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Forensic Accounting: Strategies for Detecting & Controlling Fraud D. Larry Crumbley, CPA, Cr.FA, CFFA, FCPA 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 Risk, Former chair of the Executive Board of Accounting Advisors of the American Board of Forensic Accountants, Member of the NACVA’s Fraud Deterrence Board, and On the AICPA’s Fraud Task Force (2003-2004). A frequent contributor to the Forensic Examiner and Value Examiner, Professor Crumbley is a co-author of CCH Master Auditing Guide, along with more than 50 other books and 350 articles. His latest book entitled Forensic and Investigative Accounting is published by Commerce Clearing House (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. 1 Forensic Report 2 TALLY STICKS “External auditors come down the hill after the battle and bayonet the wounded. Forensic accountants are the guys who follow behind them, going through the soldiers’ pockets looking for money.” 3 Puff Adder “What the use of finger prints was to the 19th century and DNA analysis was to the 20th, forensic accounting will be to the 21st century.” - Gordon Brown, Chancellor of the Exchequer, 10 October 2006. 4 Glimpse Forward Introduction to Forensic Accounting Risk Assessment and Fraudulent Financial Reporting Misappropriation of Assets Forensic Accounting Processes and Techniques Computer Forensics Problem-based learning case study ----------------------------------------------------------Now John at the bar is a friend of mine. He gets me my drinks for free. Sing us a song, you’re the piano man. “Piano Man”Billy Joel 5 Some Fraud Figures Australia’s annual fraud, 2003, $5.8 billion or 1.147% of GDP. Malaysia’s telecom operators lose 3% of revenue to fraud each year. A KPMG Malaysian survey found that more than a third of the polled companies lost over RM 1 million from fraud in 2 years. Fraud and abuse in U.S. is $652 billion to $1 trillion annually. The quantity of corruption crimes has continued to rise in China after the market liberalizations in 1978 (because so much more money involved). An employee at the Australian mint stole $100,145 over ten months by hiding bills and coins in his lunch box and boots. He carried away on an average 150 coins in each boot every day. 6 Fannie Mae Forensic Probe BOD hired investigators who cleared the current management of Fannie Mae of knowingly participating in any wrongdoing. The report took 17 months; 616 pages plus 2,000 plus pages of supporting documents. Cost of $60 million to $70 million. The fraud was estimated to be $11 billion. Former N.H. Senator Warren Rudman used The Huron Consulting Group. 7 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 8 Narrow vs. Broad Definition Narrow: Fraud detection is major area. Broad: Employed to seek, interpret, and communicate transactional and reporting event evidence in an objective, legally sustainable fashion, not only in situations where there are specific allegations of wrongdoing, but also in situations where interested parties judge that the risk of loss from wrongdoing is such that proper prudence requires legally sustainable evidence to support the conclusion that no wrongdoing is occurring (James Edwards). 9 Narrow Approach Accounting Forensic Accounting Internal and External Auditing Accounting Litigation Matters and Investigations Planning Risk Assessment Internal controls Audit Evidence Reporting Fraud Prevention and Deterrence Detection Investigation Remediation U.S. Dept. of Justice, Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students, Draft Copy, December 23, 2005. 10 Broad Approach “I liken it to ‘CSI’ or ‘Law & Order,’ but instead of figuring out the trajectory of a bullet, you’re trying to find out how a transaction occurred.” Terry McCarthy 11 Definition of Forensic Accounting Forensic accounting is the application of accounting, tax, auditing, finance, quantitative analysis, investigative and research skills, and an understanding of the legal process for the purpose of identifying, collecting, analyzing, and interpreting financial or other data or issues in connection with: 1) Litigation services: providing assistance for actual, pending or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of disputes between parties, or 2) Non-litigation services: performing analyses or investigations that may require the same skills used in 1, above, but may not involve the litigation process. 12 Definition of Forensic Accounting Litigation Service Forensic accounting litigation services are the professional assistance accountants provide related to the litigation process. These services may involve accounting, financial, auditing, tax, quantitative analysis, and investigative and research skills, as well as an understanding of the legal process to provide assistance for actual, pending, or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between parties. 13 Definition of Forensic Accounting Non-Litigation Services Forensic accounting non-litigation services are the professional assistance accountants provide not related to the litigation process. These services may involve accounting, financial, auditing, tax, quantitative analysis, and investigative and research skill as well as an understanding of the legal process to provide assistance in connection with matter or issues not involving the litigation process. “You’re trying to piece together a puzzle where you do not have the picture on the box to know what it’s going to look like. The facts are not settled, and actually it’s the facts that are in dispute.” Andrew Bernstein 14 Short History 1. Late 1800’s – Find fraud 2. 1930’s- Puff Adder –encyclopedia 3. 1933-1934-independent audits 4. 1950’s-Eighth edition Montgomery auditing reduced formal stress on fraud detection. 5. January 1957- H.W. Bevis, AR, questioned the benefit of discovering minor employee thefts. 6. 1960s-auditors claimed no responsibility. 7. Financial audits: Consistency. 8. Audit surveillance: test of details (disappeared). 9. Stock market bubble 10. Panel on Audit Effectiveness (2000) 11. Enron/ WorldCom/ Parmalat/ HealthSouth 12. Sarbanes-Oxley/ PCAOB 13. SAS No. 99 15 Transparency International Corruption Perceptions Index 2006 Country Rank Country 2006 CPI Score Surveys used Confidence range 1 Finland 9.6 7 9.4 - 9.7 Iceland 9.6 6 9.5 - 9.7 New Zealand 9.6 7 9.4 - 9.6 4 Denmark 9.5 7 9.4 - 9.6 5 Singapore 9.4 9 9.2 - 9.5 6 Sweden 9.2 7 9.0 - 9.3 7 Switzerland 9.1 7 8.9 - 9.2 8 Norway 8.8 7 8.4 - 9.1 9 Australia 8.7 8 8.3 - 9.0 Netherlands 8.7 7 8.3 - 9.0 Austria 8.6 7 8.2 - 8.9 Luxembourg 8.6 6 8.1 - 9.0 United Kingdom 8.6 7 8.2 - 8.9 14 Canada 8.5 7 8.0 - 8.9 15 Hong Kong 8.3 9 7.7 - 8.8 16 Germany 8 7 7.8 - 8.4 17 Japan 7.6 9 7.0 - 8.1 18 France 7.4 7 6.7 - 7.8 Ireland 7.4 7 6.7 - 7.9 Belgium 7.3 7 6.6 - 7.9 Chile 7.3 7 6.6 - 7.6 USA 7.3 8 6.6 - 7.8 Belarus 2.1 4 1.9 - 2.2 Cambodia 2.1 6 1.9 - 2.4 Côte d´Ivoire 2.1 4 2.0 - 2.2 Equatorial Guinea 2.1 3 1.7 - 2.2 Uzbekistan 2.1 5 1.8 - 2.2 Bangladesh 2 6 1.7 - 2.2 Chad 2 6 1.8 - 2.3 Congo, Democratic Republic 2 4 1.8 - 2.2 Sudan 2 4 1.8 - 2.2 Guinea 1.9 3 1.7 - 2.1 Iraq 1.9 3 1.6 - 2.1 160 Myanmar 1.9 3 1.8 - 2.3 163 Haiti 1.8 3 1.7 - 1.8 11 20 151 156 160 16 States Corruption Index Most corrupt: Least corrupt: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Mississippi North Dakota Louisiana Alaska Illinois Montana South Dakota Kentucky Florida New York Nebraska Oregon New Hampshire Iowa Colorado Utah Minnesota Arizona Arkansas Wisconsin 17 Forensic Accounting Factors Time: Forensic accounting focuses on the past, although it may do so in order to look forward (e.g., damages, valuations). Purpose: Forensic accounting is performed for a specific legal forum or in anticipation of appearing before a legal forum. Peremptory: Forensic accountants may be employed in a wide variety of risk management engagements within business enterprises as a matter of right, without the necessity of allegations (e.g., proactive). ----------------------------------------------With a single clue a forensic accountant can solve a fraudulent mystery. 18 One Small Clue A former Scotland Yard scientist tried to create the world’s biggest fraud by authenticating $2.5 trillion worth of fake U.S. Treasury bonds. When two men tried to pass off $25 million worth of the bonds in Toronto in 2001, a Mountie noticed the bonds bore the word “dollar” rather “dollars.” Police later raided a London bank vault and discovered that the bonds had been printed with an ink jet printer that had not been invented when the bonds were allegedly produced. Zip codes were used even though they were not introduced until 1963. Sue Clough, “Bungling Scientist Is Jailed for Plotting World's Biggest Fraud,” News.telegraph.co.uk, January 11, 2003. 19 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. 20 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 --------------------------------------------------------------- “ Forget the stuffed white shirt, forensic accountants are more parts Philip Marlowe than Casper Milquetoast. They open the books and crack the code, transforming a dull science of numbers into a suspenseful mystery with a logical, even riveting resolution.” Cory Johnson 21 Top Niche Services 1. Attest Services 2. Business Valuations 3. Estate/ Trust/ Estate Planning 4. Forensic/Fraud 5. Litigation Services 6. International Tax .......... 11. Personal Financial Planning 14. SOX Compliance 15. Technology consulting 87% 82% 82% 75% 75% 72% 57% 53% 53% Source: Accounting Today (2008). 22 Forensic Accounting vs. Fraud Auditing Forensic Accountant: A forensic accountant may take on fraud auditing engagements and may be a fraud auditor, but he or she will also use other accounting, consulting, and legal skills in broader engagements. In addition to accounting skills, he or she will need a working knowledge of the legal system and excellent communication skills to carry out expert testimony in the courtroom and to aid in other litigation support engagements. Crumbley, Heitger, Smith, Forensic and Investigative Accounting (CCH) 23 AICPA’s Position Public accounting firms could use forensic accountants to help revise their approach to planning and fieldwork on all audits, while requiring forensic accountants only on high risk audit clients to aid in the interpretation of forensic testing results and preventive control enhancements. Does not require auditors to carryout specific forensic procedures, but rather provide guidance on how to include forensic techniques within processes outlines in SAS 99. This combination will enhance the detection and prevention of fraudulent financial statement reporting and misappropriation of assets; thus protect investors and financial statement users. The inclusion of audit procedures focused towards detecting misappropriation of corporate assets may lead to the identification of weaknesses within corporate governance or control weaknesses. Frauds that are identified which represent a material misappropriation of assets could significantly impact public perception. 24 AICPA’s Position (cont.) Professional forensic accountants can best be used by ensuring such procedures are properly developed and executed in-line with internal audit and audit committee concerns. Forensic accountants could then be engaged in high-risk situations, or when a fraud is suspected. Companies should not use the forensic services of their outside audit firm, unless it pertains to the annual audit. Putting a price on a substantive test or forensic auditing procedure may be smart for business; however, the inherent risk is that short-cuts geared towards reducing audit costs may eventually cause investors to question the companies’ true financial position. AICPA – Discussion Memo Question Responses 25 Big-Six's Position A forensic audit is akin to a police investigation. All public companies should have a forensic audit on a regular basis. Companies would be required to have such an audit every three or five years or face these audits on a random basis. Forensic auditors scrutinize all records of companies, including emails, and would be able, if not required, to question all company employees, and to require statements under oath. Might be necessary for an audit network or a specialized forensic auditor to complete a forensic audit with the aid of independent attorneys (not these who have represented the audit client in the other engagements). Source: “Serving Global Markets and the Global Economy: A View from the CEOs of the International Audit Networks, November 2006, p. 13. 26 Forensic vs. Fraud Audit Google result, February 11, 2007 Forensic Audit, 208,000 hits Fraud Audit, 64,500 hits Fraud Examination, 74,800 hits Fraud Accounting, 45,200 hits Forensic Accounting, 1,050,000 hits Fraud Investigation, 932,000 Forensic Investigation, 512,000 Fraud Auditing, 83,500 ---------------------------------------------I don’t care what they say, but [forensic accounting] is here to stay. Danny & the Juniors ----------------------------------------------------------------------------------- I see skies of blue and clouds of white, and I think to myself, what a wonderful world. Louis Armstrong 27 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. 28 Asset Tracing Three Italian lawyers said in a filing to be presented to a bankruptcy court that they had traced $7.7 billion in missing Parmalat funds. “We are preparing a filing in which we are asking for the insolvency status to be revoked because the money was robbed and not lost,” lawyer Carlo Zauli told Reuters. But he said it would be an illusion to believe proof of electronic transfers of the funds could be found and the lawyers representing the Parmalat Creditors Committee did not say where the money was being held or if it was recoverable. An Italian website, TGfin (www.tgfin.it), said a company linked to Parmalat founder Tanzi was holding the funds in the form of U.S. bonds in an account with Bank of America. Source: Emilio Parodi and Stefano Bernabei, “Wrap-up 2: Paramalat Fraud Probe Widens to Auditors, Ex-Banker, “forbes.com, January 8, 2004. 29 Finding Unreported Income/Hidden Assets 1. 2. 3. 4. 5. 6. 7. Look at the lifestyles. Look at the expenses. Look at the cash flow. Look at the business operations. Look at the industry ratios. Consider using private investigators. Use the net worth method. Mark Kohn, “Unreported Income and Hidden Assets,” Forensic Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards, 2005, pp.49-57. 30 Fiction v. Reality The main difference between fiction and reality is that instead of using mask and gun, today’s villains use mouse and keyboard. Instead of hiding behind a lamppost in a trench coat and fedora, today’s forensic accountants are more likely to be hiding behind their own computers, searching for clues amid mountains of data. Source; “Book ‘EM! Forensic Accounting in History and Literature,” The Kessler Report, Vol.1, No. 2. ------------------------------------------------------------------------------------ “Every investigation I did as a prosecutor, you have a particular target, but it always branches off because something else gets your attention. And that’s what is going to happen with a forensic accountant.” Tom Carlucci: E-library Rueter Library September 20, 2002 31 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.” Source: Cassell Bryan Low, “Accounting Firms Attempts to Dispel the Cloud of Fraud,” Wall Street J., May 27, 2003. 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 32 Popular (cont.) E&Y’s forensic accounting team is comprised of 350 practitioners in the U.S. alone, and focuses on strategies to mitigate and manage conflict in bankruptcy disputes, financial and economic damages, fraud and investigations, government contracts and grants, insurance claims, intellectual assets, and legal technology. Deloitte’s forensic accounting expertise includes anti-money laundering, the Foreign Corrupt Practices Act, purchase price disputes, arbitrations, construction fraud, health care fraud, construction oversight, intellectual property theft, and misdirected royalty revenues, to name just a few. They have forensic labs in nine major cities across the U.S. and an additional 18 cities around the world, including Hong Kong, London, Amsterdam, Frankfurt, Cape Town and Melbourne.” All FAS labs meet the FBI’s chain of custody requirements. “They are secure, state-of-the-art, and house advanced systems for storing and accessing data, including dedicated servers and fire-resistant safes. Stuart Kahan, “Sherlock Holmes Enters Accounting,” WebCPA, February 11, 2007. 33 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. 34 Potpourri Deutsche Bank is being sued for $1.3 billion by Bruce Winston (one of the heirs of Harry Winston diamond dynasty) for priceless gems disappearing from a trust under their control. A Burlington, Kentucky city finance director is accused of embezzling more than $1.2 million to support his estranged wife and his girlfriend. Martin Frankel vanished with between $200 million in cash and diamonds one day. He accomplished this insurance fraud by buying poorly capitalized insurance companies, cooking the books to show increased premium value, and by including non-existing real estate and leases on the balance sheet. Bank of China’s Mr. Wu allegedly embezzling up to $18 million from a bank branch, using improper bills of exchange. BoC has a number of cases involving the embezzlement of $737 million from branches in the Southern Guangdong Province. A U.S. Lime officer embezzled nearly $2.2 million by forging signatures of other company officers on checks, and falsifying the company’s check register to create the impression that the amounts he received went to U.S. Lime creditors. 35 Potpourri (contd …) The Chairman of Hyundai Motor, Chung MongKoo, was sentenced in February 2007, to 3 years in prison for embezzlement ($100 million) and breach of trust at South Korea’s largest carmaker. Spanish authorities shut down Afinsa’s Forum stamp-investing programs with several hundred thousand of small investors. Alleged investments in overvalued stamps and suspected pyramid scheme. Eight officials jailed. In 2000, Rent Way’s CAO artificially reduced the company’s expenses by $127 million. WorldCom’s external auditors missed about $11 billion improperly booked items. Ahold NV, a Dutch company, said a U.S. unit had overstated revenues by $880 million by booking more discounts from suppliers than actually received. One Philippine peso coin has the same size as 1 dirham, but worth only 7 fils. Thus, dispense machine fraud. 36 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 37 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 38 Find It, or I’ll Sue Accountants must be attuned to detecting fraud at every level of service, including standard accounting services, compilations, reviews, and bank reconciliations. If there is fraud and you don’t detect it, you are going to be sued, and you will likely lose, as the public perception is the accountant is the watchdog. Robert J. DiPasquale, Parsippany, N.J. Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28. 39 Forensic Accounting Knowledge Base Investigative auditing LAW Criminology Accounting Forensic Accountant Silk, Silk, Silk 40 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. 41 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. 42 Al Capone Caper “Perhaps the most celebrated case of an accountant nailing a famous criminal was the case of Al Capone. For all of Capone’s colorful history of violent crime, the FBI could never gather enough evidence to convict him until FBI agent Eliot Ness had an idea. He gathered special agents of the IRS to track the flow of cash from Capone’s illicit activities. When the mobster failed to pay taxes on those earnings, the IRS nailed him for tax evasion. Capone went to jail and was never a factor again. IRS recruitment posters boast till this day: ‘Only an accountant could catch Al Capone.’” Source: “Book ‘Em! Forensic Accounting History and Literature,” The Kessler Report, Vol. 1, No. 2. 43 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. 44 The Essence of Forensic Accounting by Maurice Peloubet (1946): “The preparation of data for and the appearance before government agencies as a witness to facts, to accounting principles, or to the application of accounting principles is essentially forensic accounting practice rather than advocacy.” Modern Version “Let’s face it, we in the forensic profession labor in an obscure corner of the vineyard. We are the carefully selected, trusted, highly trained guardians of one of the last great secrets remaining on the face of the earth - - the $600 billion [now $652], more or less annual problem nobody knows about.” Joseph W. Koletar, Fraud Exposed, John Wiley & Sons, Inc 2003, p. 228. 45 Be like 46 Panel on Audit Effectiveness In 1998, the Public Oversight Board appointed the Panel on Audit Effectiveness to review and evaluate how independent audits of the financial statements of public companies are performed and to assess whether recent trends in audit practices serve the public interest. In 2000, the Panel issues a 200-page report, Report and Recommendations, which includes a recommendation that auditors should perform forensic-type procedures during every audit to enhance the prospects of detecting material financial statement fraud. Did not believe a GAAS audit should become a fraud audit. In all audits the degree of audit effort in forensic- type steps should be more than inconsequential [p. 24]. 