Forensic Accountants
(www.nifa.co.uk/services.htm). English group of 16
specialist accounting practices.
• Canadian Institute of Chartered Accountants (CICA) –
CA.IFA – Alliance for Excellence in Investigative
Accounting.
• Certified Forensic Investigator (CFI) – Canada Early
1980’s. www.homewoodave.com
• 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.
http://acfsnet.org.
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Forensic-Type Organizations
• The American College of Forensic Examiners located
in Springfield, Missouri, introduced a Certified
Forensic Accountant (Cr.FA) designation in 2001. A
not-for-profit educational body that provides advanced
training to its members, composed of twelve boards.
One board is the American Board of Forensic
Accounting.
• The Certified Forensic Accountant, Cr.FA, is an
advanced credential that recognizes the expertise in
forensic accounting for accountants who have
achieved additional training, experience, education,
knowledge or skill in forensic accounting and have
met all of their State Board of Accountancy
requirements.
• Two categories of professionals may apply to attain
the Certified Forensic Accountant, Cr.FA status:
– A person with a Bachelor’s degree in Business or ten
years of accounting related experience who does not
hold an accounting-related certificate (CPA, CMA,
CFFA, CVA etc.) must pass Exam 1 and Exam 2.
– A person with an accounting-related certificate (CPA,
CMA, CFFA, CVA, etc.) must pass Exam 2 only.
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Forensic-Type Organizations (contd..)
• Cr.FA literature indicates that the certificate
would benefit the following people:
–
–
–
–
–
–
–
–
–
–
–
–
–
–
Accountants
Consultants
Internal Auditors
IRS Auditors
GAO Auditors
FBI Agents [Of the 12,000 agents worldwide,
about 15% have accounting backgrounds.]
Defense department auditors
SEC accountants
Bankruptcy specialists
Lawyers
Professors
Bank examiners
Chief financial officers
Valuators of closely-held business
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Quotes
“A lawsuit is like a parachute
jump; you have to get it right
the first time.”
- Hal Rosenthal
“The party who has command
of the paper trail most often
controls in the courtroom.”
- D. Larry Crumbley
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Foreign Language
“Accounting concepts are a foreign
language to some lawyers in almost
all cases, and to almost all lawyers in
some cases.”
U.S. v. Kovel., 296 F.2d 922 (CA-2, 1961)
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© D.L. Crumbley
Three Branches of Government
Executive (regulations)
Legislative law [takes precedence]
Judicial law [a referee]
54
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Civil Procedure
Body of rules and practices by
which justice is handed out by
the legal system.
Federal Rules of Civil
Procedure (FRCP): governs
U.S. district courts.*
Federal Rules of Criminal
Procedure.
Federal Rules of Evidence.
* Find at www.law.cornell.edu/rules/frcp/overview.htm
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Hard To Convict
You have to remember one thing,
and that is the fact that our laws
aren’t designed to punish guilty
people; they’re intended to
protect innocent people.
E.J. McMillan, The Audit, Churchton, MD:
Harwood Publishing, 2000, p. 259.
-------------------------------------------------------------
Robert Durst in Galveston, Texas
admitted killing his neighbor, cutting
up the body, and tossing the pieces in
trash bags in the Gulf. He was found
innocent.
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Hard To Convict
I have never come to terms with a
system based on the principle that
it is better to let a hundred guilty
people go free rather than
wrongly convict one innocent
person. It’s okay for people to
be victimized again and again
as long as no one is mistakenly
locked up.
Clinton McKinzie, The Edge of Justice, New
York: Bantam Dell, 2002.
57
Tim McGraw’s
Position
© D.L. Crumbley
“Well you do what you do,
and you pay for your sins.”
Tim McGraw’s “Red Ragtop”
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Knowledge of Legal Concepts Necessary
Since forensic accounting is
often used in legal forums, forensic
accountants must be familiar with
legal concepts and procedures.
Nothing spoils a great case
quicker than the lack of evidence.
Expert opinions are evidence. FRE
702.
Source: D.W. Squires, “Problems Solved With Forensic
Accounting: A Legal Perspective,” Journal of Forensic
Accounting, Vol. IV, 2003, p. 132.
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Pleadings
Complaint – Plaintiff files.
Service of Process – served on
defendant.
Answer – Defendant must
admit or deny allegations.
Sharp v. U.S., 199 F. Supp. 743
(D.Del 1961), aff’d 203 F.2d
783 (3rd Cir. 1962).
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Expert Witnessing
Our purpose: Assist the trier of
the facts.
Question of Facts v. Question of
Law [not always clear].
Negligence may be either.
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Frequent Terms (1)
Appellant (Petitioner)
(Plaintiff): Person filing suit.
Respondent (Defendant):
Person sued.
Stare decisis: case once
decided, will control.
Doctrine of precedential
authority: follow prior case
only where issues/facts are
essentially the same.
Judge not required to follow
judicial precedent beyond own
jurisdiction.
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Frequent Terms (2)
 Res judicata (collateral estoppel):
Once case or issue resolved, matter
precluded from being litigated again.
 Law of the case: Once issue decided
one way, if not properly challenged,
will not be reconsidered.
 Full Faith and Credit Clause:
Court in one state must honor and
enforce judgment of another state.
 Venue: The appropriate court to
bring a dispute (cause of action
occurs or where crime committed).
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Frequent Terms (3)
Pro se: Party representing
himself or herself.
Per curiam: Decision of the
whole court.
en banc: decision rendered by
full court.
Concurring opinion: Agrees
with court’s conclusion, but…
Dissenting opinion: Disagrees
with majority.
Dicta (Dictum): incidental
facts; not binding on future
cases.
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Frequent Terms (4)
Affirmed (Aff’d; Aff’g): agrees
with lower court.
Reversed (rev’d; rev’g): disagrees
with lower court.
Writ of Certiorari: Asks Supreme
Court to hear your case.
Cert. Granted
Cert. Den.
Remand: Vacate the lower court
decision and send back for further
considerations
Overruling: Does not impact
either party in the earlier case.
Overrules a previous case
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Frequent Terms (5)
Ad hoc: for one particular or special
purpose (e.g., an Ad hoc committee)
Ad valorem: According to value
(e.g., in tax, assessment of taxes
based on property value).
Bona fide: in good faith and without
fraud or deceit.
Covenant: an agreement or promise
to do or not to do something.
Dejure: in law or lawful; legitimate.
Deposition: A written statement of a
witness under oath, often
question/answer
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67
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Frequent Terms (6)
Enjoin: to command or instruct with
authority (e.g., judge can enjoin
someone to do or not to do
something).
Habeas corpus (writ of): procedure
to determine if authorities can hold a
person in custody.
Nolo contendere: a party does not
wish to fight or continue; person will
not fight a charge.
Parol evidence: renders any
evidence of a prior understanding of
a party to a contract invalid if it
contradicts the term of a written
document.
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Frequent Terms (7)
© D.L. Crumbley
 Brief – written arguments supported by
citations of court decisions, statutes, and
other authorities.
 Stipulation – voluntary agreement before
trial between opposing parties concerning
the disposition of certain facts or points.
 Amicus-curiae – a brief filed by a party not
directly related to a lawsuit.
 Habeas corpus – a writ which permits a
prisoner to challenge a conviction on
constitutional grounds.
 Executor/executrix – one appointed by a
will to execute the provisions.
 Ex parte hearing – court hears only one
side of an issue.
 Special Master – appointed by a court or
judge to decide certain facts, etc.
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Frequent Terms (8)
 Subpoena ad testificandum – command to
appear and testify as a witness.
 Default judgment – judgment won by the
plaintiff because the defendant failed to
respond to a summons or appear at trial.
 De novo – new; a new proceeding without
regard to prior legal actions.
 Double jeopardy – prohibition in the U.S.
Constitution, 5th amendment, against trying
a citizen twice for the same crime.
 Enabling act – legislation by which an
administrative agency is created and powers
are delegated to it.
 Jurisdiction – power of a court to hear and
decide the issues in a case and to bind the
parties.
 Long-arm statute – a state law extending
personal jurisdiction over out-of-state
persons (including corporations).
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Frequent Terms (9)
 Pleadings – papers in court, with copies to
other parties, in preparation for bringing or
defending a lawsuit.
 Scienter – with intent to deceive; with
guilty knowledge.
 Voir dire – jury selection process; lawyers
and judges ask.
 Actus reus – brought about the criminal act.
 Mens rea – caused the criminal act with
guilty knowledge; state of mind indicating
culpability. Staples v. U.S., 511 U.S. 600
(1994).
 Preponderance of the evidence – greater
than 50%. Civil trial.
 Clear and convincing evidence – ca 70%.
 Beyond a reasonable doubt – greater than
95%. Criminal trial.
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The Federal Judicial System
SUPREME COURT
9 Judges
U.S. COURT OF APPEALS
Federal Circuit
U.S. COURT OF
APPEALS
12 Circuits
(Created in 1982 by a congressional
statute; formed by merging the Court
of Claims and the Court of Custom
and Patent Appeals; sit in panels of
three on cases involving customs,
copyright, trademarks, and patents.)
U.S. Tax Court
19 judges, with 1 judge
hearing most tax cases
U.S. COURT OF
INTERNATIONALT
RADE
(Created in 1980,
formerly the U.S.
District Court, instead
of the circuit courts.)
(Three-judge panels, not the
entire circuit court, hear most
cases.)
ADMINISTRATIVE
AGENCIES
(In some cases,
appeals to a U.S.
District Court, instead
of the circuit courts.)
U.S. Court of
Federal Claims and
some special
agencies (e.g.,
Board of Contract
Appeals,
Patent/Trademark
Boards, and Merit
Systems Board)
U.S. DISTRICT
COURTS
50 States
Washington, D.C.,
Puerto Rico, Virgin
Islands, Guam
U.S.
BANKRUPTCY
COURTS
U.S.
MAGISTRATES
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Facts Determination
The Seventh Circuit had this to say
about a trial court’s right to determine
facts:
The trial court … has ‘the best
opportunity to observe the verbal and
nonverbal behavior of the witnesses
focusing on the subject[s]’ reactions and
responses to the interrogatories, their
facial expressions, attitudes, tone of
voice, eye contact, posture and body
movements, as well as confused and
nervous speech patterns in contrast with
merely looking at the cold pages of an
appellate record.
Source: United States v. Duarte, 1 F.3d 644, 651 (CA-7,
1993), cert. denied, 510 U.S. 1058, 126 L.Ed. 2d 688,
114 S. Ct. 724 (1994).
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Helpfulness
Helpfulness to the trier of the facts is
the ultimate touchstone for the
admissibility of expert testimony. To be
helpful the (1) witness must be
qualified as an expert, (2) expert must
have a reasonable factual basis for the
testimony, (3) testimony must be
based upon reliable methods, and (4)
testimony must be relevant to the facts
in dispute. Accounting testimony can
be the subject of expert testimony.
Sources: In Re Paoli Railroad Yard PCB Litigation,
916 F.2d 857 (CA-3, 1990).
Fed. Rul. Evidence 702 and 703; General Electric
Co. v. Joiner, 522 U.S. 136 (1997).
Computer Systems Engineering, Inc. v. Qantel
Corp., 740 F.2d 67 (CA-1 1984).
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The Judge Controls
A 2000 dispute involved an alleged Ponzi scheme where a
defendant sold airline tickets procured by debtors using
frequent flier miles purchased by brokers. The defendant
relied on an expert who was a CPA, a bankruptcy trustee, an
insolvency accountant, and a fraud investigator with
substantial experience and impressive qualifications and
credentials. The judge, Herbert A. Ross, was not impressed
with this expert, F. Wayne Elggren, employed by Arthur
Andersen.
At trial Mr. E questioned the experts of the trustee
and the expert of the plaintiff (who had no CPA or
certification). Mr. E found numerous faults with the
methodology and analysis of the trustee and the plaintiff’s
expert, E. Jayne MacPhee. Mr. E concluded his argument by
stating there was too much unaccounted for cash and profits
from the ticket business to claim it was a sham or Ponzi
scheme. He relied on a “smoking gun” of $9 million in ticket
revenues. Ms. MacPhee found only $6 million and the trustee
only $4.8 million.
The judge said that Mr. E had misunderstood or had
been misadvised about the context of the $9 million of ticket
sales “He [Elggren] is hoisted on his own petard when he
uses it to analyze the debtors’ business history.” The rest of
his criticisms are of “such small size or consequence, or so
speculative or inclusive, that they are akin to straining at
gnats.”
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The Judge Controls
The judge had this to say about MacPhee’s lack of a CPA
degree or certification in certain accounting fraud detection
professional organizations and Mr. E’s criticism of her:
The type of expertise truly needed in this case is someone
who can take poorly kept, incomplete records, involving
commingled funds, and reconstruct the business out of them.
MacPhee has training in accounting matters and experience
in forensic accounting situations. She has worked as an
accounting analyst reconstructing what really happened in
the M&L Business Machine case, one of the major Ponzi
schemes to reach the bankruptcy courts. Experience and
training, despite the lack of a specific degree or designation,
qualify her to render an expert opinion on accounting matters
related to the reconstruction or analysis of business records,
especially when a Ponzi-type business, with commingling of
funds, is suspected.
While she does not have the credentials of belonging to all
the professional groups that Mr. E does, she has accounting
training and experience in working on Ponzi cases, and has
done an admirable job in assisting the court in understanding
debtors’ operations - - a much more intellectually honest job
than Mr. E at that. She qualifies as an expert in reconstructive
accounting in a situation where the books and records are
incomplete and not up to standards, and the funds of the
debtors are commingled.
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The Judge Controls
Likewise, the trustee, even though he is a party, may
qualify as an expert, even though his bias can be
challenged. He is a CPA and a panel trustee in Alaska,
which have given him on-the-job experience in
understanding and reconstructing financial
transactions.
Judge Ross concluded as follows:
In short, I find that Mr. E’s report is based on
substantial factual mistakes, speculation, innuendo,
and inferences which are not supported by full
explanations and analysis. It is not worthy of an expert
of his caliber, nor worthy of admission as evidence in
this case. His expert opinion will be excluded.
Source: In re Bonham, 55 Fed. Rul. Evidence Serv. (Callaghan)
419; 2000 Bankr. Lexis 727.
77
Motions
© D.L. Crumbley
Motion: Requests a rule or order in favor of the applicant
Motion to dismiss: The moving party is requesting that a cause of action be
dismissed because the alleged facts, even if proven, do not constitute a valid
legal claim.
Motion for a directed verdict: The moving party requests at trial that a
cause of action be dismissed because the party with the burden of proof has
failed to establish sufficient facts so that a reasonable fact finder (e.g., the
jury) could find in the claimant’s favor. For example, in a complex toxic tort
case, the plaintiff’s only expert witness is barred from testifying as to
causation under the Daubert rule. After the plaintiff rests, the defense moves
for a directed verdict on the grounds that the plaintiff has not submitted
sufficient proof of causation through an expert witness.
Motion for judgment notwithstanding the verdict: This motion is made by
the losing party after an adverse jury verdict. The moving party is asking that
the judge reverse the verdict of the jury. These motions may be granted if the
judge determines that the jury verdict had no reasonable support in fact or
was contrary to law.
Motion for a continuance: The moving party is requesting that a scheduled
event, for example a hearing or trial, be postponed or continued to a later
date.
Motion in limine: The moving party is requesting that evidence it expects
the opposing side to offer be held inadmissible. For example, a party may
make a motion in limine to exclude the testimony of an expert for failure to
comply with the Daubert rule.
Motion for summary judgment: The moving party is requesting, prior to
trial, and based solely on documentary evidence (including expert deposition
transcripts, reports, and affidavits), that the court grant judgment in its favor
because no material facts are in dispute. This device is used to throw a case
out of court without it ever getting to the jury. Many times a lawyer with a
weak case will seek to survive summary judgment in order to be able to settle
the case on favorable terms over the threat of a jury trial.
Source: Babitsky et. al, The Comprehensive Forensic Manual, Seak, Inc.,
www.seak.com
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Discovery: process of getting
information from the other party
Fed. R. Civ. Pro. 26(b)(1).
Parties may obtain discovery regarding
any matter, not privileged, which is
relevant to the subject matter involved in
the pending action, whether it relates to the
claim or defense of the party seeking
discovery or to the claim or defense of any
other party, including the existence,
description, nature, custody, condition, and
location of any books, documents, or other
tangible things and the identity and location
of any persons having knowledge of any
discoverable matter. The information sought
need not be admissible at trial if the
information sought appears reasonably
calculated to lead to the discovery of
admissible evidence.
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Privilege: discovery may not
be made of privileged matters
 Attorney – client
 Husband – wife
 Physician – patient
 Government secrets
 Ordained clergyman-parishioner
 Attorney work product
[But not experts who will testify]
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Elements of the Attorney-Client
Privilege
 Communication.
 Between attorney and client.
 For obtaining legal advice or
services.
 Intended to be confidential.
 Privilege is not waived.
[Be careful with e-mails and cell
phones.]
U.S. v. United Shoe Machine Corp., 89 F. Supp. 358 (D.
Mass. 1950)
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Protecting Work Product Privilege
 Attorney should directly retain the
consultant.
 Agreement should be between
attorney and expert.
 Expert should obtain facts through, or
at direction of the attorney.
 Investigation should be done at the
direction of attorney.
 Attorney included when meeting with
client.
Source: Zeph Telpner and Michael Mostek, Expert
Witnessing in Forensic Accounting, Boca Raton, FL:
CRC Press, pp. 209 – 237.
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SAMPLE AGREEMENT
Our understanding is that you have
retained us as consulting experts. If
you decide to change our status to
that of testifying experts, we will
return all documents, records and
any work product to you and
request from you only those
documents and records necessary
for our testimony.
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Accountant Privilege
(§7525)
• Taxpayer’s communications made
to federally authorized tax
practitioners (e.g., lawyers, CPAs,
enrolled agents)
• Applies only to tax advice: given
by an individual regarding a matter
that is within that individual’s
authority to practice as a federally
authorized tax practitioner under
Treasury Circular 230.
I.R.C. §7525(a)(3)(B)
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Accountant Privilege
(§7525)
• Contains many exceptions, either
poorly or not at all defined, thus
limiting the privilege’s
effectiveness in protecting the
confidentiality of taxpayer
communication.
• Can not be asserted in (1) criminal
tax matters, (2) investigations by
regulatory agencies, and (3) tax
advice regarding the promotion of
corporate tax shelters.
Source: R.J. Buchanan, “Corporate Tax Shelter
Exception to the Accounting Client Privilege,”
Tax Notes, September 16, 2002, p. 1619.
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Accountant Privilege contd …
• Tax practitioners are not entitled to
privilege when they are doing other than
lawyers’ work.
• Information provided to a practitioner
for purposes of preparing a client’s tax
return is not privileged. U.S. v.
Frederick, 182 F.3d 496 (CA-7,1999)
• Federal District Court: Most tax advice
falls into the category of return
preparation for which there is no
privilege [U.S. v. KPMG, No. 02-0259
(D. D.C. Dec.20, 2002)]
• The practice of tax is not the practice of
law (U.S. v. KPMG).
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Bureau of Prison’s Rule
• A new Bureau of Prison’s (BOP) rule
which permits federal law enforcement
agencies to eavesdrop on confidential
attorney-client communications of
persons in custody of the Department of
Justice (DOJ) under certain
circumstances, without federal judicial
oversight.
• This rule means that forensic
accountants and others hired by
attorneys to assist in providing legal
services must be on their guard to avoid
disclosure of confidential information.
•
Source: Carl Pacini, “Privileged Communications Between Forensic
Accountants, Attorney, and Clients Threatened by Federal Rule.” 28
C.F.R. §§ 500, 501 (2002): Prevention of Acts of Violence and
Terrorism, 66 Fed. Reg. 55,062 (Oct. 31, 2001).
87
E-mail Evidence
© D.L. Crumbley
• KPMG is fighting clients about questionable
tax-shelter products.
• The IRS disclosed e-mails dated March 14,
1998, in a Tax Court case involving an estate in
litigation against the IRS.
• The e-mails document discussions among high
level KPMG executives about a product known
as FLIP. One of the e-mails referred to the
product’s “troublesome issues.”
• E-mails created on a company’s system
belongs to the company.
• E-mail evidence has been used in cases
involving accounting fraud, harassment,
antitrust, discrimination, retaliation, whistleblowing, insider trading, trade secrets, and
more.
• Discovery is broad: instant messages, web
visit logs, hard drives, PDA’s, pagers, voice
mail, laptops, back up tapes, and cell phones
call records.
Source: Rita Risser, “E-mail = Evidence: How to Protect
Yourself,” Fair Measures.
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E-mail Evidence (cont.)
• In October, 2003, a special master
recommended to federal court that
KPMG does not have to produce many
tax-shelter documents.
• In mid-October 2003, a federal judge
blocked prosecutors from using an email that she wrote to her attorney as
evidence in her upcoming trial. She had
forwarded the same e-mail to her
daughter the next day after sending it to
her attorney.
Source: Rita Risser, “E-mail = Evidence: How to Protect
Yourself,” Fair Measures.
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Best Practices
• Know and follow employer
policies.
• Assume a boss or judge is reading
your e-mail.
• Don’t send e-mails in anger.
• Do not be sarcastic.
• Don’t send or receive jokes from
work.
• Insure mail lists are current for
confidential information limit
copies.
• Do not mark ‘Attorney-Client’
unless authorized.
• Don’t mark ‘Company
Confidential’ unless authorized.
Source: Rita Risser, “E-mail = Evidence: How to Protect
Yourself,” Fair Measures.
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IRS Summons
Accountants have very little
protection under federal law from
the enforcement of IRS Summons.
Couch v. U.S., 409 U.S. 322 (1973).
U.S. v. Arthur Young & Co., 465 U.S. 805 (1984).
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Methods of Discovery
 Interrogatories: Written questions
[FRCP 33(a) – max. 25 / 30 days].
 Requests for Production of
Documents.
 Depositions [FRCP 30(a): limits each
side to 10].
 Subpoenas duces tecum: request for
specified documents for inspection and
copying (especially from people not
parties to a lawsuit, e.g., expert
witnesses).
 Physical examination.
 Production of tangible things and
entry upon land.
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Civil Trial
 Jury selection and Pre-Trial Motions.
 Opening Statements.
 Burden of Proof: In Civil trial,
preponderance of evidence – 51% or
greater.
 Sometimes, higher clear and
convincing evidence.
 For the opinion of an expert to be
admissible, it must meet the 51%
test:
“My opinion is based upon a reasonable
degree of scientific (or medical or
economic or accounting) certainty.”
 Otherwise, opinion may be stricken
from evidence.
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Four Phases of Interrogation at Trial
 Direct Examination – friendly
attorney – no leading questions.
 Cross-examination – opposing
attorney – credibility of the witness
and generally what was covered in
direct. Leading questions O.K.
 Redirect examination – friendly
attorney gives expert opportunity to
clear up confusion.
 Recross-examination – not required.
New matters subject to recross-exam.
Own attorney has right for last words
with expert.
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Leading Questions
 Didn’t the defendant appear to you to
be stealing money from the cash
register?
 A question that suggests a desired
answer (e.g., yes or no).
 Leading questions can be directed to
opposing parties and adverse
witnesses during examination.
 Better questions:
How much money was the defendant
taking from the cash register?
How can you estimate that amount?
How was she taking the money?
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Getting Paid
The other side schedules a deposition,
deposes you, and does not pay you a
reasonable fee. Who is required to
pay you?
Fed. R. Civ. Pro. 26(b)(4)(c): The party
seeking discovery pays the expert a
reasonable fee for time spent in
responding to discovery.
96
Incentive Test
© D.L. Crumbley
1. A(n) ______ is a device used by courts to
have disputing parties to agree in advance of
a trial to facts, evidence, etc.
2. A(n) _____ _____ brief is filed by a party
not directly related to a lawsuit.
3. The _____ _____ doctrine states that a case
once decided will control.
4. The appropriate court to bring a dispute is
called _____ .
5. ______ is opinions of a judge which goes
beyond the facts before the court and are not
binding on future courts as precedent.
6. A higher court ______ a lower court
decision and sends it back for further
consideration.
7. You file a writ of ______ to ask the
Supreme Court to hear your dispute.
8. _____ _____ refers to a decision of the full
court.
9. A ________ is a written statement of a
witness under oath, often in a
question/answer format.
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Incentive Test
10. The ____ _____ is preliminary questioning
by the court (or lawyer) of jurors to
determine competency.
11. A motion in _____ is a request before trial
that evidence (or expert) of opposing side
is inadmissible.
12. The complaint and answer would be called
the _____ .
13. The _____ is the person sued.
14. A subpoena _____ _____ is a command to
produce documents to a court that become
evidence.
15. A subpoena _____ _____ is a command to
appear and testify as a witness.
16. A(n) _____ _____ is appointed by a court
or judge to decide certain facts, etc.
17. Models, forms, and exhibits would be
considered ______ evidence.
18. ______ ______ means a party is
representing himself.
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Incentive Test
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1. A(n) stipulation is a device used by courts
to have disputing parties to agree in advance
of a trial to facts, evidence, etc.
2. A(n) amicus curiae brief is filed by a party
not directly related to a lawsuit.
3. The stare decisis doctrine states that a case
once decided will control.
4. The appropriate court to bring a dispute is
called venue .
5. Dicta is opinions of a judge which goes
beyond the facts before the court and are not
binding on future courts as precedent.
6. A higher court remands a lower court
decision and sends it back for further
consideration.
7. You file a writ of certiorari to ask the
Supreme Court to hear your dispute.
8. En banc refers to a decision of the full
court.
9. A deposition is a written statement of a
witness under oath, often in a
question/answer format.
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Incentive Test
10. The voir dire is preliminary questioning by
the court (or lawyer) of jurors to determine
competency.
11. A motion in limine is a request before trial
that evidence (or expert) of opposing side is
inadmissible.
12. The complaint and answer would be called
the pleadings .
13. The respondent is the person sued
(defendant).
14. A subpoena duces tecum is a command to
produce documents to a court that become
evidence.
15. A subpoena ad testificandum is a command
to appear and testify as a witness.
16. A(n) special master is appointed by a court
or judge to decide certain facts, etc.
17. Models, forms, and exhibits would be
considered demonstrative evidence.
18. Pro se means a party is representing himself.
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Evidence
“Anything perceivable by the five
senses, and any proof such as
testimony of witnesses, records,
documents, facts, data, or tangible
objects legally presented at trial to
prove a contention and induce a belief
in the minds of a jury.”
Black’s Law Dictionary
----------------------------------------------A trial is too important to put in the
hands of the jury.
Runaway Jury.
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Best Evidence Rule
Under the best evidence rule (also
referred to as the original writing rule),
to prove the contents of a writing,
recording, or photograph, the original
writing, recording, or photograph
usually must be presented.
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Two Types of Evidence
Direct evidence: directly proves a
fact at issue, without the need for
an inference or presumption (e.g.,
testimony of a witness).
Circumstantial: a fact or issue
may be proved indirectly (e.g., a
person was present at the time of
the theft).
Law does not value circumstantial
evidence any less than direct
evidence.
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Ensuring Admissibility
 Assume that documents or other
evidence one handles may be used in a
legal proceeding.
 Do not mark, staple, or otherwise alter
the document.
 Record how you obtained the evidence
and who handled it.
 Keep evidence in a secure location –
fireproof safes or locked cabinets.
 If possible, avoid putting your or other
investigators fingerprints on the
document.
 Use see-through holders.
 Internal auditors at WorldCom worked at
night and put much of the records on
personal CD ROMS (e.g., bought own
CD burner).
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Ink Analysis
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 Martha Stewart may be undone by a blue
ballpoint pen.
 Stockbroker belatedly inserted a note to
help cover up Ms. Stewart’s improper
stock trading. Blue ballpoint ink used is
different from ink elsewhere on the
trading worksheet.
 Prosecutors used forensic ink analysis in
Rite Aid case to show that certain
documents were backdated (ink used to
sign letter was not commercially available
until 3 months after the letter was dated).
 Impossible to match an ink sample to a
particular printer, and matching to a brand
of printer may be impossible.
 Laserjet printer even tricker.
 Fraudsters: use pencil.
Source: Mark Maremont, “In Corporate Crimes, Paper Trail
Often Leads to Ink Analysts’ Door,” Wall Street J., July 1,
2003, p. A-1.
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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.
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High Tech Is Best
 Studies show that the average person
retains as much as 87% of information
presented visually and as little as 10%
for information given orally.
 Computer animations are even more
persuasive.
 Both types of delivery impact the weight
given to evidence by jurors (or judges).
 Use visual aids, computer animations,
and other visual help whenever possible
while on the stand.
Source: David Yale, “Computers on the Witness
Stand,” Univ. of Conn. Law School, Fall 1996,
www.dcyale.com/law_papers/daubert.html
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Important Visual Rules
 Storyboard your testimony (series of
sketches).
 Do not overdo it.
 Design illustration so jurors can take
away the message in 5 seconds. Title
should give your conclusion.
 Color is important.
 Put the most important information in
the top right-hand corner of the chart.
 Do not simply enlarge document.
Highlight important stuff.
 Practice with your exhibits.
Source: D.S. Scott and R. Laguzza,
“Communication With The Jury,“ Litigation
Services Handbook, John Wiley, 2001, pp.15-2
and 15-3.
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Benford’s Law
• Distribution of initial digits in natural numbers is not
random
• Predictable pattern:
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%
There is software to detect potentially invented
numbers in many situations
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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.
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Computer Forensics Important
Joan Feldman: “Within three years, I’m sure all
evidence collected in discovery will be
electronic-based.” President of Computer
Forensic, Inc. (Seattle).
Players from three areas:
1. Accounting-forensic units of big CPA firms.
2. Data-recovery and computer-repair specialists,
3. Litigation support services.
“Corporate investigations used to mean following
a paper trial, but these days many follow an
electronic one. Increasing demand for the skill
and technology necessary to unearth digital
secrets has led to the birth of a small but
growing industry: computer forensics.”
“They can dig up e-mail and documents that
seemingly have been deleted, determine what
web sites were visited and which key words
were used to get there.”
Source: Ellen Byron, “Computer Forensics Sleuths: Help in
Rooting Out Fraud,” Career Journal, Wall Street J., reviewed
June 16, 2003.
www.careerjournal.com/industries/computers/20030320byron.html
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Computer Forensics Primer
• Defined: acquiring and analyzing digital
evidence in a manner that protects the
integrity of the evidence to investigate a
potential fraud.
• Currently only 5% of fraud investigations
use electronic data in investigations.
• This low percentage is likely because much
of the collected digital evidence is
forensically unusable.
• SAS No. 99: In an IT environment, it may
be necessary for the auditor to employ
computer-assisted audit techniques (for
example, report writers, software or data
extraction tool, or other system-based
techniques) to identify the journal entries
and other adjustments to be tested. [par. 61].
Source: G.S. Smith, “Computer Forensic: Helping to Achieve The Auditors
Mission,” Working Paper, December 2003.
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Data Extraction v. Data
Investigation
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• There is a difference between the procedures used
for traditional data extraction (i.e., data mining)
and data investigation for evidentiary purpose.
• With traditional data extraction, tools such as
Interactive Data Extraction and Analysis (IDEA)
or ACL software are used to interactively extract,
sample, and analyze data.
• Yet simply checking a client’s files or the cross
comparing data, files for forensic investigations
are damaged. Such actions are similar to sending
a housekeeper in to tidy up a murder crime scene
before the forensic investigative team is allowed to
start analyzing the evidence.
• For forensic purposes, software tools collect
digital data without changing it. After the data is
collected, it is analyzed.
• Examples of forensic software tools are Encase,
SafeBack, or Ontrack’s Easy Recovery software.
• Increasing the time lag between initial fraud
suspicions and the recovery of the related digital
data makes the evidence less valuable.
Source: G.S. Smith, “Computer Forensics: Helping to Achieve The
Auditor’s Mission,” Working Paper, December 2003.
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Data Mining
• Data mining is an information extraction
technique designed to discover hidden facts
or red flags that may indicate previously
undetected fraud, abuse, waste, or
mismanagement.
• Using a combination of statistical analysis
algorithms, exploratory analyses, modeling
techniques and data base technology, data
mining finds patterns and subtle
relationships in data.
• One can not push a button and expect the
software to pick the one bad apple out of the
panel.
Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of
Government Financial Management, Winter, 2003 Vol. 52, No. 4, p. 11.
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Evidence (varies)
All relevant evidence is admissible,
unless inadmissible due to another
rule of evidence.
Rule 403: probative value is
substantially outweighed by the
danger of unfair prejudice,
confusion of the issues, misleading
the jury, or by considerations of
undue delay, waste of time, or
needless presentation of cumulative
evidence.
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Rule 701. Opinion Testimony by
Lay Witnesses
If the witness is not testifying as an
expert, the witness, testimony in the
form of opinions or inferences is
limited to those opinions or inferences
which are (a) rationally based on the
perception of the witness, and (b)
helpful to a clear understanding of the
witness’ testimony or the determination
of a fact in issue, and (c) not based on
scientific, technical, or other
specialized knowledge within the
scope of Rule 702.
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Federal Rules of Evidence 702 – 705
(deal with expert witnesses)
Rule 702 - Testimony by Experts
a) "If scientific, technical or other specialized
knowledge will assist the trier of fact to
understand the evidence or to determine a
fact in issue, a witness qualified as an
expert by knowledge, skill, experience,
training, or education may testify thereto in
the form of an opinion or otherwise; if (1)
the testimony is based upon sufficient
facts or data, (2) the testimony is the
product of reliable principles and
methods, and (3) the witness has applied
the principles and methods reliably to
the facts of the case.” (amendment in
bold)
b) Fed.R.Evid. Rule 702 requires the Trial
Court to perform the gatekeeper role
described in Daubert regarding all expert
testimony
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Federal Rules of Evidence
Section 702
Comparative Analysis
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
Generally, if you meet the applicable AICPA professional
standards, you probably meet Rule 702.
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Rule 703 - Basis of Opinion Testimony by Ex
a) “The facts or data in the particular case
upon which an expert bases an opinion or
inference may be those perceived by or
made known to him at or before the hearing.
If of a type reasonably relied upon by
experts in the particular field in forming
opinions or inferences upon the subject, the
facts or data need not be admissible in
evidence.”
b) Sources of information an expert may use
include:
1) Firsthand knowledge
2) Information admitted into evidence
during the trial
3) Information made known to the expert
before the trial
4) The facts themselves need not be
admissible as evidence if they are “of a
type reasonably relied upon by experts
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a) "Testimony in the form of an opinion or
inference otherwise admissible is not
objectionable because it embraces an
ultimate issue to be decided by the trier of
fact."