47 Required Forensic Audits Coming? The accounting profession may be making a strategic shift as they see that SAS No. 99 and the other rules are not protecting them from being the insurer of last resort. The Big Four along with Grant Thornton and BDO International recently released a report entitled “Serving Global Capital Markets and the Global Economy.” In the report, one of the things they are suggesting is for companies to have a forensic audit. Companies would be required to have such an audit every five years or face these audits on a random basis. “Auditing Firms Urge New Ways to Detect Fraud,” NYSSCPA.org News Staff. Posted on November 11, 2006. 48 Fraud Strategies Differ 1. 2. 3. 4. 5. 6. Forensic Accountants Internal Auditors External Auditors Fraud Examiners Certified Fraud Deterrence Analysts (CFD) or CFFAs Forensic CPA Society (FCPA) 49 Predication The ACFE group indicates that in the private sector, a fraud investigation should not be conducted without proper predication. Examples: Anonymous tips, complaints, audit inquires, conflict of interest. Thus, predication is the basis for undertaking a fraud investigation. Without predication, the target might be able to sue for real or imaginary damages. 50 Who Do You Call? Detection v. Deterrence Proactive v. Reactive 51 Three Classes of Controls Preventive controls: These controls are first in line to prevent errors, omissions, or security incidents from occurring. Examples include controls that restrict access to systems to authorized persons such as intrusion prevention systems and firewalls, and integrity constraints that are embedded within a Database Management System. Most Efficient Detective controls: These controls detect errors or incidents that have eluded the preventative controls. Examples include controls that test whether authorization limits have been exceeded, or an analysis of activity in previously dormant accounts. Important when preventive controls weak. Examples include situations where the transactions are derived from third party reports such as sales reports from franchisees, warranty claims reported by auto dealers, baggage claims reported by passengers at airports, and reports of coupons or rebates redeemed by redemption processors. Corrective controls: These controls correct errors, omissions, or incidents after detection. They vary from simple correction of data-entry errors, to identifying and removing unauthorized users from systems or networks. Corrective controls are the actions taken to minimize further losses. Sources: IIA, 2005, Global Technology Audit Guide: IT Controls, Altamonte Springs, Fl; M. J. Nigrini, “Monitoring Techniques Available to the Forensic Accountants,” J. of Forensic Accounting, Vol. 7, 2006, p. 322. 52 Where Fraud Prevention and Security Meet Fraud Prevention Sarbanes-Oxley Compliance Data Mining for Fraud Ethics Policy Anonymous Tip Line Risk Assessment Fraud Policy Security Background Checks Site Security Survey Loss Prevention Strategy Information Security Investigations Interviews Screening Tools for External Fraud Guards Closed Circuit TV Swipe Cards Locks Fences Badges Disaster Recovery Source: M.T. Biegelman and J. T. Bartow, Executive Roadmap to Fraud Prevention and Internal Controls, John Wiley, 2006, pp. 325-326. 53 Balancing Risks and Controls Excessive Risks • • • • • Loss of Assets Poor Business Decisions Noncompliance Public Scandals Increased Regulations Excessive Controls • • • • • Increased Bureaucracy Reduced Productivity Increased Complexity Increased Cycle Time Increase of no-value activities 54 Types of Controls Preventive controls • Segregation of duties • Required approvals • Securing assets • Passwords • Using document control numbers • Drug testing • Job rotation • Computer backup Detective controls • Reconciliations • Reviews • Event notifications • Surprise cash count • Counting inventory Corrective controls • Training • Process redesign • Additional technology • Quality circle teams • Budget variance reports 55 Forensic-Type Organizations American College of Forensic Examiners (2750 E. Sunshine, Springfield, MO 65804; 800-423-9737; www.acfei.com. DABFA and Cr.FA; 2000) Certified Fraud Examiners (Association of CFEs, The Gregor Bldg., 716 West Avenue Austin, TX 78701; 800-245-3321; www.cfenet.com). Certified Insolvency and Reorganization Accountant (CIRAs). Accountants, lawyers, consultants included in insolvency and bankruptcy matters. 3-part exam. 4,000 hours. 541.858.1665. AIRA, 221Stewart Avenue, Suite 207, Medford, Or. 97501. [email protected] Forensic CPA Society (FCPA); formed in July 2005, Spokane, WA. [email protected]. Certified Forensic Financial Analyst (NACVA, Salt Lake City, Utah 84106; 801-486-0600). Also, Certified Fraud Deterrence (CFD) analyst. [CFFA and CFD have merged.] National Litigation Support Services Association (NLSSA, III East Wacker Drive, Suite 990, Chicago, IL 60601; 800-8690491). Not-for-profit. About 20 firms. $1,825. Canadian Institute of Chartered Accountants (CICA) – CA.IFA – Alliance for Excellence in Investigative Accounting. Certified Forensic Investigator (CFI) – Canada Early 1980’s. www.homewoodave.com Certified Fraud Specialist (CFS), not-for-profit, educational antifraud corporation located in Sacramento, Calif., for those dealing in white-collar crime, fraud, and abuse issues. Association of Certified Fraud Specialists. http://acfsnet.org. 56 Fraud Some accountants believe that ethics is a place in England. Essex, U.K. ------------------------------------------------------ A statement made by Mark Twain about New England weather applies to fraud and corruption: “It’s hard to predict, but everyone agrees there’s plenty of it.” ------------------------------------------As Sherlock Holmes said, “the game is afoot.” -------------------------------------------------Read My Lips; It’s The Fraud, Stupid. 57 Termites, Rust, and Fraud • Just as termites never sleep, fraud never sleeps. • Just like termites, fraud can destroy the foundation of an entity. ------------------------------------------------------------Like rust, fraud never sleeps. ------------------------------------------------------------"It is simply impossible to eliminate economic crime. It's like fighting the mythical Hydra, cutting off one form of fraud merely allows another to grow. Controls alone are not enough. The answer lies in establishing a culture that supports control efforts and whistle-blowing with clear ethical guidelines. Companies need to build loyalty to the organization which gives employees the confidence to do the right thing, and identify clear sanctions for those who commit fraud, regardless of their position in the company." Steven Skalak 58 White-Collar Crime: Rich People Steal • Edwin Sutherland coined the term “white-collar crime.” [Indiana University sociology professor.] • Sutherland believed that whitecollar crime is a learned behavior, a consequence of corporate culture where regulations are regarded as harassment, and profit is the measure of the man. • “White-collar crime violates trust and thus creates distrust, and this lowers social morale and produces social disorganization on a large scale. Cynthia Crossen, “A Thirties Revelation: Rich People Who Steal are Criminals, Too,” Wall Street Journal, October 15, 2003, p. B-1. 59 FBI Crime Classification Manual 1. Personal Cause Homicide. 2. Sexual Homicide. 3. Group Cause Homicide. 4. Criminal Enterprise Homicide • • • • • • • • • Contract killing. Gang-motivated. Criminal competition. Kidnap murder. Product tampering. Drug murder. Insurance/ inheritance. Felony-murder. Commercial profit. 60 Red-Collar Crime • A person who physically harms someone that may have, or is on the verge of detecting their fraudulent behavior. • Fraud-detection homicide. • Myth: White-collar criminals not violent criminals. • Forensic accountants may be used in a homicide investigation when fraud detection may be the motive for the murder. • Fraud-detection motive may be important when a prosecutor has weak direct evidence. Source: F.S. Perri and T.G. Lichtenwald, “A Proposed Addition to the FBI Criminal Classification Manual: Fraud-Detection Homicide,” The Forensic Examiner, Winter 2007, pp. 18-30. 61 Michael Comer’s Types of Fraud 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. 1. Source: M.J. Comer, Investigating Corporate Fraud, Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5. 62 How Corruption Occurs Category Conflicts of Interest Bribery Illegal Gratuities Extortion % 61.6% 42.7% 29.8% 16.9% Source: 2006 Wells Report, ACFE. 63 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. 64 Starwoods Hotels Poll of Executives Starwoods Hotels interviewed 401 top executives who golf. The results are surprising. Consider themselves to be honest in business 99% Played with someone who cheats at golf 87% Cheated themselves at golf 82% Hated others who cheated at golf 82% Believe that business and golf behaviors are parallel 72% Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA Today, June 26, 2002, p. A-1. 65 The Cost of Fraud Organizations lose 5 percent of annual revenue to fraud and abuse. Fraud and abuse costs U.S. organizations more than $652 billion annually (about $4,500 per employee). The average organization loses more than $12 a day per employee due to fraud and abuse. Source: 2006 Wells Report 66 The Trillion Dollar Gorilla (in Billions) U.S. Business1 $256.32 Federal Government2 239.75 State Government3 354.21 Tax-exempts4 134.5 Local Government5 Annual Fraud (trillion) 68.4 $ 1.053 1. 2002 Statistics of Income, $1,281.6 trillion time 20%. 2. $2.3975 trillion budget times 10% 3. $3,542.1 million times 10% 4. $897 billion in revenue times 15%. 5. $684.6 billion times 10%. 67 Fraud Multiplier Employee Fraud = $ for $ reduction in net income Suppose $100,000 bottom line reduction. Suppose 20% profit margin How much new revenue needed to offset the lost income? $100,000 = $500,000 20% So ACFE says $652 billion lost per year (2006). $652 billion = $3.26 trillion needed 20% revenue ----------------------------------------------------The FBI estimates that white collar crime is $300 billion each year in the U.S. 68 The Cost of Fraud (cont.) Over 90% of occupational frauds involve asset misappropriations. Average length of a fraud scheme is 15 to 24 months. Most common way of detecting occupational fraud is by tips from employees, customers, vendors, or anonymous sources. Second way, by accident. Third most common detection: internal audit (2nd in 2004). The most targeted asset is cash. Source: 2006 Wells Report 69 Ernst & Young 2002 Survey • More than 20 percent of the respondents were aware of fraud in their workplace. • Nearly 80 percent would be willing to turn in a colleague thought to be committing a fraudulent act. • Employers lose a staggering 20 percent of every dollar earned to some type of workplace fraud. • More frequently committed frauds are theft of office items, claiming extra hours worked, inflating expense accounts, and taking kickbacks from suppliers. • Women are more likely than men to report fraudulent activities. • Older employees were more likely to report fraudulent activities than younger employees. Ernst & Young. “American Works: Employers Lose 20 Percent of Every Dollar to Work Place Fraud.” (2002) Available at http://www.ey.com/global/Content.nsf/US/Media_Release_-_0870 05-02DC Advantage of Compliance Spending General Counsel Roundtable says that each $1 of compliance spending saves organizations, on the average, $5.21 in heightened avoidance of legal liabilities, harm to the organization’s reputation, and lost productivity. Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April 2004, p. 47. 71 Comparison of Selected Fraud Surveys Type Time Period Number of participants (population) Response Estimated fraud in U.S. KPMG PwC ACFE Questionnaire Interview Questionnaire 2005-2006 2005 2006 4,056 (6,797) 3,634 1,134 (11,112) 59.7% Unknown 10.2% Not given $1.7 million per company $652 billion (revenue) % of companies experiencing fraud 74% reporting misconduct 45% tangible fraud Unclear (100%) Highest fraud industry Public sector Retail/ Consumers Banking/ Financial Services Second highest fraud industry Global Manufacturers Financial Services Government Top – Fraud detection – Tips Not given 28% 34.2% Fraud detection – Internal audits Not given 26% 20.2% Fraud detection – by accident Not given 6% 25.4% Some recover of fraud Not given 47% 57.9% Gender of perps - male Not given 87% 61% Likely age Not given 31-40 (38%) 41-50 (34.6%) Fraud by senior mgt. Not given 24% 20.9% Fraud by Accounting dept. Not given Not given 30.3% Fraud with undergraduate degree Not given 52% 45.6% Best control measure External audits Hotlines/ surprise audit Second best control measure Internal audits Internal audit 72 PWC 2007 Survey Fraud's pervasiveness Over 43 percent of the companies interviewed reported suffering one or more significant economic crimes. The average loss from fraud per company increased nearly 40 percent in two years from roughly US$1.7 million in 2005 to approximately US$2.4 million in 2007. Over 80 percent of our respondents who suffered fraud also stated that this had caused damage — or significant damage — to their business. No industry is immune from the threat posed by economic crime although different sectors are impacted by different types of fraud. Management's impact The level of collateral damage is directly proportional to the seniority of the perpetrator. In 29 percent of the occasions where senior managers were involved, the collateral damage to the brand was very significant. Controls and culture Internal controls are not enough. An ethical corporate culture plays an equally important role in deterring fraud. Companies with both ethical guidelines and compliance programs report suffering fewer economic crimes. 73 PWC 2007 Survey (cont.) . Emerging markets Over 43 percent of the companies interviewed reported suffering one or more significant economic crimes in the past two years. Companies in which parent and subsidiaries employed different accounting systems where more susceptible to fraud (61 percent of cases) than those operating a unilateral system (52 percent). E7 'experts' perceive significant risk associated with levels of corruption, staff integrity and legal environment in the emerging markets. Actual levels of reported fraud in the E7 countries are consistently high in the area of asset misappropriation. 44 percent of IP infringement cases (worldwide) that involved a perpetrator overseas involved a perpetrator from China. Source: PWC Global Economic Crime Survey 2007 97 Scienter Necessary To prove any type of fraud, prosecutors must show that scienter was present. That is, the fraudster must have known that his or her actions were intended to deceive. ------------------------------------------------The allure of numbers to most of us, is like the excitement of settling sand--a narcoleptic surety. Crafty criminals prey on this boredom. They pile on the numbers, spewing meaningless records in the false books. Cory Johnson 75 Fraud Legally, Black’s Law Dictionary defines fraud as: All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth, and includes all surprise, trick, cunning or dissembling, and any unfair way by which another is cheated. The four legal elements to fraud are A false representation or willful omission regarding a material fact. The fraudster knew the representation was false. The target relied on this misappropriation. The victim suffered damages or incurred a loss. --------------------------------------------------------------------- Institute of Internal Auditors definition: Any illegal acts characterized by deceit, concealment, or violation of trust. These acts are not dependent upon the applications to obtain money, property, or services; to avoid payment or loss of services; or to secure personal or business advantage. 76 How Fraud Occurs Source: KPMG Fraud Study 77 Types of Fraud Source: KPMG Fraud Study 78 Certain Fraud is Increasing Source: KPMG Fraud Study 79 Occupational Fraud By Industry Median Loss ($) Banking/ Financial Services 14.3% 258,000 Government/ Public Administration 11.5% 82,000 Manufacturing 9.7% 413,000 HealthCare 8.6% 160,000 Insurance 7.5% 100,000 Retail 7.2% 80,000 Education 7.0% 100,000 Service (General) 5.8% 163,000 Service (Professional, etc.) 5.6% 300,000 Construction 3.4% 500,000 Utilities 3.3% 124,000 Oil/ Gas 3.1% 154,000 Real Estate 2.9% 200,000 Wholesale trade 2.9% 1,000,000 Mining .01% 17,000,000 Source: 2006 Wells Report, ACFE. 80 One Piece at a Time Johnny Cash (1976) 81 One Piece At A Time Well, I left Kentucky back in '49 An' went to Detroit workin' on a 'sembly line The first year they had me puttin' wheels on cadillacs Every day I'd watch them beauties roll by And sometimes I'd hang my head and cry 'Cause I always wanted me one that was long and black. One day I devised myself a plan That should be the envy of most any man I'd sneak it out of there in a lunchbox in my hand Now gettin' caught meant gettin' fired But I figured I'd have it all by the time I retired I'd have me a car worth at least a hundred grand. CHORUS I'd get it one piece at a time And it wouldn't cost me a dime You'll know it's me when I come through your town I'm gonna ride around in style I'm gonna drive everybody wild 'Cause I'll have the only one there is a round. So the very next day when I punched in With my big lunchbox and with help from my friends I left that day with a lunch box full of gears Now, I never considered myself a thief GM wouldn't miss just one little piece Especially if I strung it out over several years. 82 One Piece At A Time The first day I got me a fuel pump And the next day I got me an engine and a trunk Then I got me a transmission and all of the chrome The little things I could get in my big lunchbox Like nuts, an' bolts, and all four shocks But the big stuff we snuck out in my buddy's mobile home. Now, up to now my plan went all right 'Til we tried to put it all together one night And that's when we noticed that something was definitely wrong. The transmission was a '53 And the motor turned out to be a '73 And when we tried to put in the bolts all the holes were gone. So we drilled it out so that it would fit And with a little bit of help with an A-daptor kit We had that engine runnin' just like a song Now the headlight' was another sight We had two on the left and one on the right But when we pulled out the switch all three of 'em come on. The back end looked kinda funny too But we put it together and when we got thru Well, that's when we noticed that we only had one tail-fin About that time my wife walked out And I could see in her eyes that she had her doubts But she opened the door and said "Honey, take me for a spin." . 83 One Piece At A Time So we drove up town just to get the tags And I headed her right on down main drag I could hear everybody laughin' for blocks around But up there at the court house they didn't laugh 'Cause to type it up it took the whole staff And when they got through the title weighed sixty pounds CHORUS I got it one piece at a time And it didn't cost me a dime You'll know it's me when I come through your town I'm gonna ride around in style I'm gonna drive everybody wild 'Cause I'll have the only one there is around. (Spoken) Ugh! Yow, RED RYDER This is the COTTON MOUTH In the PSYCHO-BILLY CADILLAC Come on Huh, This is the COTTON MOUTH And negatory on the cost of this mow-chine there RED RYDER You might say I went right up to the factory And picked it up, it's cheaper that way Ugh!, what model is it? Well, It's a '49, '50, '51, '52, '53, '54, '55, '56 '57, '58' 59' automobile It's a '60, '61, '62, '63, '64, '65, '66, '67 '68, '69, '70 automobile. 84 Missing Fraud Auditors will continue to miss fraud because much of their work is predicted on the assumption that separation of duties prevents fraud (i.e., one person hold the money and another person keeps track of it). The Equity Funding case shakes the foundations of auditing in that so much is based on the assumption that people don’t collude very long. These people work together as an efficient team for a very long time [9 years]. Lee Seidler ------------------------------------------“When the sun goes down, then the sneaks will play at night.” From Porter Wagoner “Sneaks Crawl at Night.” 85 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 86 FBI Part 2 Offenses — Female Embezzlement Fraud Forgery Larceny – theft Serial Killer (62) 41% 39% 36% 33% 20% 87 White-collar criminals have these characteristics: Likely to be married. Member of a church. Educated beyond high school. No arrest record. Age range from teens to over 60. Socially conforming. Employment tenure from 1 to 20 years. Acts alone 70% of the time. Source: Jack Robertson, Fraud Examination for Managers and Auditors (1997). 88 Other Characteristics of Occupational Fraudsters: Egotistical Risk taker Hard Worker Greedy Disgruntled or a complainer Overwhelming desire for personal gain Pressured to perform Inquisitive Rule breaker Under stress Financial need Big spender Close relationship with vendors / suppliers Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff, http://www.bus.lsu.edu/accounting/faculty/lcrumbley/fraudste r.html 89 Quotes 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. - 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 90 “Finding fraud is like trying to load frogs on to a wheelbarrow.” Larry Crumbley It’s easy to fall in love; It’s easy to commit fraud; It’s hard to catch the fraud. 