1) The ultimate issue is that which is pivotal for
the defendant or the plaintiff and determines
the -outcome.
Rule 705
Disclosure of Facts or Data
Underlying Expert Opinion
a) "In civil cases, the expert may testify in
terms of an opinion or inference and give
his reasons therefore without prior
disclosure of the underlying facts or data,
unless the court rules otherwise. The expert
may in any event be required to disclose the
underlying facts or data on crossexamination.”
1) Experts are, generally, allowed to testify
about their opinions or give reasons for their
opinions without first testifying about the
underlying facts or data.
2) The court may require the expert to disclose
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Rule 706 – Court-Appointed Experts
a) The Court has the authority to appoint an
expert whom all parties may cross-examine
when:
1) The Court believes the experts for the
litigants are “hired guns,” and their testimony
is unreliable or prejudicial.
2) The proffered expert opinions have failed to
adequately explain the complex issues upon
which the Court must decide.
b) The Court has ultimate discretion regarding
the admissibility of all expert testimony
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Special Master and Court Appointed
Experts
 A court may appoint someone (e.g.,
a financial expert) to determine
certain facts in a dispute.
 They may be appointed pre-trial,
during trial, or post-trial to oversee
one or more aspects of a dispute.
 Appellate courts generally hold that
special masters are reserved for
special or unique circumstances.
 Special Masters can be subject to
Daubert challenges.
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Rules of Evidence
The rules of evidence are the rules
governing the admissibility of evidence
in a legal proceeding and the weight to
be given to evidence that is admitted.
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What Is Evidence?
• Evidence is testimony, writings, and
material objects offered to prove an
alleged fact or proposition.
• Direct evidence is evidence that
directly proves a fact at issue,
without the need for any inference or
presumption (e.g., copy of a check
that has been altered).
• Circumstantial evidence is evidence
from which a fact at issue may be
proved indirectly (e.g., bank records
show a deposit of unknown origin).
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Relevancy and its limits
(evidence)
a) Rule 401 – Definition of “Relevant
Evidence”
a) Evidence is relevant if it tends to prove or
disprove an alleged fact.
b) Rule 402 – Relevant Evidence Generally
Admissible; Irrelevant Evidence
Inadmissible
1) It is the attorney’s responsibility to insure
that sufficient evidence is admitted at trial
to support the expert’s opinion.
c) Rule 403 – Exclusion of Relevant Evidence on
Grounds of Prejudice, Confusion, or Waste of
Time
1) Relevant evidence may be excluded if it is
prejudicial, needlessly cumulative,
threatens to confuse or mislead the jury, or
causes an unnecessary delay or waste of
time.
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Evidence
Prima facie evidence: unless
overcome by other evidence,
suffices as proof of a fact in a
dispute.
Probative evidence: testimony
which establishes or contributes
toward truth.
Parol evidence rule: an agreement
in writing can not be modified by
oral evidence.
Secondary evidence: copies of
instruments or oral evidence.
Chain of custody: a log of
evidence obtained and who had
access to such evidence.
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Hearsay (evidence)
Rule 803 – Hearsay Exceptions; Availability of
Declarant Immaterial
a)
b)
Generally, hearsay is not admissible as evidence.
Exceptions relating to expert testimony
1.
Business records such as memoranda, reports, records,
or data compilations kept on a regular basis by a person
with knowledge
2.
Public records; such as records, reports, statements, or
data compilations kept by public offices or agencies
3.
Market reports and commercial publications; such as
market quotations, lists, directories, etc. relied on by the
public
4.
Learned treatises; such as almanacs of business
information and technical literature
5.
Missing business records; reports normally prepared
daily or the fact that they were not prepared is
admissible
c)
Business records, such as computer printouts, may be
entered into evidence without the testimony of the
employee who actually prepared the records as long
as the court considers the source of the information
and the method of preparation trustworthy
d)
Experts are not required to prove that the information
upon which they have relied is trustworthy
a)
May be grounds for a Daubert/Kumho challenge if
confirmation is required or recommended by standards
of practice.
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Hearsay evidence: a statement made outside
the court to prove the truth of the matter
stated
You, Larry, try to state in the courtroom that
Joe said “Paul is a crook.”
 Hearsay may be offered to prove a
nonhearsay purpose.
Trustworthiness.
Unavailability of declarant.
Practical considerations.
Exemptions to Fed. Rules of Evidence.
 Major exceptions
Excited utterances.
Business records.
Official records.
Dying declarations.
Learned treatises.
Commercial publications.
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Most trials boil down to one
issue: Credibility
Expect the other side to present
evidence that you are biased (to
throw out your testimony).
Prior Inconsistent Statements.
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Entertainer
As strange as it may be, an attorney
wishes to present an expert who is
“guaranteed to entertain and interest
the jury - - the hallmarks of an expert
who will be able to persuade.”
Experts are now in the television and
entertainment business.
Source: D.M. Malone and P.J. Zwier, Effective Expert
Testimony, Notre Dame, IN: NITA, 2000, p. 93.
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Six Ways to Discredit Testimony
1. If an expert, the witness is not qualified.
2. The witness did not consider all the
facts.
3. The witness relied on erroneous facts.
4. If an expert, the witness’s conclusions
do not follow from a correct analysis of
the facts.
5. The witness’s testimony is inconsistent
with prior testimony.
6. The witness was biased or prejudiced
and therefore shaded his or her
perceptions or conclusions.
A fact witness employed by the defrauded
party generally will be grilled more than
an expert witness about bias or
prejudice.
Source: D.R. Carmichael, et. al, Fraud Detection, 5th, Fort
Worth: Practitioners Publishing, 2002, p. 8 – 39.
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Avoid Conflicts of Interest
You must not have present or past
relationships with individuals on
either side of the dispute which
will prevent or interfere with
objective testimony.
Checking your firm’s files and
records for professional conflicts
early is extremely important.
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Result-Oriented Work
Estate of Bessie I. Mueller v. Commissioner,
T.C. Memo. 1992-284, Doc 92-4343 (57 pages), the
issue was the valuation of stock of the Mueller Co.
The IRS produced as its expert on the valuation
questions Dr. Shannon Pratt, managing director of
Willamette Management Associates and the
acknowledged dean of business appraisers. Tax
Court Judge Renato Beghe nevertheless concluded
that “Willametie’s report was result-oriented and
this was reflected in Dr. Pratt’s testimony.” The
Judge noted that appraisers “have third-party
responsibilities – just as certified public accountants
do – to those who rely on their opinions, and their
determinations must be independent and
objective….”
Dr. Pratt strayed from the standard of
objectivity and cast aside his scholar’s mantle and
became ‘a shill’ for respondent.” In Mueller, as a
result, Judge Beghe rejected most of both the
Willamette report and Dr. Pratt’s testimony, but did
take account of Dr. Pratt’s criticism of the taxpayer’s
expert’s reports and testimony.
Source: B.J. Raby and W.L. Raby, “Reasonable Compensation, Expert
Witnesses, and the Tax Practitioner,” Tax Notes, September 15, 2003
p. 1417.
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Alternative Dispute Resolution
Mediation: appointment of an
agreed-upon third party to facilitate
settlement negotiations.
before or after suit is filed
parties control the outcome and all
resolutions are voluntary.
Arbitration: parties submit the
dispute for resolution to an agreedupon arbitrator or panel.
rules less formal
faster and cheaper
can be binding or non-binding.
Example: Arthur Andersen and Andersen Consulting.
 When testifying, remember
arbitrator more sophisticated than
the average juror.
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Written Agreement
The written agreement should cover the following
matters:
• The name of the attorney’s client.
• The litigants’ names and place for the legal
proceeding.
• The nature of the litigation services to be
performed.
• Whether the practitioner will be asked to testify
as an expert witness.
• What restrictions will be imposed on use and
disclosure of the practitioner’s work.
• Whether the practitioner has any conflicts of
interest with the litigants and/or their attorneys.
• Whether the practitioner’s work will be
protected by the attorney work product
privilege.
• Circumstances under which the practitioner may
terminate his or her engagement.
• Fee (including payment arrangements).
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Qualifying as an Expert
Witness
Under the Frye standard, the test for
admitting expert testimony is:
– Whether the expert’s testimony will
assist the trier of fact in understanding
the evidence or in determining a fact in
issue
– Whether the theories and/or techniques
relied upon by the expert are generally
accepted by the relevant professional
community
– Whether the particular expert is
qualified to present expert testimony on
the subject at issue
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Qualifying as an Expert
Witness
Under the Federal Rules of Evidence, a judge
will permit an accountant to testify as an
expert witness only if the judge decides that:
– The accountant’s testimony will help the
jurors or judge understand the evidence
or determine a fact in issue
– The accountant is qualified as an exert
by knowledge, skill, experience, training
or education
– The accountant can show that his or her
testimony (a) will be based on sufficient
facts or data and (b) will be the product
of reliable principles and methods that
have been applied reliably to the facts of
the case
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Qualifying as an Expert
Witness
In Daubert v. Merrill Dow
Pharmaceuticals, Inc., the U.S.
Supreme Court established the rule for
federal courts that trial judges have a
special responsibility to ensure that
scientific testimony is not only
relevant, but also reliable. In Kumho
Tire Company, Ltd. V. Carmichael, the
Supreme Court decided that a judge’s
“gatekeeping” obligation applies not
only to scientific testimony but to all
expert testimony.
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Qualifying as an Expert
Witness
In Daubert, the U.S. Supreme Court
suggested that judges consider the
following factors:
– Whether the theory or technique
in question can be (and has been)
tested
– Whether the theory or technique
in question has been subjected to
peer review and publication
– The theory’s or technique’s
known or potential error rate
– Whether the theory or technique
has attracted widespread
acceptance within the relevant
community
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Daubert’s Five Factors
 Whether the theory or technique used
by the expert can be, and has been,
tested;
 Whether the theory or technique has
been subjected to peer review and
publication;
 The known or potential rate of error of
the method used; and
 The degree of the method’s or
conclusion’s acceptance within the
relevant community.
 Did theory exist before litigation
began.
(on remand, CA-9 adds 5th factor)
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Kumho Tire Co. Ltd. v. Carmichael, 119
S.Ct. 1167 (1999).
• Daubert factors apply to nonscientific
testimony as well as scientific expert
testimony
• Court will probably not exclude
testimony on the basis of one factor
alone.
• Frye rule: general acceptance rule may
still apply, especially in certain state
courts.
• Daubert challenges generally occur after
the deadline for naming experts. Thus,
disaster if disqualified.
• Can open expert up to a malpractice
claim.
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Kumho Tire
Supreme Court said:
“The objective of that requirement is
[Daubert] to ensure the reliability and
relevancy of expert testimony. It is to
make certain that an expert, whether
basing testimony upon professional
studies or personal experience, employs
in the courtroom the same level of
intellectual rigor that characterizes the
practice of an expert in the relevant
field.”
143
Rejecting Experts
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In Frank J. Laureys, Jr., 92 T.C. 101
(1989), the IRS offered the testimony of Dr.
Bradford Cornell, a professor of finance and
economics at UCLA, to demonstrate that
taxpayer was never “at risk” as to his option
trading activities. About his proffered
testimony, Tax Court Judge Mary Ann
Cohen commented:
We agree with petitioner that the
factual premises of Dr. Cornell’s report are
unreliable and that neither his testimony
nor his qualifications assist in determining
petitioner’s purpose in engaging in the
transactions in issue….[W]e do not believe
that the type of economic analysis set forth
in Dr. Cornell’s report is relevant to the type
of risk covered by section 465(b)…. Dr.
Cornell’s testimony is tainted by his
perception that, from an economic
standpoint, wash sales are not legitimate.
Source: B.J. Raby and W.L. Raby, “Reasonable Compensation, Expert
Witnesses, and the Tax Practitioner,” Tax Notes, September 15, 2003,
pp. 1417-1418.
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Rejecting Experts
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Second, his isolation of data as to
certain transactions, on certain dates,
chosen from a few transactions
selected by respondent among
hundreds engaged in by petitioner, is
not reasonably representative. It is
also inconsistent with his own
statement that his analysis must
consider “the investor’s overall
strategy.”
Third, his assumption of
predictability of stock prices is
inconsistent with reality and with the
existence of an active national options
exchange in which differing views of
the future create buyers and sellers at
different prices.
Source: B.J. Raby and W.L. Raby, “Reasonable Compensation, Expert
Witnesses, and the Tax Practitioner,” Tax Notes, September 15, 2003,
pp. 1417-1418.
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Searchable Databases of Daubert Decisions
1. Daubert Tracker (launched August 2002)
• 93 accounting decisions (mid-February 2003).
• [46 accounting experts admitted, 38 denied,
9 admitted/denied in part]
• 4,000 trial and appellate opinions.
• Composed of five distinct services.
The searchable database of all reported cases.
Core documents – docket sheets, briefs and
transcripts – for each case.
An e-mail update of new cases from the previous
week.
A quarterly journal with articles by trial attorneys,
law professors, judges and experts.
A series of “Web lectures” delivered by authorities
on Daubert and scientific evidence.
• www.mdexonline.com. A year subscription is
$495.
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Searchable Databases of Daubert Decisions
(contd …)
2. “Daubert on the Web”
•
•
•
•
Online free tracking service.
www.daubertontheweb.com.
In early July, 2003, 40 cases were
under the field “Accountants and
Economists” with an admissibility
rate of .675.
There are a total of 25 fields with
various “admissibility rate,” such as
Computer experts,
Criminologists,
Marketing experts,
Polygraphers,
Toxicologists,
0.667
0.838
0.500
0.148
0.375
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Successful Daubert Challenges
•
Accountant failed to incorporate into his
opinion (without explanation) some of his
findings that contradicted his testimony
[similar to Kumho Tire engineering expert’s
testimony]. Target Marketing Pub., Inc. v.
ADVD, Inc., 136 F.3d 1139 (CA-7, 1998).
•
Accountant testified from unaudited financial
reports, did not analyze data covering the entire
period of time in question, did not compare
revenue to budget projections of revenue, and
allowed his opinion to be influenced by
subjective statements of an interested party.
SEC v. Lipson, 46 F.Supp.2d 758 (N.D. Ill.1998).
•
In comparing hosiery made by different
manufacturers, expert relied upon an
inadequate sample and destroyed the records
of his methodology.
Lithuania Commerce Corp. v. Sara Lee Hosiery, 179
F.R.D. 450 (D.N.J. 1998)
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Preparing to Testify as an
Expert Witness
• Maintaining independence from the
client
• Evidence upon which experts may
rely
• Use of confidential client
information
• Expert reports
• Working papers
• Evaluation of other experts
• Exhibits and other demonstrative
evidence
Source: Crumbley, Heitger & Smith, Forensic and
Investigative Accounting, 2003, p. 8-13
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Testifying at a Deposition
Expert witnesses can expect to be asked about the
following at a deposition:
• The scope of their
assignment
• Their current
employment (job title,
duties)
• Their educational
background
• Licenses
• Work experience
• Memberships in
professional
organizations
• Publication and
lectures
• Fields in which they
are qualified as an
expert
• Other work they have
performed as an expert
or other litigation
consultant
• What compensation
they are receiving (and
what percentage of
their compensation is
derived from testifying
as an expert witness)
• What opinions they
have formed
• The bases for their
opinions
Source: Crumbley, Heitger & Smith, Forensic and Investigative
Accounting, 2003, p. 8-13
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Differences Between Fact and Expert Witness
FACT
EXPERT
Purpose of
testimony
To provide the court with
relevant facts relating to the
case.
To help the court or trier-of-fact
understand technical issues.
Training
No specialized training is
necessary, unless the
witness undertakes a factual
investigation.
The witness must qualify as an expert.
Therefore, he or she must have
specialized knowledge, training,
experience, or other qualifications (for
example, writings) in a subject outside
the average person’s understanding.
What determines
whether the
witness will
testify?
The witness will be allowed
to testify if he or she has
information relevant to the
case, and the testimony is
not prejudicial or
unnecessarily duplicative of
evidence already presented.
The judge must determine whether the
witness has the qualifications needed
to testify in the case. The testimony
also must be relevant and must not be
unnecessarily duplicative or
prejudicial.
Testimony
Facts and observations
based on the witness’s
perceptions and everyday
common information.
Facts and opinions based on the
witness’s knowledge, training, and
experience and the fraud procedures
performed by him or her.
Evidence and
exhibits
All documents referred by
the witness must already be
in evidence.
The witness can testify about
documents that have not been entered
into evidence if they are of the type
normally relied on by experts in that
field to form an opinion.
Can the witness
testify about
hearsay
evidence?
No.
Yes, as long as it is something that is
normally relied upon by experts in the
field.
Payment of fees
The witness is only entitled
to the statutory daily fee
(which is very small in
most jurisdictions).
The witness is entitled to a reasonable
hourly rate.
Source: D.R. Carmicael, et. al, Fraud Detection, 5th, Fort Worth: Practitioners
Publishing, 2002, p. 8-3.
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Types of Witnesses
Percipient witness – one with direct
personal knowledge of the facts,
circumstances, and events
surrounding the dispute (e.g., fraud,
the robbed bank teller).
Peripheral witness – may be able to
provide background information.
Hostile – normally unfriendly to the
forensic accountant or to the lawyer.
Friendly – friendly toward your
position.
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Four Conditions
An expert witness can state an opinion or
conclusion if four conditions are satisfied:
 The validity of the opinion or conclusion
depends on special knowledge,
experience, skill, or training not ordinarily
found in lay jurors;
 The witness must be qualified as an expert
in the pertinent field;
 She must possess a reasonable degree of
certainty (probability) about her opinion or
conclusion; and
 Generally, in common law jurisdictions an
expert must first describe the data on
which her conclusion is based, or she must
testify in response to a hypothetical
question that sets forth such data.
Source: J.R. Waltz, Evidence, New York: Foundation Press,
1999, p. 15.
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Three Approaches to Testifying
1.Express opinion based upon facts
personally observed, or facts
communicated to him by another
expert.
2.Be present in courtroom and express
opinion on such evidence (that is not
in dispute).
3.Base an opinion on a hypothetical
question embracing evidence in the
record.
Source: J.R. Waltz, Evidence, New York:
Foundation Press, 1999, p. 15.
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Written Reports
An expert should never draft a
written report of any kind unless
he or she has been expressly
directed to do so by hiring
counsel.
Federal Rules of Civil Procedure
26(a)(2)(B) requires a written
report.
Keep a diary of interview dates,
etc.
Do not destroy interview notes.
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Written Report Contents
(FRCP 26(a)(2)(B))
 All opinions to be expressed and the
bases for them.
 Data or other information considered
in forming the opinions.
 Any exhibits to be used as a summary
of or support for opinions.
 Witness qualifications, including a list
of all publications authored within the
last 10 years.
 Witness compensation.
 List of other disputes in which the
witness has testified at deposition or
trial during the last 4 years.
 Signature of the expert testifying.
Note: Federal Rule of Civil Procedure
27(e)(1) indicates that an expert must
update a written report or disposition.
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Types of Expert Reports
Fact-oriented report – gathers and
evaluates facts and uses them to
prepare a report. Check and recheck the numbers and the facts.
Opinion report (e.g., valuation
report) – more subjective and rely
more on the professional judgment
of the expert.
Combination of above types.
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Ghost-Writing Reports
In a district court case in 2001, the
plaintiff’s attorney argued that the
government’s litigation consultants were
ghost-writing expert reports, and the
experts were destroying documents in
order to prevent discovery.
The court refused to allow the expert
to participate in the dispute.
“The more involvement the client’s
attorney has with the expert’s report the
more likely this involvement will be
disclosed on cross-examination and
result in the court discounting the
expert’s testimony as lacking objectivity.
Source: Jon Almeras, “Judges Offer Advice On
Expert Testimony,” Tax Notes (March 18,
2002), p. 1438.
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Citators
Commerce Clearing House
Citator (taxation)
Research Institute of America PH
Citator and Citator 2nd Series
(taxation only)
Shepard’s (for virtually every
case reporter series and
specialized areas, e.g., taxation)
RIA and Shepard’s give a
notation why the case was cited.
CCH does not.
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Citators (cont.)
 Shepard’s
 Oldest.
 Greater breadth.
 Must know court reporter citation (not just
name).
 Go through LEXIS or Westlaw.
 Does not furnish name of cited case.
 Gives references to selective law review
articles.
 Gives citations to Federal Statutes and
Regulations.
 CCH Citator (2 volumes)
 lists cited cases for each court decision in
reverse chronological order
 Missing most current cases (two or three
months).
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Things to do
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• Only use theories or techniques that have been
tested and passed.
• Use theories or techniques that are objective.
• Specify the known error rate or potential error
rate for the method.
• Use methods with acceptable error rates.
• Produce peer-review literature (i.e., journal
studies, reports, and treatises supporting the
expert’s conclusions and opinions).
• Produce reliable scientific data to prove that
her methods and conclusions are generally
accepted in the scientific community.
• Demonstrate that her theories existed prior to
the commencement of the litigation.
• Not develop novel theories to support
conclusions for specific litigation.
• Demonstrate that she maintained standards and
controls (for example, good laboratory
practices and simultaneous blinded controls).
Source: Babitsky et. al, The Comprehensive Forensic Manual,
Seak, Inc., www.seak.com
162
Things to do …
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• Demonstrate that findings can and have been
replicated by others.
• Demonstrate that her methodology followed
the scientific method as it is practiced by at
least a recognized minority of scientists in the
expert’s field.
• Offer testimony that is sufficiently tied to the
facts of the case to help the jury to resolve a
factual dispute.
• Avoid relying on coincidence.
• Avoid extrapolating unjustifiably from an
accepted premise to an unfounded conclusion.
• Adequately account for obvious alternative
explanations.
• Demonstrate the same care and accuracy as in
the regular professional work.
• Use the real-world methodology of her field.
• Use an appropriate methodology to ensure that
her opinion derives from and constitutes a form
of specialized knowledge.
Source: Babitsky et. al, The Comprehensive Forensic Manual,
Seak, Inc., www.seak.com
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Judges Can Be Mean
Judges can hurt an expert witness’
reputation by making negative comments
about the expert in open courtroom. A
judge in Florida’s Fourth District Court of
Appeal said the following about an expert
when a defense attorney asked why he
excluded the expert:
“Dr. ____ is an insidious perjurer
who wouldn’t know the truth if it leapt up
and bit him on the ***.”
The expert is a doctor since 1963 and
has testified for 25 years.
On appeal the appellate court upheld
the judge’s ruling that the expert’s claim
lacked merit.
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Risk Management
There is an emerging trend of increased expert
witness liability.
General Rule: Immunity to a witness from civil
liability from testimony / communication made
in the course of litigation.
Exceptions:
 Spoliation of evidence – losing or destroying
evidence.
 Lying under oath.
 Defamation lawsuits against opponent's
witnesses.
 Negligence (disappointed clients).
 $42M Mattco Forge decision (Acct. malpractice). Arthur
Young [reversed on appeal on technicality]
 Court appointed expert can be liable for negligence.
[e.g., Accountant in a divorce case: Levine v Wiss & Co,
478 F.2d 397 (N.J. 1984)]
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You Can Be Sued
Witness Immunity State:
State of Washington
States Ignoring Immunity:
Alaska
California
Connecticut
Louisiana
Missouri
New Jersey [court appointed]
Pennsylvania
Texas
West Virginia
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Breach of Contract
A client may win a breach of contract
dispute by showing that the expert failed
to
(a) perform a specific contracted service,
(b) perform the service in a timely
fashion,
(c) perform in a satisfactory manner, or
(d) comply with professional standards.
Examples of specific service performance
would include engagements such as a
review of a client’s internal control
system or conducting a complete audit.
Source: “Breach of Contract” (New York Practicing
Law Institute, January 2000), Ch. 3.2[B].
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Lack of Immunity
There is no immunity for
communication made outside the
context of the lawsuit.
Probably no immunity if the alleged
misconduct results in a professional
disciplinary proceeding.
If you present false evidence, may
be subject to criminal prosecution.
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10 Guidelines to Meet Potential Legal Challenges
1. Know the relevant professional standards
2. Apply the relevant professional standards
3. Know the relevant professional literature
4. Know the relevant professional
organizations
5. Use generally accepted analytical
methods
6. Use multiple analytical methods
7. Summarize the conclusions of the
multiple analytical methods
8. Disclose all significant analytical
assumptions and variables
9. Subject the analysis to peer review
10.Test the analysis – and the conclusion –
for reasonableness
Source: R.E. Figlewicz and Hans-Dieter Sprohge, “The
CPA’s Expert Witness Role in Litigation Services: A Maze
of Legal and Accounting Standards,” The Ohio CPA
Journal, July-September, 2002, p. 35
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Sufficient Relevant Data
• A practioner needs to base his or her
conclusions and judgments on
sufficient relevant data.
• Ballentine’s Law Dictionary defines
evidence as follows:
 The means by which any matter of fact, the truth
of which is submitted to investigation, may be
established or disproved. That which
demonstrates, makes clear, or ascertains the truth
of the very fact or point in issue, either on the one
side or the other.
 The law of evidence embraces those rules which
determine what testimony is to be admitted or
rejected in the trial of a civil action, or a criminal
prosecution, and what weight is given to
evidence which is admitted.
Source: Ballentine’s Law Dictionary
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Sufficient Relevant Data (contd…)
Ballentine’s further defines sufficient evidence and
relevant evidence as follows:
• Sufficient evidence—Abstractly, evidence of such
probative value as to support the verdict of the jury or
a finding of fact by the court. Practically, evidence
such as will satisfy an unprejudiced mind of the truth
of that which the court or jury has found to be the fact.
[Emphasis added]
• Relevant evidence—Any matter of fact the effect,
tendency, or design of which, when presented to the
mind, is to produce a persuasion concerning the
existence of some other matter of fact — a persuasion
either affirmative or disaffirmative of its existence.
Concisely, evidence of one fact rendering the
existence of the fact in issue probable.
• A practitioner must advise the attorney of possible
missing or questionable documents and the lack of
sufficient relevant data upon which to reach an
opinion.
Source: Ballentine’s Law Dictionary
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Eleven Guidelines for Evidence
 Relevance
 Objectivity
 Documentation
 Externality
 Sample Size
 Sample Method
 Corroboration
 Timeliness
 Authoritativeness
 Directness
 Adequacy of Controls
Source: R.L. Ratliff and I.R. Johnson, “Evidence,” Internal Auditor, August 1998,
pp.56-61
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Ten Commandments for Depositions
 Always tell the truth, but answer only the question asked.
 Think before answering.
 Never answer a question you do not understand.
 Do not guess or speculate.
 Do not bring notes, diagrams, books, or other written
material to the deposition unless a subpoena or your
attorney requires you to do so.
 Listen carefully to each objection made by your lawyer.
 Do not argue or become angry or hostile with the
examining attorney.
 Even if a question calls for a yes or no answer, ask to
explain your response if you feel a qualification or
explanation is required to complete your answer.
 Beware of questions which involve absolutes.
 Do not memorize your answers before the deposition.
Source: B.P. Brinig, “The Art of Testifying,” in Handbook of Financial Planning for
Divorce and Separation, John Wiley, 1990.
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An Expert’s Advantages
 They are experts.
 They are not intimidated by the
process.
 They can hide behind their
expertise.
 Trial work is more lucrative
than office or classroom work.
 They are more highly
educated than lawyers.
 They like to teach.
Source: D.M. Malone and P.J. Zwier, Effective
Expert Testimony, Notre Dame, IN: NITA,
2000, p. 56.
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Getting to Experts
However, Malone and Zwier point out how
to “get to” unintimidated experts; they
“may lose sight of the deposing attorney’s
goal, which is to find means to diminish the
expert’s credibility or to challenge the bases
for the expert’s opinions.”
Call it arrogant. “Because they think they
are safe within their own field, experts at
deposition may be more willing to provide
explanations and lengthy answers, to
volunteer information, and to educate their
ignorant but interested students.”
They advise lawyers to smile, nod, lean
forward, maintain eye contact, and ask open
questions to “play” the expert. Encourage
them to teach at the deposition.
Source: D.M. Malone and P.J. Zwier, Effective Expert
Testimony, Notre Dame, IN: NITA, 2000, p. 57.
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Seven Answers at Deposition
1.
2.
3.
4.
5.
6.
Yes.
No.
Green.
I don’t know.
I don’t remember.
I don’t understand the
question.
7. I need a break.
Source: D.M. Malone and P.J. Zwier, Effective
Expert Testimony, Notre Dame, IN: NITA,
2000, p. 81.
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Weaknesses of Experts
 It is the lawyer’s arena.
 They cannot resist teaching.
 Their time is finite and the
universe is infinite.
 They must rely on assumptions.
 They are concerned about
consistency.
 They worry about facts they do
not know.
 You know how to use FRE
803(18).
Source: D.M. Malone and P.J. Zwier, Effective
Expert Testimony, Notre Dame, IN: NITA,
2000, p. 73.
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Federal Rule of Evidence 803(18)
Federal Rule of Evidence 803(18) permits
the introduction of relevant material from
written sources to get around the hearsay
rule.
The opposing attorney can get the expert to
“concede the existence of reliable
authorities in the field” that later may be
used at trial to help their side.
Source: D.M. Malone and P.J. Zwier, Effective
Expert Testimony, Notre Dame, IN: NITA,
2000, p. 73.
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Jerry Lee Lewis
Judges do say negative things about experts,
and if an expert witness is denied, that side
may lose. Most often the deadline for
listing experts has passed. An old saying by
Jerry Lee Lewis is appropriate: “You don’t
miss your water until the well runs dry.” If
the expert and report is not admissible, the
lawsuit may be over.
For example, a plaintiff lost a breach of
contract and breach of fiduciary duty dispute
by summary judgment because their
accounting expert report was “pure
speculation, based upon utterly
implausible assumptions and unreliable
methodology.” But Daubert challenges must
be timely.
Sources: Target Market Publishing Co. v. ADVO, Inc.,
136 F.3d 1139 (CA-7, 1998).
Questar Pipeline Co. v. Grynberg, 2001 F.3d 1277
(CA-10, 2000).
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180
Cross Examination Tactics
© D.L. Crumbley
 No substitute exists for good preparation.
 Before your cross-examination, question your assumptions
and explore alternative positions.
 Study the opposing expert’s analysis.
 If you can’t answer the question yes or no, say so and shift
the burden back to the lawyer to frame a proper question, one
that can be simply answered or permits a fair explanation.
 Answer only the question asked.
 Become familiar with the examining attorney’s background,
skills, and tactics.
 Be yourself, but be sensitive to negative habits which may
distract from the quality or credibility of your testimony, such
as averting your eyes when asked a difficult question.
 Be polite.
 Avoid the appearance of bias or untrustworthiness.
 Do not hesitate to concede an error. But be careful:
 “So, you just picked a number?”
 “So, your study isn’t accurate, isn’t it?”
 “So, after this brief, informal interview, you decided....”
 Don’t overstate your opinion.
Source: B.P. Brinig, “The Art of Testifying,” in Handbook of Financial Planning
for Divorce and Separation, John Wiley, 1990.
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Question 3: Expert witness referral agency
Question: You are represented by an expert
witness referral agency that has agreed to work
for you by advertising, spam e-mails,
sponsorship, and bulk mail solicitations, is that
correct?
Reply 1 (Novice/Direct): Yes, I am.
Reply 2 (Aggressive/Defensive): It is not a
referral agency, but an expert witness
service which thousands of other experts
subscribe to. I know they advertise and
send out letters. I do not know anything
about e-mails or sponsorship.
Reply 3 (Artful): I do list myself with a
well-respected expert service. Lawyers
contact the service to obtain
consultations with qualified experts like
me, who sometimes can be quite difficult
to locate.
Source: Babitsky and Mangraviti, Cross – Examination: A
Comprehensive Guide for Experts, Seak, Inc., 2003.
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Question 27: Forensic income
Question: What was your forensic income last
year
Reply 1 (Evasive/Defensive): I
don’t know. My spouse takes
care of all the billings and
collection.
Reply 2 (Evasive): What do you
mean by “forensic income?”
Reply 3 (Humorous): Not nearly
enough, I can tell you that.
Reply 4 (Artful): Approximately
$80,000 gross income.
Source: Babitsky and Mangraviti, Cross – Examination: A
Comprehensive Guide for Experts, Seak, Inc., 2003
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Question 33: Missing records
Question: Where are the notes you made when
you discovered the fraud.
Reply 1 (Novice): I didn’t make any notes.
Reply 2 (Jail): I shredded them after I
received our subpoena so I would not
have to answer asinine questions like
these.
Reply 3 (Artful): I utilized the notes and
incorporated them into my typewritten
report. After I did this, I discarded the
handwritten notes because they were no
longer needed. This is the document
retention practice I have followed for the
past twelve years.
Source: Babitsky and Mangraviti, Cross – Examination: A
Comprehensive Guide for Experts, Seak, Inc., 2003
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Question 47: Research
Question: What research did you do before
you formed your opinion in this case?
Reply 1 (Novice): I reviewed the
records, reports, and depositions in the
case and also looked at my initial
report. I did no additional research as
this has been my area of specialty for
many years.
Reply 2 (Evasive): I have been
researching this issue my entire
twenty-one-year career.
Reply 3 (Artful): I consulted the text
Accountants’ Handbook as well as the
following fourteen articles…..
Source: Babitsky and Mangraviti, Cross – Examination: A
Comprehensive Guide for Experts, Seak, Inc., 2003
185
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Example 1: The opposing attorney wants to
discredit the witness’s training.
Opposing attorney: “I see from your
curriculum vitae that you have not taken
training in the highly regarded Forshay Fraud
Detection Method. Is that correct?”
Expert: “Well actually, the courses I took were
superior to that course.”
This question assumes facts that may or may not
be true. First, there is no evidence that the
course referenced in the question is, in fact, a
real course. Second, there is no evidence the
course is highly regarded.
Source: D.R. Carmichael, Fraud Detection, Vol. 1, 2002, Practitioners
Publishing Co., p. 8-43.
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Example 2: The opposing attorney wants
to
discredit the witness’s experience.
Opposing attorney: “Isn’t it true this is the first
time you have investigated fraud in the
shipping industry?”
Expert: “While it is true I have never
investigated fraud in the shipping industry, I
have investigated cash frauds on several
occasions. As such, I believe I have the
necessary level of knowledge to pursue frauds
of this type.”
This question implies the witness is
inexperienced because he or she has never
before investigated fraud in a company
exactly like the one in question. Secondly, it
incorrectly implies that only someone with
such direct experience could provide a
useful opinion.
Source: D.R. Carmichael, Fraud Detection, Vol. 1, 2002,
Practitioners Publishing Co., p. 8-43.
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Example 3 and 4: The opposing attorney tries to make the
expert’s opinion look weak or wrong.
Example 3:
Opposing attorney: “When performing your fraud detection
procedures on the company’s inventory system, did you also
test the company’s controls over cash receipts to determine
whether they were operating effectively ?”
Expert: “No. I did not.”
The question implies, incorrectly, that the practitioner cannot
. provide an opinion as to the existence of fraud in the
inventory system unless he or she has also performed
procedures in the cash receipts area. The client’s attorney
will have an opportunity to ask the expert to expand on his
or her answer during re-direct.
Example 4:
Opposing attorney: “Is it possible your conclusion is
wrong?”
Expert: “I have done my analysis to the best of my ability,
and I’ve made a conclusions accordingly. It’s always
possible I’ve made a mistake, but based on everything I’m
aware of, my testimony stands.”
It is, of course, always possible the witness is wrong, but if
the witness simply says “Yes,” the lawyer will argue to the
jury that the witness conceded the possibility of error.
-------------------------------------------------------------------------Source: D.R. Carmichael, Fraud Detection, Vol. 1, 2002, Practitioners
Publishing Co., p. 8-43.
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Cross Examination Tactics (more)
 Keep your hands on top of the table,
not hidden.
 Be sure your attorney questions you
in detail about your qualifications in
order to impress the judge/jurors.
Do not allow the other side to
stipulate you as an expert.
 Dress neatly and conservatively.
 Arrive on time at the court house.
 When taking the oath as a witness,
say loudly, “I do.”
 Be sincere and respectful.
 Talk directly to the jurors (or judge
if no jurors). Look them in the eyes.
Make contact with each of the
jurors.
189
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Judge’s Instructions to Jury:
“You have heard evidence in this case from
witnesses who testified as experts. The law
allows an expert to express opinions on subjects
involving their special knowledge, training, skill,
experience, or research. You shall determine
what weight, if any, should be given such
testimony, as with any other witness.”
Jay W. Danker’s Four Rules:
 A relevant, coherent, understandable story.
 To keep their interest at all times.
 To be spoken to in clear, definite terms.
 Respect and sincerity.*
* Jay W. Danker, Communicating with the Jury. Handout materials for the Fifth Annual National
Expert Witness and Litigation Seminar, Hyannis, Massachusetts (June 20, 21, 1996) 2.
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A Bulletproof Expert
They give opposing counsel little or nothing
productive during cross-examination. This is
dangerous to the other side because the jury
expects counsel to make some good points
during cross-examination. When few or no good
Points are made during cross-examination, the
expert’s stature is likely to grow significantly and
opposing counsel’s stature is likely to diminish.
Steven Babitsky and J.J. Mangrauiti, Cross-Examination, Seak, Inc. 2003,
p.392
191
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Three Communication Techniques
Central – focus on what you say.
Peripheral – focus on how you say
things.
• Amount of evidence presented.
• Number of points you make.
• Length of your testimony.
• Your qualifications.
• Trustworthiness.
• Likeability.
Combination.
Source: D.S. Scott and R. Laguzza, “Communication With The
Jury,” Litigation Services Handbook, John Wiley, 2001, p. 15-2.
192
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Ross Davis and Ross Laguzza Say
• At least one of the jurors will not listen
to you.
• Those that listen to you must understand
you (e.g., Accounting/Taxation/Valuation
issues are not easy).
• Jurors need to understand why you say
what you say.
• You must persuade the jurors that what
you say is correct, despite the crossexamination.
Source: D.S. Scott and R. Laguzza, “Communication With The
Jury,” Litigation Services Handbook, John Wiley, 2001, p. 15-1.
193
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Why Financial Experts Fail
1. The financial expert does not know the case
story (e.g., the strategic messages).
2. Expert never develops home base messages,
or develop the wrong ones (short simple
messages).
3. Inconsistencies between direct and crossexamination.
4. Unnecessary use of jargon and terms or art.
5. Insufficient meaningful practice.
Source: D.S. Scott and R. Laguzza, “Communication With The
Jury,” Litigation Services Handbook, John Wiley, 2001, pp.
15-10 and 15-11..
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Investigative Techniques and Evidence
 Documentary evidence – written
evidence on paper or computer medium.
 Testimonial evidence – testimony of
individuals.
 Observational evidence – evidence,
actions, or observations seen by an
investigator.
• Physical examination of evidence (e.g.,
counts or inspections).
• Fixed point observations of activities
(e.g., watching a scene and recording).
• Moving observations.
 Invigilation – strict temporary controls
are imposed so that fraud virtually
impossible. Keep detailed records.
 Covert observations.
 Forensic document examination.
Source: D.R. Carmichael et.al., Fraud Detection, Vol. I,
Practitioners Publishing Co., 2002, pp. 3-1 to 3-4
195
Evidence
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 Best evidence rule:
original documents to be produced rather
than secondary evidence (including oral
testimony)
 Many exceptions: Computer print-out –
now admissible if a foundation of
accuracy is laid.
 Copies admitted if lost.
 Generally can get around the best
evidence rule.
 Demonstrative evidence (the chalks)
objects – the gun.
models.
photographs.
videos.
charts.
exhibits
 Do they have the tendency to “assist
the trier of the facts”?
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Authentication
Requirement
To be admissible as evidence in a legal
proceeding, a document or other
material usually must be
authenticated or identified as to what
its proponent claims it to be.
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Authentication Concept
Authentication Concept: The
writing or object must be proven to
be what it purports to be
direct testimony / chain of custody.
content.
other circumstances.
e.g., computer records may be used
in the courtroom by showing that
they were prepared by an accurate
process.
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Criminal Proceedings
 No plaintiff, but a prosecutor.
 A criminal defendant.
 Due process is stronger.
 Burden of proof beyond a reasonable
doubt.
 4th Amendment, search and seizures.
 5th Amendment, right against selfincrimination.
 Obtaining information from
defendant more difficult.
 Case dismissed if prosecutorial
misconduct.
 Double jeopardy applies.
 Fewer depositions.
 Original documentation and chain of
custody important.
 Normally jury must be unanimous.
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Criminal Investigations Differ
Different mentality – look for the
financial evidence to support or
refute an allegation.
Different skill set (an investigative
competency) – inquiring,
observant, professional skepticism,
and attention to detail . Your job is
not to determine guilt or innocence.
Strategy – team approach – requires
obtaining witnesses, collecting
evidence, and proving fraudulent
intent.
Source: Laura J. East, “The Role of the Forensic
Accountants In a Criminal Investigation.” Journal of
Forensic Accounting.
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Common Problems In Criminal
Investigation
 Identifying the criminal activity and
the violation.
 Locating witnesses who have moved.
 Gaining the cooperation of witnesses.
 Establishing fraudulent intent.
 Organizing and maintaining documents
and other evidence.
 Responding to defense motions and
anticipating defenses.
 Completing investigations within the
statute of limitations.
 Investigators and prosecutors being
reassigned over the life of the case.
 Criminals adapting their schemes to
new technology.
 Competing for a prosecutor’s time.
Source: Laura J. East, “The Role of the Forensic Accountants In
a Criminal Investigations.” Journal of Forensic Accounting.
201
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Criminal Grand Jury (e.g. Fraud)
 Arrest or grand jury.
 16 – 23 sworn jurors; meet bi-weekly
or monthly.
 Indictment if at least 12 votes (without
prosecutor present).
 Accused has no right to be informed.
 Have power to accuse, not to convict.
 Can subpoena witnesses and
documents.
 If accused attends, no right to an
attorney.
 A witness may be compelled to testify
under a grant of immunity.
 If immunized witness refuses, can be
found in contempt, jailed.
 Arraignment: reading of the indictment
in open court.
 Burden of proof much higher: beyond a
reasonable doubt. Innocent until proven
guilty (U.S. constitution).
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Criminal Expert’s Report
 After a suspect has been indicted but
before the trail, an expert testifying in a
criminal trial may be asked to prepare a
written summary of the testimony
expected to be given. Under Federal
Rule of Criminal Procedures
16(a)(1)(E), a defendant has a right to
request that the government provide a
written summary of the testimony
expected to be given by the
government’s expert if prepared, the
government’s summary report should
include the information listed above.
 Once the government provides the
defendant with this summary
information, the government is entitled
under Rule of Criminal Procedures
16(b)(1)( C ) to reciprocal discovery of
the same information from the
defendant’s expert.
203
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Rule 26 Ramification
Dear Dr.
If, hypothetically, I was engaged as
an expert witness by an attorney in
connection with “undesirables” let’s say,
for example, drug dealers and I gave
expert testimony. Would the fact that I
was associated with such people be a
reason the opposing counsel or trier of
fact might use to have me dismissed as
an expert witness in future cases? I
believe that under Rule 26 I must
indicate the cases I have served on as an
expert witness. If there are negative
ramifications, that is certainly something
I wish to avoid. Will the court or anyone
else hold the above hypothetical example
against me in any way?
Thank you for your attention in this
important matter.
204
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Administrative Proceedings
 May have own particular procedures.
 Broad standard of procedural due
process.
 Technical rules of evidence may not
apply.
 Procedural formality may be missing.
 Prosecution and judicial function may
be the same.
 But be prepared to document and
support your opinion.
 Often no formal appeal from an
administrative decision.
 Therefore, must file a separate
pleading to obtain a judicial review
(e.g., writ of mandamus or writ of
review).
205
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AICPA Consulting Aids
 AICPA Consulting Services Report 93-1
(superseded by AICPA Consulting Services
Special Report 03-1, March 2003)
 AICPA Consulting Services Special Report
93-2
• CPA serving as an expert witness for a
client is not an advocate.
• Trier of fact.
 AICPA Consulting Services Practice Aid
95-2
• If a CPA acts as an expert witness,
engagement letter discoverable.
• Detailed engagement letter can be a
roadmap for opposing attorney.
• May wish to restrict services to a broad
statement.
• CPA work product not protected.
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AICPA Consulting Aids
 AICPA Consulting Services Report Practice Aid
96-3
• Minimum elements to be included in your report.
• Table of contents, executive summary,introduction and
background, objectives of the engagement, assumptions, and
references.
• Does not require a report.
• Sampling less useful for off-the-book fraud.
 AICPA Consulting Services Report Practice Aid
97-1
•
•
•
•
•
•
List of selected badges of fraud.
Description of fraud schemes.
Legal references.
Illustrative engagement letter scope paragraph.
A short letter or memorandum.
Statement of prediction, list of interviews conducted, and
summary of interview information.
• Avoid stating any conclusions about the presence and absence
of fraud.
• Avoid editorial content or judgments.
• Opinion on guilt or innocence left to judge or jury. (CFE has
similar directive).
207
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AICPA Consulting Aids
 Statement on Standards for Consulting
Services No.1 – Consulting Services
Definitions and Standards. These standards
apply.
•
•
•
•
•
•
•
Professional competence.
Due professional care.
Planning and supervision.
Sufficient relevant data.
Client interest.
Understanding with client.
Communication with the client.
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EXPOSURE DRAFT
STATEMENT ON
RESPONSIBILITIES FOR LITIGATION
SERVICES NO. 1
December 1, 2001
Prepared by
Litigation and Dispute Resolution Subcommittee
Statement on Responsibilities Task Force
Comments should be received by January 31, 2002, and
addressed to Anat Kendal, Director, Member Innovation—
Financial Planning, Harborside Financial Center,
201 Plaza Three, Jersey City, NJ 07311-3881
or via the Internet to [email protected].
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Litigation Services
 Consulting services that involve
pending or potential formal legal or
regulatory proceedings before a trier
of fact in connection with the
resolution of a dispute between two or
more parties. A trier of fact is a court,
regulatory body, or government
authority; their agents; a grand jury; or
an arbitrator or mediator of a dispute.
Roles of Litigation Services
Practitioner
 Expert witness
 Consultant
 Other
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Litigation Services Practitioner
Products and Services
Computation
Consulting
Business valuations
Proactive and reactive fraud
investigation
Pre- and post-bankruptcy
restructuring, solvency analysis,
and liquidation consulting
Special accountings, tracings,
reconstructions, and cash flow
analysis
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
211
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Litigation Services Practitioner
Products and Services (contd …)
 Tax issues assessment and analysis
 Marital dissolution’s assessment and
analysis
 Contract costs and claims assessment
and analysis
 Historical results assessment and
analysis
 Antitrust and other business
combinations assessment and
analysis
 Construction and environmental
disputes assessment and analysis
 Business interruption and other
insurance claims assessment and
analysis
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
212
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Tasks of the Litigation Services Practitioner
• Issue identification
• Locating other experts
• Fact-finding
• Analysis
• Discovery assistance
• Document management
• Settlement assistance
• Expert testimony
• Trial and deposition assistance
• Post-trial support (for example, accounting
services, and funds administration)
• Negotiations
• Arbitration
• Mediation
• Training
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
213
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Three guidelines for admissibility of expert
testimony
a. The testimony should assist the trier of fact to
understand the evidence or to determine a fact in issue.
b. The expert should have some minimum qualifications,
which would include one or more of the following:
–Special knowledge
–Special skills
–Special experience
–Special training
–Special education
c. In addition, before providing testimony, the expert
would have to show that the testimony (a) is based upon
sufficient reliable facts or data, (b) is the product of
reliable principles and methods, and (c) is the result of
the application of established principles and methods to
the facts in the case.
The reliability standards set for expert testimony are
based on three pillars: (a) reliable data, (b) a reliable
methodology, and (c) the reliable application of the
methodology.
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
214
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Pyramid of Standards and
Responsibilities
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
215
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Testimony Pyramid
Expert testimony must be based upon
sufficient facts or data, be the product
of reliable principles and methods, and
the principles and methods must be
reliably applied to the facts of the case.
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
216
Professional Responsibility
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AICPA Standards
Code of Professional Conduct
Rule 102: Objectivity and integrity
1. Conflict of interests
 expert accepts work against the interest of an
existing client.
 make conflict search of names before
receiving confidential information.
2. Objectivity and subordinating judgment
 make sure your opinion is your opinion.
 expected to defend your position
 avoid allowing opposing attorney to put
words in your mouth.
Rule 201 – General Standards




professional competence
due professional care.
adequate planning/supervision of services
sufficient relevant data.
Rule 202 – Technical Standards.
Rule 203 – Accounting principles
Rule 301 – Confidential client communication
Rule 302 – Contingent fees
 if contingent, can not be objective.
217
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Understanding With The Attorney
a. Identification of the attorney’s client
b. The title of the litigation, including the
litigants’ names, the court, and docket number
c. A description of the nature of the litigation
services to be provided or a statement that the
services will be as the attorney may direct
d. An identification of the expert witness or the
willingness of the person who will be the
expert witness if necessary
e. Reference to the absence or existence of
conflicts of interest
f. The absence or existence of the attorney’s work
product privilege
g. Restrictions of the use or exposure of the CPA’s
work
h. The CPA’s right to withdraw from and
terminate the engagement in certain
circumstances
Source: AICPA Proposed Statement on Responsibilities for
Litigation Services No. 1, December 1, 2001.
218
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Some Pertinent Laws
 Securities Act of 1933: gives full and complete disclosure
to investors about new securities being offered for sale.
Sections 11, 12, and 15 may impact auditors who prepare or
certify the accuracy of a portion of a registration statement.
 Securities Exchange Act of 1934: involves previously
issued securities. Imposes implied liability on auditors.
 Foreign Corrupt Practices Act (1977): crime for U.S.
companies to bribe foreign official; must maintain and
monitor adequate internal control system.
 Civil RICO statute: prevent and prosecute criminal
activities under the guise of a legitimate business (3 times
damages and attorney fees).
 Fair Credit Reporting Act of 1971: regulates activities of
credit, insurance, and employment investigations.
 Private Securities Litigation Reform Act of 1995: reform
to decrease frivolous lawsuits. Requires three fraud
requirements for an audit:
 Design procedures to detect illegal acts.
 Procedures to identify related-party transactions.
 Evaluate the entity as a going concern.
 Securities Litigation Uniform Standards Act of 1998:
Securities class actions are permitted only in federal courts.
219
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Federal Sentencing
Guidelines (Chapter 8)
Three Pronged Approach
Restitution
Probation
Fines
Combats fraud and abuse against
government and to eradicate all
federal crimes committed in an
organization.
Note: An organization is liable for
the criminal conduct of its
executives, employees, and
agents.
See www.ussc.gov
220
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Some Coverage of Guidelines
 Bid rigging.
 Bribes.
 Collusion.
 Conspiracy.
 Data security.
 Discrimination.
 False records.
 Fraud.
 Harassment.
 Kickbacks.
 Price fixing.
 Software piracy.
 Vendor relationship.
 Whistleblower protection.
221
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Table 1: Base Fine
Offense Level
Amount
6 or less
7
$5,000
7,500
8
9
10
10,000
15,000
20,000
11
12
13
14
30,000
40,000
60,000
85,000
15
16
17
37
125,000
175,000
250,000
$57.5 million
38
72.5 million
Source: Itamar Sittenfeld, “Federal Sentencing
Guidelines,” Internal Auditor, April 1996, p. 61.
222
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Table 2: Culpability Level
Activity
Penalty
Conviction
Tolerating, condoning, and
willfully ignoring
Prior history
Violating judicial order
Obscuring justice
+5
+4
+1 or +2
+1 or +2
+3
Source: Itamar Sittenfeld, “Federal Sentencing
Guidelines,” Internal Auditor, April 1996, p. 61.
223
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Table 3: Multiplier
Culpability
Score
Minimum
Multiplier
Maximum
Multiplier
10 or more
9
8
7
2.00
1.80
1.60
1.40
4.00
3.60
3.20
2.80
6
5
4
3
1.20
1.00
0.80
0.60
2.40
2.00
1.60
1.20
2
1
0 or less
0.40
0.20
0.05
0.80
0.40
0.20
Source: Itamar Sittenfeld, “Federal Sentencing
Guidelines,” Internal Auditor, April 1996, p. 61.
224
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Good News Table
Activity
Score*
Self-reporting to authorities
Cooperating with authorities
minus 5, or
minus 2 or
Accepting responsibility
Minus 1
(whichever of the three above is higher)
Effective compliance program
minus 3
* Subtract the higher of the first three and then
subtract for effective compliance program.
Source: Itamar Sittenfeld, “Federal Sentencing
Guidelines,” Internal Auditor, April 1996, p. 61.
225
Fraud
© D.L. Crumbley
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.”
226
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Sarbanes-Oxley Act (7-30-2002)
• Most significant change since 1934
Securities Exchange Act
• New five-member Public Company
Accounting Oversight Board (PCAOB)
• Authority to set and enforce auditing,
attestation, quality control and ethics
(including independencies) standards for
auditors of public companies.
• Empowered to inspect the auditing
operations of public accounting firms that
audit public companies as well as impose
disciplinary and remedial sanctions for
violations of the board’s rules, securities
laws and professional auditing and
accounting standards.
• Rotation of lead audit partner every five
years.
• For now no requirement to rotate auditing
firm
227
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Sarbanes-Oxley Act (7-30-2002)
• Eight types of services outlawed:
– Bookkeeping.
– Information systems design and
implementation
– Appraisals or valuation services, fairness
opinions, or contribution-in-kind-reports.
– Actuarial services
– Internal audit outsourcing
– Management and human resources services
– Broker/dealer, investment adviser, and
investment banking services
– Legal or expert services related to audit
services
• Applies to foreign accounting firms filing
with SEC.
228
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Legal Services
Under the rules, CPAs cannot provide
a service for an audit client that only
someone licensed to practice law can
perform. The concern this rule addresses is
that the auditor would be acting as an
advocate, which the SEC (partly in
reliance on United States v. Arthur Young)
concludes would preclude the CPA from
maintaining the “objectivity and
impartiality that are necessary for an
audit.”
Source: T.J. Purcell, III and D. Lifson, “Tax Service After Saebanes-Oxley,”
Journal of Accountancy, November, 2003, p. 37.
229
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Expert Service Unrelated to Audit
This covers engagements where the CPA
firm’s specialized knowledge, experience and
expertise support audit client positions in
adversarial proceedings. The prohibition
includes providing an opinion to the client or a
client representative to advocate a client’s
interests in litigation or in a regulatory or
administrative investigation or proceeding. The
rules do not define this term.
The examples involve the SEC Division of
Enforcement, forensic accounting engagements
for the client itself and helping the audit
committee investigate potential accounting
impropriety. The rules appear to reject the
proposal that the advocacy prohibition be
confined to public settings and allow internal
investigations and fact-finding engagements for
the audit committee, as well as providing factual
accounts, testimony or explanations of positions
taken, conclusions reached or work performed.
Source: T.J. Purcell, III and D. Lifson, “Tax Service After Saebanes-Oxley,” Journal
of Accountancy, November, 2003, p. 37.
230
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Tax Services Not Defined
PCAOB will not define tax services,
but will be inspecting them.
Representing an audit client in court
could impair independence.
PCAOB “will focus on the
profession’s role in both structuring and
signing off on abusive tax shelter designed
to make their clients’ financial statements
look better.”
PCAOB’s annual inspections will
examine how accounting companies audit
and structure “questionable, tax-orientated
transactions.”
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
231
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Acceptable Non-audit Services
• Payroll sales, property, state income, federal
income and other tax-compliance services,
even though the audit firm reviews the client’s
work that becomes part of the financial records
through the recording of a liability.
• Traditional tax planning services, such as
where the CPA prepares an analysts of a
transaction (lease vs. buy) and the client uses
the CPA’s work product to develop the
appropriate financial accounting entries.
• Analysis of clients records (with
recommendations for redesign) to determine
strategies for minimizing state and local
income sales, property and payroll taxes.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
232
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Acceptable Non-audit Services (cont.)
• Appraisal services undertaken for taxcompliance reasons (such as assigning values
to intangible assets under IRC section 197,
calculating gains on distributions of assets to
shareholders under section 338 election,
implementing mark-to-market values under
section 475 and allocating purchase prices
under section 1060), even though the company
uses the derived values in part for financial
statement purposes.
• Tax-consulting engagements that examine, for
example, the efficiency of internal tax
departments, procedures used to protest state
and local property tax valuations or state
income tax studies.
• “Loaning” tax staff or supervisors to an audit
client for special projects or short-term
personnel emergencies.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
233
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Acceptable Non-audit Services (cont.)
• Designing or commenting on the tax aspects
of a compensation package for specific
individuals or the general management staff of
the audit client-for example, reviewing the
applicability of antidiscrimination provisions of
IRC section 132 and the reasonable
compensation and incentive compensation
provisions of section 162(m).
• Meeting with prospective candidates for the
tax director or CFO position to discuss the tax
issues the company faces.
• Recommending that controlling shareholders
sell their stock to an ESOP to take advantage of
IRC section 1042; advising a client to consider
an ESOP as part of a benefits package (or,if an
ESOP already exists, that a client sell
additional shares to it); or recommending that
an estate sell its stock in an audit client to use
the provisions of IRC section 303 or to
otherwise efficiently administer the estate.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will
Inspect Them,” Tax Notes, October 20, 2003, p. 330; C. Bryan – Low,
“Accounting Board to Look at Abuses in Tax Shelters,” Wall Street Journal.,
October 22, 2003, p. A-2.
234
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Acceptable Non-audit Services (cont.)
• Representing the audit client in IRS exams,
sales tax proceedings, state income tax audits,
payroll tax audits, local government property
tax proceedings and the like.
• Helping an audit client prepare requests for a
ruling or changes in accounting periods or
method or for determination letters on various
issues from the IRS or other administrative
agencies.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
235
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Sarbanes-Oxley Act of 2002
• If you are going to be an auditor, you have to be an
auditor, not an auditor and a consultant [Senator Jack
Reed].
• In order to be independent, an accounting firm should
not
– Audit ones own work.
– Function as part of management or an employee.
– Act as an advocate.
• No limitations are placed upon accounting firms in
providing non-audit services to public companies they
do not audit or any private companies.
• Audit services and non-audit services (e.g., tax) must be
pre-approved by the audit committee, if not prohibited
by the Act (before the non-audit service commences).
• Auditor must report to the audit committee on a timely
basis.
• Cooling off period of one year for hiring an auditor if
CEO and other senior officers worked for the auditor.
• There is no requirement to rotate the auditors.
• There is discussion of requiring a forensic audit
irregularly. Harvey Pitt suggested this proposal.
236
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Sarbanes-Oxley (contd.)
• Many of the Sarbanes-Oxley’s provisions became
effective July 30, 2002.
• www.tnwinc.com
The Network
• Thus, SEC will control the accounting standards, not
the AICPA.
• Auditors to report to audit committee, and audit
committee must approve all services.
• Crime to corruptly alter, destroy, mutilate, or conceal
any document with the intent to impair the object’s
integrity or availability (up to 20 years).
• Statute of limitations for the discovery of fraud is now
two years from the date of discovery and 5 years after
the act.
• Maximum penalty for mail and wire fraud is increased
from 5 to 10 years.
• Financial statement filed with SEC: certified by CEO
and CFO. Maximum penalties for willful and
knowingly violation: fined not more than $5 million
and/or imprisonment of up to 20 years.
• Sense of Congress: CEO should sign the Federal
income tax return.
237
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SEC’s Proposed Rules (12-5-2002)
Auditor may not
1. Audit own work.
2. Perform management function.
3. Act as an advocate of a client.
 Traditional tax preparation service okay:
•
•
•
•
•
preparation of tax returns.
tax compliance.
tax planning.
tax recovery.
other tax-related services.
 Reviewing tax accruals is audit service.
 Tax Court representation would impair an auditor’s
independence.
 Formation of tax strategies (e.g., tax shelters) is not
okay.
 Unknown: Tax opinions for tax shelters.
 The audit committee must weigh the risk associated
with using the company auditor for tax services versus
the cost savings of using the company auditor.
Source: Sheryl Stratton, “SEC Seeks Input on Defining Scope
of Tax Service,” Tax Notes, December 9, 2002, pp. 1265 –
1266.
238
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Sarbanes-Oxley Act Creates Need For
Forensic Accounting
1. To assist corporations in their quest to
ensure compliance with the mandates
of S-O.
2. Public accounting firms must
introduce forensic techniques into
audits, and they may request help
from forensic experts.
239
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Assistance of Forensic Accountants
1. S-O requires principal executives and
financial officer to certify annual and
quarterly reports.
2. Certification must cover internal controls,
disclosure controls, and fraud. Need for a
Chief Forensic Officer? The SEC suggests
the entity assign the duties of monitoring
internal controls to a specific individual. SEC
suggests a disclosure committee, also.
3. Officers and directors are prohibited from
influencing, coercing, manipulating, or
misleading the accountant performing the
independent audit.
4. Civil and criminal penalties against officers
for violations of S-O.
5. Auditors workpaper retentions for five years.
6. PCAOB shall adopt auditing standards.
7. SEC may censure auditors.
240
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Using Work of Specialists (SAS No.73)
Specialist defined: a professional service firm
or individual who possesses special skills or
knowledge in a particular field other than
accounting and auditing
To reply on specialist’s findings, auditor
 Must understand the objectives and scope of
work performed.
 Assumptions used must be clear to auditor.
 Auditor must consider the appropriateness
of utilizing the specialists findings.
 Auditor must test the data that client
provides to the specialist.
 Auditor must evaluate whether findings
support the assertions in the financial
statements.
 If specialist’s findings inconsistent, SAS
No.73 provides additional procedures which
auditor must follow.
 Auditor will need copies of workpapers of
specialists.
241
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Michael Comer’s Types of Fraud
1. Corruptions (e.g., kickbacks).
2. Conflicts of interest (e.g., drug/alcohol
abuse, part-time work).
3. Theft of assets.
4. False reporting or falsifying
performance (e.g., false accounts,
manipulating financial results).
5. Technological abuse (e.g., computer
related fraud, unauthorized Internet
browsing).
Comer’s Rule: Fraud can happen to
anyone at anytime.
Source: M.J. Comer, Investigating Corporate Fraud,
Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5.
242
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Starwoods Hotels Poll of Executives
Starwoods Hotels interviewed 401 top
executives who golf. The results are
surprising.
Consider themselves to be honest in
business
Played with someone who cheats at golf
Cheated themselves at golf
Hated others who cheated at golf
Believe that business and golf behaviors
are parallel
99%
87%
82%
82%
72%
Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA
Today, June 26, 2002, p. A-1.
243
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The Cost of Fraud
 Organizations lose 6 percent of
annual revenue to fraud and
abuse.
 Fraud and abuse costs U.S.
organizations more than $600
billion annually ($4,500 per
employee).
 The average organization loses
more than $12 a day per
employee due to fraud and abuse.
Source: 2002 Wells Report
244
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The Cost of Fraud (cont.)
 Over 80% of occupational frauds
involve asset misappropriations.
 Average length of a fraud scheme is
18 months.
 Most common way of detecting
occupational fraud is by tips from
employees, customers, vendors, or
anonymous sources.
 Second most common detection:
accident.
 The most targeted asset is cash.
Source: 2002 Wells Report
245
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Ernst & Young Study (2000)
 Leading companies and public bodies
in 15 (82) countries
 More than 82% (50%) have been
victims of fraud in the past year.
 82% (84%) of total losses can be
attributed to staff.
 33% (50%) of the most serious frauds
were committed by the organization’s
own management.
 Most with company more than 5 years
(25% more than 10 years).
 Theft of cash and purchasing schemes
(i.e., employee kickbacks) constituted
the majority of frauds.
 Reasons: Poor internal controls and
finance directors had a limited
knowledge of internal controls.
246
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2003 PricewaterhouseCooper Survey
• Survey to several hundred of the largest
companies (with 91 responses).
• Half of the detected economic crimes at
responding companies were found by
auditors, but it did not distinguish between
internal audits. Another 36 percent of the
frauds were reported by whistle-blowers
• Although 76 percent of the United States
respondents were covered by insurance,
fewer than half were able to recover from
their insurers. And less than a third of
insured companies affected by fraud
collected more than 20 percent of the
amount lost.
• The average amount lost was $2.2 million,
and the highest levels of economic crime
were reported in Africa and North America
(including Canada and the United States).
Source: J.D. Glater, “Survey Finds Fraud’s Reach in Big Business”
www.nytimes.com/2002/07/08/business/08CHIE.html.
247
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Scienter Necessary
• To prove any type of fraud,
prosecutors must show that scienter
was present.
• That is, the fraudster must have known
that his or her actions were intended to
deceive.
248
Fraud
© D.L. Crumbley
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.
249
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SEC’s Definition of Fraud
It shall be unlawful for any person, directly
or indirectly, by the use of any means or
instrumentality of interstate commerce, or
the mails, or of any facility of any national
securities exchange,
a) To employ any device, scheme, or artifice to
defraud,
b) To make any untrue statement of a material
fact or to omit to state a material fact
necessary in order to make the statements
made, in the light of the circumstances
under which they were made, not
misleading, or
c) To engage in any act, practice, or course of
business which operates or would operate as
a fraud or deceit upon any person, in
connection with the purchase or sale of any
security.
SEC Rule 106-5
250
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Foreign Corrupt Practices Act of 1977
A)
B)
1)
2)
Public companies shall maintain adequate
internal controls:
Make and keep books, records, and
accounts, which, in reasonable detail,
accurately and fairly reflect the transactions
and dispositions of the assets of issuer; and
Devise and maintain a system of internal
accounting controls sufficient to provide
reasonable assurances thattransactions are executed in
accordance
with management’s general or specific
authorization;
transactions are recorded as necessary (1) to
permit preparation of financial statements in
conformity with generally accepted
accounting principles or any other criteria
applicable to such statements….
FCPA Section 102
251
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Federal Sentencing Guidelines
Monitoring Mechanism
Systems reasonably designed to
detect criminal conduct by its
employees and other agents and
by having in place and
publicizing a reporting system
whereby employees and other
agents could report criminal
conduct by others within the
organization without fear of
retribution.
FCPA Sec. 8A1.3(k)(5).
252
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Superseded SAS No. 53
Accounting Fraud Referred To As
“Irregularities”
The term “irregularities” refers to
intentional misstatements or omissions of
amounts or disclosures in financial statements.
Irregularities include fraudulent financial
reporting undertaken to render financial
statements misleading, sometimes called
management fraud, and misappropriation of
assets, sometimes called defalcations.
Irregularities may involve acts such as the
following:
•Manipulation falsification, or alteration of
accounting records or supporting documents
from which financial statements are prepared.
•Misrepresentation or intentional omission of
events, transactions, or other significant
information.
•Intentional misapplication of accounting
principles relating to amounts, classifications,
manner of presentation, or disclosure.
253
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Superseded SAS No. 82
Accounting Fraud Referred To As
“Misstatement”
Misstatements arising from fraudulent
financial reporting are intentional
misstatements or omissions of amounts or
disclosures in financial statements to
deceive financial statement users.
---------------------------------------------------------Three most important red flags according to
external/internal auditors (out of 25):
1) Known history of securities law violations
(14.6%)
2) Significant compensation tied to aggressive
accounting practices (12.9%)
3) Management’s failure to display
appropriate attitude about internal controls
(12.6%)
Source: B.A Apostolou et.al, “The Relative Importance of
Management Risk Factors,” Behavioral Research in
Accounting, January 1, 2001, pp. 1-24.
254
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SEC Staff Accounting Bulletin No.99
Fraudulent accounting entries
known by senior management can not be
left unadjusted merely because they are
“immaterial” by some mechanical,
quantitative standard (e.g., percentage of
net income).
Thus materiality loophole
eliminated in 1999.
Something is material if there is a
substantial likelihood that a reasonable
person would consider it important.
255
© D.L. Crumbley
SEC SAB No. 99 Examples
Among the considerations that may
well render material a quantitatively
small misstatement of a financial
statement item are—
•Whether the misstatement arises from an
item capable of precise measurement or
whether it arises from an estimate and, if
so, the degree of imprecision inherent in
the estimate.
•Whether the misstatement masks a
change in earnings or other trends.
•Whether the misstatement hides a failure
to meet analysts’ consensus expectations
for the enterprise.
•Whether the misstatement concerns a
segment or other portion of the registrant’s
business that has been identified as playing
a significant role in the registrant’s
operations or profitability.
256
© D.L. Crumbley
SEC SAB No. 99 Examples
•Whether the misstatement affects the
registrant’s compliance with regulatory
requirements.
•Whether the misstatement affects the
registrant’s compliance with loan
covenants or other contractual
requirements.
•Whether the misstatement has the effect
of increasing management’s compensation
- for example, by satisfying requirements
for the award of bonuses or other forms of
incentive compensation.
•Whether the misstatement involves
concealment of an unlawful transaction.
SAB No. 99, Appendix B.