91 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. 92 How Fraud Is Detected 2006 2004 1. Tips 34.2% 39.6% 2. By accident 25.4% 21.3% 3. Internal audit 20.2% 23.8% 4. Internal controls 19.2% 18.4% 5. External audits 12.0% 10.9% 6. Notification by police 3.8% 0.9% Source: 2006/ 2004 Wells Reports, ACFE. A British publication suggests that prosecutors think that accountants have x-ray vision. “It is assumed that if an accountant stares really hard at a set of accounts, then somehow, magically, information will appear before his/ her eyes that are invisible to lesser mortals.” NIFA News, Number 10, p.1. 93 Sources of Tips 1. Employees 64.1% 2. Anonymous 18.1% 3. Customers 10.7% 4. Vendors 7.1% Source: 2006 Wells Report, ACFE. 94 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. 95 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. 96 Quotes You should attack fraud problems the way the fictional Sherlock Holmes approached murder cases D. Larry Crumbley -------------------------------------------- To be a good fraud auditor, you have to be a good detective. Source: Robert J. Lindquist ------------------------------------------------------- Many lap-dog internal and external auditors need to be replaced with junkyard dogs. D. Larry Crumbley 97 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.ht m. 98 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. -------------------------------------------------------------------------------------- 30% of people in U.S. are dishonest. 30% situational dishonest. 40% are honest all of the time. Source: R.C. Hollinger, Dishonesty in the Workplace, Park Rider, N.Y.: London House Press, 1989, pp. 1-5. 99 Little Has Changed: CFO Survey Nearly half of CFOs – 47 percent – report they still feel pressure from their superiors to use aggressive accounting to make results look better. What is worrisome is that the pressure to make the numbers hasn’t abated much. Of these who have felt pressure in the past, only 38 percent think there is less pressure today than there was three years ago, and 20 percent say there is more. Few finance executives have much confidence in the numbers their colleagues are reporting. Only 27 percent say that if they were investing their own money, they would feel “very confident” about the quality and completeness of information available about public companies. Source: Don Durfee, “It’s Better (and Worse) Than You Think,” CFO Magazine, May 3, 2004. 100 Some Infamous Financial Statement Frauds Tyco • • • • • • • Adelphia [Greek for brothers] • • • Moved debt to subsidiaries which were not consolidated. Personal loans to the Rigas family (self-dealing). Falsified operations statistics and inflated earnings. Xerox • • Large interest-free loans to officers; then forgiven ($87.1 million). Unauthorized bonuses (no approval of BOD). Fake documents showing no loans outstanding. SEC found that PwC had prior knowledge of fraud back to 1998. Undisclosed real estate transaction with related parties. False entries in books to cover-up bribes given to foreign officials. If numbers did not meet expectations, Richard Scrushy told employees to “fix them.” Accelerated revenues from leasing equipment. Cookie jar reserves. Sunbeam • • • • Cookie-jar restructuring reserves. Channel stuffing. Guaranteed sales. Improper bill and hold. 101 Some Infamous Financial Statement Frauds Waste Management • • • • HPL Technologies (2001-2002) • • • Reduced depreciation expense by inflating salvage value and extending useful lives. No write-offs for unsuccessful land projects. Improperly capitalized a number of expenses. Made top drawer adjustments. Created many fake purchase orders from Canon sales (a Japanese distributor). Printed and pasted Canon signatures on the documents. Altered bank records to create millions of dollars in nonexistence customer payments. Borrowed millions from his brokerage account (secured by HPL stock) and channeled the funds into the company in the form of payments. Baptist Foundation of Arizona • • • • Set up subsidiaries owned by insiders to buy real estate (which had crashed in value) from BFA. BFA then recorded notes receivables in the amount of the book values. Ran a ponzi scheme using new investors’ money to pay old investors high returns. Refused to give Arthur Anderson financial statements of the subsidiaries. 102 D.R. Cressey’s Fraud Pyramid Don’t think you’re the only ones Who bend it, break it, stretch it some. We learn from you. Girls lie, too Terri Clark 103 SAS No. 99 Characteristics of Fraud Incentives / pressures Attitude / Rationalization Opportunity 104 Everyone Has A Price? President Abraham Lincoln is supposed to have thrown a man out of his office after being offered a bribe. The bribe involved a substantial sum, and Lincoln was very angry. His anger was directed at the man in question, but also at himself. He is reputed to have said, “Every man has his price, and he was getting too close to mine.”* The “price” where a person will act dishonestly (e.g., steal, cook the books) varies from person to person. What is your price? In a scene from the movie, The Family Man, an angel stands behind the counter of a convenience store and takes a $1 bill from a young woman who is purchasing a $0.99 beverage. The angel counts out change for $10 and hands the overpayment to the woman. The customer stares blankly at the clerk, takes the money and the beverage, and leaves. The angel is left to lament the lack of ethical behavior for just $9. “Character, and for what, $9; that is so disappointing”.** * From a speech by Lynn Turner, former chief accountant of U.S. Securities and Exchange Commission, given at the 39th Annual Corporate Counsel Institute, Northwestern University School of Law, October 12, 2000. ** MCA Home Video 2000. 105 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 (reduces offender’s inhibitions) “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.”) 106 Psychology of Fraud Fraud can be explained by three factors: • • • Supply of motivated offenders. Availability of suitable targets. Absence of capable guardians (e.g., internal controls). The three B’s -- babes, booze, and bets. Some fraudsters wish to make fools of their victims. They take delight in the act itself. Risk of fraud is a product of both personality and environmental (or situational) variables. Grace Duffield and Peter Grabosky, “The Psychology of Fraud,” Australian Institute of Criminology, No. 19. 107 The Fraud Diamond Incentive/ Pressures Capacity Opportunity Rationalization/ Integrity Capacity: Necessary traits; abilities; can pull it off; positional authority D.T. Wolfe and D.R. Hermanson, “The Fraud Diamond: Considering The Four Elements of Fraud,” The CPA J., December, 2004, pp. 38-42. 108 Example of Greed (or Incentive) Three Duke Energy employees were charged in April 2004 for allegedly ginning up “phony electricity and material-gas trades to boost trading volumes” and inflating “profits in a trading book that was the basis of their annual profits.” “The trading schemes are alleged to have inflated their bonuses by at least $7 million” between March 2001 and May 2002. There were 400 rigged trades that produced a $50 million profit in the trade books. Duke used mark-to-market accounting to record profit and loss contracts that might not be settled for years. So called “round-trips trades (or wash sales) were used to jack up reported trading volumes. Source: Rebecca Smith, “Former Employees of Duke Charged Over Wash Trades,” WSJ, April 22, 2004, p. A-15. 109 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 110 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. 111 Fraud’s Fatal Failings 85% of fraud victims never get their money or property back. Most investigations flounder, leaving the victims to defend for themselves against counter-attacks by hostile parties. 30% of companies that fail do so because of fraud. Source: Michael J. Comer, Investigating Corporate Fraud, Burlington, VT: Gower Publishing, 2003, p. 9. 112 Sarbanes-Oxley Act (7-30-2002) Most significant change since 1934 Securities Exchange Act New five-member Public Company Accounting Oversight Board (PCAOB) Authority to set and enforce auditing, attestation, quality control and ethics (including independencies) standards for auditors of public companies. Empowered to inspect the auditing operations of public accounting firms that audit public companies as well as impose disciplinary and remedial sanctions for violations of the board’s rules, securities laws and professional auditing and accounting standards. Rotation of lead and concurring audit partners every five years (5 year time-out period). 113 Sarbanes-Oxley Act (7-30-2002) Eight types of services outlawed: + Bookkeeping. + Information systems design and implementation + Appraisals or valuation services, fairness opinions, or contribution-in-kind-reports. + Actuarial services + Internal audit outsourcing + Management and human resources services + Broker/dealer, investment adviser, and investment banking services + Legal or expert services related to audit services Applies to foreign accounting firms filing with SEC after July 15, 2006. http://www.pcaob.us, to get free subscription to PCAOB Update. 114 Sarbanes-Oxley Act of 2002 If you are going to be an auditor, you have to be an auditor, not an auditor and a consultant [Senator Jack Reed]. In order to be independent, an accounting firm should not Audit ones own work. Function as part of management or an employee. Act as an advocate. No limitations are placed upon accounting firms in providing non-audit services to public companies they do not audit or any private companies. Audit services and non-audit services (e.g., tax) must be pre-approved by the audit committee, if not prohibited by the Act (before the service commences). Auditor must report to the audit committee on a timely basis. Cooling off period of one year before a member of the audit engagement team can begin working for the registrant in certain positions. There is no requirement to rotate the auditors. There is discussion of requiring a forensic audit irregularly. Harvey Pitt suggested this proposal. 115 SOX’s Effects on Smaller Firms 1. Smaller firms have incurred higher SOXrelated costs. 2. 3. 4. 5. 6. Larger increase in audit fees – ineffective internal controls. Complex standards affect smaller firms because they lack in-house staff. Larger firms stopped working with smaller firms. Larger non-audit fees. Directors fees much higher. Potential benefits for smaller firms are higher for small firms. Overall, SOX imposes a net loss on all firms. CEOs and CFOs spent as much as 90% of their time on compliance, forcing them to defer investments. SOX reduced the value of small firms—no effect or positive for large firms. Source: E. Kamar, P.K. Mandic, and E. Talley, “SOX’s Effects on Small Firms: What Is the Evidence?” June 2007. 116 Parallel Universe: Two Opinions External auditors must do a regular audit of a company (e.g., financial statements are fairly stated) and must also audit the internal controls that are to ensure that the financial statements are accurate (e.g., issue two opinions). Prior to the external auditors’ arrival, the company itself must review its internal controls and issue a report on the effectiveness of these controls. There will be two external opinions: on management’s assessment of the internal controls over financial reporting and another one on the effectiveness of the internal controls themselves (e.g., statements are fairly stated). PCAOB Release 2004-001. 117 Anti-Fraud Strategy The company’s stance on fraud and other breaches of the ethical code. What will be done and by whom in the case that frauds or other breaches are suspected. The key initiatives which the company proposes; Who will lead these initiatives. Clear deadlines and measures for monitoring effectiveness of implementation. Source: David Davies, Fraud Watch, 2nd Edition., London, ABG Professional Information, 2000, p. 77. 118 Anti-Fraud Program An auditor must perform “company-wide anti-fraud programs and controls and work related to other controls that have a pervasive effect on the company, such as general controls over the company’s electronic data processing.” Further, the auditor must “obtain directly the ‘principal evidence’ about the effectiveness of internal controls.” PCAOB endorses the COSO Cube [pp. 24-26 and A-25 and A-26] Source: PCAOB Release 2004-001. 119 Frameworks Being Used by CFOs • COSO 82% • Auditing Standard No. 2 28% • COBIT (Control/ Objectives for Inf./ Related Technology) 33% • SAS 55/78 (AICPA) 13% • Others 2% 120 COSO CUBE (5 components of internal controls) 121 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. www.erm.cosous.org 122 COSO New Cube: Enterprise Risk Management Source: erm.coso.org. See Apostolou and Crumbley, “ Sarbanes-Oxley Fall-out Leads to Auditing Standards No. 2: Importance of Internal Controls,” The Value Examiner, November/December 2004, pp. 55-60. 123 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. 35-60 124 CONTROL ACTIVITIES Segregation of Accounting Duties Effective segregation of accounting duties is achieved when the following functions are separated: Authorization—approving transactions and decisions. Recording—Preparing source documents; maintaining journals, ledgers, or other files; preparing reconciliations; and preparing performance reports. Custody—Handling cash, maintaining an inventory storeroom, receiving incoming customer checks, writing checks on the organization’s bank account. If any two of the preceding functions are the responsibility of one person, then problems can arise. Source: Accounting Information Systems, 10e Romney/Steinbart, PH 125 CONTROL ACTIVITIES • • • • • • CUSTODIAL FUNCTIONS Handling cash Handling inventories, tools, or fixed assets Writing checks Receiving checks in mail EXAMPLE OF PROBLEM: A person who has custody of cash receipts and the recording for those receipts can steal some of the cash and falsify accounts to conceal the theft. SOLUTION: The pink fence (segregation of custody and recording) prevents employees from falsifying records to conceal theft of assets entrusted to them. • • • • RECORDING FUNCTIONS Preparing source documents Maintaining journals, ledgers, or other files Preparing reconciliations Preparing performance reports AUTHORIZATION FUNCTIONS • Authorization of transactions Source: Accounting Information Systems, 10e Romney/Steinbart, PH 126 CONTROL ACTIVITIES • • • • CUSTODIAL FUNCTIONS Handling cash Handling inventories, tools, or fixed assets Writing checks Receiving checks in mail RECORDING FUNCTIONS Preparing source documents Maintaining journals, ledgers, or other files Preparing reconciliations Preparing performance reports • • • • • • AUTHORIZATION FUNCTIONS • Authorization of transactions EXAMPLE OF PROBLEM: A person who has custody of checks for transactions that he has authorized can authorize fictitious transactions and then steal the payments. SOLUTION: The green fence (segregation of custody and authorization) prevents employees from authorizing fictitious or inaccurate transactions as a means of concealing a theft. Source: Accounting Information Systems, 10e Romney/ Steinbart, PH 127 CONTROL ACTIVITIES CUSTODIAL FUNCTIONS • Handling cash • Handling inventories, tools, or fixed assets • Writing checks • Receiving checks in mail • • EXAMPLE OF PROBLEM: A person who can authorize a transaction and keep records related to the transactions can authorize and record fictitious payments that might, for example, be sent to the employee’s home address or the address of a shell company he creates. SOLUTION: The purple fence (segregation of recording and authorization) prevents employees from falsifying records to cover up inaccurate or false transactions that were inappropriately authorized. RECORDING FUNCTIONS • Preparing source documents • Maintaining journals, ledgers, or other files • Preparing reconciliations • Preparing performance reports AUTHORIZATION FUNCTIONS • Authorization of transactions Source: Accounting Information Systems, 10e Romney/Steinbart, PH 128 Risk Assessment Benefits A major step in a forensic audit is to conduct a risk assessment, which entails a comprehensive review and analysis of program operations in order to determine where risks exists and what those risks are. Any operation developed during the risk assessment process provides the foundation or basis upon which management can determine the nature and type of corrective actions needed. A risk assessment helps an auditor to target high-risk areas where the greatest vulnerabilities exist and develop recommendations to strength internal controls Source: B.l. Derby, “Data Mining for Improper Payments,” Journal of Government Management, Winter 2003, Vol.52, No. 4, pp. 10-13. 129 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 130 Swimming Lanes Mary Ben Controls Cash X Entries in Books X Deposits Checks Does Reconciling Controls Accounts Receivable Jane Sam X X X X X X X X X X 131 Sophisticated Approaches 1. 2. 3. The Quad Method The Staggered Box Method The Chessboard Method 132 COSO Guidance Risk Assessment Matrix See COSO, “Guidance for Smaller Public Companies,” www.ic.coso.org 133 PCAOB’s AS2 Report: Hindrances 1. 2. 3. 4. 5. 6. 7. Failure to coordinate or integrate the AS2 audit of internal controls with the financial audit. Doing detail testing before the top down audit looking for the high risk areas (e.g., fishing). Inadequate consideration of the unique risk factors of the company (e.g., avoid the checklist mentality). Do not audit the low risk areas. Inefficient walkthroughs of transaction controls. Too little reliance on others. Insufficient evaluation of compensating controls when there is a discovery of control deficiencies. Inadequate testing of controls over financial statement presentation and disclosures. 134 GAP Analysis Actual Internal Controls Organization’s Stated Internal Controls Best Practice Internal Controls 135 SAS No. 99 Types of Fraud Unlike errors, fraud is intentional and most often involves deliberate concealment of facts by management, 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. 136 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 137 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. 138 Parmalat Deceptions Parmalat, an Italian diary company, had a nonexistence Bank of America bank account worth $4.83 billion. A SEC lawsuit asserts that Parmalat “engaged in one of the largest and most brazen corporate financial frauds in history.” Apparently, the auditors Grant Thornton relied on a fake Bank of America confirmation prepared by the company. SAS No. 99 does not prohibit clients from preparing confirmations. The fraud continued for more than a decade. At least $9 billion unaccounted for. Therefore, the audited company should not be in control of the confirmation process. The owner treated the public company as if it was his own bank account. An unaware phone operator was the fake chief executive of more than 25 affiliated companies. Some $3.6 billion in bonds claimed to be repurchased had not really been bought. 139 Examples Enron issued $1.2 billion of stock to special purpose entities and recorded a $1.2 billion notes receivable (rather than a contra account to stockholders equity). Both assets and owners equity were overstated by $1.2 billion. HealthSouth allegedly overstated profits by at least $14 billion by billing Medicare for physical – therapy services the company never performed. The company submitted falsified documents to Medicare to verify the claims over 10 years. E&Y collected $2.6 million from HealthSouth (as audit-related fees) to check the cleanliness and physical appearances of 1,800 facilities. A 50point checklist was used by dozens of junior-level accountants in unannounced visits. For 2000, E&Y audit fee, $1.03 million; other fees, $2.65 million. 140 Journal Entries at Year End: Those Magic Changes Apparently, Arthur Andersen was given limited access to the general ledger at WorldCom, which had a $11 billion fraud (largest accounting fraud in history). Most of the original entries for online costs were properly placed into expense accounts. However, near the end of the period these entries were reversed. One such entry was as follows: Other Long-term Assets $629,000,000 Construction in Progress $142,000,000 Operating Line Costs $771,000,000 The support for this entry was a yellow postit note. WorldCom’s outside auditors refused to respond to some of Cynthia Cooper’s questions and told her that the firm had approved of some of the accounting methods she questioned. 