257
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COSO’s Most Common Fraud Methods
1.
2.
3.
4.
5.
Overstatement of earnings.
Fictitious earnings
Understatement of expenses.
Overstatement of assets.
Understatement of allowances for
accounts receivables.
6. Overstatements of the value of
inventories by not writing down the
value of obsolete goods.
7. Overstatement of property values and
creation of fictitious assets.
258
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COSO’s Major Motives for Fraud
1. Cover up assets misappropriated for
personal gain.
2. Increase the stock price to increase the
benefits of insider traders and to
receive higher cash proceeds when
issuing new securities.
3. Obtain national stock exchange listing
status or maintain minimum exchange
listing requirements to avoid
delisiting.
4. Avoiding a pretax loss and bolstering
other financial results.
259
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Fraudulent Disbursements
 Fraudulent disbursements
account for three-quarters of
the losses, and the most
expensive tend to be fraudulent
disbursements through billing
schemes (45%).
 Therefore, internal auditors
seeking to get the biggest bang
for their investigative bucks
should begin by making sure
company vendors are for real.
 Check tampering (30%).
Source: J.T. Wells, “An Unholy Trinity,” Internal
Auditor, April 1998, p. 33.
260
Joseph W. Koletar’s Opinions
© D.L. Crumbley
“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.
261
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The Methods
 Asset misappropriation
accounted for more than four out
of five offenses (80%).
 Bribery and corruption
constituted about 13 % of
offenses.
 Fraudulent statements were the
smallest category of offense
(most costly). $4.25 million per
scheme.
Source: 2002 Wells Report
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Restatements of Financial Statements
2002
-
330
2001
-
270
2000
-
233
1999
-
216
1998
-
158
Reasons for 2002 restatements:
1. Accounting rules.
2. Human and system errors.
3. Fraudulent behavior.
• Although the number of public registrants have
decreased by 14% since 1999, restatements
have risen by 53%. Revenue recognition was
the cause of 85 of the restatements (22%) in
2002.
• Arthur Andersen had averaged 11 restatements
before 2002. In 2002, they had 40, with 26
after new auditors were retained.
Source: “An Analysis of Restatement Matters,” Huron Consulting
Group, www.huronconsultinggroup.com.
263
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Cynthia Cooper’s Suggestions
•
•
•
•
•
•
•
Improve the tone at the top (e.g.,
a fish rots from the top).
Robust Codes of Conduct.
Training on Ethics/Internal
Controls.
Holistic approach to Risk
Assessment/Internal Controls.
Fraud Hotlines.
Control self-assessment.
Control repositories.
Source: Cynthia Cooper, L.S.U., November 24, 2003.
264
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Triple Fraud Sting
 A Michigan woman received an email from a Nigerian asking her to set
up a bank account in the U.S. in order
to help him steal $18 million.
 She set up the bank account (to help
pay the so-called bribes and fees) by
allegedly embezzling $2 million from
her employer during seven months in
2002.
 Guess what? She never received a
penny. She was indicted on 13 counts
of wire fraud.
 Fraud schemes are much like
derivatives. They spring up, die out,
and new ones are started each week.
Source: Kim Komando, “Delete These Scams – Now,”
MSN Business,
www.bcentral.com/articles/komando/109.asp.
Reviewed June 15, 2003.
265
Rite Aid Fraud Case
© D.L. Crumbley
 Former CEO Martin Glass bragged that the
computer used to generate backdated letters had
disappeared at sea. “They have no computer.
The letters that were done on the
computer…they do not have and never will have,
unless they use a Trident submarine.”
 Wrong. President Timothy Noonan was wearing
a wire. He recorded 6 meetings over 10 weeks.
Federal investigators heard everything.
 CFO Franklyn Bergonzi:
 Obtained $30 million in extra profits by dunning
Rite Aid’s suppliers for merchandise that was
supposedly outdated or damaged (but not so).
 Another $75.6 million came from rebates from
pharmaceutical firms that had yet to be earned.
 Failed to report certain expenses properly.
 Increased the useful life of some assets.
 The financial restatements wiped out $1.6 billion
in profits.
 KPMG agreed to pay $125 million fine.
Source: Mark Maremont, “Call To Account: Rite Aid Case
Gives Early View of Fraud on Trial,” Wall Street J., June
11, 2003, p. A-6.
266
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The Perpetrators
 First-time offenders.
 Losses from fraud caused by
managers and executives were 3.5
times greater than those caused by
non-managerial employees.
 Losses caused by men were 3 times
those caused by women. [53% males;
47% females]
 Losses caused by perpetrators 60 and
older were 27 times those caused by
perpetrators 25 or younger.
 Losses caused by perpetrators with
post-graduate degrees were more than
3.5 times greater than those caused by
high school graduates.
Source: 2002 ACFE Report
267
White-collar criminals have these
characteristics:
© D.L. Crumbley







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).
268
© D.L. Crumbley
Other Characteristics of Occupational
Fraudsters:
 Egotistical
 Inquisitive
 Risk taker
 Rule breaker
 Hard Worker
 Under stress
 Greedy
 Financial need
 Disgruntled or a
complainer
 Big spender
 Close relationship
 Overwhelming
with vendors /
desire for personal
suppliers
gain
 Pressured to
perform
Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff,
http://www.bus.lsu.edu/accounting/faculty/lcrumbley/fraudster.html
269
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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.
270
Quotes
© D.L. Crumbley
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
271
© D.L. Crumbley
“Finding fraud is like trying to
load frogs on to a wheelbarrow.”
Larry Crumbley
272
© D.L. Crumbley
Fraud Catching
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.
273
© D.L. Crumbley
Forensic Audit of a Forensic audit
Harris Tories (Canada) tarred by
Andersen Consulting and Accenture
deals - - $200 million blown to save
$16 million in welfare funds.
Firms found $58.2 million in socalled welfare fraud, saving up to $16
million.
James Clancy calls for forensic
audit of Ontario’s payments to the two
companies.
The union leader said, “instead of
wasting $200 million in this manner,
the money could have been used to
improve education, healthcare, and all
the other social services.”
274
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How Fraud Is Detected
1. Tips from employees (26.3%).
2. By accident (18.8%).
3. Internal audit (18.6%).
4. Internal controls (15.4%).
5. External audits (11.5%).
6. Tips from customers (8.6%).
7. Anonymous tips (6.2%).
8. Tips from vendors (5.1%).
Therefore, 46.2% from tips.
Source: 2002 Wells Report.
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Tips Are Important
Some of the biggest recent accounting
scandals (e.g., HealthSouth, Xerox, Waste
Management) involve situations where the
auditors were tipped off or otherwise
alerted to possible frauds but they failed to
investigate them deeply enough.
In her book Power Failure, Sherron
Watkins says she talked to Jim Hecker, at
Arthur Andersen, on the phone about the
dangers of the Raptors and Fastow’s
inherent conflict. Hecker wrote a memo to
the files and forwarded copies to David
Duncan and Enron’s audit partner, Debra
Cash. His note: “Here is my draft memo,
for your review, for ‘smoking guns’ that
you can not extinguish.” p. 285.
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Finding Fraud In The Midst of a Conspiracy
When speaking about the fraud of HealthSouth, a
spokesman for Ernst & Young emphasized the
difficulty of detecting accounting fraud in the
midst of a conspiracy of senior executives and
false documentation.
An accountant testified that HealthSouth employees
would move expenses of $500 to $4,999 from the
income statement to the balance sheet throughout
the year. Overall the SEC said about $1 billion in
fixed assets were falsely entered. The employees
moved only those expenses less than $5,000,
because Ernst & Young automatically looked at
those expenses over $5,000.
An ex-bookkeeper even sent Ernst & Young an email flagging one area of the fraud, but E & Y still
did not catch it. Employees actually produced
false invoices when the accounting firm asked for
back-up.
Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose
HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1
and A-13.
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HealthSouth
Billy Massey, 37-year-old CPA, had a wife
and two children and looked like an
accountant from central casting.
Massey was the personal accountant for
HealthSouth’s Richard Scrushy. He was
Scrushy’s personal CFO for his private
interests, doing the financing, paying the
bills, moving around money – and stealing
some $500,000.
Massey spent the money on lavish dinners
and gifts for his mistress. One week after
he was found to be an embezzler and
adulterer, he committed suicide.
Source: John Helyar, “The Insatiable King Richard,” Fortune,
July 7, 2003, p. 78.
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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
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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.
30-34.
www.investigation.com/artilces/library/2002Articles/15.htm.
280
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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.
30-34.
www.investigation.com/articles/library/2002Articles/15.htm
281
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D.R. Cressey’s Fraud Pyramid
“It was definitely the perfect fraud…
unfortunately they hired the perfect
investigator.”
Cartoon in M.J. Comer’s book
282
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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,
www.investigation.com/articles/library/2001articles.
283
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SAS No. 99 Characteristics of Fraud
Incentives / pressures
Attitude /
Rationalization
Opportunity
284
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Fraud Pyramid
 Motive
 Excessive spending to keep up
appearances of wealth.
 Other, outside business financial strains.
 An illicit romantic relationship.
 Alcohol, drug or gambling abuse
problems.
 Opportunity
 Lack of internal controls.
 Perception of detection = proactive
preventative measure.
 Rationalization
 “Borrowing” money temporarily.
 Justifying the theft out of a sense of
being underpaid.(“I was only taking
what was mine”)
 Depersonalizing the victim of the theft.
(I wasn’t stealing from my boss; I was
stealing from the company.”)
285
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Financial Statements Fraud FormulaCRIME
Cook
Recipes
Incentives
Monitoring (lack of)
End Results
CRIME
+
+
+
+
=
Source: Zab Rezaee “Cooking The Books Is a Crime, Journal of
Forensic Accounting Vol. IV (2003), pp. 137-144
286
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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.
http://www.sec.gov/news/press/2002-92.htm
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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: http://www.sec.gov/news/press/2002-92.htm
288
Rite Aid’s (Cont.)
© D.L. Crumbley
•Upcharges — Rite Aid
systematically inflated the
deductions it took against
amounts owed to vendors for
damaged and outdated products.
For vendors who did not require
the unusable products to be
returned to them, Rite Aid
applied an arbitrary multiplier to
the proper deduction amount,
which resulted in overcharging
its vendors by amounts that
ranged from 35% to 50%. These
practices, which Rite Aid did not
disclose to the vendors, resulted
in overstatements of Rite Aid's
reported pre-tax income of $8
million in FY 1998 and $28
million in FY 1999.
Source: http://www.sec.gov/news/press/2002-92.htm
289
Rite Aid’s (Cont.)
© D.L. Crumbley
•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: http://www.sec.gov/news/press/2002-92.htm
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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: http://www.sec.gov/news/press/2002-92.htm
291
Rite Aid’s (Cont.)
© D.L. Crumbley
•"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: http://www.sec.gov/news/press/2002-92.htm
292
Rite Aid’s (Cont.)
© D.L. Crumbley
•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: http://www.sec.gov/news/press/2002-92.htm
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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: http://www.sec.gov/news/press/2002-92.htm
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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: http://www.sec.gov/news/press/2002-92.htm
295
Rite Aid’s (Cont.)
© D.L. Crumbley
• "Dead Deal" Expense — Rite Aid
routinely incurred expenses for legal
services, title searches, architectural
drawings and other items relating to
sites considered but later rejected for
new stores. Rite Aid capitalized these
costs at the time they were incurred.
Rite Aid subsequently determined not to
construct new stores at certain of these
sites.
Under Generally Accepted
Accounting Principles, Rite Aid should
have written off the pertinent "dead
deal" expenses at the time that it
decided not to build on each specific
site. Such writeoffs would have reduced
reported income in the relevant periods.
Instead, Rite Aid continued to carry
these items on its balance sheet as
assets. By the end of FY 1999, the
accumulated dead deal expenses
totaled $10.6 million.
Source: http://www.sec.gov/news/press/2002-92.htm
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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: http://www.sec.gov/news/press/2002-92.htm
297
Rite Aid’s (Cont.)
© D.L. Crumbley
• 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: http://www.sec.gov/news/press/2002-92.htm
298
Rite Aid’s (Cont.)
© D.L. Crumbley
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: http://www.sec.gov/news/press/2002-92.htm
299
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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: http://www.sec.gov/news/press/2002-92.htm
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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: http://www.sec.gov/news/press/2002-92.htm
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Which of these statements are false?
a. A high degree of competition accompanied by
declining margins would be an example of an
opportunity for fraudulent financial reporting.
b. Personal guarantees of debt of a company that are
significant to one’s personal net worth is an
example of a pressure/incentive for fraudulent
financial reporting.
c. A heavy concentration of one’s wealth in a
particular company would be an example of a
rationalization condition for fraudulent financial
reporting.
d. An excessive interest by management in
maintaining a company’s stock price is an
example of rationalization for fraudulent financial
reporting.
e. Anticipated future layoff would be an example of
an incentive to misappropriate assets.
f. A large amount of cash on hand would be an
example of a rationalization to misappropriate
assets.
g. Inadequate internal controls is an example of an
opportunity to misappropriate assets.
302
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Which of these statements are false?
a. A high degree of competition accompanied by
declining margins would be an example of an
opportunity for fraudulent financial reporting. F
(I/P)
b. Personal guarantees of debt of a company that are
significant to one’s personal net worth is an
example of a pressure/incentive for fraudulent
financial reporting. T
c. A heavy concentration of one’s wealth in a
particular company would be an example of a
rationalization condition for fraudulent financial
reporting. F (I/P)
d. An excessive interest by management in
maintaining a company’s stock price is an
example of rationalization for fraudulent financial
reporting. T
e. Anticipated future layoff would be an example of
an incentive to misappropriate assets. T
f. A large amount of cash on hand would be an
example of a rationalization to misappropriate
assets. F (O)
g. Inadequate internal controls is an example of an
opportunity to misappropriate assets. T
303
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KPMG’s Causes or Indicators of Fraud (1998)









Personal financial pressure.
Substance abuse.
Gambling.
Real or imagined grievances.
Ongoing transactions with related
parties.
Increased stress.
Internal pressures to meet
deadlines/budgets.
Short vacations.
Unusual hours.
Source: KPMG’s 1998 Fraud Survey
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How Fraud is Discovered-Singapore 2002
•
•
•
•
•
Management investigation (41%).
Anonymous letter/informant (35%).
Internal controls (33%).
By chance (26%).
Internal auditor review (12%).
Source: KPMG Fraud Survey Report, 2002.
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Singapore Fraud Survey, 2002
•
•
•
•
•
•
Management investigation, informant
notification, and good internal controls
rank highly as methods of fraud
detection.
76% of the frauds were perpetrated
internally [management (41%) and nonmanagement employees (35%)]
Poor internal controls, override of
internal controls, and collusion between
employees and third parties were the top
three reasons cited as to why frauds were
allowed to take place
“Red flags,” which should have alerted
respondents to the fraud, were present
and ignored in 29% of cases.
The main reason for not reporting fraud
was lack of evidence
The typical fraudster is predominantly
male within the age group of 26-40 years
and has an annual income between
$15,000 to $30,000. 44% of fraudsters
have tertiary educational qualifications.
306
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Rationalization
Sherron Watkins provides an
excellent comment about
rationalization with respect to
Enron’s Jeff Skilling and Andy
Fastow.
At what point did they turn
crooked? “But there is not a defining
point where they became corrupt. It
was one small step after another,
with more and more rationalizations.
There was a slow erosion of values
over time.”
Source: Pamela Colloff, “The WhistleBlower,” Texas Monthly, April 2003, p. 141.
307
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Fraud’s Fatal Failings
 85% of fraud victims never get
their money or property back.
 Most investigations flounder,
leaving the victims to defend for
themselves against counterattacks 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.
308
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SAS No. 99: Brainstorming
Aims to make the auditor’s consideration
of fraud seamlessly blended into the
audit process and continually updated
until the audit’s completion.
Brainstorming is now a required
procedure to generate ideas about how
fraud might be committed and
concealed in the entity.
No ideas or questions are dumb.
No one owns ideas.
There is no hierarchy.
Excessive note-taking is not allowed.
Source: Michael Ramos, “Auditors’ Responsibility for Fraud
Detection,” J. of Accountancy, January, 2003, pp. 28 – 36.
309
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More Brainstorming
• Best to write ideas down, rather than say
them out loud.
• Take plenty of breaks.
• Best ideas come at the end of session.
• Important to not define the problem too
narrow or too broad.
• Goal should be quantity, not quality.
• Geniuses develop their most innovative ideas
when they are generating the greatest
number of ideas.
• No such things as bad ideas.
• Many companies are great at coming up with
good ideas, but lousy at evaluating an
implementing them.
Source: A.S. Wellner, “Strategies: A Perfect Brainstorm,” Inc. Magazine,
October 2003, pp. 31-35
310
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Potential Pitfalls
•
•
•
•
Group domination: one or two
participants dominating the process
can quickly squelch the creative
energies of the groups as a whole,
reducing the likelihood the team will
identify any actual fraud risks.
Social loafing: participants disengage
from the process, expecting other team
members to pick up the slack.
Groupthink: team members become
so concerned with reaching consensus
that they fail to realistically evaluate
all ideas or suggestions.
Group shift: avoid allowing the team
to take an extreme position on fraud
risk.
Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud
Risks,” Journal of Accountancy, December 2003, pp. 33-34.
311
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Three Types of Brainstorming
•
•
•
Open brainstorming: unstructured;
few rules; free-for-all; someone should
record ideas.
Round-robin brainstorming: start with
no talking, silent period; assigned
homework ahead; each individual
presents own ideas; each member has a
turn.
Electronic brainstorming: shortens
meetings, increases ideas, and reduces
personalizing ideas because an idea’s
author remains anonymous.
Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming
Fraud Risks,” Journal of Accountancy, December 2003, pp.
33-34.
312
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How Management Overrides Controls
(SAS No. 99)
 Recording fictitious journal
entries (especially near end of
quarter or year).
 Intentionally biasing
assumptions and judgments used
to estimate accounts (e.g.,
pension plan assumptions or bad
debt allowances).
 Altering records and terms
related to important and unusual
transactions.
313
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Journal Entries at Year End
Apparently, Arthur Andersen was given
limited access to the general ledger at
WorldCom, which had a $11 billion fraud
(largest accounting fraud in history). Most
of the original entries for online costs were
properly placed into expense accounts.
However, near the end of the period these
entries were reversed. One such entry was
as follows:
Property, Plant & Equipment $647,000,000
Operating Expenses
$647,000,000
The support for this entry was a yellow
post-it note.
Now, a number of companies are trying to
obtain IRS refunds for inflated incomes.
314
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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.
315
© D.L. Crumbley
WorldCom Fraud Massive (contd.)
 David Schneedan, CFO at a division,
refused to release reserves twice.
 E-mail from David Myers, WorldCom
comptroller, to Schneedan:
“I guess the only way I am going to get
this booked is to fly to DC and book it
myself. Book it right now; I can not wait
another minute.”
 Buddy Gates [director of general
accounting] said to an employee
complaining about a large accounting
discrepancy:
“Show those numbers to the damn
auditors, and I’ll throw you out the
f_____ window.”
Source: Rebecca Blumenstein and Susan Pullian,
“WorldCom Fraud Was Widespread,” Wall Street J., June
10, 2003, p. 3.
316
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Fraudulent financial reporting may
occur by the following:
 Manipulation, falsification, or
alteration of accounting records,
or supporting documents from
which financial statements are
prepared.
 Misrepresentation in or
intentional omission from the
financial statements of events,
transactions, or other significant
information.
 Intentional misapplication of
accounting principles relating to
amounts, classification, manner
of presentation, or disclosure.
Source: SAS No. 99, “Consideration of Fraud in a
Financial Statement Audit,” New York: AICPA
317
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Falsification
Enron’s crude oil trading operation based in
Valhalla, New York was fictitious,
according to one auditor. “It was pretend. It
was a playhouse. There were a lot of
expensive people working there, and it was
impressive looking, but it wasn’t legitimate
work.
The traders were keeping two sets of books,
one for legitimate purposes – to show Enron
and auditors from Arthur Andersen – one
other set in which to record their ill-gotten
gains.
Source: Mimi Swartz and Sherron Watkins, Power
Failure, New York: Doubleday, 2003, p.31.
318
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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.
319
Examples
© D.L. Crumbley
 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 juniorlevel accountants in unannounced visits.
For 2000, E&Y audit fee, $1.03 million;
other fees, $2.65 million.
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TRUTH
Given the right pressures, opportunities, and
rationalizations, many employees are capable of
committing fraud.
Bev Harris says that fraudsters and embezzlers are the
nicest people in the world:
Wide-eyed mothers of preschoolers. Your best
friend. CPAs with impeccable resumes. People
who profess deep religious commitments. Your
partner. Loyal business managers who arrive
early, stay late, and never take a vacation. And
sometimes, even FAMILY MEMBERS. So if
you’re looking for a sinister waxed mustache
and shifty eyes, you’re in for a surprise –
scoundrels come in every description.
Source: “How to Unbezzle A Fortune,” www.talion.com/embezzle.htm,
p. 1.
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SAS No. 99 Types of Fraud
Unlike errors, fraud is intentional and
most often involves deliberate
concealment of facts by mgt.,
employees, or third parties
 Fraudulent Financial Reporting: does
not follow GAAP (e.g., recording
fictitious sales)
 Misappropriation of Assets:
embezzling receipts, stealing assets, or
causing an entity to pay for goods or
services that have not been received.
Often accomplished by false or
misleading records or documents,
possibly created by circumventing
internal controls.
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Comparison of Auditing and Forensic Examination
Issue
Audit
Forensic Examination
Timing
Recurring: audits are
conducted on a regular
basis
Nonrecurring: fraud
examinations are
nonrecurring. They are
conducted only with
sufficient predication.
Scope
General: collection of
sufficient, competent
data to support the
opinion rendered.
Specific: the fraud
examination is conducted to
resolve specific allegations.
Objective
Opinion: express
opinion on financial
statements
Affix blame: determine if
fraud occurred and who is
responsible. Adversarial in
nature.
Methodology Audit techniques
applied primarily to
financial data.
Presumption
Fraud examination
techniques include document
examination, public record
searches, and interviews.
Professional skepticism Proof to support or refute an
allegation of fraud.
Source: Apostolou, B, “Course 992003: Fundamentals of Fraud
Detection and Prevention,” www.education.smartpros.com, 1998.
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The Good, The Biased, and Ugly Results
 Auditors are vulnerable to “unconscious bias,”
because accounting is subjective and the
relationship between accounting firms and clients
are often tight.
 Auditor may unintentionally distort the
numbers in ways to mask a company’s true
financial picture.
 Psychological studies show that our desires have
a powerful influence on the ways we interpret
information.
 We tend to discount information that contradicts
the conclusions we wish to reach.
 Five structural aspects of accounting create
opportunity for bias to influence judgment.





Ambiguity.
Attachment (They hire and fire us).
Approval.
Familiarity (Not willing to harm friends).
Discounting (focus on immediate events).
Source: M.H. Bazerman et.al, “Why Good Accountants Do
Bad Audits,” Harvard Business Review, November 2002. 324
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Assessment of Internal Controls
The PCAOB believes that an
attestation is an expert’s communication
of a conclusion about the reliability of
someone else’s assertion (e.g., a financial
statement audit is a form of attestation).
S-O Act Section 404(b) states that an
auditor’s attestation of management’s
assessment of internal controls is not a
separate engagement. Instead, PCAOB
states that an “integrated audit results in
two audit opinions: one on internal control
over financial reporting and one on the
financial statements.”
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
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Internal Controls
PCAOB states that internal controls over
financial reporting includes company policies
and those procedures “designed and operated
to provide reasonable assurance - -a high,
but not absolute, level of assurance - - about
the reliability of a company’s financial
reporting and its process for preparing
financial statements in accordance with
generally accepted accounting principles.”
Also included are those policies and
procedures for “the maintenance of
accounting records, the authorization of
receipts and disbursements, and the
safeguarding of assets.”
Even the PCAOB believes that internal
controls “cannot provide absolute
assurance of achieving financial reporting
objectives because of inherent limitations
(e.g., a process that involves human diligence
and compliance can be intentionally
circumvented).”
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
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The Costs and Benefits of Internal Controls
Reliable financial reporting adds value
and also can offset risks in a manner that is
cost-beneficial to a company.Evaluating a
company’s internal control over financial
reporting is sometimes costly, but also has
many far-reaching benefits.
Some of the benefits of a company
developing, maintaining, and improving its
system of internal controls include
identification cost-effective procedures,
reducing costs of processing accounting
information, increasing productivity of the
company’s financial function, and simplifying
financial control systems.
The primary benefit, however, is to
provide the company, its management, its
board and audit committee, and its owners,
and other stakeholders with a reasonable basis
to rely on the company’s financial reporting.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
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Auditing Internal Controls
1.
2.
3.
4.
5.
The audit of internal controls includes
these steps:
Planning the audit.
Evaluating the process management
used to perform its assessment of
internal control effectiveness.
Obtaining an understanding of the
internal controls.
Evaluating the effectiveness of both the
design and operation of the internal
controls.
Forming an opinion about whether
internal controls over financial reporting
is effective.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
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Anti-Fraud Program
An auditor must perform
“company-wide anti-fraud programs and
controls and work related to other
controls that have a pervasive effect on
the company, such as general controls
over the company’s electronic data
processing.”
Further, the auditor must
“obtain directly the ‘principle evidence’
about the effectiveness of internal
controls.”
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
329
Walkthroughs
© D.L. Crumbley
An auditor must perform
“walkthroughs” of a business’ significant
processes. PCAOB suggest that an auditor
should confirm his or her understanding by
performing procedures that include making
inquires of and observing the personnel that
actually perform the controls; reviewing
documents that are used in, and that result
from, the application of the controls; and
comparing supporting documents (for example,
sales invoices, contracts, and bills of lading) to
the accounting records.”
According to PCAOB, in a
walkthrough an auditor traces “company
transactions and events – both those that are
routine and recurring and those that are unusual
– from origination, through the company’s
accounting and information systems and
financial report preparation processes, to their
being reported in the company’s financial
statements.” Auditors should perform their own
walkthroughs which provides auditors with
appropriate evidence to make an intelligent
assessment of internal controls.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
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Material Weaknesses
•
•
•
PCAOB provides several strong
indicators that material weaknesses
exist in internal controls:
Ineffective oversight of the company’s
external financial reporting and internal
control over financial reporting by the
company’s audit committee.
Material misstatement in the financial
statements not initially identified by the
company’s internal controls.
Significant deficiencies that have been
communicated to management and the
audit committee but that remain
uncorrected after a reasonable period of
time.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
331
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Pre SAS 99
Consulting
Standards
Auditing
Standards
Traditional
Investigation
Traditional
Audit
Post SAS 99
Auditing
Standards
Consulting
Standards
Traditional
Investigation
Forensic
Procedures in
the Audit
Environment
SAS 99
Source: Ronald L. Durkin et.al, Litigation and Dispute Resolution
Services Subcommittee, Incorporating Forensic Procedures in an
Audit Environment, AICPA, 2003, Fraud Task Force.
332
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Steps Toward Forensic Audit
Traditional audit [forensic
techniques & fraud prevention
program].
If suspect fraud, bring in-house
forensic talent into the audit.
If no in-house talent or fraud
complex, engage an outside
forensic accountant (e.g., Cr.FA,
CFFA, or CFE).
As audit moves toward forensic
investigation, auditor must
comply with litigation services
standards (consulting).
333
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AICPA Audit Committee Toolkit
“In some situations, it may be
necessary for an organization to look
beyond the independent audit team for
expertise in the fraud area. In such
cases, CPA forensic accounting
consultants can provide additional
assurance or advanced expertise, since
they have special training and
experience in fraud prevention,
deterrence, investigation, and
detection.
Forensic accounting consultants
may also provide fresh insights into the
organization’s operation, control
systems, and risks. The work of
forensic accounting consultants may
also provide comfort for the
organization’s CEO and CFO, who are
required to file certifications under
Sarbanes-Oxley.”
334
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Types of Forensic Engagements
 Determine if fraud is occurring.
 Support criminal or civil action against
dishonest individuals.
 Form a basis for terminating a
dishonest employee.
 Support an insurance claim.
 Support defense of an accused
employee.
 Determine whether assets or income
were hidden by a party to a legal
proceeding (such as a bankruptcy or
divorce).
 Identify internal controls to prevent it
from happening again.
Source: D.R. Carmichael, et. al, Fraud Detection, 5th, Fort
Worth: Practitioners Publishing, 2002, p. 2 – 4.
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Two Major Types of Fraud
Investigations
• Reactive: Some reason to suspect
fraud, or occurs after a significant
loss.
• Proactive: First, preventive
approach as a result of normal
operations (e.g., review of internal
controls or identify areas of fraud
exposure). There is no reason to
suspect fraud. Second, to detect
indicia of fraud.
Source: H.R. Davia, “ Fraud Specific Audting,” Journal of
Forensic Accounting, Vol. 111, 2002, pp. 111-120
336
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Fraud Deterrence Review
• Analysis of selected records and
operating statistics.
• Identify operating and control
weaknesses.
• Proactively identify the control
structure in place to help prevent fraud
and operate efficiently.
• Not an audit; does not express an
opinion as to financial statements.
• May not find all fraud especially
where two or more people secretively
agree to purposely deceive with false
statements or by falsifying documents.
[Always get a comprehensive, signed
engagement letter defining objectives.]
337
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Guilt Pyramid
Source: Michael Kurland, How to Solve A Murder: Macmillan,
1995, pp. 7-8
338
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Koletar’s Murder vs. Fraud Comparison
 Fraud is committed for only one reason - greed.
 Fraud is committed in the workplace, where
there should be tighter controls.
 Those committing fraud return to the scene
of their crime time and time again, often for
many years.
 Fraud tends to be accumulative, getting
bigger with time.
 Fraudsters wear the same employee badges
we do and eat in the same cafeterias.
 Normally, there is a victim available with a
fraud, with detailed knowledge about the
perp, technique, and motive.
 Since the penalties are less severe for fraud,
the possibilities for cooperation is
increased.
Source: J.W. Koletar, Fraud Exposed, John Wiley &
Sons, 2003, p. 153.
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How Fraud Occurs
HOW FRAUDS OCCUR
59
58
Poor Controls
36
36
Management Override
34
High Risk Industry
33
31
3rd Party Collusion
Employee Collusion
19
1994
23
1998
7
8
No Ethics Policy
6
No Director Control
11
2
Other
0
20
40
60
80
Source: KPMG Fraud Study
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Measures Helpful in Preventing Fraud
1. Strong Internal Controls (1.62)
2. Background checks of new
employees (3.70)
3. Regular fraud audit (3.97)
4. Established fraud policies (4.08)
5. Willingness of companies to
prosecute (4.47)
6. Ethical training for employees (4.86)
7. Anonymous fraud reporting
mechanisms (5.02)
8. Workplace surveillance (6.07)
1 = Most effective
8 = Least effective
Source: 2002 Wells Report
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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.”
342
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SAS No. 99
Recommendations
• Brainstorming.
• Increased emphasis on professional
skepticism.
• Discussions with management.
• Unpredictable audit tests.
• Responding to management override
of controls.
343
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Public Company Accounting
Oversight Board (PCAOB)
• The Sarbanes-Oxley Act of 2002
created a new, five-member
oversight group called the PCAOB.
• The PCAOB is empowered to set
accounting standards that establish
auditing, quality control, and ethical
standards for accountants.
• The PCAOB is also empowered to
adopt or amend standards issued or
recommended by private accounting
industry groups or to adopt its own
standards independent of such
private industry standards or
recommendations.
• http://www.pcaob.us, to get free
subscription to PCAOB Update.
344
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Internal Auditors and Fraud
Detection
The Institute of Internal Auditors’ Due
Professional Care Standard (Section 280)
assigns the internal auditor the task of
assisting in the control of fraud by
examining and evaluating the adequacy
and effectiveness of the internal control
system.
However, Section 280 says that
management has the primary
responsibility for the deterrence of
fraud, and management is responsible for
establishing and maintaining the control
systems. In general, internal auditors are
more concerned with employee fraud
than with management and other external
fraud.
345
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When Fraud Is Discovered
1.
2.
3.
4.
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.
346
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Audit Committee
The audit committee is the
subcommittee of an organization’s
board of director’s charged with
overseeing the organization’s financial
reporting and internal control
processes. The audit committee’s
biggest responsibility is monitoring the
component parts of the audit process.
347
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Management’s Role
The Sarbanes-Oxley Act of 2002
mandates that CEOs and CFOs certify
in periodic reports containing financial
statements filed with the SEC the
appropriateness of financial statements
and disclosures.
348
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Audit Tests
The Panel on Audit Effectiveness
recommended that surprise or unpredictable
elements should be incorporated into audit
tests, including:
– Recounts of inventory and unannounced
visits to locations
– Interviews of financial and nonfinancial
client personnel in different locations
– Requests for written confirmations from
client employees regarding matters about
which they have made representations to
the auditors
– Tests of accounts not normally
preformed annually
– Tests of accounts traditionally or
frequently deemed “low risk”
349
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SAS No. 99: SKEPTICISM
 An attitude that includes a
questioning mind and a critical
assessment of audit evidence.
 An auditor is instructed to
conduct an audit “with a
questioning mind that recognizes
the possibility that a material
misstatement due to fraud could
be present, regardless of any
past experience with the entity
and regardless of the auditor’s
belief about management’s
honesty and integrity.”
350
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SKEPTICISM
Ronald Reagan said with
respect to Russia, “Trust, but
verify.”
FA’s motto should be “Trust
no one; question everything;
verify.”
351
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Example of Management Override/Skepticism
“And second, I want to tell you that you and your people did nothing short
of uncovering a quarter-of-a-million –dollar embezzling scheme that Loomis [the
controller of the entity who had a gambling problem] was involved in.”
Looking around the room, he explained to the other partners how Pat [an auditor]
investigated the mysterious check made out to Richard Loomis and how he used
the bank and Nationwide Express to get the statement back to the unsuspecting
controller.
He told them that Pat had talked privately to Gordon Banks [Executive Director],
explaining to him how Loomis had switched the checks before giving the
statement back to Pat.
“After Pat left Banks’ office, Gordon called me personally and told me that he
needed my help. He wanted a fresh pair of eyes to look over what Pat showed
him.
“So Russell and I drove down there the same day to meet Gordon. He showed us
the check made payable to the post office, and it appeared to have cleared the
bank. And sure enough, it was for the same amount and had the same check
number as the check that did, in fact, clear the bank with Loomis as the payee.
Fortunately, Pat made a copy of the check before Loomis had a chance to destroy
it.”