141 Those Magic Changes: Yellow Peril Fourth Quarter of 1999: "The $239 million [international line cost accrual release] was entered in WorldCom's general ledger ... The only support recorded for the entry was '$239,000,000,' written on a Post-it Note and attached to a printout of the entry." Third Quarter of 2001: "Myers gave Sethi a Postit Note that said 'Assume $742 million.' Later, Myers and Sethi had a conversation confirming that $742 million identified on the Post-it Note was the line cost capitalization entry for the quarter.” http://thestreet.com/pf/markets/dumbestgm/10093441.html ----------------------------------------------------Those Magic Changes “Oh my heart arranges, oh those magic changes, oooh yeah.” Grease 142 Yellow Peril First Quarter of 2002: "In Capital Reporting, Myers told Sethi to go see Vinson, who would have the amount to be capitalized. When Sethi did so, Vinson handed him a Post-it Note that had the $818 million adjustment on it. Brian Higgins once again refused to make the necessary allocation for the first-quarter 2002 capitalization entry. Despite his growing concerns, Sethi made the allocation because he was concerned that his immigration status would be jeopardized if he lost his job." First Quarter 2002: "$109.4 million was taken from the general accrual account that Vinson set up and reclassified to several SG&A balance sheet accounts in five large, round-dollar amounts. The only supporting documentation that we were able to locate for these entries was a Post-it Note listing the various SG&A accounts and the amounts that should be taken from the Vinson account." http://thestreet.com/pf/markets/dumbestgm/10093441.html 143 Cooking-the-Books Often Collaborative Effort • For restatements between January 1, 1997 to June 30, 2002, 45% were accused of securities fraud and subject to shareholder suits. • Average of 7 individuals were implicated, including CEOs CFOs COOs General counsel Directors Internal/external auditors Source: Robert Tillman and Michael Indergaard, Control Overrides in Financial Statement Fraud. 144 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. 145 Differences Between Auditing/Forensic Accounting Auditing Forensic 1. Recurring 2. Express an opinion 1. Non-recurring 2. Resolve an allegation or deterrence review 3. Follow consulting standards 4. Materiality not important 5. Detailed financial analysis 6. Establish scienter 3. Follow GAAS and SAS 99 4. Materiality important 5. Sampling activity 6. Use professional skepticism 7. Audit program 7. No set of rules 146 Financial Audit v. Forensic Audit The typical financial audit is a sampling activity that doesn’t look at every transaction and can therefore be exploited by someone who knows how to rig the books. Forensic accounting focuses on a specific aspect of the books and examines every digit. While the average accountant is trying to make everything add up, a forensic accountant is performing a detailed financial analysis to find out why everything doesn’t or shouldn’t add up. It’s a far more time-consuming enterprise and can be significantly more expensive than regular auditing work. Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004, http://www.phoenix.edu/students/future/oldissues/Winter2004/fra ud.htm 147 Pre SAS 99 Consulting Standards Auditing Standards Traditional Investigatio n Traditional Audit Post SAS 99 Auditing Standards Consulting Standards Traditional Investigation Forensic Procedures in the Audit Environment SAS 99 Source:AICPA, “Forensic Services, Audits, and Corporate Governance: Bridging the Gap,” Discussion Memorandum, 2004. 148 Steps Toward Forensic Audit Traditional audit [forensic techniques & fraud prevention program]. If suspect fraud, bring in-house forensic talent into the audit. If no in-house talent or fraud complex, engage an outside forensic accountant (e.g., Cr.FA, CFFA, or CFD). As audit moves toward forensic investigation, auditor must comply with litigation services standards (consulting). 149 Inexperienced Forensic Auditors Find out who did it. Do not worry about all the endless details. Be creative, think like the fraudster, and do not be predictable. Lower the auditing threshold without notice. Take into consideration that fraud often involves conspiracy. Internal control lapses often occur during vacations, sick outages, days off, and rest breaks, especially when temporary personnel replace normal employees. H. R. Davia, Fraud 101, New York: John Wiley & Sons, 2000, pp. 42-45. 150 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. 151 Two Major Types of Fraud Investigations Reactive: Some reason to suspect fraud, or occurs after a significant loss. Proactive: First, preventive approach as a result of normal operations (e.g., review of internal controls or identify areas of fraud exposure). There is no reason to suspect fraud. Second, to detect indicia of fraud. Source: H.R. Davia, “ Fraud Specific Auditing,” Journal of Forensic Accounting, Vol. 111, 2002, pp. 111-120 152 Proactive Is Beneficial The threat of a future investigation reduces the occurrence of fraudulent behavior from 75% to only 43%. The larger the pay-off, the more likely a person will commit fraudulent behavior. Give the fox a key to the hen house and he/ she is going to eat hens. Source: S. L. Tate et. al, “The Small Fraud Paradigm: An Examination of Situational Factors That Influence the Non-Reporting of Payment Errors,” J. of Forensic Accounting, Vol.7, 2006, p. 406. --------------------------- The greater the risk of detection, the less likely a person is to violate the law. Jeremy Bentham 18th Century Philosopher 153 Proactive vs. Reactive Approaches Proactive approaches include Effective internal controls, Financial and operational audits, Intelligence gathering, Logging of exceptions, and Reviewing variances. Reactive detection techniques include Investigating complaints and allegations, Intuition, and Suspicion. Jack Bologna and Robert Lindquist, Fraud Auditing and Forensic Accounting, 2d Edition, New York: John Wiley, 1995, p. 137. 154 Proactive Is Best When the IRS began requiring banks to issue Form 1099s reporting interest, the reported interest income increased by $8 billion (even though for 3 years the IRS did not have computer matching capacity). When the IRS began to require taxpayers to list a social security number for dependents, the next year the number of reported dependents dropped by seven million. More than 11,000 of these taxpayers claimed seven or more dependents in 1986, but they claimed none in 1987. When the IRS began to require taxpayers to list a name, address, and social security number for babysitters, two years later 2.6 million babysitters disappeared. 155 Fraud Deterrence Better Than Fraud Investigation 1. 2. 3. 4. 5. Fraud deterrence less expensive. Deterrence is more comprehensive. Fraud deterrence produces greater savings. Deterrence is faster. Fraud deterrence promotes better customer relations. Daniel Finnegan, “Deterring Fraud,” Quality Planning Corporation, 1991. 156 Is Company Proactive? Fraud hotline (reduce fraud losses by 50% re Wells 2002 Report). Suggestion boxes. Make everyone take vacations. People at top must set ethical tone. Widely known code of conduct. Check those employee references. Reconcile all bank statements. Count the cash twice in the same day. Unannounced inventory counts. Fraud risk assessment (CFD). 157 $7.4 Billion Losses at Societe Generale • • • • • • • • Jerome Kerviel evaded all of the French bank’s controls to bet $73.5 billion on European markets – more than the bank’s market value. Six year employee; junior employee. Kerviel reported to work early, stayed late, and took only 4 days off in 2007. In France six weeks of vacation is fashionable. Starting in early 2005, he made small unauthorized trades. The bank missed the illicit trades and the red flags. Kerviel described growing increasingly daring after no one at the bank detected a series of small, unauthorized trades that he placed. He entered fictitious and offsetting trades to minimize the odd of big losses. He stole other people’s computer access codes, falsified documents, and employed other methods to cover his tracks. He had an excellent understanding of the bank’s processing and control procedures so he could circumvent all of the controls. His motive: quest for glory and a bonus. 158 Some Hints Need to really understand the business unit. What they really do. Have a mandatory vacation policy. Rotation of assignments. Have a written/signed ethics policy. Do things differently each time you audit a unit. Do not tell client what you are doing. Hard to find fraud in the books. Look/listen. Look for life style changes. Do not rely on internal controls to deter fraud. Auditors must have control of the confirmation process. Careful of related parties. Careful of “trusted” employees. 159 Stamp Mates Afinsa, a Spanish stamp company, controls 72% of Escala, a U.S. company (formerly Greg Manning Auctions). Escala says all sales to Afinsa takes place at independent established prices. But Escala’s reported gross margin on stamp sales to Afinsa exceeds 44% [like land flipping]. Compared to less than 14% on those to other clients. Therefore, Escala was manipulating the value of stamps sold to Afinsa to artificially boost its own bottom line. Escala’s stock fell from $32 to $5 in five days after the May 8, 2006 arrests of seven executives. Police found $12.6 million behind one dealer’s freshly plastered walls in his home (e.g., unreported profits?). Escala owns A-Mark Precious Metals, which buys and distributed more than one-half of the gold coins handed each year by the U.S. mint. 160 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.] 161 Fraud Detection Process Discuss facts and objectives with client/attorney (e.g., conflict of interests). 2. Evaluation whether to accept the engagement. 3. Prepare a work program. 4. Develop time and fee schedule. 5. Obtain approval of work program, staff assignments, and fee estimates. 6. Obtain an engagement letter. 7/8. Identify fraud exposures and symptoms. 9/10. Evaluate evidence obtained and determine if more evidence is needed. 11/12. Search for and evaluate additional evidence. 13. Discuss preliminary findings with client/attorney. 14. Draft a final report. 15. Review the report and work papers. 16. Resolve professional disputes. 17. Clear review points and open items. 18. Communicate report or findings. 19. Help attorney prepare court case/testify. 20. Perform follow-up procedure. 21. File work papers/report. 1. Source: Carmichael et. al, PPC Fraud Detection, Vol.1, Ch. 2 (2002). 162 Financial Audit v. Forensic Audit “ During one investigation, we found in the auditing working papers written in the margin of the internal audit working papers by the internal audit manager: ‘Conceal from bankers,’ says Nicholas L. Feakins, CPA, partner at San Mataeo, Calif based forensic accounting firm Feakins & Feakins. “ It sounds amazing, but the [third-party] auditors has put B-level staff on the project who simply didn’t read the documents and missed it.” ----------------------------------------------------------------MiniScribe, one of the world’s largest disk-drive makers, which in the late 1980s was surreptitiously shipping bricks instead of disk drives to the Far East and receiving credit from the bank for the amount of the shipments. “After all,” he says “it’s going to be 90 days until they ship the brick back to you. “MiniScribe’s public accounting firm, Coopers & Lybrand, didn’t catch the falserevenue scam during its regular audits-but a forensic accountant did.” Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004, http://www.phoenix.edu/students/future/oldissues/Winter2004/fra ud.htm 163 Materiality Unimportant “Auditing is governed by materiality. In investigative accounting, it is the opposite. I am looking for one transaction that will be the key. The one transaction that is a little different, no matter how small the difference, and that will open the door.” Lorraine Horton, owner of L. Horton & Associates in Kingston, R.I. ----------------------------------------------------------------------------------------------------- “Fraud usually starts small. It begins with little amounts, because the perpetrator is going to test the system. If they get away with it, then they keep on increasing and increasing it.” Robert J. DiPasquale Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28. 164 Forensic Accounting v. Auditing “Forensic accounting is very different from auditing in that there is no template to use. There are no set rules. You don’t know when you go into a job how it is going to be.” Lorraine Horton, Kingston, R.I ------------------------------------------------------------------------------ “Forensic accounting “is a very competitive field. What is interesting is that you may be a good accountant, but not a good forensic accountant. The training and the way you look at transactions are different.” Robert J. DiPasquale, Parsippany, N.J. ---------------------------------------------------------“Unlike auditing, lower-level staff often can’t be used for an engagement. They normally will not spot anything out of the ordinary, and an experienced person should be the one testifying as well as doing the investigative work.” Lorraine Horton, Kingston, R.I. Source; H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28. 165 SAS No. 99 Recommendations Brainstorming. Increased emphasis on professional skepticism. Discussions with management. Unpredictable audit tests. Responding to management override of controls. 166 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.” “Things are not always as they appear, sonny boy.” James Patterson, Honeymoon, Warner Books, 2006. 167 SKEPTICISM Ronald Reagan said with respect to Russia, “Trust, but verify.” FA’s motto should be “Trust no one; question everything; verify.” ----------------------------------------------------- This ain’t my first rodeo I didn’t make it all the way through school. But my mama didn’t raise no fool. I may not be the Einstein of our time. But honey, I’m not dumb and I’m not blind. Vern Gosdin 168 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. 169 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. 170 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 and implementing them. Source: A.S. Wellner, “Strategies: A Perfect Brainstorm,” Inc. Magazine, October 2003, pp. 31-35 171 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. 172 Wildcatting The SEC has recently adopted the proactive strategy of “wildcatting” where investigations into entire industries and business sectors are begun after evidence emerges from only one company in the group regarding financial reporting problems. Over time, the PCAOB will probably be able to identify peculiarities within existing or evolving industries that require either standard setting or regulatory attention, or both. Source: Berton, L., “U.S. Accounting Watchdogs Try to Shut Barn Door,” Bloomberg.com, April 2, 2004; J.H. Edwards, “Audit Committees: The Last Best Hope,” Journal of Forensic Accounting, Vol. IV (2004), pp. 1-20. 173 Walkthroughs An auditor must perform a walkthrough of a company’s significant processes (each major class of transactions). Can not be achieved secondhand. According to PCAOB, in a walkthrough an auditor traces “company transactions and events – both those that are routine and recurring and those that are unusual – from origination, through the company’s accounting and information systems and financial report preparation processes, to their being reported in the company’s financial statements.” Auditors should perform their own walkthroughs which provides auditors with appropriate evidence to make an intelligent assessment of internal controls. Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003. 174 Slot Machine Example 175 Revenue Flows 176 Wandering Around • Informal observations while in the business. • Especially valuable when assessing the internal controls. • Observe employees while entering and leaving work and while on lunch break. • Observe posted material, instructions, job postings. • Observe information security and confidentiality. • Observe the compliance with procedures. • Appearance is not necessarily reality. Man of La Mancha 177 New Terms in Financial Reports: Deficiencies Have No Bright Lines Control deficiency – one that might allow a bad number to get into the financial reports (e.g., the likelihood that a company misstates reports is remote– 1 out of 20). Example: company does not check changes made by a salesman in a minor contract. Significant deficiency – more serious flaw or a number of flaws that increase the chances that wrong numbers will significantly distort financial statements (e.g., more than remote). Example: company not checking for changes to terms of several key contracts. Need only to report to BOD, but some companies are making them public. 178 Deficiencies Have No Bright Lines Material weakness – deficiencies are so bad that there is more than a remote change of a material misstatement in financial statements. Example: a bank does not regularly check for errors in estimating loan-loss expenses (i.e., Fannie Mae reported a $1.3 billion error from its computer model, many in an uncontrolled environment). They must be reported. David Henry, “How Clean Are the Books?” Business Week, March 7, 2005, pp. 108-109. ----------------------------------------------------Firms that reported material weaknesses in tax accounting lost an average of 5.8% of their stock value 60 days after the announcement. ----------------------------------------------------As of 11-14-05, 695 companies have disclosed material weaknesses in their annual report. 179 Material Weakness Areas AREAS OF FAILURE 2005 2004 Tax accruals/ deferrals 34.5% 32.0% Revenue recognition 28.4 31.3 Inventory/ vendor cost of sales 23.7 27.4 Fixed/ Intangible assets 16.0 18.6 Leases or contingencies 9.3 16.8 Cash flow (FAS 95 error) 8.8 -- Consolidation (Fin 46 issues) 6.7 9.0 * 10% of corporate filers in 2005 and 16% in 2004. Source: AuditAnalytics.com 180 Law Suits Few So Far • Companies reporting problems with internal controls have not seen a big increase in class-action lawsuits, according to a study by Deloitte & Touche between November 2003 and August 2004. • Deloitte said only 6% of the 290 companies reporting internal-control flaws were sued. • 52% of the firms had material weakness in their internal controls. • These internal control announcements did not seem to send prices downward. • Highest incidence of internal controls: -computer-software firms -manufacturers -health-care and pharmaceutical companies. - financial-services firms -telecommunication companies. Source: Judith Burns, “Few Firms Are Sued Over Flaws in Internal Controls, Study Finds, WSJ, December 29, 2004, p. B-5. 181 Think Like A Crook Know your enemy as you know yourself, and you can fight a hundred battles with no danger of defeat.” Chinese Proverb. Military leaders study past battles. Football and basketball teams study game films of their opponents. Chess players try to anticipate the moves of their opponent. Examples: If contracts above $40,000 are normally audited each year, check the contracts between $30,000-$40,000. FAs must learn the tricks of the trade as well as the trade. 182 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? 183 Three Major Phases of Fraud The Act itself. 2. The concealment of the fraud (in financial statements). 3. Conversion of stolen assets to personal use (interest free loans to Tyco executives forgiven). One can study any one of these phases. 1. Examples: Things being stolen: conduct surveillance and catch fraudster. If liabilities being hidden, look at financial statements for concealment. If fraudster 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. 184 The Methods Asset misappropriation accounted for more than four out of five offenses or 91.5% in 2006 (92.7% in 2004). $150,000 Bribery and corruption constituted about 30.8% in 2006 (30.1% in 2004) of offenses. ($538,000) Fraudulent statements were the smallest category of offense 10.6% in 2006 (7.9% in 2004) (most costly). $2 million per scheme. Source: 2006 Wells Report, ACFE. 185 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. 186 Restatements of Financial Statements 2006 2005 2004 1,420 (10%) 1,225(8.6%) 650 2003 514 2002 330 2001 270 1999 216 1998 158 Reasons for 2004 restatements: 1. Revenue recognition. 2. Equity accounting. 3. Revenues, accruals, contingencies. • • 15% were repeat filers. Arthur Andersen had averaged 11 restatements before 2002. In 2002, they had 40, with 26 after new auditors were retained. Source: Greg Farrell, “Restatements of Earnings in 2005 to Break Record,” USA Today 12/29/2005; Stephen Taub, CFO.com, March 3, 2006. 187 Class Action Securities Fraud Actions Year Year 2006 114 2000 215 2005 181 1999 208 2004 233 1998 240 2003 223 1997 175 2002 267 1996 112 2001 497 1995 188 Although the number of shareholder class action lawsuits have gone down, settlements are now much bigger (average $65 million). Unions and retirement funds are playing an increasing role, resulting in much higher settlements. Stanford Law School Securities Class Action Clearing House, securities.stanford.edu/index.html; “Classier Actions,” The Economist, February 17, 2007, pp. 76-77. 188 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.” 189 An Average of Seven People Involved Authors Robert Tillman and Michael Indergaard found that of the 834 companies that issued restatements between January 1, 1997 and June 30, 2002, 374 or 45% were accused of securities fraud. An average of 7 persons were normally involved – CEOs, CFOs, COOs, general counsel, directors, and internal and external auditors. 190 Measures Helpful in Preventing Fraud 1. 2. 3. 4. 5. 6. 7. 8. 9. Strong Internal Controls (3.66) Willingness of companies to prosecute (3.44) Regular fraud audit (3.40) Fraud training for auditors (3.33) Anonymous fraud reporting mechanisms (3.27) Background checks of new employees (3.25) Established fraud policies (3.12) Ethical training for employees (2.96) Workplace surveillance (2.89) Source: 2004 Wells Report 191 Anti-Fraud Measures – Months to Detect – Median Loss YES NO 1. Hotlines $100,000 (15) $200,000 (24) 2. Internal audits $120,000 (18) $218,000 (24) 3. External audits $181,000 (23) $125,000 (18) 4. Surprise audits $100,000 (15) $200,000 (24) 5. Fraud awareness/ Ethics Training $100,000 (15) $200,000 (24) Source: 2006 Wells Report, ACFE. 192 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. 