“What did you do next?” Bob Ramsey asked. He and the others were
mesmerized.
“I asked Gordon to get a few old bank statements for us, and Russell and I pulled
out every check payable to the post office, and the three of us went to the bank.”
“And?”
“We asked the bank to pull their photocopy of each check that we had payable to
the U.S. Postal Service. There was the proof. The bank’s copies of several of the
checks had the same number and were for the same amount, but had Loomis as
the payee.”
352
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Example of Management Override/Skepticism
“But you said that the checks had the same check numbers, and appeared to have
cleared the bank. How did he manage to do that?” Ramsey asked again,
astonished.
“Actually, it was very simple once it was uncovered. As it turned out, Loomis
ordered two sets of identically numbered checks from two different checkprinting companies. They looked exactly the same.”
“And?”
“He ran checks routinely on his office computer. Every week or so, he would
make one check out to the U.S. Postal Service and, of course not mail it because
the post office had nothing to do with it. He’d go home with a copy of the
diskette he used to make out the checks in the office. There he used his name as
the payee on that particular check, printed the check on his printer, forged a
signature, and cashed the check at a different bank, of course. Because he got the
bank statements, he only had to pull out the check he cashed, destroy it, and
replace it with the original check from the bank statement, payable to the post
office.”
“But you said that it looked like the check had been cashed and it had a receipt.
How did he manage that?” one of the other partners asked.
“Simple. He had a friend who worked at the post office in on the scheme. His
friend endorsed the check with the post office’s actual endorsement stamp and
then gave him a real post office receipt.”
“But how about the bank’s encoding information on the bottom right front of the
check and their clearinghouse stamps on the back. How did he fake that?” Bob
Ramsey asked, incredulous.
“That wasn’t hard,” Autry continued, “He had duplicates of clearinghouse stamps
made at a rubber stamp company. They’ll make just about anything you need. He
stamped them himself, and they looked authentic enough to fool anyone.”
Source: E.J. McMillan, The Audit, Churchton, MD: Harwood Publishing, 2000, pp. 36-39.
353
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SAS No. 99: Questions for Management






Whether management has knowledge of any fraud
that has been perpetrated or any alleged or suspected
fraud.
Whether management is aware of allegations of
fraud, for example, because of communications from
employees, former employees, analysts, short sellers,
or other investors.
Management’s understanding about the risks of
fraud in the entity, including any specific fraud risks
the entity has identified or account balances or
classes of transactions for which a risk of fraud may
be likely to exist.
Programs and controls the entity has established to
mitigate specific fraud risks the entity has identified,
or that otherwise help prevent, deter, and detect
fraud, and how management monitors those
programs and controls.
For an entity with multiple locations, (a) the nature
and extent of monitoring of operating locations or
business segments, and (b) whether there are
particular operating locations or business segments
for which a risk of fraud may be more likely to exist.
Whether and how management communicates to
employees its views on business practices and
ethical behavior.
354
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BE SKEPTICAL
 Assume there may be wrong
doing.
 The person may not be truthful.
 The document may be altered.
 The document may be a forgery.
 Officers may override internal
controls.
 Try to think like a crook.
 Think outside the box.
355
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Think Like A Crook
•
•
•
•
Know your enemy as you know yourself,
and you can fight a hundred battles with no
danger of defeat.” Chinese Proverb.
Military leaders study past battles.
Football and basketball teams study game
films of their opponents.
Chess players try to anticipate the moves of
their opponent.
Examples: If contracts above $40,000 are
normally audited each year, check the
contracts between $30,000-$40,000.
356
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Think Outside the Box
American astronauts returning from
space complained that they could
not write with their pens in zero
gravity. NASA set aside $1 million
to develop a sophisticated pen that
would function in space.
The Russians encountered the same
problem. What did they do?
357
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See Things Differently
Can’t see a way out? Take the time to see
things differently. See the two white swans
instead of the one black one. See the slice of pie
instead of the pie with the slice missing.Flip the
Necker cube outward instead of inward. Master
the gestalt. It will make you free. (p.327).
--------------------------------------------------------“Must always look for butterfly. In the
middle of nothing, thing that does not belong. In
cascade of digital transfer codes, you ask: is
there butterfly? Yes. Always butterfly. Flap, flap,
flap. So. You must know how to look.” (pp. 242243)
Robert Ludlum, The Janson Directive, New York: St. Martin’s
Paperback, 2002.
358
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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
Behavioral
Interaction
Considerations
Supportiveness
Satisfaction
Source: G.J. Bologna and R.J. Lindquist,
Fraud Auditing and Forensic Accounting,
2nd Edition, New York: John Wiley, 1995,
pp. 36-37
359
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Behavioral Concepts Important
“Not all fraud schemes can effectively
be detected using data-driven approaches.
Instances of corruption-bribery,
kickbacks, and the like – and collusion
consistently involve circumvention of
controls.
Searching relevant transaction data
for patterns and unexplained relationships
often fails to yield results because the
information may not be recorded, per se,by
the system.
Behavioral concepts and qualitative
factors frequently allow the auditor to look
beyond the data, both with respect to data
that is there and the data that isn’t.”
Source: S. Ramamoorti and S. Curtis, “Procurement Fraud & Data Analytics,
“Journal of Government Financial Management, Winter 2003, Vol. 52, No. 4,
pp. 16-24.
360
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Investigative Techniques
“Facts weren’t the most important part of
an investigation, the glue was. He said
the glue was made of instinct,
imagination, sometimes guesswork and
most times just plain luck.” (p. 163).
-------------------------------------------------“In his job, he [Bosch] learned a lot about
people from their rooms, the way they
lived. Often the people could no longer
tell him themselves. So he learned from
his observations and believed that he was
good at it.” (p. 31).
-------------------------------------------------Michael Connelly, The Black Ice, St. Martin’s
Paperbacks, 1993.
361
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Three Major Phases of Fraud
1. The Act itself.
2. The concealment of the fraud (in
financial statements).
3. Conversion of stolen assets to personal
use.
One can study any one of these phases.
Examples:
Things being stolen: conduct surveillance and
catch perp.
If liabilities being hidden, look at financial
statements for concealment.
If perp has unexpected change in financial
status, look for source of wealth.
Source: Cindy Durtschi, “The Tallahassee Bean Counters:
A Problem-Based Learning Case in Forensic Audit,”
Issues in Accounting Education, Vol. 18, No. 2, May
2003, pp. 137-173.
362
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Be Proactive
 Fraud hotline (reduce fraud losses
by 50%).
 Suggestion boxes.
 Make everyone take vacations.
 People at top must set ethical tone.
 Widely known code of conduct.
 Check those employee references.
 Reconcile all bank statements.
 Count the cash twice in the same
day.
 Unannounced inventory counts.
 Fraud risk assessment.
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Hot Lines – Sarbanes-Oxley
 Audit Committee (AC) must provide a
mechanism for employees to remain
anonymous when reporting concerns
about accounting and auditing problems.
 AC must provide a process for the
receipt, retention, and treatment of
complaints regarding accounting
problems.
 Annual report must contain a statement
regarding the effectiveness of internal
controls.
 Employees have the right to sue
companies for whistle-blowing
retaliation.
 Managers found guilty of retaliation face
penalties, including up to 10 years in
prison.
See The Network, www.tnwinc.com/hotlines
364
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Ethics Programs/Background Checking
Stephen J. Burns: “If only on paper, corporate
business ethics programs exist in most large
international companies. Unfortunately, many of
these efforts would have to be regarded as
meaningless.”
The good news is there is no more effective and,
in the long run, efficient process to select
employees than through the use of a
professional, fair, well-designed, and well-run
background and selection program. Basic
background inquiries for about $50 per person.”
J.W. Koletar, p. 141.
“There are also companies and vendors who will
sell or design software programs that permit an
organization’s own human resources (HR)
department to do these checks themselves.”
Koletar, p. 141.
Sources: Burns, “Combating Corruption,”
Internal Auditor, June 1997, p. 56; J.W. Koletar,
Fraud Exposed, John Wiley & Sons, 2003
365
© D.L. Crumbley
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
366
Whistle-Blowing
© D.L. Crumbley
It almost always turns out badly for the
whistle-blower. Often they regret it. They
lose their job, have family problems, or they
are shunted off to the side. The kiss of death
for a career to get a reputation as someone
who is not a team player.
Fate of Recent Whistle-Blowers
Name
Company
Allegations
Personal
Outcome
Company
Outcome
David Chacon
Salmon Smith
Barney
Improper
IPO
allotments
Left firm,
filed
lawsuit
Subject of
congressional
and NASD
probes
Cynthia Cooper
WorldCom
Massive
accounting
fraud
Talking to
U.S. Justice
Department
Forced into
bankruptcy
Roy Olofson
Global Crossing
Round-trip
trades and
improper
accounting
Fired, filed
lawsuit
Forced into
bankruptcy
Barron Stone
Duke Energy
Improper
accounting
Forced to
change jobs
at Duke
Awaiting
results of an
audit
Sherron Watkins
Enron
Massive
acctg. Fraud
Testified to
Congress
Forced into
bankruptcy
Source: Joseph McCafferty, “Whistle-Blowing, Talk or Walk,” CFO, October 2002, pp. 90-91.
367
© D.L. Crumbley
RED FLAGS
AICPA’s Statement on
Auditing Standards No. 82
provides many red flags for
external auditors in the
detection of financial
statement fraud.
Replaced by SAS No. 99
368
© D.L. Crumbley
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.
369
© D.L. Crumbley
Roadmap For An Embezzler: 14 Ways
1.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.
2.He set up dummy bank accounts to skim funds
before they made their way into legitimate
accounts.
3.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.
4.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,” www.talion.com/embezzle.htm.
370
© D.L. Crumbley
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).
6. He diverted bank statements to his home and
altered them before filing them at the office.
7. Sam volunteered to run daily deposits to the
bank, skimming off the cash and changing the
deposit tickets.
8. He made reimbursements to himself and his
wife for “business expenses” that didn’t exist.
9. Sam set up his landlord, once or twice a year,
as an accounts payable.
10. 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.)
5.
Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm.
371
© D.L. Crumbley
Roadmap For An Embezzler: 14 Ways (contd …)
11. 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.
12. 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,” www.talion.com/embezzle.htm.
372
© D.L. Crumbley
Roadmap For An Embezzler: 14 Ways (contd …)
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.
13. Increasingly arrogant, he began making
“phone-authorized” wire transfers out of
company accounts into his personal checking
account.
14. 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,” www.talion.com/embezzle.htm.
373
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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.
374
© D.L. Crumbley
Code of Ethics Required by
Sarbanes-Oxley
Section 406: Public issuer has to
adopt a code of ethics for senior
financial officers to deter
wrong –doing and to promote
1. Honest and ethical conduct.
2. Full, fair, accurate, timely and
understandable disclosure in
SEC filings.
3. Compliance with government
laws, rules, and regulations.
4. Prompt internal reporting code
violations;
5. Accountability for adherence to
the code.
375
More Hints …
© D.L. Crumbley
 Check employee references/resume.
 Stop giving the employee/client the
answer when you ask a question.
 Zero tolerance for allowing
employee/executive to get away
with anything.
 Always reconcile the bank
statements.
 Try to think like a criminal.
 Get inside the criminal’s mind. Be a
detective.
 Do not assume you have honest
employees.
 Bond employees.
Source: Gary Zeune
376
© D.L. Crumbley
Check References and Resume
Fraud 101: Fraudsters can change
their job and address, but they can
not change who they are.
377
© D.L. Crumbley
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.
378
© D.L. Crumbley
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.
379
© D.L. Crumbley
Tyco’s Payments to Executives
The accountant, Sheila Rex, testified that Tyco
had three accounts where Mr. Dennis Kozlowski’s
spending was recorded – his Key Employee Loan
account, intended to help pay taxes on restricted stock
after it was vested; a relocation account, where
mortgages and other house-related spending were
logged; and a third account, for short-term loans, to be
paid back within 30 days.
Ms. Rex told jurors the accounting department
had procedures for recording spending by Mr.
Kozlowski. Mr. Swartz and other senior executives. Mr.
Kozlowski’s relocation loans were listed under “Note
Receivable Employee A,” Ms. Rex said, Mr. Swartz was
“Note Receivable Employee C.”
The third account, where Sardinia expenses
were logged, was “Notes Receivables LDK,” Ms. Rex
said.
She also described the way forgiven loans were
accounted for on Tyco’s books, including $38.5 million
that was forgiven in 1999. Of that amount; Mr.
Kozlowski received $25 million; Mr. Swartz, $12.5
million; and an events planner, Barbara Jacques, $1
million.
Source: Bloomberg News, “Accountant at Tyco Tells of Payments to Executives,”
New York Times, November 11, 2003, C-3.
380
© D.L. Crumbley
$6,000 Shower Curtain
In Dennis Kozlowski’s $18
million apartment on Fifth Avenue in
Manhattan paid from Tyco
International funds.
• $6,000 shower curtain in maid’s
room.
• Art work by French Impressionists.
• $15,000 umbrella stand.
• $70,000 salary for maid, with two
$10,000 bonuses.
381
© D.L. Crumbley
To Find Compensation Data






www.monster.com
www.careerjournal.com
www.overseasjobs.com
www.careerbuilder.com
www.salary.com
www.jobsmart.com
382
© D.L. Crumbley
Internal and External Fraud
Internal Fraud
Employee
Stock theft
Misappropriation of
cash/assets
Lapping
Check forgery
Expense account
Petty cash
Kickbacks
Loans/investments
Management
Lapping
Expense accounts
False financial
statements
Misappropriation of
cash/assets
Unnecessary purchase
Check forgery
Kickbacks
Ghost vendors
Diversion of sales
External
Check Forgery
False insurance claims
Credit card fraud
False invoices
Product substitution
Bribes/secret
commission
Bid rigging/price fixing
False representation of
funds
Shoplifting
Source: KPMG, Fraud Awareness Survey, Dublin: KPMG, 1995, pp. 10-12.
383
© D.L. Crumbley
External Fraud-Shoplifting
It’s not just stars (e.g., Bess
Myerson, Hedy Lamarr, and may
be Winona Ryder). Why, each year,
ordinary people shoplift $13 billion
of lipstick, batteries, and bikinis
from stores.
800,000 times a day the thrills and
temptations win over fear – a
product of the late 19th century with
the larger stores.
Source: Jerry Adler, “The Thrill of Theft,”
Newsweek, February, 2002.
384
© D.L. Crumbley
Three M’s of Financial
Reporting Fraud
• Manipulation, falsification, or
alteration of accounting records or
supporting documents from which
financial statements are prepared
• Misrepresentation in or intentional
omission from the financial
statements of events, transactions, or
other significant information
• Intentional misapplication of
accounting principles relating to
amounts, classification, manner of
presentation, or disclosure
Source: Zab Rezaee, Financial Statement Fraud, 2002,
John Wiley.
385
© D.L. Crumbley
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.
386
© D.L. Crumbley
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.
D. Larry Crumbley
387
© D.L. Crumbley
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, NonAudit 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.
388
© D.L. Crumbley
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.
389
© D.L. Crumbley
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. 27-50
390
© D.L. Crumbley
Professor Ketz’s Shoddy Accounting
Practices
•Pro forma means “as if,” so pro forma
earnings means earnings that would have
been reported had the corporation been
using alternative methods (e.g., everything
but the bad stuff).
•“Today, however, pro forma numbers are
seldom published for the purpose of
informing investors and creditors in a better
manner. Instead, these disclosures have
become a way of underminding orthodox
accounting by not recognizing a variety of
items as expenses.”
•Examples: Goodwill never declines.
Moving expenses and losses from operating
items to so-called nonrecurring items.
•Contrast the income with the firm’s
operating cash flow.
Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003
391
© D.L. Crumbley
Hiding Debt
Companies hide debt by these techniques:
1.
Using the equity method (rather than
Trading Security and Available for Sale
methods). Nets the assets and liabilities of
the investee.
2. Lease accounting (arguing that leases are
operating leases). Understates 10 to 15% .
3. Pension accounting – netting of the
projected benefit obligation and the pension
assets. Must unnet them.
4. Hiding debt inside Special – Purpose
Entities – trillions of dollars of SPE debt is
off the books (e.g., securitization, SPE
borrowings, synthetic leases).
Readers can make analytical adjustments by
searching footnotes for 1,2, and 3. But no
disclosures for asset securitization, SPE
borrowings, and synthetic leases.
Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003
392
© D.L. Crumbley
Components of Internal
Controls
• Control environment
• Risk assessment
• Control activities or control
procedures
• Information and communication
systems support
• Monitoring
Source: COSA
393
© D.L. Crumbley
The COSO Model
1.
2.
3.
4.
5.
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.
394
Risk Assessment
Benefits
© D.L. Crumbley
A major step in a forensic audit is to
conduct a risk assessment, which entails a
comprehensive review and analysis of program
operations in order to determine where risks
exists and what those risks are.
Any operation developed during the risk
assessment process provides the foundation or
basis upon which management can determine
the nature and type of corrective actions
needed.
A risk assessment helps an auditor to
target high-risk areas where the greatest
vulnerabilities exist and develop
recommendations to strength internal controls
Source: B.l. Derby, “Data Mining for Improper Payments,”
Journal of Government Management, Winter 2003, Vol.52,
No. 4, pp. 10-13.
395
© D.L. Crumbley
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. 35-60
396
Corporate Fraud Task Force
© D.L. Crumbley
 Interagency Corporate Fraud Task Force was formed in
July 2002.
 To coordinate investigations into alleged misconduct at
major corporations (e.g., Adelphia Communication and
Quest Communications).
 To equip local staffs with the expertise and resources to
obtain indictments.
 In the past accounting fraud has been difficult to
prosecute, but lawyers now believe many common
accounting restatements can put corporate executives
at risk for jail time.
 According to John K. Markey, “With the new SarbanesOxley requirement to have strong internal controls and
officer certification of financial statements, the bar has
been lowered on the ‘knew or should have known’
standard,” says Markey. “The presumption will be that
the CFO must have known if something has gone
wrong.”
 The Department of Justice is now encouraging
prosecutors to “flip” lower level participants to get the
“big guys.” The FBI has an agency-staffed hotline that
should “generate four or five new corporate fraud
cases each month.”
Source: Alix Nyberg, “Fraud Squad,” CFO, April 2003, pp. 36-44
397
Corporate Fraud Task Force…
© D.L. Crumbley
The following 17 offices (with the then holders) make up the Task
Force, with the Deputy Attorney General as the chairperson:
Larry Thompson, Deputy Attorney General (leader)
Robert Mueller, Director of the Federal Bureau of Investigation
Michael Chertoff, Assistant Attorney General for the DOJ’s Criminal
Division
Eileen O’Connor, Assistant Attorney General for the DOJ’s Tax
Division
James Comey, U.S Attorney for the Southern District of New York
Roslynn Mauskopf, U.S. Attorney for the Eastern District of New
York
Patrick Fitzgerald, U.S. Attorney for the Northern District of Illinois
Michael Shelby, U.S. Attorney for the Southern District of Texas
Kevin Ryan, U.S. Attorney for the Northern District of California
Debra Yang, U.S. Attorney for the Central District of California
John Snow, Secretary of the Treasury
Elaine Chao, Secretary of Labor
William Donaldson, Chairman of the Securities and Exchange
Commission
James Newsome, Chairman of the Commodity Futures Trading
Commission
Patrick Wood III, Chairman of the Federal Energy Regulatory
Commission
Michael Powell, Chairman of the Federal Communications
Commission
Lee Heath, Chief Postal Inspector of the U.S. Postal Inspection
Service
398
Indictments
© D.L. Crumbley
Adaptec
•US v. Michael Allen Ofstedahl Indictment
Adelphia
•US v John J. Rigas, Timothy J. Rigas, Michael J. Rigas, James R. Brown,
Michael C. Mulcahey Sealed Complaint
•Indictment
Allfirst
•US v. John M. Rusnak Indictment, June 5, 2002
Alliance
•US v. Susan Denice Browne, Charles Edward Browne, Laurence Crowell
Leafer, David Lee Halsey, Braccus Lucien Giavanno, Jonathan Walter Lang
Indictment
Anicom
•US v. Carl Putnam, Donald Welchko, John Figurelli, Daryl Spinell, Ronald
Bandyk, and Renee Levault Indictment
AremisSoft
•US v. Lycourgos K. Kyprianou, Roys S. Poyiadjis, and M.C. Mathews
Indictment
•US v. Roys S. Poyiadjis Indictment
Biocontrol
•US v. Fred E. Cooper Information
Capital City Bank
•US v. Clinton Odell Weidner II, and David C. Wittig First Superseding
Indictment
Capital Consultants
•US v. Dean Kirkland, Gary Kirkland, Robert Legino Indictment, August 22,
2002
Cendant
•US v. Walter A. Forbes and E. Kirk Shelton Superseding Indictment
Commercial Financial
•US v. Jay Lowell Jones Information, September 13, 2002
•US v. William R. Bartmann Indictment, December 12, 2002
Countrymark
•US v. David Heath Swanson Superseding Indictment
Critical Path
•US v. Jonathan A. Beck Information
•US v. Kevin P. Clark Information
•US v. Timothy J. Ganley Indictment
•US v. David A. Thatcher Information
399
© D.L. Crumbley
Indictments
eConnect
•US v. Thomas S. Hughes First Superseding Indictment
•Complaint Affidavit
Enron
•US v. Jeffrey S. Richter Information
FLP Capital Group
•US v. Frank L. Peitz, Daniel B. Benson, Peter A. Loutos,
Sr., Robert D. Paladino, Randall W. Law, and Monica M.
Iles Indictment
FPA Medical Management
•US v. Steven Mark Lash Indictment
Health Maintenance
•US v. Clifford G. Baird Information, July 29, 2002
•US v. Donavon C. Claflin Information, July 29, 2002
•US v. Kevin L. Lawrence Indictment, July 31, 2002
•US v. Kevin McCarthy Information, July 19, 2002
•US v. James N. Wuensche Information, November 26,
2002
HealthSouth
•US v. Angela C. Ayers, Cathy C. Edwards, Rebecca Kay
Morgan, Virginia B. Valentine Information
•US v. Aaron Beam Information
•US v. Emery Harris Information
•US v. Kenneth K. Livesay Information
•US v. Michael Martin Information
•US v. Malcolm McVay Information
400
Just Say No
•
•
•
•
© D.L. Crumbley
James Comey (U.S. Attorney): “Just following
orders is not an excuse for breaking the law.”
Betty Vinson, accountant for WorldCom, was
asked by her bosses to make false accounting
entries; initially she refused but eventually
caved.
“Over the course of six quarters she continued
to make the illegal entries transferring
expenses to capital accounts to bolster
WorldCom’s profits at the request of her
superiors. At the end of 18 months, she had
helped falsify at least $3.7 billion in profits.”
She eventually confessed, hoping to be a
witness. A more aggressive prosecutor made
her a target. She and another accountant, Troy
Normand, pleaded guilty to two criminal
counts, carrying a maximum charge of 15
years in prison.
“When an employee’s livelihood is on the line,
it’s tough to say no to a powerful boss.”
Source: Susan Pulliam, “A Staffer Ordered to Commit Fraud Balked,
Then Caved,” Wall Street Journal, June 23, 2003, p. A-1.
401
© D.L. Crumbley
Fraud Multiplier
Employee Fraud = $ for $ reduction in net
income
Suppose $100,000 bottom line reduction.
Suppose 20% profit margin
How much new revenue needed to offset the
lost income?
$100,000 = $500,000
20%
So ACFE says $600 billion lost per year.
$600 billion = $3 trillion needed revenue
20%
402
© D.L. Crumbley
Fraud Identifiers to Spot Fraudsters
• Large ego
• Substance abuse problems or
gambling addiction
• Living beyond apparent means
• Self-absorption
• Hardworking/taking few
vacations
• Under financial pressure (e.g.,
heavy borrowings)
• Sudden mood changes.
Source: G.E. Moulton, “Profile of a Fraudster,” Deloitte
Touche Tohatsu, www.deloitte.com, 1994.
403
© D.L. Crumbley
Audit Procedures
Audit evidence is gathered in two
fieldwork stages:
1. internal control testing phase
2. account balance testing phase
404
© D.L. Crumbley
Definitions
• Materiality is the measure of whether
something is significant enough to
change an investor’s investment
decision.
• Control risk is risk that a material error
in the balance or transaction class will
not be prevented or detected.
• Inherent risk is risk that an account or
transactions contain material
misstatements before the effects of the
controls.
• Detection risk is risk that audit
procedures will not turn up material
error when it exists.
405
© D.L. Crumbley
External Auditors and
Fraud Detection
Although auditors have previously had the
responsibility to detect material
misstatement caused by fraud, SAS No. 82
details more precisely what is required to
fulfill those responsibilities.
Now, auditors must specifically assess and
respond to the risk of material
misstatement due to fraud and must assess
that risk from the perspective of the broad
categories in the SAS.
External auditors have to satisfy new
documentation and communication
requirements. Superseded by SAS No. 99.
406
© D.L. Crumbley
Statement of Financial Accounting
Concepts No. 2
Provides nine qualities and characteristics
that make financial information useful for
investors, creditors, analysts, and other
users of financial information
• Relevance.
• Timeliness.
• Reliability.
• Verifiability.
• Representational faithfulness.
• Neutrality.
• Comparability and Consistency.
• Materiality.
• Feasibility or Costs or Benefits.
•Transparency.
407
© D.L. Crumbley
Types of Financial Statement Fraud
Schemes
Three professors have broken financial
statement fraud schemes into these ten
types:
1. Fictitious and/or overstated revenues
and assets (e.g., nonordered or cancelled
goods). Sunbeam created revenues by
contingent sales, a bill-and-hold strategy,
and accelerated sales. Digital Lightware,
Inc. recognized fraudulent billings.
2. Premature Revenue Recognition (e.g.,
holding books open).
3. Misclassified Revenues and Assets (e.g.,
combining restricted cash accounts with
unrestricted cash accounts). School
districts and universities may engage in
this strategy with dedicated funds.
Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud
Types and Auditor Litigation,” The Accounting Review, October
408
1998, pp. 503-532.
© D.L. Crumbley
Types of Financial Statement Fraud
Schemes (contd …)
4. Fictitious Assets and/or Reductions of
Expenses/Liabilities (e.g., recording
consigned inventory as inventory).
Cendant Corporation created fictitious
revenues, and Knowledge Ware inflated
revenues with phony software sales.
5. Overvalued Assets or Undervalued
Expenses/Liabilities (e.g., insufficient
allowance for bad debts).
6. Omitted or Undervalued Liabilities
(e.g., understated pension expenses).
7. Omitted or Improper Disclosures (e.g.,
stock option expense estimates).
409
© D.L. Crumbley
Types of Financial Statement Fraud
Schemes (contd …)
8. Equity fraud (e.g., recording
nonrecurring and unusual income
or expense in equity).
9. Related-Party Transactions (e.g.,
fictitious sales to related parties).
Enron had many related-party
transactions.
10. Financial Fraud Going the Wrong
Way (e.g., for tax purposes
reducing income or increasing
expenses).
410
© D.L. Crumbley
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.
411
© D.L. Crumbley
Tax Issues
• The company used a so-called
linked swaps to shift at least $420
million into the future.
• Internal report said the linked swaps
had minimal business justifications
other than the shifting of operating
earnings.
• Company’s recent disclosure:
potential additional tax liability as
much as $750 million, plus interest.
Source: Dawn Kopecki and J.D. Mckinnon, “IRS Probes Tax
Issues at Freddie Mac,” Wall Street Journal, October 22,
2003, p.A-6.
412
© D.L. Crumbley
AICPA Indicia of Fraud
• Lack of written corporate policies and
standard operating procedures
• Lack of interest in or compliance with
internal control policies, especially
division of duties
• Disorganized operations in such areas as
bookkeeping, purchasing, receiving, and
warehousing
• Unrecorded transactions or missing
records
• Bank accounts not reconciled on a timely
basis
• Continuous out of balance subsidiary
ledgers
• Continuous unexplained differences
between physical inventory counts and
perpetual inventory records
413
© D.L. Crumbley
AICPA Indicia of Fraud (contd …)
• Bank checks written to cash in large
amounts
• Handwritten checks in a computer
environment
• Continual or unusual fund transfers
among company bank accounts
• Fund transfers to offshore banks (Enron
had more than 880 offshore accounts)
• Transactions not consistent with the
entity’s business
• Deficient screening procedures for new
employees
• Reluctance by management to report
criminal wrongdoing
• Unusual transfers of personal assets
• Employees living beyond their means
414
© D.L. Crumbley
AICPA Indicia of Fraud (contd …)
• Vacations not taken
• Frequent or unusual related-party
transactions (e.g., the Enron special
purpose entities)
• Employees in close association with
suppliers
• Expense account abuse
• Business assets dissipating without
explanation
• Inadequate explanations to investors
about losses
• A few other indicia of fraud are:
• Heavy selling of stock by insiders (e.g.,
Enron)
• Sudden resigning of an officer (e.g.,
Jeffrey Shilling at Enron)
415
AICPA Indicia of Fraud (contd …)
© D.L. Crumbley
• Unconsolidated special purpose entities
(Enron had more than 3,500 subsidiary
companies, some hiding billion-dollars of
debts and others used as tax shelters).
• Greater than 5% of “other revenue”
• Large loans to executives (Baptist
Foundation of Arizona loaned companies
controlled by one director and two former
directors almost $140 million which they
invested in real estate)
• Negative cash flow from operations
• Recurring nonrecurring charges
• Off-balance sheet financing
• Related Parties – SFAS 57 says a related
party is any party that controls or can
significantly influence the management or
operating policies of the company to the
extent that the company may be prevented
from fully pursuing its own interests.
Source: http://aicpa.org/members/div/mcs/fraudin.htm.
416
© D.L. Crumbley
Seven Investigative Techniques
1. Public document review and
background investigation (nonfinancial documents).
2. Interviews of knowledgeable
persons.
3. Confidential sources.
4. Laboratory analysis of physical and
electronic evidence.
5. Physical and electronic
surveillance.
6. Undercover operations.
7. Analysis of financial transactions.
Source: R.A. Nossen, The Detection, Investigation and
Prosecution of Financial Crimes, Thoth Books, 1993.
417
© D.L. Crumbley
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
418
© D.L. Crumbley
Investigative Activities
 A forensic accountant must be careful not to
misrepresent either the identity or the purpose of the
contact with a questionable party.
 Surveillance is not an activity which accountants
normally perform (e.g., may need a private
investigator’s license).
 Typical state statute requires a PI license for: “the
investigation by a person or persons for the purpose of
obtaining information with reference to any of the
following: the causes and origin of, or responsibility
for, … damage or injuries to real or personal property;
the business of securing evidence to be used before
investigating committees or boards of award or
arbitration or in the trial of civil or criminal cases and
the preparation therefore….”
 In Florida, Legal Opinion 97-9 provides that any
person who holds a professional license under the
laws of this state, and when such person is providing
services or expert advice in the profession or
occupation in which that person is so licensed, is
exempt from private investigator licensing
requirements. Thus, a licensed accountant (e.g., CPA)
would be permitted to perform forensic accounting
without a private investigator’s license.
419
© D.L. Crumbley
Investigative Techniques
Public Document Review
• Real and personal property records.
• Corporate and partnership records.
• Civil and criminal records.
• Stock trading activities.
Laboratory Analysis
• Analyzing fingerprints.
• Forged signatures.
• Fictitious or altered documents.
• Mirror imaging or copying hard
drives/company servers.
• Use clear cellophane bags for paper
documents.
420
© D.L. Crumbley
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.
421
© D.L. Crumbley
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.
422
© D.L. Crumbley
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
Dollar
Amount
Horizontal
Comparison
$180,000
180%
Year 3
Year 2
Year 1
$140,000 $120,000 $100,000
140%
120%
100%
423
© D.L. Crumbley
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).
424
© D.L. Crumbley
Five Statistically Significant Ratios
• Use the ratios for two successive fiscal
years.
• Convert into indexes for benchmarking.
• All indexes should be close to one.
Day’s Sales in Receivable Index:
(Accounts Receivable t / Sales t )
(Accounts Receivable t-1 / Sales t-1)
Index for manipulators: 1.5 to 1
-------------------------------------------------------Gross Margin Index:
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
Index for manipulators = 1.2 to 1
-------------------------------------------------------Source: M.D. Beneish, “The Detection of Earnings
Manipulation,” Financial Analysts Journal,
September/October, 1999. t-1 = prior year.
425
© D.L. Crumbley
Five Statistically Significant Ratios
Asset Quality Index =
1-
(Current Assets t + Net Fixed Assets t )
Total Assets t
1-
(Current Assets t-1 + Net Fixed Assets t-1)
Total Assets t-1
Index for manipulators = 1.25 to 1
----------------------------------------------------------------Sales Growth Index : Sales t / Sales t-1
Manipulators: 60%
Non manipulators 10%
Source: M.D. Beneish, “The Detection of Earnings
Manipulation,” Financial Analysts Journal,
September/October, 1999. t-1 = prior year.
426
© D.L. Crumbley
Five Statistically Significant Ratios
Total Accruals to Total Assets =
Δ Working Capital t - Δ Cash t - Δ Current Taxes
Payable t - Δ Current Portion of LTD t - Δ
Accumulated depreciation and amortization t
Total Assets t
TATA for manipulators: .031
TATA for non manipulators: .018
Source: M.D. Beneish, “The Detection of Earnings
Manipulation,” Financial Analysts Journal,
September/October, 1999. LTD = Long-term debt.
427
© D.L. Crumbley
A Charles Lundelius Example
Comparison to peer group benchmarks:
Characteristic
DSRI
GMI
AQI
SGI
TATA
MPS
1.56
2.00
1.23
1.50
0.10
Peer group
1.03
1.10
1.04
1.20
0.05
% over peers
51%
82%
18%
25%
100%
Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p.
129.
428
© D.L. Crumbley
Ratio Analysis
1. Current ratio =
Current assets (cash and equivalents, receivables and inventories)
Current liabilities (payables, accruals, taxes, and debt due in 1 year)
2. Quick ratio =
Cash and equivalents plus receivables
Current liabilities
3. Working capital = Current assets – Current liabilities
Cost of goods sold
4. Inventory turnover = Average inventory
The number of days inventory is on hand can be calculated as
365
Inventory turnover
Net credit sales
5. Receivables turnover = Average receivables
6. Gross Margin = 1 –
Cost of goods sold
Sales
429
© D.L. Crumbley
7. Expense ratio =
Selling general and administrative expenses
Sales
8. Operating margin =
9. Profit margin =
Operating income
Sales
Net income before extraordinary items
Sales
10. Interest coverage ratio =
11. Margin of safety =
Income before interest and taxes
Fixed charges
Income after fixed charges before income taxes
Sales
430
© D.L. Crumbley
12.Debt-to-equity ratio =
Total current and long-term + capitalized leases
Total stockholder’s equity
Or
Total debt at book value
Total debt and preferred stock + common stock at market
Net income
13.Return on assets (ROA) = Average total assets
Or
Earnings before interest and taxes
Average total assets
Net income
14.Return on equity (ROE) = Average common equity
15. Return on invested capital =
Earnings before interest and taxes
Average invested capital
16.Number of years to pay off debt by application of internally generated cash flows
Total fixed obligations
= Operating cash flows
17. Ratio of senior debt to capital =
Total senior debt
Subordinated debt + net worth
431
Problems
© D.L. Crumbley
The following information is taken from the
accounting records of Donald Company:
Average receivables
Cost of goods sold
Sales
Average inventory
Net credit sales
Operating income
$700,000
2,900,000
8,000,000
1,100,000
1,200,000
900,000
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
• None of the above.
432
© D.L. Crumbley
Problems
Solution:
Inventory Turnover =
C of GS
Average Inventory
= $2.9 million = 2.64%
1.1 million
Operating Margin = Operating Income
Sales
= $900,000 = .1125
$8 million
433
© D.L. Crumbley
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.
434
© D.L. Crumbley
Interviewing Executives
One way to detect fraud is to interview company personnel. The AICPA
Fraud Task Force provides an interviewing template of 13 questions
for CEOs, CFOs, and Controllers.
1. Explain the purpose of interview- need to assess risk and comply with
audit responsibilities
2. Inquire whether they are aware of any instances of fraud within their
organization- Do they have reason to believe that fraud may have occurred
or is occurring?
3. Has the CEO or CFO ever approved an accounting treatment for
transactions that were not appropriate?
4. Have there been any instances where someone has attempted to inflate
assets or revenue or deliberately understate liabilities and expenses?
5. Is there any member of management that has a direct interest or indirect
interest in any customer, vendor, competitor, supplier or lender?
6. Is any member of management related to any other member of
management?
7. Does anyone in the company have any personal, financial or other
problems that might affect their job performance?
8. If there was an area within the company that might be vulnerable to fraud,
what would that be?
9. Has anyone within the accounting department been let go or resigned
within the past year?
10.Is there anyone in management that appears to be living a lifestyle beyond
their means? – expensive cars, trips, jewelry, vices
11.Has anyone been involved in civil or criminal proceedings or filed
bankruptcy
12.Does the company have a strong ethics policy?
13.Has anyone ever been fired for committing fraud against the company?
Source: Ronald L. Durkin et. al, “Incorporating Forensic Procedures in an
Audit Environment,” Litigation and Dispute Resolution Services
Subcommittee, New York: AICPA, 2003.
435
© D.L. Crumbley
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.
436
© D.L. Crumbley
Advantage and Disadvantages
Advantages of an interview (nonaccusatory)
• 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.
437
© D.L. Crumbley
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.
438
© D.L. Crumbley
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,”
http://members.tripod.com/nwacc_communication/id25.htm.
439
© D.L. Crumbley
Posture Language
Truthful
• Frontally aligned.
• Upright or forward.
• Open (perhaps crossed legs).
• Dynamic, comfortable changes.
Deceptive
• Non-frontally aligned.
• Slouched, retracted or leaning.
• Barriers (crossed arms, purse in lap).
• Frozen and rigid.
Source: John E. Reid Associates, Inc.
440
© D.L. Crumbley
Some Lying Signs
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Covering mouth with hand.
Rubbing nose.
Frequent blinking.
Biting lip.
Moving or tapping foot.
Crossing arms.
Leaning forward.
Handling objects (e.g., pencil, pen).
Avoiding eye contact or averting eyes.
Clearing the throat.
Closing and opening coat.
Picking at lint on clothing.
Playing with collar.
Moving away.
Shrug gestures.
Slow response.
Higher pitch.
Long answer.
Gap between words becomes longer.
Non-words such as uh.
Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”
http://members.tripod.com/nwacc_communication/id25.htm.
441
© D.L. Crumbley
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. 9293).
-------------------------------------------------Source: Michael Connelly, The Black Ice, St. Martin’s Paperback,
1993.
442
Some Financial Outlaws © D.L. Crumbley
Andrew S. Fastow (Enron)
Dennis Kozlowski (Tyco)
Crazy Eddie Antar (Electronics)
Robert E. Brennan (New Era Philanthropy)
Barry Minkow (ZZZZ Best)
Robert Vesco (Investors Overseas)
Charles K. Ponzi
John Bennett
Michael Milken (junk bonds)
Scott Sullivan (WorldCom)
John D. Apfelbaum (stamps)
John Rigas (Adelphia)
Frank W. Abagnale (great imposter)
Richard Scrushy (HealthSouth)
Narcissistic personality disorder: a
pervasive pattern of grandiosity (in fantasy
or behavior), need for admiration, and lack
of empathy.
443
© D.L. Crumbley
HealthSouth’s Richard Scrushy
• The beauty of acquisition accounting – perfectly
legal - - was the room it allowed for all sorts of
gimmicks and restatements, masking true
operating performance.
• Enter Richard Scrushy (HealthSouth). Allegedly
King Richard and 11 other co-conspirators were
called the “family.” From 1997 through mid-2002,
the SEC says HealthSouth overstated its earnings
by $2.5 billion - - 2,500% higher than true
earnings.
• Scrushy allegedly met monthly with company
financial executives, and he would say, “If we are
not making the numbers, go figure it out.”
• Lower-level bean counters then inflated assets and
used other creative accounting to plug the
difference. They overstated profits by at least $1.4
billion by billing Medicare for physical-therapy
services the company never performed. They
submitted falsified documents to Medicare to
verify the claims.
Source: John Helyar, “The Insatiable King Richard,” Fortune,
July 7, 2003, p. 84.
444
© D.L. Crumbley
Non-Audit Fees
• E&Y classified $1.3 million as an auditrelated fee for HealthSouth in 2001, which
was called pristine audit janitorial
inspections.
• These “audits” included checking toilets,
parking lots, and other parts of HealthSouth
facilities for cleanliness (50-point
questionnaire).
• Fortune said E&Y missed billions in
financial fraud, but they were great at
finding dust bunnies in their white-glove
tests.
Source: John Helyar, “The Insatiable King Richard,” Fortune,
July 7, 2003, p. 82.
445
© D.L. Crumbley
Look For Fraud Symptoms
•Source Documents.
•Journal Entries.
•Accounting Ledgers.
446
© D.L. Crumbley
Source Documents
•
•
•
•
•
•
•
•
Checks.
Employee time cards.
Sales invoices.
Shipping documents.
Expense invoices.
Purchase documents.
Credit card receipts.
Register tapes.
447
© D.L. Crumbley
Source Documents Fraud Symptoms
•Photocopies of missing documents.
•Counterfeit/false documents.
•Excessive voids/credits.
•Second endorsements.
•Duplicate payments.
•Large numbers of reconciling items.
•Older items on bank reconciliations.
•Ghost employees.
•Lost register tapes.
Source: John Helyar, “The Insatiable King
Richard,” Fortune, July 7, 2003, p. 82.
448
© D.L. Crumbley
Journal Entries Fraud Symptoms
•Out-of-balance.
•Lacking supporting documents.
•Unexplained adjustments.
•Unusual/numerous entries at end of
period.
•Written entries in computer
environment.
449
© D.L. Crumbley
Ledger Fraud Symptoms
•Underlying assets disagree.
•Subsidiary ledger different than
general ledger.
450
© D.L. Crumbley
AICPA Top Technologies
Task Force
The task force found the following top ten technologies
for 2002 in descending order of importance:
1. Business and financial reporting applications
2. Training and technology competency
3. Information security and controls
4. Quality of service
5. Disaster recovery (includes business continuation
and contingency planning)
6. Communication technologies bandwidth
7. Remote connectivity tools
8. Web-based and web-enabled applications
(Internet)
9. Qualified IT personnel
10.Messaging applications (e-mail, faxing,
voicemail, instant messaging)
451
© D.L. Crumbley
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
452
© D.L. Crumbley
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
453
© D.L. Crumbley
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.
454
© D.L. Crumbley
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.”
455
Preventive Measures
© D.L. Crumbley
• 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.
456
© D.L. Crumbley
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].
457
© D.L. Crumbley
Some Employee Schemes (contd …)
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.
458
© D.L. Crumbley
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.
459
© D.L. Crumbley
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.
460
© D.L. Crumbley
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.
461
© D.L. Crumbley
Accounts Receivables Schemes
• Lapping.
• Fictitious receivables [for a
fictitious sale], which is later
written off.
• Borrowing against receivables
(use receivable as collateral).
• Improper posting of credits
against receivables.
462
© D.L. Crumbley
Lapping
Lapping
• Recording of payment on a customer’s
account some time after receipt of
payment. Later covered with receipt from
another customer (robbing Peter to pay
Paul).
• Lapping is more successful where one
employee has both custody of cash and
record keeping responsibility.
Audit Steps
• Independently verifying customers who
do not pay.
• Reviewing write-offs.
• Reviewing customers’ complaints.
463
© D.L. Crumbley
Lapping (cont.)
• Compare the checks on a sample
of deposit slips to the details of the
customers’ credits that are listed
on the day’s posting to the
customer’s account receivables.
464
© D.L. Crumbley
Inventory
Inventory Fraud
• Stealing inventory/supplies for personal use or
for sale at flea markets/garage sales.
• Kickback schemes (vendor/supplier and an
employee). Sale of unreported inventory or at
inflated prices.
• Use renumbered inventory tags matched to
count sheets; use count procedures for work-inprogress items; separate duties between
purchasing and logging receipts of shipments
Audit Steps for Inventory Fraud
• Check for same vendors.
• Prices higher than other vendors.
• Purchasing agent does not take vacation.
• Only photocopies of invoices are available.
• Age of inventory.
• Inventory turnover
• There is data-mining software.
465
© D.L. Crumbley
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.
466
© D.L. Crumbley
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.
467
© D.L. Crumbley
Some Employee Schemes (contd …)
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.
468
© D.L. Crumbley
Some Employee Schemes (contd …)
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.
469
© D.L. Crumbley
Some Employee Schemes (contd …)
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.
470
© D.L. Crumbley
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.
471
© D.L. Crumbley
Hammersmith Trust Ponzi Scheme
• Hundreds of sophisticated investors put
$100 million in this prime banking scheme
that promised as much as 1,600% annual
return.
• The scheme revolved around the so-called
international prime banking instruments
(e.g., high-yield commercial paper or
secret bank debenture programs). There is
no market for prime bank instruments.
• “Not a single dime is invested in anything
– save the fraudulent pyramid itself, with
some money going from one investor to
the other in the form of purported
“interest” and “return of principal
“payments – while most of it sticks to the
pyramid or rather, to the people running
the
pyramid.”
Source: John Anderson, “Take The Money & Run,” Smart Money,
December 2003, pp. 122-130.
472
© D.L. Crumbley
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.
473
© D.L. Crumbley
Bid Rigging Red Flags
• Low turnout of auction attendees.
• Winking, hand signals or other similar signs
among dealers after the bidding is opened.
• A uniformity to the bidding. For example,
Dealer One bids on a particular lot and buys it
with little or no activity, and then Dealer Two
buys another lot, again with little or no
competition.
• Difficulty getting things going.
• A lot of handshaking and other signs of
recognition among several dealers before or
after the auction takes place.
• An air of silence throughout the auction since
auctions are generally noisy – or conversely, a
lot of conversation among bidders during the
sale of lots they normally should be bidding on.
• Low competition among known dealers who
normally bid strongly against one another.
Source: www.harryrinker.com/bidrigging: The Official Government
Auction Guide.
474
© D.L. Crumbley
Forensic Auditing Steps
•
•
•
•
Count the Petty Cash Twice in a Day
Investigate Suppliers (Vendors)
Investigate Customers
Examine Endorsements on Canceled
Checks
• Add Up the Accounts Receivable
Subsidiary
• Audit General Journal Entries
• Match Payroll to Life and Medical
Insurance Deductions
Source: Jack C. Robertson, Fraud Examination for Managers
and Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216.
475
© D.L. Crumbley
Forensic Auditing Steps (contd …)
• Match Payroll to Social Security
Numbers
• Match Payroll with Addresses
• Retrieve Customer’s Checks
• Use Marked Coins and Currency
• Measure Deposit Lag Time
• Document Examination
• Inquiry, Ask Questions
• Covert Surveillance
Source: Jack C. Robertson, Fraud Examination for Managers
and Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216.
476
Anti-fraud Checklist
© D.L. Crumbley
Business policy
• Is there a published ethics policy with
definitions of fraud?
• Is fraud included in the company’s
overall business risk assessment?
• Is there a plan in place to respond to
risk and to limit damage to the
business?
Staff
• Does the company check job
applicants’ references and get
certificates for qualifications for
appointments at all levels?
• Are staff trained to notice signs of all
types of fraud?
• Are whistle blowers encouraged to
come forward?
Source: Adapted from Moody, M., “Fraud – enemies within”
in Director (April 2000), p. 16.
477
Anti-fraud Checklist (contd …)
© D.L. Crumbley
Commercial activities
• Does the company follow strict creditmanagement practice and enforce
credit limits?
• Does the company follow good
practices on credit cards and
counterfeit money?
• Are goods received and their prices
checked against delivery notes and
invoices?
• Is ownership checked on productrefund requests?
Security
• Have physical security arrangements
been reviewed recently?
• Are visitors identified (e.g., name tags)
and accompanied?
Source: Adapted from Moody, M., “Fraud – enemies within”
in Director (April 2000), p. 16.
478
© D.L. Crumbley
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.
479
© D.L. Crumbley
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.
480
© D.L. Crumbley
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.
481
© D.L. Crumbley
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.
482
© D.L. Crumbley
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.
483
© D.L. Crumbley
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
484
© D.L. Crumbley
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.
485
© D.L. Crumbley
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.
486
© D.L. Crumbley
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-toyear 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
487
© D.L. Crumbley
Market Segment
Specialization Program
The Market Segment Specialization
Program focuses on developing highly
trained examiners for a particular market
segment. An integral part of the approach
used is the development and publication of
Audit Technique Guides.
These Guides contain examination
techniques, common and unique industry
issues, business practices, industry
terminology, and other information to assist
examiners in performing examinations. A
forensic accountant can use this resource
to learn about a particular industry.
http://www.irs.gov/business/small/article/0,
,id=108149,00.html
488
© D.L. Crumbley
Minimum Income
Probes
• For nonbusiness returns, an agent
question the taxpayer or
representative about possible sources
of income other than reported on the
return. If there is no other
information in the file indicating
potential unreported income, the
minimum income probe is met.
• For taxpayers who are self-employed
and file a Schedule C or F, an
analysis is made of tax return
information to determine if reported
income is sufficient to support the
taxpayer’s financial activities.
489
© D.L. Crumbley
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.
490
© D.L. Crumbley
Preliminary Cash-T
Gross Receipts:
Schedule C
Business Expenses:
$120,000 Schedule C
Personal Living
Expenses
Preliminary
Understatement
$95,000
$60,000
$155,000
$35,000
491
Preliminary Cash-T (contd …)
© D.L. Crumbley
The cash hoard defense is
illustrated in the Edwin Edwards’
gambling corruption trial in 2000. An IRS
agent testified that Edwards spent
hundreds of thousands of dollars more in
cash than he reported in earnings.
On Monday, jurors got another
avalanche of numbers as prosecutors tried
to prove their charge that Edwards hid
money he extorted from riverboat casino
owners.
A financial analyst testified for the
prosecution about how the former
governor spent his cash, testimony the
defense challenged every step of the way.
Don Semesky, a special agent for
the Internal Revenue Service, used a chart
to show that Edwards spent $872,000
more in cash than he reported receiving
from 1986 to 1997.
Source: C. Baughman, “Prosecution Concludes Case In
Edwards’ Trial,” The Advocate Online, April 4, 2000.
492
Preliminary Cash-T (contd …)
© D.L. Crumbley
Semesky said Edwards started
1986 with $82,000 in cash. He based that
figure on Edwards’ own testimony in an
unrelated trial in 1985.
In the current trial, Edwards
testified he always had between $250,000
and $500,000 in cash during the mid1980s. Using $250,000 as a starting
point, Semesky said, Edwards still spent
$704,000 more in that period than he
reported receiving.
“I believe the evidence in this case
is that Mr. Edwards received cash from
other, unreported sources,” Semesky told
prosecutor Mike Magner.
In either calculation, Edwards
started spending more cash in 1996,
Semesky said. He agreed with Magner’s
allegation that the increase in spending
coincided with Edwards getting extortion
payments from Robert Guidry.
493
© D.L. Crumbley
Preliminary Cash-T (contd …)
Guidry, the former owner of the
Treasure Chest casino in Kenner, testified
he paid Edwards and his son along with
Edwards’ former, aide Andrew Martin,
$100,000 a month from early 1996 until
August 1997.
Like he did with Laura East, Small
wasted little time attacking Semesky’s
numbers, which were displayed for the
jury on a chart.
Semesky’s total for cash spent by
Edwards included $383,500 the FBI
seized from his safe-deposit box on April
29, 1997.
Edwards testified that cash was left
over from $400,000 Eddie DeBartolo Jr.
had given him in a legitimate business
deal on March 12, 1997. He said it was
primarily to prepare for a gambling
election in Bossier City, where DeBartolo
was applying to put in a casino boat.
494
© D.L. Crumbley
Preliminary Cash-T (contd …)
DeBartolo, who has pleaded guilty
in the case, testified for the prosecution
that Edwards extorted the $400,000 from
him.
But while Semesky showed the
$383,500 as cash spent, he did not show
the $400,000 from DeBartolo as cash
received, Small said.
“Isn’t it a fact that you screwed up
and you missed the $400,000?” Small
asked Semesky.
“Mr. Small, you’re not
understanding the concept of this chart,”
Semesky said. “The government’s
contention in this case is that it (the
$400,000) came from extorted
payments.”
The purpose of the chart was to
show legal sources of cash, Semesky
said. That included $1,586,800 in net
495
© D.L. Crumbley
Preliminary Cash-T (contd …)
But Small said the cash
shortfall that Semesky found - about $872,000 - - could be made up
by starting with $500,000 in cash in
1986, as Edwards testified he might
have had.
Add the $400,000 from
DeBartolo and the shortfall
disappears, Small said.
Later in 1997, DeBartolo
reported to the IRS he had given
Edwards the money, Small said.
But Semesky maintained that
the $400,000 could not be counted
as a legitimate source of cash.
“It doesn’t belong on that
schedule,” he said.
496
© D.L. Crumbley
497
© D.L. Crumbley
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.
498
© D.L. Crumbley
Source/Application of Funds
Application of funds:
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
2002
2003
$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
$3,600
49,500
7,000
3,000
0
$63,100
$12,200
$1,700
53,000
13,000
3,000
7,000
$77,700
$46,000
Known sources of funds:
Cash on hand
Salary
Consulting
Dividends and interest
Loan proceeds
Balance
Net unreported funds
499
© D.L. Crumbley
Net Worth Method
The net worth method is a common indirect
balance sheet approach to estimating income.
To use the net worth method, an IRS agent or
forensic accountant must:
1. Calculate the person’s net worth (the
known assets less known liabilities) at
the beginning and ending of a period
2. Add nondeductible living expenses to
the increase in net worth
3. Account for any difference between
reported income and the increase in net
worth during the year as (a) nontaxable
income and (b) unidentified differences
Hollard v. U.S., 348 U.S. 121 (1954).
500
Net Worth Example
© D.L. Crumbley
Total assets (at cost)
$1,200,000
Less: Total liabilities
(550,000)
Net worth, end of the year
650,000
Net worth at beginning of year
530,000
Increase or decrease in net worth
120,000
Add: living expenditures
145,000
Estimated Income
265,000
Less: Known sources of income
(130,000)
Unexplained income
$135,000
501
© D.L. Crumbley
Net Worth Application
2003
Calculated Net Worth1
Computed Net Worth2
Net Asset increase
Unexplained net worth
increase
Income
Expenses
Net asset increase
2004
2005
$225,000 $421,000
225,000 310,000
0 $111,000
11,000
21,000
$610,000
420,000
$190,000
23,000
$90,000
$167,000
$81,000
60,000
$21,000
$87,000
64,000
$23,000
$62,000
51,000
$11,000
1 Actual Net Worth recalculated based upon actual assets less
liabilities.
2 Net Worth based upon reported income less expenses.
502
© D.L. Crumbley
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).
503
© D.L. Crumbley
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
504
© D.L. Crumbley
Formula for Expenditure Method
Expenditures
less: Known sources of income
=
Unknown sources of income
$210,000
115,000
$95,000
505
Percentage of Markup Method © D.L. Crumbley
Gross Profit on Sales Formula
Sales per books
$100,000
25%
Gross profit percentage
$25,000
Gross profit as recomputed
Sales on Cost of Sales Formula Cost of SalesPercentage of Sales Price
Cost of Product A
$10,000
$20,000
Cost of Product B
Cost of Sales – Percent of Selling Price
Product A
25%
Product B
50%
Recompiled Sales of products A and B
Product A
$40,000
(10,000/.25)
Product B
$40,000
(20,000/.5)
Sales as recomputed
$80,000
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
506
© D.L. Crumbley
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:
$900
1,100
$990,000
720,000
$270,000
Suppose:
Beginning inventory
Ending inventory
$220,000
$250,000
507
Some Exercises
© D.L. Crumbley
30) Given the following facts about Sammie Bright,
calculate his preliminary understatement using the
Cash-T method.
Schedule C expenses
$102,000
Personal living expenses
59,000
Schedule C receipts
112,000
31) Based upon the following facts about Phil Tizzard, in
Sour Lakes, Texas, calculate any unexplained net worth
increase (if any):
Computed Net worth (reported income
less expenses)
$520,000
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%
508
Some Exercises
© D.L. Crumbley
509
© D.L. Crumbley
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. 196-198.
510
© D.L. Crumbley
Witness and Attorneys Have Testy Session
On cross examination, Edwards’
defense attorney, Dan Small, attacked Ms.
East’s testimony. Below is the exchange
between Laura East and Dan Small, taken
from a reporter’s version:
Laura East was on the stand eight hours
Wednesday. Dan Small used much of that
time to attack the numbers she came up
with for prosecutors.
East had testified Edwards had about
$98,000 in cash at the beginning of 1994
that was not deposited in banks.
She used a financial statement from
January 1994 that said Edwards had
$200,000 in cash. East said she subtracted
about $102,000 Edwards had in a bank to
come up with the $98,000 cash on hand.
Source: B. Barrouquere, “Appeal Questions Edwards Case
Money Trail,” The Advocate Online, April 10, 2002.
511
© D.L. Crumbley
Witness and Attorneys Have Testy Session
But East agreed with Small that cash
on hand in financial statements can “be all
screwed up.”
Using the $98,000 as a starting point, East
concluded that Edwards had a total of
$855,652 in undeposited cash from 1994 to
1996.
She said he spent $1,597,853. East
concluded that Edwards had another,
unreported source of income totaling
$742,301.
But Small suggested that East had
underestimated Edwards’ cash on hand by
starting at $98,000.
Small focused attention on financial
disclosure forms public officials must file
with the state. Officials report their
holdings in ranges.
512
© D.L. Crumbley
Witness and Attorneys Have Testy Session
Except for 1993, Edwards had consistently
reported having $200,000 or more in cash,
Small said. In 1993, Edwards checked the
$150,000-$199,999 range for cash.
And Small used tax returns to show
Edwards won $1,104,000 gambling
between 1987 and 1993.
Although some of the winnings came in
the form of checks, East agreed most
probably was cash.
But East said she only looked at Edwards’
finances between 1994 and 1996.
“I didn’t review his tax returns from
1987,” said East, a former FBI financial
analyst. “It was beyond the scope of my
assignment.”
Small also attacked other calculations East
made, pointing out the vast differences
between some numbers in her draft report
on the ranch and those in her final version.513
© D.L. Crumbley
Witness and Attorneys Have Testy Session
A draft report East prepared in December
showed Edwards had spent $231,000 in
cash on improvements on his Double E
ranch in Mississippi.
East based some of her report on a
handwritten list FBI agents seized from
Edwards during a 1997 raid.
But Small contended the list did not denote
cash spent. It was a tally of improvements
Edwards made in anticipation of selling the
ranch, such as siding and roofing, he said.
East said that in her final report, she
revised the cash expenditures for the ranch
down to $70,560, using what she could
confirm as cash spent from 1994 to 1996.
And she defended her calculations of what
Edwards spent building a home in the
Country Club of Louisiana.
514
© D.L. Crumbley
Witness and Attorneys Have Testy Session
East calculated the home cost about $1.3
million. Of that, Edwards had spent $733,567
in cash, she said.
Small said East had overestimated by almost
$200,000 how much Edwards actually spent in
cash.
For example, Small said, East figured Edwards
spent about $76,000 in cash buying lumber
and supplies from his mother-in-law, Pat
Picou, who owns Picou Builders’ Supply.
Picou testified Edwards had given her about
$47,000 in cash.
East said she found a lot of Edwards’
transactions to be “suspicious,” and had made
some assumptions based on those suspicions.
“So the jury needs to believe your
assumptions, and not the testimony in front of
it?” Small asked.
Source: C. Baughman and A. Angelette, “Witness and
Attorneys Have Testy Session,” The Advocate Online, March
2, 2000, pp. 3 and 4.
515
© D.L. Crumbley
Tax Fraud
•
•
•
•
•
•
•
Tax fraud is somewhat different than
legal fraud. The Supreme Court in
Spies v. U.S. provides some badges of
tax fraud:
Abnormal cash dealings.
False entries in records or creation of
false documents such as invoices.
Duplicate set of books.
Concealing assets or sources of
income.
Fictitious transactions.
Expenses not deducted to divert
attention from unreported income.
Destruction of books or records.
Source: 317 U.S. 492 (1943).
516
Tax Fraud
•
•
•
•
•
•
•
•
•
•
•
© D.L. Crumbley
Bradford v. Commissioner provides
other badges of fraud:
Understatement of income.
Inadequate records.
Failure to file tax returns.
Implausible or inconsistent
explanations of behavior.
Concealing assets.
Failure to cooperate with tax
authorities.
Engaging in illegal activities.
Attempting to conceal illegal activities.
Dealing in cash.
Failing to make estimated tax
payments.
Many of these badges and others may
be found in the Internal Revenue
Manual.
Source: 796 F. 2d 303 (CA-9, 1986).
517
© D.L. Crumbley
Tax Fraud Schemes
• Slavery Reparation Credit – 80,000
claims in 2001, totaling $2.7 billion. IRS
paid out $30 million.
• Social Security Refund – promoters tell
taxpayers they can recover all of their
FICA and Medicare taxes paid. Typical
charge: $100 plus 10% of the refund.
• Home – based businesses – claim
deductions for home – based businesses
(i.e., hobby losses).
• Domestic and foreign trust schemes
charges range from $5,000 to $70,000
• Many frivolous protestor theories.
See: S.F. Holub, “Tax Fraud and Tax Protesters,” The Tax Adviser,
December 2002, pp. 790-792.
518
© D.L. Crumbley
Venue for Tax Fraud
Criminal Tax Fraud: Federal District
Court
Civil Tax Fraud:
• Federal District Court.
• U.S. Tax Court.
• Federal Claims.
519
Fraud vs. Avoidance
Chevron
50%
© D.L. Crumbley
Texaco
50%
Caltex (Indonesian companies)
• U.S. companies paid Caltex excessive
amounts for Indonesian Crude Oil ($4.55
per barrel).
• Therefore, excessive dividend income, with
foreign tax credits and cost of sales
deductions on U.S. income tax returns.
• To compensate Caltex for the extra taxes it
paid, Indonesian Government provided
Caltex with oil in excess of the amount
called for under the formal productionsharing contract.
• Total Federal and State taxes avoidance of
$8.6 billion and $433 million.
Source: J.D. Gramlich and J.E. Wheeler, “How Chevron, Texaco,
and Indonesian Government Structured Transactions to
Avoid Billions in U.S. Income Taxes,” Accounting Horizons,
June 2003, pp. 107-122.
520
© D.L. Crumbley
Financial Statement Fraud May
Serve Many Purposes:
1. Obtaining credit, long-term
financing, or additional capital
investment based on misleading
financial statements;
2. Maintaining or creating favorable
stock value;
3. Concealing deficiencies in
performance;
4. Hiding improper business
transactions (e.g., fictitious sales or
misrepresented assets); and
5. Resolving temporary financial
difficulties (e.g., insufficient cash
flow, unfavorable business
decisions, defense control in
maintaining prestige).
Source: Zab Rezaee, Financial Statement Fraud, New
York: John Wiley & Sons, 2002.
521
© D.L. Crumbley
Management may also engage in
financial statement fraud to obtain
personal benefits of:
1. Increasing compensation
through higher reported
earnings;
2. Enhancing value of personal
holding of company stock
such as stock-based
compensation;
3. Converting the company’s
assets for personal use; and
4. Obtaining a promotion or
maintaining the current
position within the company.
Source: Zab Rezaee, Financial Statement Fraud, New
York: John Wiley & Sons, 2002.
522
© D.L. Crumbley
KPMG provides 10 steps to follow when an
organization finds or suspects fraud:
1. Shut the door! Keep assets secure until
you can provide appropriate long-term
security.
2. Safeguard the evidence. Ensure that all
records and documents necessary for an
investigation remain intact and are not
altered by you or anyone else.
3. Notify your insurer. Failure to notify
may negate your coverage.
4. Call a professional. Do not confront or
terminate the employment of a
suspected perpetrator without first
consulting your legal advisor.
5. Prioritize your objectives. What’s most
important: punishment, loss recovery,
prevention, detection of future
occurrences?
523
© D.L. Crumbley
KPMG’s 10 steps to follow contd..
6. Consider prosecution. Before you make
the call, weigh the plusses and minuses
and determine if your insurance
company requires prosecution.
7. Terminate business relations. If the
fraud is external, business relations with
the suspect individual or organization
should be terminated.
8. Seek advice and assistance. An
important consideration is whether you
have the knowledge and resources
necessary to effectively manage the
process.
9. Prepare a witness list. It is important
that statements be taken before a “party
line” can develop.
10. Consider the message. Whatever you do
will affect future situations. Now may
be the time to change the way your
business operates.
524
© D.L. Crumbley
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.
525
© D.L. Crumbley
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.
526
© D.L. Crumbley
State and Local
Government Susceptibility
Government bankruptcy is an
important issue for fraud prevention
and detection because likes business
corporations and organizations,
governments facing severe financial
difficulties can be fertile ground for
fraud. Government bankruptcy also
may trigger an investigation in order to
determine if fraud has contributed to
such financial distress.
527
© D.L. Crumbley
Governmental Frauds
The Office of Management and
Budget reported that in fiscal year
2001 the federal government paid out
$20 billion in erroneous payments.
On June 19, 2003: We analyzed a
portion of the programs and already
know that erroneous payments
exceeded $35 billion a year.” Office of
Mgt. And Budget
528
© D.L. Crumbley
Governmental Frauds
The Internet site of Ashcraft &
Gerel indicates that 10 percent of the
U.S. annual budget is paid to
companies or persons who are
defrauding the government.*
•Ashcraft & Gerel, “Whistle Blower Litigation Under The
Federal False Claims Act - - Qui Tam Claims,”
www.ashcraftandgerel.com/whistleb.html#History
--------------------------------------------------------------
2002 Wells Report: 25% of fraud
incidents occurred in government agencies,
with a $48,000 median loss (.25 times $600
billion = $150 billion).
529
© D.L. Crumbley
New Zealand Government Fraud
•The Ministry of Social Development
was defrauded of $1.1 million by a
trusted employee.
•The employee created 67 fictitious
invoices for payment over 28 months,
at a time when there had been changes
in management or at the time of the
month when there was pressure to
approve payment of accounts payable.
•Another employee noticed his own
signature apparently forged on a
document.
Source: Helen Bishop and Ashley Burrows, “Fraud in New Zealand
Government Despite Auditor General’s Warning,” Journal of
Government Financial Management, Winter 2003, Vol. 52, No. 4, pp.
42-46.
530
© D.L. Crumbley
Government Quiz 101
The ________ in 2002, improperly recorded
some expenses, kept “inappropriate
balances” in some accounts, and failed to
verify how much money it was collecting in
transaction fees.
While this government agency’s overall
internal controls were “effective,” their
financial reports are not presented in
accordance with applicable federal
accounting requirements.
This agency did not properly record capital
leases for computer hardware and did not
properly account for its software licensing
fees and other in-house expenses. They need
to do a better job of tracking transaction
fees.
Source: Deborah Soloman, “SEC’s Own Accounting
Requires Tightening, Internal Audit Says,” Wall Street J.,
July 3, 2003, A-2.
531
© D.L. Crumbley
GASB Statement No. 34
•Governmental Accounting Standards Board:
nonprofit agency charged with setting GAAP for
state and local governments.
•Although GASB has no authority to set law, many
public agencies follow its standards.
•Statement No. 34 retains the fund accounting focus
(good for budgeting and short-term focus), but adds
government-wide financial statements (e.g., account
for all assets and liabilities).
•Requires capitalization and depreciation of
infrastructure assests.
•Goes from the Governmental Funds Statements to
the Statement of Net Assets and Statement of
Activities.
•Goes from the modified accrual statements to the
full accrual statements.
•New Management Discussion and Analysis (MD
& A) Statement – a narrative discussion of any
significant changes in the overall financial picture
of a given agency.
Source: K. Middaugh, “The Great GASB,” Government Technology,
October 2003, pp. 50-52.
532
© D.L. Crumbley
Qui Tam Suits
• The Qui Tam suit allows any
concerned citizen to seek relief in
the name of the government.
• Many whistle-blowers initially file
qui tam suits to get a dispute on the
books and started.
• Once a qui tam suit is initiated, the
U.S. Department of Justice evaluates
the case to see whether the DOJ
believes there are sound reasons to
pursue the conflict.
• Whatever parts of the qui tam suit the
U.S. DOJ does not take, a whistleblower and his or attorney can
continue to litigate.
533
© D.L. Crumbley
Taxpayers Against Fraud
The Taxpayers Against Fraud has an
Internet site called “The False Claims Act
Legal Center.” Their Qui Tam Attorney
Network assists attorneys in their efforts to
provide effective representation to qui tam
plaintiffs. This group disseminates
information about the False Claims Act and
qui tam provision.