193 More Hints … Check employee references/resume. Stop giving the employee/client the answer when you ask a question. Zero tolerance for allowing employee/executive to get away with anything. Always reconcile the bank statements. Try to think like a criminal. Get inside the criminal’s mind. Be a detective. Do not assume you have honest employees. Bond employees. Uni-ball gel pens. Source: Gary Zeune 194 Auditing Hints • SAS No. 99 does not require auditors to make inquiries of “others,” as opposed to management. Auditors must talk to and interview others below management level. If asked, employees may be willing to report suspicious activities. • Use independent sources for evaluating management (e.g., financial analysts). Surf the internet. • Auditors need to follow the performance history of managers and directors. • If a company has an anonymous reporting system, obtain information about the incidents reported and consider them when assessing fraud risk. • Be sure to perform analytical procedures, and the work should be reviewed by senior members of the audit team. 195 Auditing Hints (cont.) • Auditors should select sample items below their normal testing scope (e.g., HealthSouth). • Fraud procedures should be more than checklists. Audits should focus on finding and detecting fraud. • Ask for and review all “top drawer” entries. • Ask for and review all side agreements. 196 Check References and Resume Fraud 101: Fraudsters can change their job and address, but they can not change who they are. 197 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. 198 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. 199 Impaired Independence The independence of the auditor will probably be impaired and reduce the quality of financial statement audits, if any of the following conditions occur during financial statement audits: 1) 2) 3) 4) 5) auditor’s excessive personal loyalty to the audit client, auditor’s fear of losing client to a competitive CPA, auditor’s fear of a lawsuit if CPA withdraws from audit engagement, auditor’s fear of harming client with audit opinion other than unqualified, and auditor’s conflict between consulting and auditing services offered. G. D. Moyes and A. Anandarajan, “CPAs’ Perceptions of Factors Influencing the Quality of Financial Statement Audits: Substandard Performance and Impaired Independence,” J. of Forensic Accounting, Vol. 7, 2006, p. 133. 200 Earnings Management Earnings management may be defined as the “purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.” – Katharine Schipper, “Commentary on Earnings Management,” Accounting Horizon, December 1989, p. 92. Earnings management occurs when managers use judgments in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers. P. Healy and J. Wahlen 201 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 202 Capital Market Incentives to Manage Earnings 1. 2. 3. 4. 5. 6. 7. 8. 9. Management buyout firms, on average, manage their earnings downward prior to the buyout. Roughly 12 percent of firms making seasoned or initial equity offerings manage their earnings upward by about 5% of total assets prior to the offers. Firms who are in danger of failing to meet management earnings forecasts, on average, manage their earnings upward prior to releasing the annual earnings figure. Firms, on average, manage their earnings to meet or beat expectations of financial analysts. Firms that meet or beat analysts’ expectations earn about 8% incremental annual market-adjusted returns relative to firms that fail to do so. Firms with zero or a positive earnings surprise earn incremental quarterly returns of 2.3%, and firms with positive earnings surprise earn further incremental quarterly returns of 3.4%. About 40% of firms confronted with reporting slight losses tend to manage their earnings in order to report positive earnings. About 12% of firms confronted with reporting slight earnings decreases tend to manage their earnings in order to report small earnings increases. Investors do not see through most earnings management as evidenced by the fact that firms flagged for earnings management by regulators show an average stock price decline of 9%. Source: Masser Spears, “The Impact of Earnings Mgt. on the Credibility of Corporate Financial Reporting,” Petroleum Acctg. and Financial Mgt., Summer 2007, pp. 47-48. 203 Contracting Incentives to Manage Earnings 1. There is no evidence of earnings management behavior by firms close to their dividend covenant. Instead, these firms tend to manage their cash flows. 2. There is inconclusive (mixed) evidence of earnings management behavior by firms to other debt covenants, such as interest coverage or leverage ratios. 3. Some managers manipulate earnings to increase bonus awards. There is no evidence on the pervasiveness or the stock market impact of this form of earnings management. Source: Masser Spears, “The Impact of Earnings Mgt. on the Credibility of Corporate Financial Reporting,” Petroleum Acctg. and Financial Mgt., Summer 2007, pp. 47-48. 204 Regulatory Incentives to Manage Earnings 1. There is strong evidence that suggests that firms manage earnings (a) to avoid regulatory constraints, (b) to take advantage of governmental benefits, and (c) to avoid regulatory exposure. 2. There is no direct evidence about how and whether regulators impound those forms of earnings management behavior. Source: Masser Spears, “The Impact of Earnings Mgt. on the Credibility of Corporate Financial Reporting,” Petroleum Acctg. and Financial Mgt., Summer 2007, pp. 47-48. 205 Management or Manipulation? More than one-half of CFOs say they can legally influence reported earning by 3% or more. Operational levers: delaying operational spending, accelerating order processing, and driving sales force more. Accounting steps: changing the timing of an accounting change and adjusting estimates. One-third of CFOs would try to influence results: 24% upward or 8% would try to cut them. Few CFOs think their auditors would catch them. If the auditors caught it, they probably would not bring it up to management. Don Durfee, “Management or Manipulation?” CFO, December, 2006, p. 28. 206 Financial Statement Fraud Schemes Category % Concealed Liabilities 45.0% Fictitious Revenues 43.3% Improper Asset Valuations 40.0% Improper Disclosures 37.5% Timing Differences 28.3% Source: 2006 Wells Report, ACFE. 207 Good Earnings Management Careful timing of capital gains and losses; Use of conferencing technology to reduce travel costs; and Postponement of repair and maintenance activities when faces with unexpected cash flow declines. L. G. Weld et. al, “Anatomy of a Financial Fraud,” The CPA Journal, October 2004. 208 Abusive Earnings Management Improper revenue recognition (e.g., bill and hold sales). Improper expense recognition. Using reserves to inflate earnings in years with falling revenues (cookie jar accounting). Shifting debt to SPE. Channel stuffing. Capitalizing marketing costs rather than expensing. Extending useful lives and inflating salvage values. Cookie jar reserves. Accelerating revenue from leasing equipment. SPEs not consolidated. 209 Early Warning Signs of Earnings Management Cash flows that are not correlated with earnings; Receivables that are not correlated with revenues; Allowances for uncollectible accounts that are not correlated with receivables; Reserves that are not correlated with balance sheet items; Acquisitions with no apparent business purpose; and Earnings that consistently and precisely meet analysts’ expectations. Magrath and Weld, “Abusive Earnings Management and Early Warning Signs,” The CPA Journal, August 2002. 210 Some Red Flags of Earnings Management 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. CEO is also Chairperson of BOD (e.g., Parmalat). Insiders have majority control of BOD. Weak system of internal controls. Performance emphasis on short-term goals. Weak or non-existent Code of Ethics (e.g., Parmalat). Questionable business strategies with opaque disclosures (e.g., special purpose entities). CEO is uncomfortable with criticism (Enron’s Jeff Skilling). CEO or other senior management turnover (Qwest’s CFO). Insiders selling stock (Enron’s Ken Lay). Independence problem from large non-audit fees paid to external auditors (e.g., HealthSouth). Company’s investment banker has independence problems (e.g., Parmalat, Enron). 211 Types of Financial Statement Fraud Schemes Three professors have broken financial statement fraud schemes into these ten types: 1. 2. 3. Fictitious and/or overstated revenues and assets (e.g., non-ordered or cancelled goods). Sunbeam created revenues by contingent sales, a bill-and-hold strategy, and accelerated sales. Digital Lightware, Inc. recognized fraudulent billings. Cendant Corporation created fictitious revenues, and Knowledge Ware inflated revenues with phony software sales. Xerox, Bristol-Mayers, Merck. Premature Revenue Recognition (e.g., holding books open). 35-day month. Misclassified Revenues and Assets (e.g., combining restricted cash accounts with unrestricted cash accounts). School districts and universities may engage in this strategy with dedicated funds. Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud Types and Auditor Litigation,” The Accounting Review, October 1998, pp. 503-532. 212 Types of Financial Statement Fraud Schemes (contd …) 4. 5. 6. 7. 8. 9. 10. Fictitious Assets and/or Reductions of Expenses/Liabilities (e.g., recording consigned inventory as inventory). WorldCom. Overvalued Assets or Undervalued Expenses/Liabilities (e.g., insufficient allowance for bad debts). Enron. Omitted or Undervalued Liabilities (e.g., understated pension expenses). Hiding losses (Allied National Bank). Omitted or Improper Disclosures (e.g., stock option expense estimates). Equity fraud (e.g., recording nonrecurring and unusual income or expense in equity). Related-Party Transactions (e.g., fictitious sales to related parties). Enron had many related-party transactions. REFCO, Adelphia. Financial Fraud Going the Wrong Way (e.g., for tax purposes reducing income or increasing expenses). 213 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 C11. Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005, pp. 123-140. 214 Fannie Mae’s Problem • Fannie Mae was ordered by the SEC [2004] to a restatement of earnings of $ 9 billion (reducing earnings since 2001). Misuse of hedge-accounting transactions and improper accounting for loans. • CFO J. Timothy Howard resigned with an annual pension of $400,000 and lifetime access to Fannie Mae’s Medical benefits. Plus $ 4 million of stock options. •CEO Franklin Raines was paid more than $60 million over a 6 year period. On Dec. 21, 2004, Raines took early retirement. $ 1 million annually for life. •The Board replaced KPMG as Fannie’s auditor. Source: Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005, pp. 123-140. Mike McNamee, “Franklin Raines Lost Gamble,” Business Online, December 22, 2004. 215 Cooking the Books-Symbol Technologies From 1998 through February 2003, Symbol used a socalled “Tango sheet” process through which fraudulent “topside” accounting entries were made to reserves and other items to conform the unadjusted quarterly results to management’s projections; Fabrication and misuse of restructuring merger and other non-recurring charges to artificially reduce operating expenses, create “cookie jar” reserves (overstating inventory write-offs) and further manage earnings; Channel stuffing and other revenue recognition schemes, involving both product sales and customer services; stuffed the channel by granting resellers return rights and contingent payment terms in side agreements. Manipulation of inventory levels and accounts receivable data to conceal the adverse side effects of the revenue recognition schemes. 216 Cooking the Books-Symbol Technologies Warehouse arrangement with a large foreign distributor that served as a vehicle for improperly recognizing several millions of dollars. Directed employees to refrain from scanning new components or returned goods into the automated accounting system. Backdated (cherry picked) stock option exercise dates. When “days sales outstanding’ because too large because of fraudulent revenue recognition, reclassified past due trade accounts receivable into notes receivables. A growing DSO figure is often a sign that receivables are impaired due to channel stuffing, etc. Deferred $3.5 million of FICA insurance costs to a later year. Recognized revenue that was processed in one quarter, but shipped the next quarter. 217 Seven Investigative Techniques 1. 2. 3. 4. 5. 6. 7. Public document review and background investigation (nonfinancial documents). Interviews of knowledgeable persons. Confidential sources. Laboratory analysis of physical and electronic evidence. Physical and electronic surveillance. Undercover operations. Analysis of financial transactions. Source: R.A. Nossen, The Detection, Investigation and Prosecution of Financial Crimes, Thoth Books, 1993 . 218 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 “Objectively obtaining and evaluating evidence is the essence of auditing.” (AAA, Committee on Basic Auditing Concepts, 1973, 2) 219 Investigative Techniques Public Document Review Real and personal property records. Corporate and partnership records. Civil and criminal records. Stock trading activities. Check vendors. Laboratory Analysis Analyzing fingerprints. Forged signatures. Fictitious or altered documents. Mirror imaging or copying hard drives/company servers. Use clear cellophane bags for paper documents. 220 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. 221 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. 222 Beware Inter-company Entries HealthSouth used PeopleSoft, with at least 2,000 different ledgers. Suspense Account Revenue Accounts Receivable xx Inventory Property Suspense Account xx xx xx xx xxx Most of the entries were inter-company entries. During 2005, 2004, and 2003, professional fees associated with the reconstruction of HealthSouth’s financial records and restatement of 2001 and 2002 consolidated financial statements approximated $206.2 million and $70.6 million, respectively. 223 Financial Statement Fraud Audit 1. 2. 3. 4. 5. 6. 7. 8. Obtain current year’s financial statements. Obtain prior 3 years’ financial statements. Perform vertical/ horizontal analysis of the 4 years, plus all current quarters. Pay attention to footnotes. Analysis of %s and footnotes by senior auditors. Nonsense %s and footnotes inquire explanations from financial management. Interview lower level financial employees who approved questionable journal vouchers. Combine explanations with visits to accounting records/ source documents. 224 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: Dollar Amount Horizontal Comparison Year 4 Year 3 Year 2 Year 1 $180,000 $140,000 $120,000 $100,000 180% 140% 120% 100% 225 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). 226 More Red Flags Look for aggressive revenue recognition policies (Qwest Communication, $1.1 billion in 1999-2001). Beware of hockey stick pattern. Beware of the ever-present nonrecurring charges (e.g., Kodak for at least 12 years). Check for regular changes to reserves, depreciation, amortization, or comprehensive income policy. Related-party transactions (e.g., Enron). Complex financial products (e.g., derivatives). Unsupported top-side entries (e.g., WorldCom). Under-funded defined pension plans. Unreasonable management compensation Source: Scott Green, “Fighting Financial Reporting Fraud,” Internal Auditor, December 2003, pp. 58-63. 227 Five Statistically Significant Ratios Use the ratios for two successive fiscal years. Convert into indexes for benchmarking. Day’s Sales in Receivable Index: (Accounts Receivable t / Sales t ) (Accounts Receivable t-1 / Sales t-1) Index for manipulators: 1.5 to 1 -------------------------------------------------------Gross Margin Index: [(Sales t-1 - Cost of Sales t-1 ) / Sales t-1] [(Sales t - Cost of Sales t ) / Sales t] 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. 228 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. 229 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. 230 A Charles Lundelius Example Comparison to peer group benchmarks: Characteristic peers DSRI GMI AQI SGI TATA MPS Peer group 1.56 2.00 1.23 1.50 0.10 1.03 1.10 1.04 1.20 0.05 % over 51% 82% 18% 25% 100% Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p. 129. 231 Z-Score Methodology 1. 2. Altman’s Z-Score (Manufacturers) AZ-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5 Where: X1 = Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Market Value of Equity/Total Liabilities X5 = Sales/Total Assets Above 2.99, indicates sound financial health. Grey zone, no conclusion can be drawn. Below 1.81, indicates financial distress. Altman’s Double Prime Z-Score (nonmanufacturers) Change X4 to Total Shareholders’ Equity Drop X5 ADPZ-Score = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4 Above 2.6, strong. Grey zone, no conclusion can be drawn. Below 1.1, weak. 232 Z-Score Methodology (cont.) 3. 4. Private Company Model Use book value rather than market value of equity. PMZ-Score = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5 Above 2.90, safety zone. Grey zone, no conclusion. Lower than 1.23, distress zone. Hillegeist DPM Gives probability of default. HZ-Score = 3.835 + 1.13X1 + 0.005X2 + 0.269X3 + 0.399X4 – 0.033X5 Where 3.835 is constant. Higher the score, the better. 233 Exercises 1. In order to determine how risky a particular company is that you are auditing, you prepare these five ratios along with the same ratios of this company’s peers: Company Peers Day’s Sales in Receivable Index 1.51 1.05 Gross Margin Index 1.98 1.11 Asset Quality Index 1.21 1.01 Sales Growth Index 1.53 1.19 Total Accruals to Total Assets 0.11 0.06 What are your thoughts about the risk potential of this company? 2. You are provided the following information about a company for two years (in millions): Sales Cost of Sales 2005 2006 $23,000 32,000 11,960 17,600 4,830 10,560 Accounts Receivable Calculate: a. Days Sales in receivable index. b. Gross margin index. c. Sales growth index. Any thoughts about this company? 234 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 235 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. 236 Investigative Technique: Videotapes Average big city resident caught on videotape about 75 times a day. Common in workplaces and stores (USA). Former Coca-Cola secretary convicted of conspiring to steal and willing to sell confidential Coca-Cola documents and samples of products that the company was developing to Pepsi. Coca-Cola security expert testified that surveillance cameras were monitoring Joya Williams’ movements. The surveillance was a key part of the government’s evidence. She stole the materials and was attempting to sell for at least $1.5 million. Deeply in debt, unhappy at job, and seeking a big payday. Could face 10-years in prison. Myway, “Video Shows Coke Worker Taking Documents,” January 26, 2007. 237 Fraud Awareness Auditing: Unrefined Oil 238 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 239 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 Covert Aspects Water line 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. 3637 240 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. 241 Life Styles Important For someone who earned a salary of just $1,000 a month, Rana Koleilat managed to live a pretty nice life. She traveled by private jet, took along her servant and hairdresser, and stayed at luxurious locality in London and Paris. Back home in Beirut, Lebanon, she lived in a three-story penthouse. To anyone who asked how she lived so well, she replied that she had a “rich uncle.” Actually, Koleilat helped manage a private bank in Beirut, and thereby hangs a tale. The chairman of the bank said he lost $1.2 billion, and depositors lost another several hundred million dollars E.T. Pound, “Following the Old Money Trail,” U.S. News & World Report, April 4, 2005, p. 30. 242 Be An Investigator “Because I was an investigator,” he said. “O.K.,” she said. “Investigators investigate. That, I can follow. But don’t they stop investigating? I mean, ever? When they know already?” “Investigator never know,” he said. “They feel, and they guess.” “I thought they dealt in facts.” “Not really,” he said. “I mean, eventually they do, I suppose. But ninety-nine percent of the time it’s ninety-nine percent about what you feel. About people. A good investigator is a person with a feel for people.” Lee Child, Echo Burning, N.Y.: Jove Books, 2001, p. 281. 243 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. 244 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. 245 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. 246 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. 247 Management’s Role The Sarbanes-Oxley Act of 2002 mandates that CEOs and CFOs certify in periodic reports containing financial statements filed with the SEC the appropriateness of financial statements and disclosures. -------------------------------------------------------- In March 2005, the SEC said that executives are gatekeepers. Thus, an executive can be in trouble if in a position to detect wrongdoing below them and do not move forcefully to prevent the fraud. It does not matter if the executive has been lied to. An executive has the responsibility to cut through the lies and try to root out the truth. Carol. J. Loomis, “The SEC Turns the Screws on Gatekeepers,” Fortune, April 18, 2005, p. 38. 