An attorney may request an amicus
brief submission. They state that
enforcement of the False Claims Act and
its qui tam provisions have returned more
than $12 billion to the U.S. Treasury over
the past 17 years ($2.1 billion in 2003
fiscal year).
Whistle-blowers paid $319 million in
2003 fiscal year (up to 25% of judgment).
534
© D.L. Crumbley
Assess Financial Health
Ratio
Purpose
Negative
Indicator
Financial
Position:
Unrestricted Net Assets
Expenses
Measures a government’s
ability to provide basic
government services
Decreasing
Financial
Performa
nce:
Change in Net Assets
Total Net Assets
Measures a government’s
financial performance during
the current fiscal year by
comparing the change in the
Net Assets derived from the
Statement of Activities to the
total net assets.
Decreasing
(General Revenues +
Transfers) / Expenses
Measures the extent to which
the cost of services are paid
for out of general revenues.
Decreasing
Liquidity:
(Cash + Current
Investments +
Receivables) / Current
Liabilities
Measures the extent to which
current liabilities are covered
by the more liquid current
assets.
Decreasing
Solvency:
Long-term Debt / Assets
Measures a government’s
long-term financial viability
by comparing the extent to
which assets are financed by
incurring long-term debt.
Increasing
(Change in Net Assets +
Interest Expense) / Interest
Expense
Measures the government’s
ability to generate a stream
of inflows sufficient to make
interest payments.
Decreasing
Source: B.A. Chaney, D.M. Mead, and K.R. Schermann, “The New
Governmental Reporting Model,” Journal of Governmental Management,
Spring 2002, p. 29.
535
© D.L. Crumbley
Early Warning Signals of Possible Trouble for Municipal Entities
1. Current year operating deficit
2. Two consecutive years of Operating Fund deficit
3. Current year operating deficit that is larger than the previous
year’s deficit
4. A General Fund deficit in the current year – balance sheet –
current position
5. A current General Fund deficit (two or more years in the
last five)
6. Short-term debt outstanding at the end of the fiscal year,
greater than five percent of main Operating Fund Revenues
7. A two-year trend of increasing short-term debt outstanding
at fiscal year end
8. Short-term interest and current year-end service greater than
20 percent of total revenues
9. Property taxes greater than 90 percent of the tax limit
10.Debt outstanding greater than 90 percent of the debt limit
11.Total property tax collections less than 92 percent of total
levy
12.A trend of decreasing tax collections – two consecutive
years in a three-year trend
13.Declining market valuations – two consecutive years –
three-year trend
14.Expanding annual unfunded pension obligations
Source: H.C. Grossman and T.E. Wilson, “Assessing Financial
Health,” Handbook of Governmental Accounting & Finance,
Somerset, N.J.: John Wiley & Sons, 1992, pp. 38-1 to 38-13.
536
Assess Financial Health of
Governmental Units
© D.L. Crumbley
Ratios
Negative
Indicator
Credit
Industry
Benchmark
Cash and investments/current
liabilities
Decreasing
Less than 1%
Operating surplus (deficit)/total Decreasing
revenue
5% or
consecutive
Elastic revenue (sales, utilities,
other elastic taxes)/total
revenue
Decreasing
Varies
State and federal aid / total
revenue
Increasing
Varies
Current liabilities/total revenue
Increasing
5%
Uncollected property taxes/
current tax levy
Increasing
Greater than
8%
Fixed costs/ total expenditures
Increasing
Varies
Debt service/total revenue
Increasing
Greater than
20%
Tax levy/tax limit
Increasing
Greater than
90%
Debt outstanding/debt limit
Increasing
Greater than
90%
Source: S.M. Winckler and Dewey Ward, “Can City Hall Go Broke? The Going Concern
Issue,” Journal of Accountancy, May 1984.
537
Office of New York State Comptroller © D.L. Crumbley
Indicator 1: Revenue and Expenditures Per Capita
Recurring Revenues Per Capita
a. Gross Revenues
Population
b. Gross Expenditures
Population
c. Recurring Revenues (Gross Revenues – One-Time Revenues)
Population
Negative Trend: Indicator 1b increasing faster than indicator 1a or 1c.
Indicator 2: Real Property Taxes Receivable
Real Property Taxes Receivable
Real Property Tax Revenue
Negative Trend: The percentage increases over time.
Indicator 3: Fixed Costs – Personal Services and Debt Service
a. Salaries and Fringe Benefits
Gross Expenditures
b. Debt Service Expenditures
Gross Expenditures
c. Salaries and Fringe Benefits + Debt Service
Gross Expenditures
Negative Trend: Percentages increasing over time.
Some analysts use a variation of the 3b ratio based upon debt service
expenditures as a percentage of revenues. A ratio of 25% for debt
service expenditures to “own source” revenues is considered a danger
signal.*
* J.R. Razek et. al, Introduction to Governmental and Not-For-Profit
Accounting, Prentice-Hall, 2000, p. 412.
538
Office of New York State Comptroller © D.L. Crumbley
Indicator 4: Operating Surplus/Deficit
a. Gross Revenues – Gross Expenditures
Gross Expenditures
b. Gross Revenues – Gross Expenditures – One-Time Revenues
Gross Expenditures
Negative Trend: Percentages decreasing over time.
Indicator 5: Unreserved Fund Balance and Appropriated
Fund Balance
a. Unreserved Fund Balance
Gross Expenditures
b. Appropriated Fund Balance
Gross Expenditures
Negative Trend: Percentages decreasing over time.
Deficits in major funds in excess of 1.5% of fund expenditures or
$50,000 (whichever is greater) are generally causes for
concern. Some analysts use a variation of this ratio: the
budgetary cushion. Here the fund balance is compared to
revenues. The greater the fund balance as a percentage of
revenues, the more likely a local government may weather
hard times. A good rule of thumb is that a fund balance should
be at least 5% of revenues.[1]
[1] J.R. Razek et. al, op. cit., p. 411.
539
Office of New York State Comptroller © D.L. Crumbley
Indicator 6: Liquidity
Cash and Investment as a Percentage of Current Liabilities
Cash and Investments as a Percentage of Gross Monthly Expenditures
a. Cash and Investments
Current Liabilities
b. Cash and Investments
Gross Expenditures/12
Negative Trend: Percentages decreasing over time.
A government should generally have year-end cash equal to about
50% of current liabilities and 75% of average monthly expenditures.
A governmental accounting textbook states that this quick ratio (or
acid test) omits receivables and amounts due from other funds
because of difficulties converting them into cash. They suggest that a
large state government should consider a quick ratio of less than 50
percent as an indicator of financial stress.*
Indicator 7: Long-Term Debt
Long-Term Debt
Population
Negative Trend: Percentage increase over time
Note: An increase in #7 would likely trigger a future increase in #3
formula as well as a decrease in #8.
Indicator 8: Capital Outlay
Capital Outlay
Gross Expenditures
Negative Trend: Percentage decreasing over time
Note: This eighth indicator is an early warning sign of financial
stress.
* Razek and Hosch, ibid., p.411.
540
© D.L. Crumbley
Office of New York State Comptroller
Indicator 9: Current Liabilities
Current Liabilities
Gross Revenues
Negative Trend: Percentage increasing over time
Indicator 10: Intergovernmental Revenues
Intergovernmental Revenues
Gross Revenues
Negative Trend: Percentage increasing over time.
Indicator 11: Economic Assistance Costs
Economic Assistance Cost
Gross Expenditures
Negative Trend: Percentage increasing over time.
541
© D.L. Crumbley
Office of New York State Comptroller
Indicator 12: Public Safety
Public Safety Cost
Gross Expenditures
Negative Trend: Percentage increasing over time
Indicator 13: Tax Limit Exhausted
Tax Levy
Tax Limit
Negative Trend: Percentage increasing over time
The tax limit is the maximum amount of taxes that can be levied
based upon some statutory authority.
Indicator 14: Debt Limit Exhausted
Total Debt Subject to Limit
Debt Limit
Negative Trend: Percentage increasing over time
Debt limit is the maximum amount of debt that can be issued
under applicable statutory authority. Compare this ratio with
indicators 3 and 7.
542
Some Exercises
© D.L. Crumbley
1. You have the following data for a city in the southwest. Calculate the
quick ratio. Is this ratio favorable or unfavorable?
Current Liabilities
$28 million
Cash
$27 million
Investments (current)
$36 million
Accounts Receivables
$12 million
Due from other funds
$2.5 million
2. You have the following information about a mid-west city. Calculate
the ratios of fund balance to revenues and determine if they are
favorable or unfavorable.
General Fund
$62 million
Unreserved Fund
$54 million
General Fund Revenues
$401 million
3. You determine the following data about a local government in the
southeast. Determine the ratios of unreserved fund balance and
reserved fund balance to total revenues. Are these ratios favorable?
Revenues from Property Taxes
$36 million
Unreserved Fund Balance
$5 million
Reserved Fund Balance
$3.5 million
4. Assume the following facts about a local government. Determine the
Tax Limit Exhausted and the Debt Limit Exhausted ratios.
Tax Limit
$11 million
Debt Limit
$13 million
Tax Levy
$8.5 million
Total Debt subject to Limit
$9 million
5. Assume that Debt Service Expenditures is $16.2 million and Total
Revenues is $70.1 million. Calculate the Debt Service/total revenue
ratio. Is the ratio favorable?
543
© D.L. Crumbley
6. Determine if the following situations are negative indicators of
the financial health of a government unit.
a. Cash and investments divided by current liabilities ratio is
decreasing over several years.
b. Current liabilities divided by total revenues ratio is
decreasing.
c. Fixed costs divided by total expenditures ratio is increasing.
d. Real Property Taxes Receivables divided by Real Property Tax
Revenue ratio is increasing over time.
e. Debt Service expenditures as a percentage of revenues is
greater than 25%.
f. Debt Service Expenditures divided by Gross Expenditures
ratio is decreasing over time.
g. Gross Revenues – Gross Expenditures : Decreasing over time.
Gross Expenditures
h. The debt service expenditures as a percentage of revenues is
25% or larger.
i. A fund balance is greater than 10% of revenues.
j. Unreserved fund balance divided by gross expenditures ratio
is decreasing over time.
k. The quick ratio of a large state government is 2.2 to 1.
l. Long-Term Debt divided by population ratio is decreasing
over time.
m.Current Liabilities divided by Gross Revenues ratio is
increasing over time.
n. Tax Levy divided by Tax Limit ratio is decreasing over time.
544
© D.L. Crumbley
Favorable
545
© D.L. Crumbley
6. Determine if the following situations are negative indicators of the
financial health of a government unit.
a. Cash and investments divided by current liabilities ratio is
decreasing over several years. Negative
b. Current liabilities divided by total revenues ratio is decreasing.
Positive
c. Fixed costs divided by total expenditures ratio is increasing.
Negative
d. Real Property Taxes Receivables divided by Real Property Tax
Revenue ratio is increasing over time. Negative
e. Debt Service expenditures as a percentage of revenues is greater
than 25%. Negative
f. Debt Service Expenditures divided by Gross Expenditures ratio is
decreasing over time. Positive
g. Gross Revenues – Gross Expenditures : Decreasing over time.
Gross Expenditures
Negative
h. The debt service expenditures as a percentage of revenues is 25%
or larger. Negative
i. A fund balance is greater than 10% of revenues. Favorable
j. Unreserved fund balance divided by gross expenditures ratio is
decreasing over time. Negative
k. The quick ratio of a large state government is 2.2 to 1. Favorable
l. Long-Term Debt divided by population ratio is decreasing over
time. Favorable
m.Current Liabilities divided by Gross Revenues ratio is increasing
over time. Negative
n. Tax Levy divided by Tax Limit ratio is decreasing over time.
Favorable
546
Not-For-Profits
© D.L. Crumbley
• There are more than 1 million not-forprofits in the U.S.
• Often there is little segregation of duties.
• They often deal in an atmosphere of trust,
with employees having little accounting
and business experience.
• Difficult to estimate and control the cash
contributions and revenues (e.g., Salvation
Army’s Christmas kettles take in $1,000 $1,500 per day).
• Fountains at charitable organizations may
take in several thousand dollars in coins.
• The Non Profit Times (www.nptimes.com).
• Some people believe the Sarbanes-Oxley
Act will be imposed on large not-forprofits.
• Moral: Do not go to a hospital that you are
giving away money to in your will.
547
© D.L. Crumbley
Fraud in Not-for-Profit
Organizations
The website of Clark, Schaefer,
Hackett & Company states the
following reasons not-for-profit
organizations become targets of fraud:
Many smaller not-for-profits just don’t
have the personnel size required for a real
segregation of duties. They often don’t
require much approval for disbursements.
And, when fraud is discovered, they
frequently don’t prosecute it very
aggressively because of the perceived
negative publicity.
548
© D.L. Crumbley
Don’t Volunteer For Trouble
Dos and Don’ts
If you volunteer CPA services to an NPO, do
• Avoid the appearance of impropriety.
• Check the volunteer liability statutes in your state.
• Examine the NPO’s internal controls, bylaws and
procedures.
• Educate yourself about how the organization operates.
• Attend board orientation and understand job
descriptions.
• Attend as many board meetings as you possibly can and
document votes and discussions.
• Make sure the organization has proper insurance
coverage.
• Be prepared to contribute time, talent and resources.
Your follow-through is important, so don’t
• Skip board meetings.
• Rubber-stamp decisions.
• Sign checks without documentation.
• Ignore employee complaints of discrimination or sexual
misconduct.
• Serve if you are unable to regularly attend meetings.
Source: Joan Sompayrac, “Don’t Volunteer for Trouble,”
Journal of Accountancy, January 2003, p. 82.
549
© D.L. Crumbley
Elements of a Damage Claim
1. Violation of an entity’s rights (e.g.,
breach of contract infringement, or
a tort claim)
2. Defendant’s action or non-action
harmed plaintiff (causation)
3. Proximately related to defendant’s
action (but-for rule) – but for the
actions of defendant, the plaintiff
would have ….
550
© D.L. Crumbley
Legal Framework of
Damages
In order to win an award for damages,
the injured party must generally prove
two points:
– That the other party was liable for
the damage
– That the injured party suffered
damages as the results of the
actions or lack of actions of the
offending party
551
© D.L. Crumbley
Legal Framework of
Damages
• Proximate (direct) cause—The
damages caused were a direct result
of the offending party’s actions or
lack of actions
• Reasonable certainty—That it is
“reasonably certain” that the injured
party would have earned the claimed
amount of damages “but-for” the
actions of the other party
• Forseeability—That a prudent
person could look into the future and
see that the actions of the offending
party would damage the other party
to the litigation
552
Obtaining Damages
© D.L. Crumbley
A New York District Court explains what a plaintiff
must do to obtain damages:
First, it must be demonstrated with certainty that
such damages have been caused by the breach
and, second, the alleged loss must be capable of
proof with reasonable certainty. In other words,
the damages may not be merely speculative,
possible or imaginary, but must be reasonably
certain and directly traceable to the breach, not
remote or the result of other intervening causes….
In addition, there must be a showing that the
particular damages were fairly within the
contemplation of the parties to the contract at the
time it was made.
Thus, in New York a plaintiff may be awarded only
out-of-pocket damages rather than expectation
damages.
Source: Telewide System, Inc., 794 F.2d 766 (CA-2, 1986).
553
Huge Settlements
© D.L. Crumbley
Here are some disputes with the award or
settlement:
Honeywell v. Litton
Polaroid v. Eastman Kodak
Smith v. Hughes
DCS Communication
v. General Instruments
Fonar v. G.E.
Honeywell v. Minolta
3M v. Johnson & Johnson
$1.2 billion
$873.2 million
$204.8 million
$140 million
$128 million
$128 million
$107.3 million
554
© D.L. Crumbley
Recovery Rules
Types of Claims Recovery
Buyer of goods
Difference between purchase price
and market value + incidental
damages, - expenses saved.
Sellers of goods
Difference between resale price and
contract price, plus incidental
expenses, less expenses saved.
Breach of
warranty
Difference between value of goods
accepted and value if had been
warranted.
Agency
contracts
Lost profits.
Covenants not to Difficult. Maybe defendant’s gain.
compete/unfair
compensation
Fraud
Out-of-pocket or benefit-of-the
bargain theory.
Source: Brining et al, Guide to Litigation Support
Services, 7th, Fort Worth: Practitioners Publishing Co.,
2002, pp. 3.5 and 3.6.
555
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Two Types of Harm
• Tort—The occurrence of the harmful
act itself is wrongful
• Breach of contract—A failure
without excuse or justification to
fulfill one’s obligations under a
contract
556
© D.L. Crumbley
•
•
•
•
•
•
•
•
•
Some Contract Breaches
Employment contract.
Insurance contract.
Failure to pay/provide services.
Broken covenant not to compete.
Stock sales.
Sale of a business.
A construction contract.
Sale of inventory.
Real estate contract.
557
© D.L. Crumbley
Some Tort Lost Profits
•
•
•
•
•
•
•
Theft/conversion of funds.
Trademark/patent infringement.
Professional malpractice.
Fraud (e.g., kickbacks).
Defamation.
Simple/gross negligence.
Slander/Libel.
Tort: Wrongful damage, injury, or act, other than
a breach of contract, for which there is a civil
remedy
Good read: John Grisham, The King of Torts
(2003).
558
© D.L. Crumbley
Two Types of Damages
Restitution: harmful act has unjustly
enriched the defendant at the expense of
the plaintiff.
Reliance: the harmful act is fraudulent and
the intent of damages is to restore the
plaintiff to the position as if no promises
were made.
1986 AICPA’s Possible Types of Damages
• Lost profits.
• Lost value.
• Lost cash flows.
• Lost revenue.
• Extra costs.
Notice: Can not find these accounts in the general
ledger.
559
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Types of Damages
Compensation damages• Economic (lost earnings) and
noneconomic damages (pain and
suffering).
• Special (receipts) and general damages.
• Hedonic damages (loss of quality of life).
Avoid.
 Punitive damages (punish the person).
 Nominal damages (e.g., $10).
560
© D.L. Crumbley
Two Different Jurisdictions For Fraud
• Out-of-pocket costs: puts plaintiff in
the same position as before plus out-ofpocket costs (maybe attorney fees).
• Benefit-of-the Bargain: can sue for
investment put into the transaction plus
any profits he or she would have made.
• Debra (defendant) sells Paula
(plaintiff) an asset with an alleged
value of $2 million for $1.8 million.
However, the asset really had a market
value of only $1.6 million. Calculate
fraud damage.
• Out-of-Pocket loss rule:
$1.8 million - $1.6 million = $200,000
• Benefit-of-the Bargain rule
(majority):
$2 million - $1.6 million = $400,000
561
© D.L. Crumbley
Benefit-of-Bargain Rule Example
S agrees to buy a house from P for
$205,000
6 months later P says no sale
House is now worth $325,000
Judge gave S $120,000
562
© D.L. Crumbley
Alternatives
• Some Benefit-of-Bargain states allow
the plaintiff to use the out-of-pocket
approach (e.g., plaintiff’s option).
• Some states have a “flexible rule”
which is really a combination of both
rules (e.g., plaintiff’s option).
Example:
Plaintiff pays $2,250 for a stamp collection.
Court found the collection only worth $1,500.
Defendant said worth was $5,500.
Benefit-of-the-bargain ($5,500 - $1,500 = $4,000).
Out-of-pocket states ($2,250 - $1,500 = $750).
Excellent book: R.L. Dunn, Recovery of Damages For
Fraud, 2nd Edition, Westport, CT: Lawpress, 1995.
563
© D.L. Crumbley
Benefit-of-Bargain Rule
In benefit-of-bargain jurisdictions
expert can include money
invested plus any lost profits and
extra costs.
Computation requires at least five
factors:
1. Method.
2. Damage period.
3. Definition of profit.
4. Growth rate.
5. Discount rate.
564
© D.L. Crumbley
Methods
• Direct method – contract may explain
how.
• Before-and-after method – compare
sales or sales growth before wrongful
act with comparable figures afterward.
Fails to consider increases in sales. May
not be good for a growing business.
• Yardstick (benchmark) method –
compare the particular entity to other
entities or industry averages. Useful if
no historical patterns.
• But-for (market model) method
(simulation or mathematical method) –
incorporate inputs from internal and
external sources. Not necessarily
historical. Example, Polaroid v. Kodak.
• May use combination of methods.
565
© D.L. Crumbley
Format For Calculating Damages
Earnings
before trial,
had the
harmful event
not occurred
Projected
earnings after
trial, had the
harmful event
not occurred
=
–
Actual
earnings before
trial
+
Prejudgment
interest
Projected
earnings after
trial
–
Discounting
Damages
before trial
–
=
Damages after
trial
Source: V.A. Lazear, “Estimating Lost Profits and
Economic Losses,” in R.L. Weil et. al. Litigation
Services Handbook, New York: John Wiley, 2001,
Chapter 5.2.
566
Net Profits
© D.L. Crumbley
Damages for lost profits are based on
net profits rather than gross receipts.
Thus, a plaintiff may not recover its fixed
overhead costs, such as administrative
salaries, real estate taxes and insurance,
and other types of costs. A plaintiff must
present evidence of its expenses in order
to establish its net loss.
If a plaintiff presents only evidence of
gross receipts or fails to prove expenses
with some specificity, there may not be
any recoverable damages. Plaintiff must
submit evidence of costs and other
expenditures related to the gross sales
revenue.
Sources: Thomasville Furniture Indus., Inc. v. The ElderBeerman Stores, Corp., 250 B.R. 624 (S.D. Ohio 1998), appeal
dismissed 201 F.3d 1440 (CA-6, 1999). Omura v. American River
Investors, 894 P.2d 115 (Haw. App. Ct. 1995); Clayton v. Howard
Johnson Franchise Systems, Inc., 954 F.2d 652 (CA-11, 1992).
567
© D.L. Crumbley
Defendant’s Damages
Estimate
The defendant’s expert report would
include his or her damages estimate
along with support for the numbers
presented. In order to arrive at a “zero”
damages estimate, a defendant must
demonstrate to the court that the
plaintiff suffered no financial damages.
568
© D.L. Crumbley
Plaintiff’s Damages
Estimate
Much of the support for the damages
estimate for the plaintiff come from
various accounting records, but the use of
those supporting data also shows that
damages estimates are both an art and a
science.
The scientific part is primarily the
understanding and appropriate use of
accounting information. The art part of
the process is in knowing how the
accounting information is used in
creating components of the damages
estimate.
In addition, expert witnesses frequently
use many other kinds of information
other than traditional accounting records
in arriving at and defending damages
calculations.
569
© D.L. Crumbley
Expert’s Journey
Through the
Legal System
• Testimony early in case
– Pretrial summary judgments
– Decision to try the case
• Defending the expert report
– Deposition testimony
– Preparation for trial testimony
– Trial testimony
– Questioning by client’s attorney
– Questioning by opposing attorney
– Rebuttal testimony
570
© D.L. Crumbley
Discounting After-trial
Damages
There are two major approaches to
discount amounts to present values.
– One approach is to project a
plaintiff’s hoped-for income stream
by modifying losses to a realistic
expectation by factoring in future
losses to a present value at a riskreduced relatively low discount rate.
– Another approach is to project the
hoped-for-but-lost amounts and then
apply a higher discount rate that
already includes risk or uncertainty
in order to determine the present
value.
571
© D.L. Crumbley
Discounting Future Losses (5%)
Years in
Future
Loss
Discount
Factor
Discounted
Loss
0
$1,000
1.0
$1,000
1
1,200
0.95238
1,088
2
1,300
0.90703
1,179
3
1,500
0.8638375
1,296
572
© D.L. Crumbley
Consider Incremental Costs
A plaintiff’s sales were $1 million before a
wrongful act, and expenses were $600,000.
After the harmful event, sales decreased to
$800,000 and expenses fell to $520,000.
Calculate any lost profits, considering the
incremental costs.
Lost profits = Lost sales less avoidable costs.
$1 million - $800,000 = $200,000
$600,000 - $520,000 = ($80,000)
$120,000
573
Cost Behavior
© D.L. Crumbley
Cost behavior: The way that costs change
with respect to changes in the volume of
activity.
Relevant range: Area where there is a
specific relationship between the level of
activity (volume) and the cost in question.
Fixed costs: those not driven by the changes
in the volume of activity (e.g., lease
payment, mortgage, depreciation,
property taxes, plant fire insurance,
supervisory salaries). FCs remain
unchanged over the relevant range, but
become smaller and smaller per unit as
quantity increases.
Variable costs: change directly and
proportionately with the volume of
activity (e.g., direct materials, direct
labor, sales commissions).
574
Cost Behavior (contd…)
© D.L. Crumbley
Mixed costs: contain both a fixed and a
variable component (e.g., store labor
costs, utility costs, maintenance costs,
overhead costs, marketing costs).
Semi-variable costs: change with the
volume of activity, but not in proportion
with activity change (called learning
curve costs, e.g., introduction of a new
product or service). Or shipping supplies
may increase 6% with a 10% increase in
sales.
Step-fixed costs: increase in steps or jumps
(e.g., depreciation costs of a finished
goods warehouse)
Cost Driver: some variable or factor that
causally effects costs over the relevant
range (e.g., level of activity or volume).
Time Horizon: The longer the time period,
the more likely the cost will approach
variable.
575
© D.L. Crumbley
Mitigation, etc.
• A plaintiff must take whatever
steps or actions necessary to
overcome or mitigate any
damages.
• Law does not necessarily allow
interest.
• Consequential damages may be
allowed.
• Pre-tax or after-tax basis?
576
© D.L. Crumbley
Damage Future Period
The damage future period is always a
difficult issue in lost profits disputes. In
an alleged appropriation of trade secrets
by
a
defendant,
Ensign-Bickford
Company, the plaintiff’s expert assumed
that technological innovation would have
a shelf life of twenty years.
The court said that the expert’s lack of
factual support for his assumptions was
staggering. The court rejected the expert’s
testimony with the following statement:
577
Damage Future Period …
© D.L. Crumbley
Perhaps most astonishing is Mr.
Schachter’s assumption that not only would
the technological innovation achieve
worldwide acceptance and profitability, but
that this profitability would last twenty
years. Mr. S confesses that the sole basis for
this assumption is that the technological
innovation would mirror the life of the
original technology: “I projected royalties out
to 2020 because the original technology, the
hot wire technology or hard wire technology
in the airbags of current automobiles, came
into existence in the early 1980s and has had
a life in excess of twenty years.” Yet Mr. S
made no inquiry into the historical
performance of the current hot wire
technology and admits that “it is possible that
the SCB could be displaced during the next
twenty years or earlier.”
Source: K & V Science Company v. Ensign-Bickford
Company, 2002 Conn. Super. LEXIS 3606.
578
© D.L. Crumbley
Back Door Attempt
In Schonfeld v. Russ Hilliard, the Second
Circuit disagreed with a District Court that a
CPA’s lost profits analysis was a back door
attempt to recover lost profits. The plaintiff
could not prove, with reasonable certainty, the
existence or amount of damages for lost
profits.
“The damages may not be merely speculative,
possible or imaginary.” The District Court
said that the CPA’s technique probably would
not survive a Daubert inquiry. This trial court
declined to exclude the evidence under
Daubert because it had already held that the
plaintiff failed to establish a foundation for
the existence of damages from lost profits.
On appeal the Second Circuit held that the
district court improperly excluded the
accountant’s testimony.
Source: Schonfeld v. Russ Hilliard,218 F.3d 164
(CA-2, 2000).
579
© D.L. Crumbley
Assumptions
AICPA Guideline 6.31 states that the
appropriateness of a particular assumption should
be commensurate with the likely relative
impact of that assumption on the prospective
results. Assumptions with greater impact should
receive more attention than those with less
impact. The Supreme Court explains making
inferences from existing data:
Trained experts commonly extrapolate from
existing data. But nothing in either Daubert or the
Federal Rules of Evidence requires a district
court to admit opinion evidence which is
connected to existing data only by the mere
opinion of the expert. A court may conclude
that there is simply too great an analytical gap
between the data and the opinion offered.
Source: General Electric Co. v. Joiner, 522 U.S.
136 (1997).
580
© D.L. Crumbley
Knowledge of The Client
A bankrupt oil brokerage business and its
owners sued a secured creditor for fraud, breach
of duty of good faith and fair dealing, negligence,
breach of fiduciary duty, and tortuous
interference with business relations.
The court said the following about the
plaintiff’s expert, a CPA with eighteen years of
experience in general accounting, advisory
services, computer consulting and litigation
support, who estimated the future profitability of
an oil company (Pointer Oil) for 1990 to 1996:
The problem with Mr. [Gary L.] Atnip’s
affidavit is that it is not based upon a review of
the actual transactions of POC. Mr. A admitted
in his deposition that he was not familiar with
the actual operating results of POC for 1990,
that he had not reviewed cash flow or performed
a cash flow analysis of POC. Additionally, Mr. A
assumed a gross profit margin of 3% but
throughout its entire existence POC never
attained a gross profit margin of 3%.
581
“A” Is For Rejection
© D.L. Crumbley
Mr. A’s opinion also fails to take into account
possible loss of customers in spite of the fact that
customers, such as the State of Tennessee, the
company’s single largest account, were lost in
1990. Mr. A acknowledges in his deposition that he
was unaware that the State of Tennessee had
terminated POC’s contract due to nonperformance
and admitted that the loss of this contract would
drastically alter his projections for future revenues.
Mr. A opined that POC experienced approximately
$500,000.00 in annual contract revenue growth per
month during the last six months POC operated out
of the offices of TECC. Mr. A, however, could not
remember how he arrived at this number.
Mr. Smith’s review of the actual cash revenue
of the company does not bear out this assumption.
Moreover, Mr. A admitted he had not analyzed
Mr. Smith’s [defendant’s expert] analysis and had
no idea whether it was accurate or not. Mr. A based
his opinions on projected expenses and on
projected revenue. Mr. Smith, however, based his
analysis on actual aggregate cash expenditures of
the company.
Source: Pointer v. Tenn. Equity Capital Corp., 2001
Tenn. App. LEXIS 918.
582
© D.L. Crumbley
Replication Is Important
Moral: Unless your work can
be replicated, it is not evidence.
583
© D.L. Crumbley
584
© D.L. Crumbley
Industry-specific Experience
An expert does not necessarily have
to have industry-specific experience. As
one court said, “we are not persuaded to
abandon this principle in favor of a bright
line rule that expert witnesses must
possess prior industry-specific experience.
Industries
may
be
segmented
infinitesimally. Some economists’ and
accounting professionals’ skills may be
transferred between industries.”
Source: Beverly Hills Concepts v. Schatz & Schatz, 247
Conn. 48, 63, 717 A.2d 724 (1998).
585
© D.L. Crumbley
Industry Specific Investigations:
IRS’s Audit Technique Guides
(ATGs)
•
•
•
•
•
•
•
Market Segment Specialization
Program produces ATGs.
At least 74 different ATGs.
Length: 13 to 237 pages.
58 ATGs on IRS website.
See CCH Internet Tax Research
Network.
60 more under study.
Usually contain:
 Common and unique practices.
 Industry terminology.
 Examination techniques (e.g.
interview questions).
 Other information.
586
© D.L. Crumbley
Some ATGs
•
•
•
•
•
•
•
•
•
•
•
•
Attorneys.
Auto Dealerships.
Bars and Restaurants.
Child Care Providers.
Construction Industry.
Oil and Gas Industry
Pizza Restaurants.
Retail Gift Shops.
Scrap Metal.
Taxicabs.
Trucking Industry.
Wine Industry.
587
Inconsistent Judges
© D.L. Crumbley
In one dispute a district court was unkind to a
number of experts. The trial court held that a
manager of an accounting firm’s “fairly simple
pass” opinion was not acceptable merely
because he was an expert in accounting. This
expert conceded that he did not employ the
methodology that experts in valuation find
essential. The accounting expert used a
discounted cash flow analysis, assigning a value
of zero to a number of projects that had low or
negative net cash flow.
Thus, his method implied that raw land and a
large office building had no value even though it
was fully leased. The judge also would not allow
a report of a University of Chicago accounting
professor (testifying for the defendant) because
the witness had not disclosed his opinion
sufficiently far in advance of trial. However, the
same judge allowed three other witnesses for the
plaintiffs to give extensive testimony that had not
been disclosed until the last minute.
Source: Frymire-Brinati v. KPMG Peat Marwick, 2
F.3d 183 (CA-7, 1993).
588
© D.L. Crumbley
Weaving a Story
In a Michigan District Court dispute a CPA
spent 2,000 hours assisting in the prosecution
of a claim for damages because of alleged
wrongdoings of defendants. The judge said that
an expert may not opine on the ultimate
liability of defendants even though an expert
may give the jury all of the information from
which the jury can draw inferences as to the
ultimate issues.
Further, expert testimony is not needed to
determine if someone is telling the truth.
After listening to the expert’s testimony, the
judge said the expert was trying to “weave a
story.” He “selected those portions of the
available material which support his client’s
position, and has deliberately ignored other
portions that do not support his client’s claim.”
Source: DeJager Construction v. Schleininger, 938
F.Supp. 446 (D.Ct. Mi, 1996).
589
© D.L. Crumbley
Valuation Societies/Certifications
1. American Society of Appraisers (ASA)
oldest, 555 Herndon, Suite 125, Herndon,
VA. 20170. 2 years of appraisal
experience and 1 ½ years of BV
experience.
2. Institute of Business Appraisers (CBA
and BVAL) P.O. Box 17410, Plantation,
FL 33318.
3. National Assoc. of Certified Valuation
Analysts (NACVA) 1111 Brickyard Road,
Suite 200, Salt Lake City, Utah. 841065401.(AVA and CVA)
4. AICPA’s Accredited Business Valuation
(ABV). Recently calling it Business
Valuation/Forensic & Litigation Services.
October 15, 2003.
www.aicpa.org/members/div/msc/abv.htm.
10 BV engagements
. About 1,500.
590
© D.L. Crumbley
Internal Revenue Service Position:
FMV
No general formula, but the price at
which property will change hands
between a willing buyer and a willing
seller, when the former is not under any
compulsion to buy, and the latter is not
under any compulsion to sell, and both
parties have reasonable knowledge of
relevant facts.
Rev. Rul. 59-60, 1959-1 C.B. 237; amplified by Rev. Ruls.
83-120, 80-213, and 77-287.
591
© D.L. Crumbley
AICPA’s Position of Valuation
The valuation process is an art and not
a science, and the results may vary
depending on the methods used. A
practitioner may use various methods to
value a business, although
circumstances generally dictate which
method to use.
Source: AICPA, Valuation of Closely Held Business,
Management Advisory Service Practice Aid No. 8, 1987, p.