248 Pressures On All Sides CEOs are now being squeezed as a result of SOX by BODs, auditors, and lawyers because these watchdogs are finally facing genuine liability for their failures. These watchdogs are trying to protect their hides. Arthur Andersen is out of business, and directors at WorldCom and Enron are paying off fraud claims out of their own pockets. Hank Greenberg, former Chairman and CEO of AIG said that the balance of power in corporate America has shifted. Diane Brady and Joseph Weber, “The Boss on the Sidelines,” Business Week, April 25, 2005, p. 88. 249 Significant Variables of Fraudulent Companies Percentage of total Board of Directors holdings held by insiders. Insiders having greater than 50% control of the BOD. CEO also being chairman of the BOD. CEO being the company’s founder. Lack of an audit committee. SEC Accounting and Auditing Enforcement Releases (1982-1992). 250 CEO Duality Eight of the ten recent scandals had board chairs who were also CEO: 1.Enron 5. HealthSouth 2.Adelphia 6. Quest 3.Tyco 7. Homestore 4.Waste Management 8. Sunbeam WorldCom and Global Crossing had different Chairman and CEO. -------------------------------------------------------Aging Board of Directors. “Easier for Management to get away with misdeeds.” Enron’s Audit Committee chairman was 72. “They can be hard of hearing.” Nearly 10% of directors in the S & P’s 500 stock index are 70 or over. Source: Louis Lavelle, “Directors: Know When to Fold Them, “Business Week, May 24, 2004, p.14. 251 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 performed annually Tests of accounts traditionally or frequently deemed “low risk” 252 Audit Committee Red Flags • Independence of audit committee from management. Audit committee should report to BODs. • The clarity with which the audit committee’s responsibilities are articulated, such as in the charter, and how well the audit committee and management understand those responsibilities; • The audit committee’s interactions and involvement with the independent and internal auditor; and • Whether the audit committee raises and pursues with management and the independent auditor the appropriate questions, including questions that indicate an understanding of the critical accounting policies and judgmental accounting estimates. 253 Computer Forensics “Today’s Sergeant Joe Friday does not write in a small notebook in the course of solving crimes; he now reconstructs the data from imaging hard drives.” Joe Anastasi, The New Forensics, John Wiley & Sons, 2003. “Corporate criminals don’t always tell the truth. Their computers usually do.” Thomas Talleur, KPMG • “The need for computer forensics has dramatically increased. This represents the use of computer science principles and investigative techniques to obtain digital evidence from computer systems that is admissible in a court of law,” says Bruce Dubinsky. • Statistics indicate that 92 percent of new data is created electronically and that 70 percent of this data never migrates to paper. When investigators ignore electronics evidence, it’s analogous to only reviewing three out of 10 boxes containing potentially relevant and discoverable information. S. Kahan, “Sherlock Holmes Enters Accounting,” WebCPA, February, 2007. 254 Data Mining Found WorldCom Mess Auditors should perform all of the analytics themselves, and they must be educated in fraud detection and introduced to data mining techniques. When the concept of data mining is brought up, audit managers cringe and argue that they cannot afford to employ statisticians. However, while there is data mining software that requires a statistician’s level of expertise (such as IBM’s Intelligent Miner), there also are products, such as WizSoft Inc., that can be employed by most auditors who are acquainted with the fundamentals of Microsoft Office and who are curious as to why they obtained their audit results. Source: Bob Denker, “Data Mining and the Auditor’s Responsibility,” Information Systems Audit and Control Association InfoBytes. 255 Technology Knowledge Important Ruby Sharma, at E&Y, says that computer forensic services, as well as electronic discovery and forensic data analysis, are provided by its legal technology services practice, which currently consists of 52 professionals, around one-fourth of whom are primarily devoted to computer forensics and closely related disciplines. These computer forensics professionals provide a range of services to clients beyond the traditional identification, preservation and extraction of electronic evidence from digital media, she says. They also provide forensic investigations and analysis of digital media to determine the circumstances surrounding the creation, deletion or modification of specific documents; determine the provenance of documents; locate and recover evidence that has been either intentionally or unintentionally deleted; and determine timelines and event sequences of computer activity that may be of value to the investigation. Frank Piantidosi, at Deloitte, says that technology is the heart of most financial investigations, and electronic data drives the investigation. He says that this group provides repositories of all the data to the legal teams electronically, rather than through the antiquated system of boxes and boxes of hard copy files. We have developed technology solution that can quickly find and accumulate data from various sources anywhere in the world, then read the data files using software from India, then store the data using Australian technology for 5 to 10 years. S. Kahan, “Sherlock Holmes Enters Accounting,” WebCPA, February 11, 2007. 256 Careful of E-mail and Text Messages Do not put anything in an e-mail or text message that you do not wish to see in the newspaper or on the Internet. 14,000 flirty and sometimes sexually explicit text messages between married Detroit Mayor Kwame Kilpatrick and his top aide Christine Beatty reprinted in Detroit Free Press. Found on the city-issued pager of Beatty. Both denied under oath having a physical relationship. 257 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 258 Technology is Here “Extensive knowledge and use of technology is an absolute necessity. The ability to go into an electronic image and download information, and to get information from systems that don’t talk to each other. All the accumulated information can then be reviewed for financial improprieties.” Bert Lacativo, Southlake, Texas ------------------------------------------------------“We use off-the-shelf software (IDEA) to import large databases, read different data files, set up queries, and compare database files such as addresses, telephone numbers, and Social Security numbers. This process will tell us, for example, if a purchase order was done on Saturday or Sunday when the company isn’t open.” Cal Klausner, Bethesda, Md. H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28 259 Data Analysis vs. Data Mining Software ACL, IDEA, and SAS are data analysis (DA) software used to ensure the integrity of data, to program continuous monitoring, and to detect fraudulent transactions. DA requires a program to be set up and run against the data. The program is written by auditors (i. e., humans) who may be prejudice in the routines that are executed. Data Mining finds patterns and subtle relationships in data. Wiz Rule (from WizSoft, Inc.) and IBM’s Intelligent Miner are data mining software. Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html. 260 Wiz Rule Data Auditing Tool Based upon data mining. Performs complex analysis of data, finding errors, inconsistencies, and situations that require further investigation. WizRule reveals all the if-then rules, mathematical formula rules, and spelling irregularities. Divides situations deviating from the rules into data entry errors and suspicious errors. Can be used in auditing, fraud detection, data scrubbing, and due diligence reviews. Learning curve is short. Cost license is $1,395 and yearly maintenance fee is $279. Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html. 261 Who Uses IDEA? External and Internal Auditors Forensic Accountants/ Fraud Investigators Financial managers General and systems consultants Educators Statisticians Information systems professionals 262 IDEA Benefits • Sort • Compare • Manipulate • Sample • Extract data • Mathematical testing • Exception reports • Aging • Statistics • Find missing data • Analytics • Convert test files to data base • Create summary reports 263 Using Data Mining Match employee addresses against vendor addresses. Sort vendor list by size to determine the most highly paid suppliers. Review the structure of vendor names. Uncover indications of ghost employees (e.g., N.O. Police dept.). Fraudulent expense reports (even amounts, $6). Repeated withdrawals of even amounts from petty cash. 264 Computer Forensics “I need you to step away from your computer please,” Lee Altschuler said. Morgan Fay’s chief financial officer glanced up from her computer screen. She regarded the man standing at her office doorway for a moment. “Excuse me?” Cindy Shalott asked. “We’d like you to please conclude your business for the day.” Lee Altschuler said. “I’d appreciate it if you could complete whatever you’re doing as quickly as you can. Please leave your computer in the way that it is now. Don’t turn it off.” The chief financial officer swung her desk chair around. “Just move away from your computer please,” Altschuler repeated. “Who are you?” Cindy Shalott asked. Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91 265 Ink Analysis Martha Stewart was undone by a blue ballpoint pen. Stockbroker belatedly inserted a note to help cover up Ms. Stewart’s improper stock trading. Blue ballpoint ink used is different from ink elsewhere on the trading worksheet. Prosecutors used forensic ink analysis in Rite Aid case to show that certain documents were backdated (ink used to sign letter was not commercially available until 3 months after the letter was dated). Xerox laser printers now encode the serial number of each machine in tiny yellow dots in every printout, nestled within the printed words and margins. It tracks back to you like a license plate. Advice for fraudsters: use pencils. Source: Mark Maremont, “In Corporate Crimes, Paper Trail Often Leads to Ink Analysts’ Door,” Wall Street J., July 1, 2003, p. A-1. 266 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. 267 Benford’s Law Distribution of initial digits in natural numbers is not random Predictable patterns: 0= ----1= 30.1% 2= 17.6% 3= 12.5% 4= 9.7% 5= 7.9% 6= 6.7% 7= 5.8% 8= 5.1% 9= 4.6% 12% 11.4% 10.9% 10.4% 10% 9.7% 9.3% 9% 8.8% 8.5% 10.2% 10.1% 10.1% 10.1% 10% 10% 9.9% 9.9% 9.9% 9.8% There is software to detect potentially invented numbers in many situations. Compare actual frequency with Benford’s frequency. 268 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. 269 Some Uses of Picalo Analyzing financial data, employee records, and purchasing systems for errors and fraud Importing Excel, XML, EBCDIC, CSV, and TSV files into databases Interactively analyzing network events, web server logs, and system login records Importing email into relational or textbased databases Embedding controls and fraud testing routines into production systems 270 Picalo Architecture Detectlets allow non-programmers to run analysis routines created by others . 271 When Benford Analysis Is or Is Not Likely Useful When Benford Analysis is Likely Useful Examples Sets of numbers that result from mathematical combination of numbersResult comes from two distributions. Accounts receivable (number sold times price). Accounts payable (number bought times price). Transaction-level data – No need to sample. Disbursements, sales, expenses. On large data sets – The more observations, the better. Full year’s transactions. Accounts that appear to conform – When the mean of a set of numbers is greater than the median and the skewness is positive. Most sets of accounting numbers. When Benford Analysis Is Not Likely Useful Examples Data set is comprised of assigned numbers Check numbers, invoice numbers, zip codes. Numbers that are influenced by human thought. Prices set at psychological thresholds ($1.99), ATM withdrawals. Accounts with a large number of firmspecific numbers. An account specifically set up to record $100 refunds. Accounts with a built in minimum or maximum. Set of assets that must meet a threshold to be recorded. Where no transaction is recorded. Thefts, kickbacks, contract rigging. Source: Durtschi, Hillison, and Pacini, “The Effective Use of Benford’s Law to Assist in Detecting Fraud in Accounting Data,” J. of Forensic Accounting, Vol. V, 2004, p. 24. 272 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 273 Acquisition/Payment Cycle From 62 standard audit procedures, external and internal auditors judged these 20 procedures to be more efficient is detecting fraud in the acquisition and payment cycle (in descending order). • Examine bank reconciliation and observe whether they are prepared monthly by an employee who is independent of recording cash disbursement or custody of cash. • Examine the supporting documentation such as vendor’s invoices, purchase orders, and receiving reports before signing of checks by an authorized persons. • Examine the purchase requisitions, purchase orders, receiving reports, and vendors’ invoices which are attached to the vouchers for existence, propriety, reasonableness and authenticity. •Examine internal controls to verify the cash disbursement are recorded for goods actually rendered to the company. •Discuss with personnel and observe the segregation of duties between accounts payable and custody of signed checks for adequacy. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 204-205 274 Acquisition/Payment Cycle (Contd.) • Confirm inventories in public warehouse and on consignment. •Examine internal controls to insure the vendor’s invoices, purchase orders, and receiving reports are matched and approved for payment. • Examine internal controls for the following documents: vendor’s invoices, receiving reports, purchase orders, and receiving reports. • Trace a sample of acquisitions transactions by comparing the recorded transactions in the purchase journal with the vendor’s invoices, purchase requisitions, purchase orders, and receiving reports. • Establish whether any unrecorded vendors’ invoices or unrecorded checks exist. • Examine the internal control to verify the proper approvals of purchase requisitions and purchase orders. • Reconciled recorded cash disbursement with disbursements on bank statements. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal 275 of Forensic Accounting, Vol. 4, 2003, p. 204-205 Acquisition/Payment Cycle (Contd.) • Discover related party transactions. • Examine the internal control to verify the approvals of payments on supporting documents at the time that checks are signed. • Discuss with personnel and observe the procedures of examining the supporting documentation before the signing of checks by an authorized person. • Examine canceled checks for authorized signatures, proper endorsements, and cancellation by the bank. • Account for the numerical sequence of prenumbered documents (purchase orders, checks, receiving reports, and vouchers). • Trace a sample of cash payment transactions. • Trace resolution of major discrepancy reports. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 204-205 276 Sales/Collection Cycle These 10 standard audit procedures were judged as being more effective for detecting fraud in the sales and collection cycle (in descending order) • Observe the proper and appropriate segregation of duties. • Review monthly bank reconciliation and observe independent reconciliation of bank accounts. • Investigate the difference between accounts receivable confirmation and customer account receivable balances in the subsidiary ledger and describe all these exceptions, errors, irregularities, and disputes. • Review sales journal, general ledger, cash receipts journal, accounts receivable subsidiary ledger, and accounts receivable trial balance for large or unusual amounts. • Verify accounts receivable balance by mailing positive confirmations. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 209 277 Sales/Collection Cycle (Contd.) • Examine internal controls to verify that each cash receipts and credit sales transactions are properly recorded in the accounts receivable subsidiary ledger. • Examine subsequent cash receipts and the credit file on all accounts over 120 days and evaluate whether the receivable are collectible. • Compare dates of deposits with dates in the cash receipts journal and the prelisting cash receipts. • Examine copies of invoices for supporting the bills of lading and customers’ orders. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 209 278 Inventory/Warehouse Cycle These 14 standard audit procedures were judged by external and internal auditors as being more effective for detecting fraud in the inventory and warehousing cycle (in descending order): • Discover related party transactions. • Follow up exceptions to make sure they are resolved. • Review major adjustments for propriety. • Review inventory count procedures: a. Accounting for items in transit (in and out); b. Comparison of counts with inventory records; and c. Reconciliation of difference between counts and inventory records. • Review adequacy of physical security for the entire inventory. • Confirm inventories in public warehouse. • Review procedures for receiving, inspecting, and storing incoming items and for shipments out of the warehouses. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 206-207 279 Inventory/Warehouse Cycle (Contd.) • Trace shipments to sales records, inventory records, and bill of lading (shipping documents). • Determine if access to inventory area is limited to approval personnel. • Observe the physical count of all location. • Recount a sample of client’s counts to make sure the recorded counts are accurate on the tags (also check descriptions and unit of count, such as dozen or gross) • Trace inventory listed in the schedule to inventory tags and the auditor’s recorded counts for existence, descriptions, and quantity. • Trace shipments to sales journal. • Perform compilation tests to insure that inventory listing schedules agrees with the physical inventory counts. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 206-207. 280 Payroll/Personnel Cycle These 12 standard audit procedures were judged the more effective for detecting fraud in the payroll and personnel cycle (in descending order): • Sample terminated employees and confirm that they are not included on subsequent payrolls and confirm propriety of termination payments. • Observe the actual distribution of payroll checks to the employees. • Observe the duties of employees being performed to insure that separation of duties between personnel, timekeeping, journalizing payroll transactions, posting payroll transactions, and payroll disbursement exists. • Examine internal controls to verify that hiring, pay rates, payroll deductions, and terminations are authorized by the personnel department. • Sample personnel files and physically observe the presence of personnel in the work place. Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 208. 281 Payroll/Personnel Cycle (Contd.) • Examine internal control over payroll records to verify that payroll transactions are properly authorized. • Discover related party transactions. • Review the files of new hires for appropriate approvals, pay rates, and dates of accession. • Review the payroll journal, general ledger, and employee individual pay records for large or unusual amounts. • Examine internal controls to verify that unclaimed payroll checks are secured in a vault or safe with restricted access. • Examine internal controls to verify that employee time cards and job order work tickets are reconciled. •Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 208. 282 Class Discussion How can you defraud your own organization, working either from the inside or outside? ------------------------------------------“Fraudsters … identify and exploit weaknesses specific to the organization.” Herling, D.J., and J. Turner, “Fraud: Effective Use of Legal Remedies for Corruption,” 9th International Anti-Corruption Conference, October 13, 1999. PowerPoint presentation slide 56. http:// www.transparency.org/iacc/9th_iacc/papers/day3/ws1/dnld/d3ws1_djherling.ppt 283 Exercises 1. 2. 3. 4. 5. You receive a tip on the company’s hot line that there has been some fraud in the collections area. What five audit steps would you suggest using in order to find the fraud? During a brainstorming session, a suggestion is made that the most likelihood of fraud in a particular division is in the area of acquisition and payment cycle. Outline five audit steps to help find any potential fraud. While auditing a company you notice an employee in payroll who is living beyond his means (e.g., clothes, automobiles, housing). His wife does not work. Suggest six audit steps to help satisfy you there is no fraud in the payroll and personnel cycle. An anonymous e-mail is sent to an internal auditor that there is fraud in the inventory/ warehousing cycle. Suggest some appropriate audit steps. What is meant by the hockey stick pattern? 284 Characteristics of Less Complex IT Environments Transaction processing. Data inputs can be readily compared or reconciled to system outputs. Management tends to rely primarily on manual controls over transaction processing. Software. The company typically uses offthe-shelf packaged software without modification. The packaged software requires relatively little user configuration to implement. Systems configurations. Computer systems tend to be centralized in a single location, and there are a limited number of interfaces into the system. End-user computing. The company is relatively more dependent on spreadsheets and other user-developed applications, which are used to process, accumulate, summarize, and report the results of business operations, and perform straightforward calculations using relatively simple formulas. Source: PCAOB, October 17, 2007, pp. 26. 285 Evaluating Management’s Oversight Whether management recognizes situations for which additional expertise is needed to adequately identify and address risks of misstatement. How management determines that the outside professionals possess the necessary qualifications. Whom management designates to oversee the services and whether they possess the suitable skill, knowledge, or experience to sufficiently oversee the outside professionals (Note: Management is not required to possess the expertise to perform or re-perform the services). Whether management has established controls over the work of the outside accounting professional (e.g., controls over the exchange of information and controls to test their work) and over the completeness and accuracy of the information provided to the outside professional. How management participates in matters involving judgment, for example, whether management understands and makes significant assumptions and judgments underlying accounting calculations prepared by an outside professional. How management evaluates the adequacy and the results of the services performed, including the form and content of the outside accounting professional's findings, and accepts responsibility for the results of the services. Source: PCAOB, October 17, 2007, pp. 36. 286 Pervasive Control Deficiencies Ineffective control environment (considering the risk profile of the company). An ineffective control environment can increase the risk associated with a control. Also, certain controls in the control environment, such as maintaining financial reporting competencies, might be necessary for the effective functioning of other controls. Ineffective IT controls or information systems. For example, ineffective information systems could impair the effectiveness of certain IT-dependent controls. Pervasive lack of segregation of duties without appropriate alternative controls. When a person performs two or more incompatible duties, the effectiveness of some controls might be impaired without appropriate alternative controls. Frequent management override of controls. A control that is frequently overridden is less likely to operate effectively. Source: PCAOB, October 17, 2007, pp. 46. 287 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 288 Rest Of The Story: Fraudsters Should Be Prosecuted Although large frauds may be reported to law enforcement agencies, smaller frauds are often not reported. This failure to report fraud incidents and the reluctance of police to aggressively tackle the issue only empowers the fraudsters 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. 289 Use IRS Form 1099 Threat For fraudsters and embezzlers, use the threat of filling a Form 1099 for amounts stolen. Ask for an installment payback. If they stop payment, report them to the IRS on a Form 1099. 290 KPMG provides 10 steps to follow when an organization finds or suspects fraud: 1. 2. 3. 4. 5. Shut the door! Keep assets secure until you can provide appropriate long-term security. Safeguard the evidence. Ensure that all records and documents necessary for an investigation remain intact and are not altered by you or anyone else. Notify your insurer. Failure to notify may negate your coverage. Call a professional. Do not confront or terminate the employment of a suspected perpetrator without first consulting your legal advisor. Prioritize your objectives. What’s most important: punishment, loss recovery, prevention, detection of future occurrences? 291 KPMG’s 10 steps to follow contd.. 6. 7. 8. 9. 10. Consider prosecution. Before you make the call, weigh the plusses and minuses and determine if your insurance company requires prosecution. Terminate business relations. If the fraud is external, business relations with the suspect individual or organization should be terminated. Seek advice and assistance. An important consideration is whether you have the knowledge and resources necessary to effectively manage the process. Prepare a witness list. It is important that statements be taken before a “party line” can develop. Consider the message. Whatever you do will affect future situations. Now may be the time to change the way your 292 business operates. Catch Me If You Can Punishment for fraud and recovery of stolen funds are so rare, prevention is the only viable course of action. Frank W. Abagnale 30 years ago Abagnale cashed $2.5 million in fraudulent checks in every state and 26 foreign countries. Was later associated with the FBI for 25 years. 293 Over-all Fraud Plan Background checks Avoid Nepotism Signed Conditions of Employment Agreement Non-compete Agreement Confidentiality of Information Agreement Bonding Two-signatures on checks/ wire transfers/ lines of credit Lockbox Positive pay Check security and restrictive endorsements Check stock (can not be scanned and it smears easily) Close out cash registers at unpredictable times Back up computer files Accounting personnel can not cancel debt Have an internal audit CEO signs numbered check request form E.J. McMillan, Policies and Procedures to Prevent Fraud & Embezzlement, 2006, John Wiley. 294 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 Inventory fraud Fictitious disbursements Accounts receivable fraud Lapping Fictitious receivables Borrowing against accounts receivable Stealing inventory Short shipments with full prices Doctored sales figures Sham payments Price manipulations: land flipping, pump and dump, and cybersmearing Money laundering Bid rigging 295 How Cash Is Misappropriated % Median Loss Skimming 18.9% $76,000 Cash larceny 14.2% 73,000 Billings 28.3% 130,000 Expense Reimbursements 19.5% 25,000 Check Tampering 17.1% 120,000 Payroll 13.2% 50,000 Wire transfers 6.5% 500,000 Register Disbursements 1.7% 26,000 Inflow: Disbursements: Source: 2006 Wells Report, ACFE. 296 Cash Wheel Accounts Receivable Adjusting Entries Accounts Payable Depreciation Accruals Cash Source: Fraud Auditing Small Businesses With The Wheel , James A. Goldstine 297 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. 298 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.” Camera surveillance. 299 Preventive Measures Segregation of duties, mandatory vacations, and rotation of duties help prevent cash larceny. Review and analyze each journal entry to the cash account. Two windows at drive-through restaurants. Signs: Free meal if no receipt. Blank checks and the automatic check signing machine should be kept in a safe place from employees. Pre-numbered checks should be logged and restricted to one responsible employee. Require two signatures on cashier checks. 300 Processing Checks Best Procedure Step 1. The invoice is approved for payment. Step 2. A check request form is completed. Step 3. The CEO approves the check request. Step 4. The check request is forwarded to accounting. Step 5. Accounting processes the check. Step 6. The CEO signs the check. Step 7. A second designated employee (who does not approve the payment and is not in the accounting department) should cosign the check. Therefore, 4 people involved. E.J. McMillan, Policies & Procedures to Prevent Fraud & Embezzlement, John Wiley, 2006, p.44. 301 Processing Checks Best Procedure Invoice is approved for payment. Check request form is prepared. The CEO approves/ signs the numbered check request form. Check request form is forwarded to accounting. Accounting processes the check. The check is signed by two authorized individuals. The check is mailed. The bank statements are sent to the CEO’s home (or P.O. box) for review. The CEO forwards the reviewed bank statements to accounting for reconciliation. E.J. McMillan, Policies & Procedures to Prevent Fraud & Embezzlement, John Wiley, 2006, p.45. 302 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]. 303 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. 304 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. 305 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. 306 Accounts Receivable 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. 307 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. 308 Warning Signs of Lapping • Increase in complaints. • Excessive billing errors. • Delays in posting customer payments. • Trend of decreasing accounts receivable payments. • Accounts receivable details do not agree with the general ledger. 309 Lapping (cont.) Audit Steps Independently verifying customers who do not pay. Reviewing write-offs. Reviewing customers’ complaints. Compare the checks on a sample of deposit slips to the details of the customers’ credits that are listed on the day’s posting to the customer’s account receivables. Closely monitor aging accounts. 310 How Non-Cash Assets are Misappropriated – 2006 Category % Median Loss Inventory 16.6% $55,000 Information 3.6% 78,000 Securities 1.5% 1,850,000 Source: 2006 Wells Report, ACFE. 311 Inventory Inventory Fraud Stealing inventory/supplies for personal use or for sale at flea markets/garage sales. Kickback schemes (vendor/supplier and an employee). Sale of unreported inventory at inflated prices. Audit Steps for Inventory Fraud Use renumbered inventory tags matched to count sheets; use count procedures for workin-progress items; separate duties between purchasing and logging receipts of shipments Check for same vendors. Prices higher than other vendors. Purchasing agent does not take vacation. Only photocopies of invoices are available. Aging of inventory. Inventory turnover There is data-mining software. 312 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. 313 Accounts Payable Fraud Red Flags Duplicate payments (2% of total purchases) $80 million times 2% = $1.6 million loss. Extract only the numerical digits of an invoice number and match on only the numbers portion of the invoice. Try identifying the dates that are similar such as dates that are less than 14 days. Try matching on the absolute value of the amount. 2. Rounded-amount invoices. 3. Invoices just below approval amounts. 4. Abnormal invoice volume activity (two invoices one month and 60 the next). 5. Vendors with sequential invoice numbers. LC 0002, LC 0003, LC 0004 6. Above average payments per vendor. 1. C. Warner and B. G. Dubinsky, “Uncovering Accounts Payable Fraud,” Fraud Magazine, July/ August 2006, pp. 29-51. 314 Look For Fraud Symptoms Source Documents. Journal Entries. Accounting Ledgers. 315 Source Documents Checks. Employee time cards. Sales invoices. Shipping documents. Expense invoices. Purchase documents. Credit card receipts. Register tapes. 316 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. Lots of round numbers. Too many beginning 9’s. 317 Journal Entries Fraud Symptoms Out-of-balance. Lacking supporting documents. Unexplained adjustments. Unusual/numerous entries at end of period. Written entries in computer environment. Many round numbers. Too many beginning 9’s. 318 Controls Over Journal Entries Controls that prevent or detect unauthorized journal entries can reduce the opportunity for the quarterly and annual financial statements to be intentionally misstated. Such controls might include, among other things, restricting access to the general ledger system, requiring dual authorizations for manual entries, or performing periodic reviews of journal entries to identify unauthorized entries. As part of obtaining an understanding of the financial reporting process, the auditor should consider how journal entries are recorded in the general ledger and whether the company has controls that would either prevent unauthorized journal entries from being made to the general ledger or directly to the financial statements or detect unauthorized entries. Tests of controls over journal entries could be performed in connection with the testing of journal entries required by AU sec. 316. Source: PCAOB, p. 21. 319 Unusual Entries Officer Loan Cash $40,000 Officers Salary Officer Loan $40,000 Staff Salaries Officers Salary $40,000 $40,000 $40,000 $40,000 ---------------------------------------- Cost of Goods Sold Inventory $35,000 $35,000 [No related sales transaction] ---------------------------------------Allowance of Bad Debts $32,000 Account Receivables $32,000 ---------------------------------------Expense accounts where no department or person has control General maintenance account General transportation account Stationary/ general office supplies Scrap disposal accounts Suspense and cash sweep accounts Deferred asset or liability Contra-accounts (bad debt reserve, accumulated depreciation) Intercompany accounts Accounts over which a sole, domineering, incompetent, or frequently absent individual has control. 320 Ledger Fraud Symptoms Underlying assets disagree. Subsidiary ledger different than general ledger. Investigate and reconcile differences between control accounts and supporting ledger. Difference may be concealed fraud. 321 Which of these statements are false? a. b. c. d. e. f. g. A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting. Personal guarantees of debt of a company that are significant to one’s personal net worth is an example of a pressure/incentive for fraudulent financial reporting. A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting. An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting. Anticipated future layoff would be an example of an incentive to misappropriate assets. A large amount of cash on hand would be an example of a rationalization to misappropriate assets. Inadequate internal controls is an example of an opportunity to misappropriate assets. 322 Which of these statements are false? a. b. c. d. e. f. g. A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting. F (I/P) Personal guarantees of debt of a company that are significant to one’s personal net worth is an example of a pressure/incentive for fraudulent financial reporting. T A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting. F (I/P) An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting. T Anticipated future layoff would be an example of an incentive to misappropriate assets. T A large amount of cash on hand would be an example of a rationalization to misappropriate assets. F (O) Inadequate internal controls is an example of an opportunity to misappropriate assets. T 323 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. 324 Stop Ghost Employees Ensure that the payroll preparation, disbursement and distribution functions are segregated. Look for paychecks without deductions for taxes or Social Security. Completely fictitious employees frequently don’t have any. Examine payroll checks that have dual endorsements. Although most of them are legitimate, two signatures could signal the forgery of a departed employee’s endorsement, which the thief also endorses and deposits into his or her own account. Use direct deposits. This method, although not foolproof, can cut down on payroll chicanery by eliminating paper paychecks and the possibility of alteration, forgery and most theft, although it doesn’t prevent misdirection of deposits into unauthorized accounts. Check payroll records for the presence of duplicate names, addresses and Social Security numbers. On occasion, hand-deliver paychecks to employees and require positive identification. If you have leftover paychecks, make sure they belong to actual employees, not ghosts. Be wary of budget variations in payroll expense. Higherthan-budgeted labor costs can indicate ghost employees. Source: J. T. Wells, “Keep Ghosts Off The Payroll,” Journal of Accountancy, December 2002. 325 Some Employee Schemes (contd …) Fictitious Disbursements Multiple payments to same payee. Multiple payees for the same product or service. 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. 326 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. 327 Forensic Auditing Steps Count the Petty Cash Twice in a Day Investigate Suppliers (Vendors) Investigate Customers’ Complaints Examine Endorsements on Canceled Checks Add Up the Accounts Receivable Subsidiary Audit General Journal Entries Match Payroll to Life and Medical Insurance Deductions Source: Jack C. Robertson, Fraud Examination for Managers and Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216. 328 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. 329 Vendor Allowances • In exchange for better shelf space or advertisement mentioning its products, a merchandise vendor will pay stores an extra fee--an allowance often based upon the amount of products sold. • Employees at OfficeMax “fabricated supporting documents for approximately 3.3 million in claims billed to a vendor to its retail business.” Six employees were fired, and CEO Christopher Milliken resigned. • The SEC sued three former executives in December 2004 at Kmart Holding Corp. for their role in a $24 million accounting fraud that booked these allowances early. •The SEC settled a case in October 2004 with Ahold NV involving allegations of fraudulent inflation of promotional allowances at U.S. Foodservice, Inc. unit. Source: David Armstrong, “OfficeMax Results To Be Restated; CEO Steps Down,” WSJ, February 15, 2005, p. A-3. 330 Potpourri of Bribes Vernon Jackson admitted to bribery of Rep. William Jefferson, D-LA. More than $400,000 to one million paid to a company controlled by the congressman’s wife in exchange for help promoting iGate. Gave 24% stake in iGate and paid $80,000 in travel expenses to Africa. [$90,000 found in Jefferson’s freezer.] Two prominent Baton Rouge restaurateurs and four other businessmen accused of bribing a parish tax auditor and an undercover FBI agent with cash, diamonds, trips, whiskey and women to avoid paying taxes on $10 million, face federal charges. An indictment alleges Laymon offered an undercover FBI agent posing as an East Baton Rouge Parish auditor $800, a weekend trip to Costa Rica and two prostitutes a day if he concluded that Arzi’s didn’t owe any sales tax. BR Advocate (12-17-06). 331 Potpourri of Bribes A Greek prosecutor is investigating claims that Siemens Greece paid up to $550 million in bribes to officials at the defense and interior ministries in order to win a security contract for the 2004 Olympic games in Athens. A senior Siemens accountant said bribery was a common practice at Siemens. A Paris judge launched an investigation into allegations that Total, a French oil and gas group, paid bribes to win a $2 billion gas contract in Iran. The investigation stems from the discovery of $82 million in two Swiss bank accounts, allegedly by Total to an Iranian intermediary to help the French company consortium to win an Iranian contract. A report claims that AWB, the company responsible for selling Australia wheat, paid over $221 million to Alia, a Jordanian hauling company, ostensibly to distribute its wheat in Iraq. In fact, the money was going to the Iraq government. 332 Potpourri of Bribes Armstrong Williams, an American columnist and television host, was paid $240,000 by the Dept. of Education to comment regularly on “No Child Left Behind,” an education-reform bill. Nineteen individuals indicated for receiving bribes and rigging bids for school window washing contracts. Congressman Randy Cunningham, R-Calif., resigned from Congress (2005), hours after pleading guilty to taking at least $2.4 million in bribes to help friends and campaign contributors win defense contracts. Prosecutors said he received cash, cars, rugs, antiques, furniture, yacht club dues, moving expenses, and vacations from four co-conspirators in exchange for aid in winning defense contracts. In January 2007, Peter Hartz was given a two year suspended prison sentence and fines for bribing the head of the labor union ($3.25 million) for secret bonuses and fake consultancy fees. Involved sex holidays and paying for prostitutes for labor officials. 333 Potpourri of Bribes In the 1950s in the U.S., record companies would pay money for the broadcast of records on radio, called payola. Now outlawed. In England, police interviewed Prime Minister Tony Blair in February 2007, about allegations that honors, including seats in the House of Lords and Knighthoods, were given to individuals who loaned money to the Labour party ($9.8 million). Under Bill Clinton, Democratic National Committee donors were allowed to spend the night in the Lincoln bedroom for a contribution of $150,000 (e.g., Chairman of Occidental Petroleum). Then in 1997, Clinton made an exception so that OP could pursue a venture in Sudan. A lawsuit in February 2007, alleged that Intel provided secret kickbacks to Dell in order to ensure it remained the computer makers sole microprocessor supplier. 