10.
592
© D.L. Crumbley
Needed Valuations
Valuations are needed for various
purposes:
• Tax purposes (estate tax, gift tax,
charitable contributions, casualty loss,
sale of securities, state tax, etc.)
• Divorce distributions.
• Liquidations (partnerships, sole
proprietorships, corporations)
• Employee share ownership plans.
• Lost profit analysis.
• Mergers and acquisitions.
• Minority shareholder disputes.
593
© D.L. Crumbley
Several Valuation Standards:
• Fair market value (gift, estate,
divorce).
• Intrinsic value (theoretical value at
which an analyst thinks a stock should
be selling).
• Book value (assets – liabilities).
• Historical cost (original cost paid).
• Replacement cost (cost to replace).
• Ad valorem value.
• Net present value.
• Fair value (defined statutorily and
often used in shareholder disputes).
• Investment value (strategic value to a
specific buyer).
594
© D.L. Crumbley
Valuation premise:
• Going concern value.
• Forced sale value.
• Liquidation value.
Good Resource: AICPA, Valuation of a Closely
Held Business, Small Business Consulting
Practice Aid No. 8 (1987).
595
© D.L. Crumbley
Major Valuation Methods
1. Income Approach
•
Discounted future earnings.
•
Discounted net cash earnings.
•
Capitalization of earnings.
•
Capitalization of net cash flow (or gross)
•
Excess earnings.
2. Market Approach
•
Using guideline companies (calculate
multiples and ratios).
•
Comparative sales method.
•
Past transaction method.
•
Rules of thumb.
3. Cost Approach [Balance Sheet]
•
Book value.
•
Adjusted book value.
596
© D.L. Crumbley
Guideline Company Data
•
•
•
•
•
•
Price/earnings.
Price/gross cash flow.
Price/dividends.
Price/book value.
Price/revenues.
Price/net asset value
Source: J.E. Fishman, PPC’s Guide to Business Valuation, 13th
edition, Practitioners Publishing Co., January 2003, p. 2-7.
597
© D.L. Crumbley
Valuation Methods
1. Agreed or legal value – a contract, buysell agreement, or other agreement may
state how to value.
2. Fair Market Value (e.g., securities closing
prices at end of year).
3. Market comparison (compare company
with companies in the same industry)
4. Net Asset Approach (value of company’s
assets less liabilities).
5. Prior Transactions (prior transactions in
the stock or asset) or a Comparative sale.
6. Capitalization of earnings or cash flow
(actual earnings of a business is divided
by a factor to obtain an overall valuation).
Example: average earnings for past 5 years,
with a capitalization rate of 10%
Thus, $10,000 = $100,000 value
10%
598
Valuation Methods
© D.L. Crumbley
7.Capitalization of excess earnings: earnings in
excess of the reasonable return on tangible assets
is capitalized to arrive at a valuation). IRS uses
15% to 20%, if no better rate (or multiply by 5),
for capitalizing excess earnings and a 8% to 10%
after-tax return for net tangible assets.
8.Cash Flow Capitalization: future earnings are
projected and discounted to present value. The
sum of the present value represents the value of
the business.
a) Enterprise discounted cash flow – value of the
company’s operations less, the value of debt and other
investor claims. Good for a multi-business company.
Value of operations equals the discounted value of
expected future free cash flow. Free cash flow = aftertax operating earnings + noncash charges – investments
in operating working capital, property, plant, equipment
and other assets.1 Most widely used.
b)Economic profit model2
EP = Invested Capital X [Return on Invested Capital –
Opportunity Cost of Capital]
Highlights whether a company is earning its cost of capital.
1 T. Copeland, T. Koller, and J. Murrin, Valuation: Measuring
and Managing the Value of Companies, 3rd, New York: John
Wiley, 2000, Chapter 8.
2 Ibid., p. 37
599
© D.L. Crumbley
Valuation Methods
c) Adjusted Present value (good for leveraged
buyout targets)3
d) Equity DCF – good for financial
institutions4
9. Price to Earnings Method – earnings are
multiplied by a factor to determine the value of
a business.
Weighted average net income times P/E ratio
$88,000 x 15 = $1,320,0005
10. Dividend capitalization method6
Weighted Average Earnings
Weighted Average Industry Payout ratio
Dividend capacity
Weighted Average Industry Dividend Yield
$88,000
0.38
$33,440
0.062
Value of company
$539,355
3 Ibid., p. 131
4 Ibid., p. 150
5 J.H. Lipman, Valuation of Closely-held Business, Handbook of
Financial Planning for Divorce and Separation, New York:
John Wiley, 1990, p. 305.
6 Ibid., p. 303
600
Valuation Methods
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11. Industry Methods
Rules of thumb are applied to value a business based
upon the industry within it operates.
G. Desmond, The Handbook of Small Business
Valuation Formulas, Los Angeles: Valuation Press,
1987.
e.g., Manufacturer’s representative organization: 50%
to 150% of commission income payable.
12. Book Value and Economic Net Worth
Methods.
Use historical cost of business asset to determine a
business’ value.
Adjust these historical amounts to current values of the
tangible and intangible assets.
13. Weighted Average of several methods:
Valuation Method Valuation Amount Weighting Value
A
$3,500,000
.60 $2,100,000
B
3,200,000
.20
640,000
C
4,500,000
.20
900,000
Weighted average valuation
$3,640,000
601
© D.L. Crumbley
Valuation of An S Corporation
Actual
S Earnings
Capitalization
Valuation
Tax-Adjusted
$1,000,000
650,000
25%
25%
$4,000,000
$2,600,000
Which is the proper valuation?
602
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S Corporations (continued)
1.
2.
3.
4.
5.
Walter L. Gross, Jr., T.C. Memo. 1999-254, aff’d
(CA-6, 2001). In a gift tax situation, courts would
not accept a reduction for a hypothetical corporate
tax.
John E. Wall, T.C. Memo. 2001-75. In a gift tax
situation, tax-affecting “is likely to result in an
undervaluation.” Experts had tax-affected by 34%
and 40%.
Estate of Heck, T.C. Memo. 2002-34. In an estate
situation, neither expert tax-affected the estate,
except for 1.5% California state income tax. One
expert included a 10% discount for “additional risk
associated with S corporation,” e.g., loss of
election.
Estate of William G. Adams, T.C. Memo. 2002-80.
Tax Court said “it is appropriate to use a zero
corporate tax rate to estimate net cash flow when
the stock being valued is stock of an S corporation.
Estate of Natalie M. Leichter, T.C. Memo. 2003-66.
No tax-affecting by experts.
Note: Two-thirds of the $10 billion tax valuations are in
dispute (Howard A. Lewis, June 2003)
603
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Comparison of the Capitalized Returns and
Discounted Future Returns Method
Capitalized Returns
Method
Used when –
Future operations are expected
to be similar to current
operations.
Discounted Future
Returns Method
Future operations are expected
to be “significantly different”
from current operations.
Information used –
Cash flows or earnings from a
single period.
A forecast of cash flows or
earnings for several future
periods and an estimated value
of the business in the final year
of the forecast.
How is value calculated –
A capitalization rate is applied
to the single period amount
A discount rate is used to
determine present value
factors, which are applied to
the period amounts and to the
final year value.
How the rate is determined –
The capitalization rate is
determined by taking the
discount rate and subtracting out
the estimated growth rate for the
company.
The discount rate can be
determined in several ways,
including the build-up
approach.
Source: B.P. Brinig, Guide to Litigation Support Services, FortWorth:
Practitioner Publishing Co., 2002, p. 10-30.
604
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Miscellaneous
• Many people believe that the income statement provides
the most useful information in valuing profitable operating
businesses.
• Valuation approaches may be broken into asset-based,
market, and income approaches.
• Asset-based: what the equipment and real estate are worth.
• Income approach: How much money a buyer can make
from the business.
• Market approach: what others have paid for similar items.
• The most common method is using price-earnings ratios.
• Discounting income (or cash flow) is probably a better
approach.
• The dividend yield approach may be appropriate for
minority shareholders.
• IRS believes that intangible assets are worth from 5 to 6.67
times excess earnings (Rev. Rul. 68-609). This is the
reciprocals of the 15 to 20% capitalization rates.
• Rev. Rul. 59-60, the courts, and ESOP Association have
discredited valuation formulas, such as the excess earnings
formula [value = book value + capitalized excess earnings]
• The IRS Valuation Policy Council will issue valuation
guidelines shortly. Look for these.
605
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Some Basics
Discount rate: Amount expressed in a percentage
that a buyer will pay to receive some
estimated level of cash in the future, given the
level of risk of not receiving the future cash
flows. The higher the risk, the higher the
discount rate, which results in lower current
values.
E.g., 5%
Next year 1/1.05 = .9523809
Next year 1.05 x 1.05 = 1.1025 = 1/1.1025 =
0.907029
10%
Next year 1/1.10 = 0.9090909
Next 1.10 x 1.10 = 1.21 = 1/1.21 = 0.8264462
Discount rate is the inverse of price earnings
ratio. Say 6 firms have P/E ratio ranging from
6 to 8, with 7 average.
If average earnings are $293,000, valuation is
$2,051,000 [$293,000 x 7]
Or capitalization rate of 1/7 = 0.142857143
So, $293,000 / 0.142857143 = $2,051,000
606
Some Basics (contd …)
© D.L. Crumbley
Capitalization factor:
Worth $1 million
= 10 factor or 10%
Current earnings $100,000
Capital Asset Pricing Model (CAPM): complex way of
obtaining discount rate.
Built-up Method: way of calculating the discount rate.
B.P. Brinig, et al says
Capitalization rate is derived from company’s discount
rate: subtract the company’s expected average
compound growth rate from its discount rate.
Discount rate – Long-term growth rate = capitalization
rate.
Since a company’s cash flow is often less than its
earnings (because of working capital and fixed
assets investments), a company’s discount rate for
net cash flow is usually less than discount rate of net
earnings.
Source: B.P. Brinig, et. al, Guide to Litigation Support Services, Vol.
3, Fort Worth: Practitioners Publishing, 2002, Chapter 10
607
Eleven Valuation Tips
© D.L. Crumbley
1. Understand your appraisal assignment.
2. Comply with competency and
independence standards.
3. Watch the market.
4. Know the difference between fair market
[IRS] and investment value [to a
particular person].
5. Know when to use the invested capital
and equity model.
6. Do not let rates of return distort values.
7. Beware of earnings measures - - cash is
king.
8. Verify all rates of return.
9. Always challenge long-term growth rates.
10.Challenge premiums or discounts.
11.Have pride in your report.
Source: F.C. Evans, “Tips For The Valuator,” J. of Accountancy,
March 2000, pp. 35 – 41.
608
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$
---Relevant Range---
Total Revenue
Total Costs
BE
Variable
Costs
Fixed
Costs
Q
Total Costs = FC + VC
Total Costs = FC + Q (Variable Cost per unit)
Total Revenue = Price X Q
B.E. = Break Even Point
= Loss zone
609
© D.L. Crumbley
Cost Behavior Defined
In its simplest form, cost
behavior is the way that cost(s)
change with respect to changes in
the volume of activity.
610
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Ways of Estimating Cost Behavior
1. Account Analysis Method: classify
the cost accounts in the subsidiary
ledger as fixed, variable, etc. based
upon experience and judgement.
Cheap, but is subjective.
2. High-low method (simplest
quantitative analysis)
Basic formula: y = a + b x,
Where b = unit variable cost per
measure of activity
b = Cost at High Activity Level – Cost at Low Activity Level
High Activity Level – Low Activity Level
b=
Change in Total Cost
Change in Activity Level
b = Unit variable cost per measure of activity.
Source: Barfield et. al, Cost Accounting, 5th, Mason, Ohio: SouthWestern, 2003, p. 89.
611
© D.L. Crumbley
Ways of Estimating Cost Behavior
Independent
Dependent
Machine hours Associated total cost
High activity
9,000
$350
Low activity
4,600
$218
Change
4,400
$132
b = $132 / 4,400 = 0.03 per machine hours
High level: Total variable costs = 0.03 (9,000) = $270
Low level: Total variable costs = 0.03 (4,600) = $138
High level: a = $350 - $270 = $80 fixed
High level: a = $218 - $138 = $80 fixed
3. Regression Analysis (more accurate)
Computer programs may be used to find
relationships between the cost driver or volume
(independent variable) and a cost (dependent
variable).
4 Engineering or work-measurement method
This industrial engineering approach can be
expensive.
612
General Observations
© D.L. Crumbley
• Valuation analysts must ignore their
client preferences and provide
independent, unbiased opinions of
value.
• Valuation analysts must possess:
– Strong written and verbal communication
skills.
– Attention to detail.
– Ability to interpret financial statements.
– Understanding of relevant economic
forces.
– Knowledge of, and the ability to research
and learn about relevant industry forces.
– Organizational skills.
– Thorough conceptual understanding of
valuation concepts and methodologies.
Source: G.S. Gaffen, “Guidance for The CPA Entering the
Business Valuation Profession,” The Ohio CPA Journal, July
– September 2002, pp. 22 – 28.
613
Tax Court Valuation
© D.L. Crumbley
• Fair market value is a factual
determination considering all relevant
evidence.
• Fair market value is as of a specific date.
• The taxpayer generally has the burden of
proving that the IRS valuation is wrong.
• The taxpayer’s standard of proof is by a
preponderance of the evidence.
• If taxpayers fail to carry the burden of
proof, the IRS will prevail.
• An arm’s-length transaction near the
valuation date is a strong indicator of
FMV.
• If arm’s-length data is not available, a
hypothetical willing seller and willing
buyer must be considered.
• Both the willing seller and the willing
buyer must receive equal consideration.
Source: Estate of Kaufman, TCM 1998-157.
614
Tax Court Valuation
© D.L. Crumbley
• The willing seller and willing buyer both
seek to maximize profit.
• In the absence of arm’s-length data, a twostep process will be used: (1) estimate the
value of the stock as if it were publicly
traded, and (2) determine a marketability
discount for the value so determined.
• In this case, Judge Bighe, in rejecting the
IRS experts opinion, stated that the use of
the capital asset pricing model and the
weighted average cost of capital method
are not “the proper analytical tools to
value a small, closely held corporation
with little possibility of going public.”
The judge also found that the IRS expert’s
computation of earnings before interest,
taxes, depreciation, and amortization was
faulty.
Source: Estate of Furman, TCM 1998-157; W.E. Bradley, “Tax
Court Valuation Standards,” Valuation Strategies,
November/December 1999, pp. 35-39.
615
© D.L. Crumbley
Gathering Initial
Information
Goals of pre-engagement phone
contact include:
– Develop trust and rapport
– Gain a brief understanding of the
business
– Determine who will be responsible
for gathering information
– Explain the valuation process and
timing
– Determine methods of
corresponding with the client
616
© D.L. Crumbley
Discerning What Data Is
Required
• Request forecasts of future financial
results
• Review articles on industry-related
valuation issues
• Request client information prior to
company interviews
617
© D.L. Crumbley
Spreading Financial
Statements
Financial spreadsheet reports include:
– Actual and common-sized income
statements
– Actual and common-sized balance
sheets
– Financial statement ratios
– Trend statements
618
© D.L. Crumbley
Analyzing Financial
Statements for Trends
and Risks
The purpose of analyzing a company’s
historic financial statements is to
provide information about these factors
that are crucial in the preparation of a
valid valuation:
– Trends and what they say about the
possible future
– How well or how poorly a
company performs compared to
industry peers
– Key elements of company strategy
619
© D.L. Crumbley
Income Statement
Profitability Analysis
Income statement profitability analysis helps valuators
determine the following:
– Judgments about the historic performance of the
company and the variability of results.
– Results against which to assess management’s
strengths and weaknesses, and how this would
impact an investor’s perception of the shares as an
investment, and their associated risk.
– An objective basis for comparing a company’s
performance relative to its industry peers.
– Insight into a company’s economics and how the
business achieves its net profit on a given level of
revenues.
– Clues concerning the internal and external forces
that affect the business, and what this suggests about
risk, future threats, and opportunities.
620
© D.L. Crumbley
Income Statement
Analysis
• Revenues
–
–
–
–
–
Past trends
Growth rates
Variability in individual annual results
Overall observed results
Identification of the appropriate
questions
• Gross profits
– Components of goods sold
– Calculation of goods sold
•
•
•
•
Operating expenses
Operating profits
Other income and expense
Pretax profitability
621
© D.L. Crumbley
Business Valuation
Standards
• Uniform Standards or Professional
Appraisal Practice (USPAP) from
The Appraisal Foundation
• Code of Professional Conduct from
the American Institute of Certified
Public Accountants (AICPA)
622
© D.L. Crumbley
Features of the
Standards
• Independence
• Fee not contingent on appraised
value
• Limiting conditions
• Professionals participating in the
assignment
• Information sources used
• Report content
• Data collection and analysis
• Methodology
• Reconciliation of findings of value
• Adjustments to valuation findings
• Conclusion of value
623
© D.L. Crumbley
Report Content
• Purpose and scope of the assignment
• Standard of value used
• Identification of the specific interest
being valued
• Specific valuation date used
• Relevant state law governing the
entity
• Scope of the valuation report
624
© D.L. Crumbley
Organization of the
Report
1. Front pages
A. Cover sheet
(with company
name and
valuation date)
B. Transmittal
letter
C. Table of
contents
2. Introduction
3. Company
information
4. Financial
condition
5. Valuation
methodology
6.
7.
Valuation
conclusion
Exhibits
A. Limiting conditions
B. Definitions of
valuation terms
C. Qualifications of the
valuation
professionals who
worked on the
report
D. Common size
balance sheets of
the company
E. Common size
income statements
of the company
F. Ratio analysis of the
company
625
© D.L. Crumbley
Definition
A definition of money laundering that
covers both legal and illegal contexts is
to take money that comes from one
source, hide that source, and make the
funds available in another setting so
that the funds can be used without
incurring legal restrictions or penalties.
626
© D.L. Crumbley
Steps in Money
Laundering
The traditional money laundering
process can be divided into three steps:
1. Money is deposited in a bank or
financial institution.
2. A set of complex transfers is made
to disguise the original source for
the money and to hide the audit
trail. (This step is called layering
the transactions.)
3. The money is integrated back into
the legitimate money supply.
627
© D.L. Crumbley
Cybercash Creates New
Laundering
Opportunities
Using the Internet, it will be
possible for anyone to transfer large
sums of money from one location to
another without using a bank and with
the transfers being totally anonymous.
Today, cybercash transactions are
beginning to take place without the need
for third parties and the consequential
scrutiny that might otherwise exist.
Furthermore, cybercash transfers can be
structured so that they originate in a
jurisdiction where such activities are not
considered illegal.
628
© D.L. Crumbley
Who Uses Money
Laundering Practices?
• Grant recipients
• Criminals
• Political asylum seekers
629
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
1. Often exchange small
denomination bills for one
hundred dollar bills. This
techniques reduces the bulk of the
currency several fold and makes it
easier to conceal and transport.
2. Purchase monetary instruments
such as money order, travelers
checks, bank drafts, cashiers
checks, treasurers checks, and
official bank checks with currency
in amounts below the $3,000
record-keeping requirement,
thereby reducing the bulk of
currency.
630
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
3. Purchase the monetary instruments
mentioned above in increments just
below the $10,000 Currency
Transaction Report threshold. This
will result in the financial institution
identifying the purchaser and
maintaining a log of these
transactions; however, money
launderers recognize that the log is
not filed with the government.
4. Bulk ship currency to a jurisdiction
with bank secrecy laws. Although a
Currency and Monetary Instrument
Report must be filed with the U. S.
Customs Service anytime currency
and/or monetary instruments are
exported from the U. S. or imported
into the U. S. money launderers do
not file the report. Section 371 of the
USA PATRIOT Act makes bulk
shipping cash into or out of the
United States a crime.
631
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
5. Recognize that financial institutions
report repeated deposits of just
under $10,000. Therefore many
money launderers will open several
accounts in the names of family
members and possibly friends at
several financial institutions and
deposit small amounts of currency in
each account. The deposited amount
in these situations may be less than
$1,000 on a daily basis or $2,000 to
$3,000 twice or possibly three times
a week. These deposited amounts
remain below the thresholds of any
known internally developed
monitoring system and would
probably only be detected using
comprehensive technology along with
a compliance team.
632
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
6. May purchase a currency generating
business to launder funds. Money
launderers have used businesses such as
restaurants and service/gasoline
stations. These businesses serve as both
a method to place and layer dirty money
simultaneously.
7. Use electronic transfers to move dirty
money. A money launderer may fund an
electronic transfer with up to $3,000 in
currency without providing identification.
These funds can be rapidly transferred
anyplace in the world. In many cases
the money launderer may request that a
representative of a money service
business (MSB) execute several wire
transfers during the course of a day all
below the $3,000 record-keeping
threshold. The money launderer will
normally offer the MSB employee a bribe
for the accommodation.
633
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
8. May elect to execute electronic transfers
below the $3,000 record-keeping
threshold at several financial
institutions. Doing this will keep these
transfers under the radar screen since
they are small increments and they are
being distributed to multiple places.
9. Purchase a big-ticket item such as a car
and use currency to pay down loans at
an accelerated rate. The dealership is
required to file a currency report if the
money launderer uses currency and/or
monetary instruments with a face value
of $10,000 or less and the total value of
the currency and the monetary
instruments aggregates to over
$10,000. Financing the automobile and
making accelerated payments on the
loan will evade the filing of a currency
report.
634
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
10. Attempt to disassociate
themselves from the proceeds of a
fraud quickly. Money launders may
deposit the fraudulent proceeds
into an account and almost
immediately withdraw those funds
in the form of currency at various
branches of an institution or via
ATMs.
Source: Don Temple, “Money Laundering 101: Ten
Ways to Place Dirty Money,” July 26, 2002,
http://www.smartpros.com/x34833.xml
635
© D.L. Crumbley
Extent of Money Laundering
You know how much dirty money
moves in and out of America every
year? Maybe three hundred billion.
Bigger than the GDP of most
countries. Banks wire transactions,
yes? And how do you find this? Know
how much moves in and out of
American banks every day?”
“I expect you’ll tell me.”
“Two trillion dollars. Pretty soon
you’re talking real money!” Berman
slapped the table in merriment. “All
bank wire transactions. Where you
hide grain of sand so nobody find? On
beach.
“Phony companies, Grigori. You
invented companies that existed only
on paper.”
“Nowadays, these people move
beyond that. Buy real companies.
Insurance companies in Austria,
banks in Russia, trucking companies
in Chile. Cash goes in, cash comes out,
who can say where and when? Who
stops them?
Source: Robert Ludlum, The Janson Directive, New York: St.
Martin’s Paperback, 2002, p. 241.
636
© D.L. Crumbley
Correspondent Banking
Correspondent banking takes place
when one bank provides services to
another bank to move funds, exchange
currencies, and access investment
services such as money market
accounts, overnight investment
accounts, CDs, trading accounts, and
computer software for making wire
transfers and instant updates on account
balances.
A payable-through account enables the
respondent bank’s clients within the
country where the bank is registered to
write checks that are drawn directly on
the respondent bank’s correspondent
account in the United States.
637
© D.L. Crumbley
Tools Banks Use to
Identify
Money Launderers
• Monitoring software
• Currency Transaction Reports
(CTRs) $ 10,000 or above.
• Suspicious Activity Reports (SARs)
See: Don Temple, “Money Laundering 101,” July 26, 2002,
http://www.smartpros.com/x34833.xml
638
© D.L. Crumbley
Due Diligence Laws for
Banks
Laws and regulations require
that a bank perform due diligence in its
relationships with other banks and
important clients as well as continually
monitor account transactions.
Within banks, due diligence
must co-exist with the client’s need for
privacy and the secrecy laws existing
in many foreign jurisdictions that
prevent access to bank documents.
639
© D.L. Crumbley
Shell and Offshore
Banks
• Shell banks are generally high-risk
banks that exist without any physical
presence in any legal jurisdiction.
These banks have a banking license in
a specific country, but they are not
likely to have a staff and may be
operated as part of another business or
operated out of an individual’s personal
residence.
• An offshore banking license prevents
the organization from transacting
banking activities with any citizens of
the licensing jurisdiction or transacting
business with the currency of the
licensing jurisdiction. These bank
operations solely exist within
international financial transactions.
640
© D.L. Crumbley
Warehouse Bank
John stood up and went to an easel. He
took a felt marking pen and began drawing a
chart. “What we’ve done is set up something
called a warehouse bank,” he said, pointing to the
first block. “We take deposits into numbered
accounts, and that’s very important. Once we
establish an account and give you a number, we
destroy any record that would show who owns
the account. This drives the IRS crazy. I saw a
quote from one official who said that
investigating a warehouse bank is like looking for
a needle in a stack of needles.” This got a good
laugh.
“Now, let’s say you open your account
with ten thousand dollars. We then transfer these
funds to certain western banks. When you want
to pay a bill, you send an e-mail to the warehouse
with your instructions and your account number;
that is transmitted to the partner bank, which
sends a banker’s draft to our creditor. So the bill
is paid without your name being mentioned, only
your account number with the creditor. If you
want some cash, you request that by e-mail, too,
and the money is sent by certified mail or an
overnight delivery service.
641
© D.L. Crumbley
Warehouse Bank (cont.)
“At no point in this process are you
identified by anything other than an account
number, so the IRS can’t examine your
records to find out how much money you’re
depositing or how much you’re spending.
This effectively puts a stop to the
enforcement of the income tax laws.”
A man raised his hand. “How much
can we save in taxes this way?”
“Depends on how much you earn,”
John said. “Recently, one of our warehouse
bank customers became the first of us to save
one million dollars in taxes. I can tell you that
we’ve saved our members, collectively, a
quarter of a billion dollars in income taxes.”
Source: Stuart Woods, Orchid Blues, Signet Book 2002, pp. 215216.
642
© D.L. Crumbley
Attacks Against Warehouse Banks
• A Federal jury convicted six defendants
of conspiracy to defraud the IRS in
association with the Christian Patriot
Association, a warehouse bank located in
Boring, Oregan
• Christian Patriot Association (CPA)
members would send deposits of checks,
cash, money orders, and cashiers checks
to CPA. The deposits of all members
were commingled into commercial bank
accounts held in the name of CPA
Services in Oregan and Arizona. CPA
would then pay bills for and mail cash to
CPA members. As a result, the banking
transactions of CPA members were
virtually untraceable.
Source: “News from U.S. Department of Justice, June 7, 2002.
643
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Cash-Oriented
Businesses
•
•
•
•
Currency exchanges
Online auctions
Casinos
Purchasing departments
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Audit Trail
• Churning
• Laundering cycles
1.
2.
3.
4.
5.
Illegal cash
Deposited into bank
Purchase asset
Sell asset
Documented legal cash
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Finding Money
Laundering Schemes
• Web logs
– Tracing IP addresses
– HTTP common logfile format
• Wire transfers
• Bank reports
646
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Guarding Against Money
Laundering
• Individual due diligence
– Business associations
– Employment
• Company due diligence in
verification procedures
– Corporate ownership and
governance
– Bearer shares
• Trust due diligence
– Trust deeds
– Beneficiaries
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Accountant’s Role as
Gateway Keeper
• AICPA Auditing Standards
Governing Money Laundering
– SAS No. 54, Illegal Acts by Clients
– SAS No. 82, Consideration of Fraud in
a Financial Statement Audit (now
replaced by SAS No. 99)
• Lack of Reporting Requirement
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USA Patriot Act of 2001
• International Money Laundering
Abatement and Financial AntiTerrorism Act of 2001 (MLAA)
• Payable-through accounts
• Enhancements and restrictions under
MLAA
• Reporting requirements under
MLAA
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Patriot Act Ineffective
Two years later, some 3,200 banks,
6,000 brokerage firms and 4,400 insurance
companies have yet to implement basic
watch lists to screen new customers,
according to Celent. In many cases, small
outfits would rather pay a fine than install
costly new technology
-----------------------------------------------------Even companies spending big bucks to
comply with the law seem to be fighting a
losing battle. No institution has figured out
a way, for example, to install a centralized
customer-identification system for the
entire company.
Source: M.D. Hovanesian and D. Fairlamb, “Still Drowning in Dirty
Money,” Business Week, December 1, 2003, pp. 102-103.
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Antitrust Laws
Antitrust laws are an outgrowth
of the early years of the Industrial Age
in the United States when a small
number of powerful businessmen used
any tactic at their disposal to force
competitors out of business.
Because such business practices
were not in the best interest of the
country, federal legislation was passed
that prohibits the formation and
continuation of monopolies, except
when in the best interest of the public.
651
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Role of Accountants in
Antitrust Litigation
Accountants may be called
upon to determine whether there is
liability under the antitrust laws. The
primary issue that forensic
accountants address is whether the
defendant has engaged in predatory
pricing.
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Predatory Pricing
• Predatory pricing is the act of
pricing a product so low that the
only logical explanation is that the
pricing is designed to drive
competitors out of business.
• The operational definition is whether
a company prices its products or
services below “average variable
cost” and, if so, predatory pricing is
present.
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Estimating Cost
Behavior Patterns
• Graphic analysis and high-low
method
• Regression/correlation analysis
• Simple linear regression
– Variables
– Least squares regression line
– Standard error of the estimate
• Correlation analysis
– Coefficient of correlation
– Coefficient of determination
– Coefficient of nondetermination
• Association vs. causation
– Movements in the independent
variable
– Reasons for the unexpected
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Federal False Claims Act
The Federal False Claims Act
was passed to protect the government
from the unscrupulous acts of a few
government contractors that
intentionally or carelessly overcharge
the government for goods or services.
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Federal False Claims Act
Litigation
• Fraud allegations
• Whistleblower allegations
– Qui tam suits
– Reasons for bringing action
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Accountant’s Role in
Federal False Claims Act
Litigation
Accountants may act as an
expert witness for the defense, the
government, or a whistleblower
litigating the qui tam parts of the
case.
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Accountant’s Role in
Federal False Claims Act
Litigation
Typical questions that accountants help courts
to answer are:
– What costs should be included in the
contract?
– How should costs be measured under the
contract?
– What is the correct timing of the costs
and/or revenues under the contract?
– What accounting concepts, rules, etc.,
apply under this contract?
– What is the magnitude of the damages
that occurred because of the fraud that
took place?
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Accountant’s Role in
Federal False Claims Act
Litigation
Under the Federal False Claims
Act, a person acts knowingly with
respect to information if the person
has:
– Actual knowledge of information
– Acts in deliberate ignorance of the
truth or falsity of the information
– Acts in reckless disregard of the
truth or falsity of the information
659
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Hacker Defined
A hacker is generally defined as
an individual or group whose intent is
to gain access to a computer network
for malicious purposes.
660
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Collecting Clues and
Evidence
A forensic investigator needs to
be familiar with the protocols used on
the Internet to be able to collect clues
about either internal or external
attackers.
In addition, when law
enforcement officials send requests or
subpoenas for information about a
company’s logs, the forensic analyst
must understand the type of
information being sought.
661
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Protocols
Internet protocols are those rules
allowing different operating systems
and machines to communicate with one
another over the Internet.
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Transmission Control
Protocol (TCP) and
Internet Protocol (IP)
• TCP/IP protocols are the
communication guidelines used and
widely supported over the Internet.
• Almost every packet of information
sent over the Internet uses the
datagrams contained within a TCP/IP
envelope. The datagrams consist of
layers of information needed to verify
the packet and get the information
from the sender’s to the receiver’s
location following traffic control
guidelines.
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Transmission Control
Protocol (TCP) and
Internet Protocol (IP)
• Message encapsulation is used in
sending the packets.
• In message encapsulation, each layer
of information in the sent packet is
interpreted by the same layer at the
receiving end of the transmission.
• Additionally, each layer can only
communicate with the one directly
above or below it.
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Transmission Control
Protocol (TCP) and Internet
Protocol (IP)
Layered Operating System
Interconnection (OSI) Model
Application Layer
Transportation Layer
Network Layer
Data Link Layer
Hardware Layer
Electronic Impulse
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Transmission Control
Protocol (TCP) and
Internet Protocol (IP)
• The application layer issues the commands
that define the operations.
• The transportation layer functions to
provide reliable message delivery.
• The network layer controls the route the
data takes to get to its destination.
• The data link layer transfers the datagram
from one network node to another.
• The hardware layer (or physical layer)
provides the means of sending and
receiving data on a network by converting
bits into voltages for transmission to a coax
cable.
666
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IP Address Defined
An IP address is a 32-bit number (four
bytes) that identifies the sender and
recipient who is sending or receiving a
packet of information over the Internet.
667
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Web Log Entries
• One important method for finding the web
trail of an attacker is in examining web
logs.
• Recorded network logs provide
information needed to trace all website
usage.
• Information provided in a log includes the
visitor’s IP address, geographical location,
the actions the visitor performs on the site,
browser type, time on page, and the site the
visitor used before arriving.
• Logs should be stored on a separate
computer from the web server hosting the
site so they cannot be easily altered.
668
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TCPDUMP
• TCPDUMP is a form of network
sniffer that can disclose most of the
information contained in a TCP/IP
packet.
• A sniffer is a program used to
secretly capture datagrams moving
across a network and disclose the
information contained in the
datagram’s network protocols.
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Decoding Simple Mail
Transfer Protocol
(SMTP)
• SMTP is the protocol used to send email over the Internet.
• SMTP server logs can be used to
check the path of the e-mail from the
sending host to the receiving host.
• Most of the important information
about the origin of an e-mail
message is in the long form of the
header. The most important data for
tracing purposes is the IP addresses
and the message ID.
670
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Tracing and Decoding IP
Addresses
•
•
•
•
Traceroute
Whois
Ping
Finger searches
671
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Narrowing the Search
• Preliminary Incident Response
Form
• John Doe subpoena
672
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Informational Searches
• Internet databases
– General searches
– Name, telephone number, and email address search engines
– Internet relay chat (IRC), FTP,
and Listserv searches
– Usenet postings search
– Legal records
– Instant messaging (IM)
• Web page searches
• Government data searches
• Miscellaneous searches
673
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Cash Receipts Statement?
The receiver, Thomas F. Lennon, hired a CPA,
William Ling, from San Diego. The receiver’s
November 6, 1997 “cash receipt statement”
prepared by Mr. Ling appeared as follows:
Beginning
Balance
$268,439
Money
Distributed to
Investors
$2,281,255
Money
6,704,320 Employees /
Raised From
Principals /
Investors
Overhead
$2,332,066
Oil and Gas
Production
394,575
Oil Field
Operations
$1,616,000
Other
194,575
Attorney’s Fees
Other
1,027,984
158,626
$145,978
674
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The End Is Here
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