334 Bribes/ Kickbacks Scenario Something of Value Later Influence an Official Act Cash Gifts Trips Entertainment Drugs Sexual favors Loans Credit cards Fees Spouse’s high salary Discounts (e.g., house) Awarding Selection Higher Prices Excessive Quantity Accepting Lower Quality No, Delayed, or Short Delivery •Prove the corrupting influence circumstantially through factors on the right, or outsider received more and more business as the insider gets more and more value. •Use indirect methods on employee. 335 Some Bribery Red Flags Lack of standard invoices. Requests for fund to be routed to a foreign bank. Requests for checks made payable to “cash” or to “the bearer.” Commission substantially higher than going rate. Requests for a large line of credit from a customer. Insistence by a government official that a certain third-party agent or supplier be used. Lack of staff or facilities to actually perform the service. Request by a local agent for a rate increase in the middle of negotiations. Suggested need to utilize more than one local agent. Source: M. T. Biegelman and J. T. Bartow, Executive Roadmap to Fraud Prevention and Internal Controls, John Wiley, 2006, pp. 325-326. 336 Duty to Cooperate 337 Audit Rights 1. Audits under clause 2 may be conducted of: a) b) c) d) e) f) the Contractor's practices and procedures as they relate to the Contract, including security procedures; the manner in which the Contractor performs its obligations under the Contract; the compliance of the Contractor's invoices and reports with its obligations under the Contract; the Contractor's compliance with all its obligations under the Contract; the Contractor's compliance with its confidentiality, privacy, security and Commonwealth policy obligations under the Contract; and any other matters determined by [Agency] to be relevant to the performance of the Contractor's obligations under the Contract. 2. Audits i. The Contractor must participate in audits of the Contract at the frequency and in relation to the matters specified by [Agency], (including on an ad hoc basis if requested by [Agency]), for the purpose of ensuring that the Contract is being properly performed and administered. [Agency] may appoint an independent person to assist in the audits. Audits may consider all aspects of the Contractor's performance including but not limited to any performance indicators, benchmarks or targets. ii. The Contractor must participate promptly and cooperatively in any audits conducted by [Agency] or its nominee. iii. Except for those circumstances in which notice is not practicable or appropriate (eg. caused by a regulatory request with shorter notice or investigation of theft or breach of contract), and without limiting any other right, recourse or remedy of [Agency], must give the Contractor reasonable notice of an audit and where reasonably practicable an indication of which documents and/or class of documents the auditor may require. iv. Subject to any express provisions in the Contract to the contrary each party must bear its own costs of any audits. v. Subject to clauses 2.6 and 3.6, the requirement for, and participation in, audits does not in any way reduce the Contractor's responsibility to perform its obligations in accordance with the Contract. vi. [Agency] must use reasonable endeavors to ensure that audits performed pursuant to clause 2.1 do not unreasonably delay or disrupt in any material respect the Contractor's performance of its obligations under the Contract. vii. [Any amendments to the Contract resulting from audits must be effected by agreement in writing between the parties in accordance with the Contract amendment provisions of the Contract.] viii. The Contractor must promptly take, at no additional cost to [Agency], corrective action to rectify any error, non-compliance or inaccuracy identified in any audit in the way the Contractor has under the Contract: (a) supplied any goods or services; or (b) calculated fees, or any other amounts or charges billed to [Agency]. 338 Purchasing Agent’s Kickback Checklist He or she doesn’t take time off. The purchasing agent has personal financial problems. The agent’s lifestyle is too extravagant for his or her income. Close personal relationship between purchasing agent and vendor. Favoritism toward one vendor. Excessive purchases from one vendor. Prices charged are higher than market average. Expenditures come in just under the review limit. Multiple purchases over a short period. Substandard products or services. Accelerated payment of invoices. Sole-source purchases of merchandise or services. Be sure different personnel handle the following duties: vendor approval, purchase requisitions, purchase approval, receiving, and payment (e.g., separation of duties). Source: J. T. Wells, “The Case of the Pilfering Purchasing Manager,” Journal of Accountancy, May, 2004. 339 Red Flags for Phantom Vendors Invoices for unspecified consulting or other poorly defined services. Unfamiliar vendors. Vendors that have only a post-office-box address. Vendors with company names consisting only of initials. Many such companies are legitimate, but crooks commonly use this naming convention. Rapidly increasing purchases from one vendor. Vendor billings more than once a month. Vendor addresses that match employee addresses. Large billings broken into multiple smaller invoices, each of which is for an amount that will not attract attention. Source: J. T. Wells, “Billing Schemes Part I: Shell Companies That Don’t Deliver,” Journal of Accountancy, July, 2002. 340 More Phony Vendors Red Flags Ensure those involved in purchasing cannot approve vendors. Before approving a new vendor, evaluate its legitimacy by Obtaining its corporate records and other relevant documents. Checking its credit rating. Confirming that it is listed in telephone directories. Contacting its references from clients and others. Being particularly cautious about a vendor with a post-office-box address or a name composed entirely of initials. Determining whether its business address matches any employee’s home address. Once the company approves a new vendor, the CPA should closely monitor the account by Watching for increases in the amount or frequency of billings. Observing variances from budgets or projections. Comparing its prices with those charged by other sources. Source: J. T. Wells, “Billing Schemes Part I: Shell Companies That Don’t Deliver,” Journal of Accountancy, July, 2002. 341 Some Forensic Accounting Tools Chain of Custody. Questioned Documents. Continuous Controls. Timeline Analysis. Tracing Schedule. Link Analysis. Invigilation. Genogram. Proof of Cash. Entity Charts. Full - and False – Inclusion Tools. 342 Chain of Custody Just as in the movies or on a television show such as CSI, forensic accountants must safeguard evidence through a financial chain of evidence. There must be a way to show that the evidence has not been tampered with or damaged. If documents are seized, the forensic accountant should put his or her initials and date of the seizure on the back of each document. Or put the document in a transparent envelope and write a description on the envelope. Store the original and work only with a copy. 343 Enforcement Manual Enforcement Manual History and Custody of Documents U.S. Department of Labor Pension and Welfare Benefits Administration Date _______________________________ Case Number________________________ Case Name __________________________ 22. How were the documents obtained? ____ By consent (note any significant comments of the principal or third party witness and any unusual circumstances which occurred)? ____ By legal process (describe). 2. What is the relationship between the documents and the person submitting them? 22. Were manual transcripts or facsimile copies made of any of the documents either in whole or in part?. ______ Yes ______No If Yes, list documents copies. Manner of reproduction 22. Have all copies been compared with the original documents and identified? _____Yes _____No If No, why not? 22. Were the original documents described herein under your control or supervision at all times prior to their return to the principal, third party witness, or representative? _____Yes _____No If No, set forth circumstances of any transfer in control. 22. Did the principal, third party witness, or a representative request access to the documents during your custody? ___ Yes ___ No If Yes, who requested access and what action was taken? Signature ___________________ Title ________________________ PWBA 219 (May 1987) 344 Continuous Monitoring • Correlation is well suited to environments where there are (a) a large number of audit units (departments, divisions, franchisees, or customers, etc.), (b) a series of time-stamped revenues, expenses or loss amounts, and (c) the goal of developing a formal process to compare each audit unit against a valid benchmark. • Correlation and time-series analysis are techniques that could be used by forensic accountants in a monitoring role to find evidence of intentional or unintentional errors in situations where there are many audit units. • The techniques could be used to proactively search for errors without any preconceived belief as to their existence, magnitude, or pervasiveness, or where the forensic accountant seeks to provide additional evidence showing that such errors occurred after the errors were detected using some other detection method. • If intentional errors were discovered using other methods of discovery, then the techniques could be used by the forensic accountant to show that the revenue or expenditure or loss streams of an audit unit differed significantly from a valid benchmark. M. J. Nigrini, “Monitoring Techniques Available to the Forensic Accountant,” J. of Forensic Accounting, Vol. 7, 2006, pp. 321-344. 345 Continuous Monitoring • Management engages an independent outside supplier to install and manage software to continuously analyze every transaction within business applications to detect improper activities and anomalies that indicate errors, control overrides, and fraud [Oversight Systems]. • The software sorts incidents into errors, misuse, and fraud (a detective control). • Suspicious transactions can be identified and categorized for future follow-up. • Flag items such as manual income-increasing adjustments, adjustments made late in the year, large dollar amounts. • Large companies with revenues over $1 billion. • Over the course of a year monitoring each module (e.g., A/P, Sales, G/L) is designed to cost approximately the amount the company would pay for one fulltime internal auditor per module. • One company saved $2 million of external auditing fees for using C/M in the 404 area. D. R. Hermanson, B. Moran, C. S. Rossie, and D. T. Wolfe, “Continuous Monitoring of Transactions to Reduce Fraud, Misuse, and Errors,” J. of Forensic Accounting, Vol. 7, 2006, pp. 17-30. 346 Timeline Analysis Timeline analysis (TA) may be used to show the chronology of a dispute, and certain software tools can prepare trial exhibits. Investigative analysis software can show all detail from the beginning of the event until the apprehension of the target. TA helps forensic accountants communicate the timing of case related events and summarizes the investigation. Each link of the timeline chart includes a reference to a source or a direct link to a database. An insurance fraud scheme timeline from i2 Inc is shown in the next Table: 347 Insurance Fraud Scheme 348 Tracing Schedule A tracing schedule can be used to show the flow of funds from bank-to-bank, from bankto-entity, from entity-to-entity, or from person-to-person. A tracing schedule is helpful in money laundering cases. 349 Link Analysis Link analysis (LA) is a subset of network analysis which shows associations between people and data. For example, a link analysis could compare the mailing addresses of company executives and the cell phone numbers that they have dialed during a given time frame. LA provides crucial relationships between many objects of different types that are not apparent from isolated pieces of data. Table 5.1 is an example of LA with respect to the primary suspect, David Hoover. Wikipedia, the free encyclopedia, en.wikipedia.org. Stuart Weiss, “Forensic Accounting Tools and Techniques,” The Value Examiner, January/ February, 2007, pp. 12-13. 350 Table 5.1 Link Analysis 351 Invigilation Invigilation is a rather expensive investigating technique that can be used in potential fraud situations to discover the fraud and can later be used in the courtroom. Here detailed records are kept before and after the invigilation period to determine the amount of fraud. During the invigilation period strict controls are imposed (e.g., cameras) so that the fraud is virtually impossible. Or the invigilation period could be while the suspect is on vacation. 352 Invigilation Technique No controls Controls or vacation No controls 14 days 14 days 14 days $67,000 lost $0 lost $62,000 lost 353 Genogram A genogram is a pictorial display of personal relationships among related or unrelated parties. There are software programs that are custom designed for genograms, such as GenoPro 2007 ($49 at www.genopro.com). Simple symbols represent the gender (box for male and circle for female), with various lines to illustrate family relationships. People who are not related would not be connected with a line, but could be placed on the genogram. They can lead to determining the motive of a crime or provide evidence that the person had no direct involvement in the fraud. 354 Genogram 355 Proof of Cash The proof of cash procedure is similar to a bank reconciliation, except more detailed and extensive. This procedure can be used to verify that cash accounts on the books are in agreement with the cash transactions recorded by the bank. The Wyoming Department of Audit’s proof is shown as Table 5.2. 356 Table 5.2 357 Entity Charts Entity charts show entities and owners with the relationship between them. The charts can show how income and assets are diverted, particularly among seemingly unrelated parties and entities. Microsoft Excel drawing tools may be used to prepare entity charts. For example, an entity chart could show the creation date of off-shore bank accounts and the subsequent decrease in the target’s U.S. bank accounts. Or identification of other unrelated parties may suggest additional investigation is needed. D. D. Dorrell and G. A. Gadawski, “Financial Forensics II,” May, 2005, Vol. 3, No. 3, p. 50. 358 Full – and – False Inclusion Tests These tests are used to ascertain the proper universe of data under investigation, so that no appropriate data is excluded and no extraneous data is included. Full-and-false inclusion tests may be helpful for finding hidden assets. 359 Questioned Documents Invoices and other documents may be fake or altered when Font sizes or types are not consistent No address is shown for the vendor or customer; this situation is especially suspicious if a vendor has not identified an address to which a check can be sent. The document has no identifying numbers such as invoice number, purchase order number, or customer number. All invoice numbers – on invoices from vendors – are numbered sequentially, with no numbers skipped. No tax is shown for taxable items. No shipping or freight cost is shown for items that would have been shipped at the purchaser’s expense. Little or no detail is provided on the invoice or document. T. W. Golden, S. L. Skalak, and M. M. Clayton, A Guide to Forensic Accounting Investigation, Hoboken, N.J.: John Wiley & Sons, 2006, pp. 156-157. 360 A Stamp Perforation match Paper shreds demonstrating different optical properties under ambient and specialized lighting Inks of different intensities used on the same document 361 Exhibit 70A-1 Sample Engagement Letter 1—Litigation Services CPA & Company Anytown, USA September 4, 200X John A. Smith, Esq. Smith, Smith & Jones 100 Courthouse Way Anytown, USA Dear Mr. Smith: You have asked me to read and analyze certain documents relating to a lawsuit brought against your client, XYZ Company. You have also asked that I be available to testify at the time of trial should you decide to use me as an expert witness. Any written reports or other documents that I prepare are to be used only for the purpose of this litigation and may not be published or used for any other purpose without my written consent. Irrespective of the outcome of this matter, I understand that you will compensate me at my standard hourly rate (currently $___) for all time spent, including travel, whether or not the engagement is completed or its results are used. You will also compensate me for any out-ofpocket costs that I may incur. I will submit bills monthly, which are due and payable on receipt and in all events prior to the commencement of my testimony. [Optional sentence: Before commencing work on this engagement, I would like a retainer of $___ which will be applied to final billing on this engagement or refunded to the extent that it exceeds such billing.] Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by binding arbitration, in [insert desired venue], in accordance with the Commercial Arbitration Rules of the American Arbitration Association, and judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. I look forward to assisting you in this matter and hope that my services will be beneficial. If you approve of the engagement terms described above, I would appreciate your signing the enclosed copy of this letter and returning it to me. Sincerely yours, Accepted: John Jones, CPA Name of attorney's firm 362 Exhibit 70A-2 Sample Engagement Letter 2—Litigation Services [Optional additions are bracketed] CPA & Company Anytown, USA September 4, 200X John A. Smith, Esq. Smith, Smith & Jones 100 Courthouse Way Anytown, USA Dear Mr. Smith: The purpose of this letter is to summarize our understanding of the assistance that CPA & Company will provide to you and your client, XYZ, Inc. in the matter of XYZ, Inc. v. ABC Corporation et al. before the Superior Court of the State of California, County of Los Angeles, which matter is Case. No. XXXXXX. You have requested that we assist you with analysis and consultation with regard to the XYZ litigation matter as you may direct. I would also be prepared to provide testimony at deposition and trial should you decide that to be appropriate. I will be responsible for the performance of our engagement with you and your client. My hourly billing rate is $XXX. From time to time, if necessary, other professionals may also assist when appropriate and needed. The hourly rates for our professionals are in the following ranges: Senior managers and managers — $XXX to $XXX; senior accountants and senior consultants — $XXX to $XXX; and consultants — $XXX to $XXX. [Our hourly rates are subject to change from time to time. We will advise you immediately if the rates are being adjusted by our firm.] Fees for our services are based upon the actual time expended on the engagement at the standard hourly rates for the individuals assigned. In addition to our professional fees, we are reimbursed at cost for any travel and out-of-pocket expenses. Bills are rendered and are payable monthly as work progresses. [We reserve the right to defer rendering further services until payment is received on past due invoices.] [Our normal practice is to obtain a retainer, and we herewith request such a retainer in the amount of $XX,XXX. This retainer is not intended to represent an estimate of the total cost of the work to be performed. The retainer will be held against the final invoice for the engagement; any unused retainer will be refunded.] 363 Exhibit 70A-2 Sample Engagement Letter 2—Litigation Services We are certain that you recognize that it is difficult to estimate the amount of time that this engagement may require. The time involved depends upon the extent and nature of available information, as well as the developments that may occur as work progresses. It is our intention to work closely with you to structure our work so that the appropriate personnel from our staff are assigned to the various tasks in order to keep fees at a minimum. [Furthermore, you, your client and I, all agree that any dispute over fees charged by our firm in this engagement will be submitted for resolution by arbitration in accordance with the rules of the American Arbitration Association. Such arbitration is limited only to the issue of fees charged and shall be binding and final. In agreeing to arbitration, we each acknowledge that in the event of a dispute over fees, each of us is giving up the right to have the dispute decided in a court of law before a judge or jury and instead are accepting the use of arbitration for resolution.] [You or your law firm or the court itself will advise us (with sufficient notice) of the work to be performed by us and the requirement for appearance in court. If there is a substitution or change in the association of attorneys involved in this litigation, we reserve the right to withdraw from this engagement.] If the arrangements described in this letter are acceptable to you and the services outlined are in accordance with your requirements, please sign and return a copy of this letter. We look forward to working with you in this matter. If I can provide you with any additional information, please do not hesitate to call me at (555) 123-4567. The proposed terms of this letter are subject to change if not accepted within 60 days of the date of this letter. Very truly yours, _______________________ (Name and Title) CPA & Company The services described in this letter are in accordance with our requirements and are acceptable to me and my client. Accepted: John A. Smith, Esq. Smith, Smith & Jones Date 364 365 The End Is Here 366